Accounting Questions - Advanced Flashcards
How is GAAP accounting different from tax accounting?
- GAAP is accrual-based while tax is cash-based.
- GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
- GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.
What are deferred tax assets/liabilities and how do they arise?
Deferred tax assets arise when a company pays more in taxes upfront than required or has incurred expenses that are recognized for accounting purposes now but are deductible for tax purposes later. It’s like a tax credit the company can use to reduce future tax payments. Deferred tax liabilities arise when a company doesn’t pay the full amount of taxes due now, often due to temporary differences between how income or expenses are recognized for accounting versus tax purposes. For example, a company might use accelerated depreciation for tax purposes (reducing taxable income now) but straight-line depreciation for financial reporting. This means the company defers paying some taxes until later periods. In M&A, deferred tax liabilities often arise from an asset write-up, which increases the value of assets on the balance sheet, leading to higher taxes in the future. On the other hand, deferred tax assets can result from an asset write-down, which allows the company to offset future tax payments.
Walk me through how you create a revenue model for a company.
There are two ways to create a revenue model: bottom-up build and top-down build. For bottom-up builds, you start with the most detailed levels of individual drivers and components that generate revenue, such as individual products or customers and estimates of average sales. This method requires very detailed data, so it’s considered more accurate, but it’s also very time-consuming. Top-down builds are broader and not used as frequently. You use big-picture metrics such as overall market size, then estimate the company’s market share and project its growth. While top-down models are faster and easier to produce, they don’t go into the same level of detail as bottom-up models.
Walk me through how you create an expense model for a company.
Creating an expense model for a company involves similar methods to those used for revenue models, with some adjustments for expenses. In a bottom-up build, you start by breaking down expenses by department. This includes averaging costs such as salaries, bonuses, benefits, and other operational expenses. You would typically link the number of employees to revenue and apply growth rates to these expense metrics. For Cost of Goods Sold (COGS), you associate these costs with revenue, recording each unit sold as an expense. Additional miscellaneous expenses can be forecasted based on internal company plans or tied to revenue for a more straightforward model. This method provides detailed and accurate expense projections but can be time-consuming. A top-down build can also be used, where you start with high-level expense targets and allocate them among broad categories. However, this approach is less commonly applied for expense modeling due to its less detailed nature.
Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?
We would rely on estimates. For revenue models, if detailed data on product lines or divisions is unavailable, we can just assume a simple growth rate into future years. For expense models, if detailed employee-level information isn’t provided, we can estimate major expenses such as Selling, General & Administrative (SG&A) costs as a percentage of revenue and carry this assumption forward. These estimates allow us to build workable models even with limited data.
Walk me through the major items in Shareholders’ Equity.
Common items include:
1. Common stock - Simply the par value of however much stock the company has issued.
2. Retained earnings - How much of the company’s Net Income it has “saved up” over time.
3. Additional Paid in Capital - This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering.
4. Treasury Stock - The dollar amount of shares that the company has bought back.
5. Accumulated Other Comprehensive Income - This acts as a miscellaneous section that includes items that don’t fit anywhere else, such as the effects of foreign currency exchange rate changes.
Walk me through what flows into Retained Earnings.
Retained earnings = Last year’s retained earnings balance + net income - dividends and repurchases.
Walk me through what flows into Additional Paid-In Capital (APIC).
APIC = Last year’s APIC + stock-based compensation + stock created by option exercises.
What is the Statement of Shareholders’ Equity and why do we use it?
The statement provides a detailed summary of changes in the company’s equity over a period of time. Major items typically include common stock, additional paid-in capital, retained earnings, treasury stock, and other comprehensive income. While it might not be used as frequently as other financial statements, it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.
What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?
In order for a charge to be added back, it needs to affect Operating Income on the Income Statement. Examples of these can include:
1. Restructuring Charges
2. Goodwill Impairment
3. Asset Write-Downs
4. Bad Debt Expenses
5. Legal Expenses
6. Disaster Expenses
7. Change in Accounting Procedures
How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?
Normally you’d make very simple assumptions:
1. Project Accounts Receivable as a percentage of Revenue.
2. Project Deferred Revenue as a percentage of Revenue as well.
3. Project Accounts Payable as a percentage of COGS.
4. Project Accrued Expenses as a percentage of Operating Expenses or SG&A.
How should you project Depreciation & Capital Expenditures?
For the simple way: project each one as a percentage of revenue or PP&E balance. For the more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset’s useful life, and then assumes capital expenditures based on what the company has invested historically.
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
On the Income Statement, the tax expense would be reduced for the period. On the Balance Sheet, the NOLs would create deferred tax assets. On the Cash Flow Statement, the NOLs would reduce operating cash flow. In a financial model, the quick way to show the effects of NOLs is to reduce the amount from your taxable income, apply the same tax rate, then subtract that number from your original Pretax Income number. The way you should do it however, is to create a book vs cash tax schedule, where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet. Since DTL, a liability is rising, this method more clearly reflects the fact that you’re saving on cash flow.
What’s the difference between capital leases and operating leases?
Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. They show up on the Income Statement as operating expenses. Capital leases are used for longer-term items and involve ownership rights. They depreciate over time and incur interest payments, and are counted as debt.
Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement?
On the Cash Flow Statement, depreciation and amortization are added back because they’re non-cash outflows. The only reason they would be different from what’s on the Income Statement is if they are embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A.
