Accounting Questions - Advanced Flashcards
Theoretical
Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?
A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future – in other words, you’ve underpaid on taxes and need to make up for it in the future.
A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future – you’ve paid too much before, and now you get to save on taxes in the future.
Both DTLs and DTAs arise because of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes.
You see them most often in 3 scenarios:
1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes).
2. When Assets get written up for book, but not tax purposes, in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.
How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?
They are similar, but not the same exact idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the current year.
For example, if a company owes $300 in taxes at the end of each quarter during the year, on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months, at which point Income Taxes Payable would decrease once again.
By contrast, DTAs and DTLs tend to be longer-term and arise because of events that do NOT occur in the normal course of business.
Walk me through how you project revenue for a company.
The simplest way to do it is to assume a percentage growth rate – for example, 15% in year 1, 12% in year 2, 10% in year 3, and so on, usually decreasing significantly over time.
To be more precise, you could create a bottoms-up build or a tops-down build:
- Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in customers / transactions and customer / transaction values to tie everything together.
- Tops-Down: Start with “big-picture” metrics like overall market size, and then estimate the company’s market share and how that will change in coming years and multiply to get to their revenue.
Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible.
Walk me through how you project expenses for a company.
The simplest method is to make each Income Statement expense a percentage of revenue and hold it fairly constant, maybe decreasing the percentages slightly (due to economies of scale), over time.
How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses over several years in a 3-statement model?
Normally you assume that these are percentages of revenue or expenses, under the assumption that they’re all linked to the Income Statement:
* Accounts Receivable: % of Revenue.
* Prepaid Expense: % of Operating Expenses.
* Inventory: % of COGS.
* Deferred Revenue: % of Revenue.
* Accounts Payable: % of Operating Expenses.
* Accrued Expenses: % of Operating Expenses.
Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company.
How should you project Depreciation and Capital Expenditures?
You could use several different approaches here:
* Simplest: Make each one a % of revenue.
* Alternative: Make Depreciation a % of revenue, but for CapEx average several years of previous CapEx, or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year).
* Complex: Create a PP&E schedule, where you estimate a CapEx increase each year based on management’s plans, and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added, using the same approach.
What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing its financial statements?
- Restructuring Charges
- Goodwill Impairment
- Asset Write-Downs
- Bad Debt Expenses
- One-Time Legal Expenses
- Disaster Expenses
- Changes in Accounting Policies
What’s the difference between capital leases and operating leases? How do they affect the statements?
Operating Leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as Operating Expenses on the Income Statement and impact Operating Income, Pre-Tax Income, and Net Income.
Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate, incur Interest Expense, and are counted as Debt.
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pre-Tax Income number (which should stay the same). Then you can deduct whatever you used up from the NOL balance (which should be a part of the Deferred Tax Asset line item).
Let’s say you’re creating quarterly projections for a company rather than annual projections. What’s the best way to project revenue growth each quarter?
It’s best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example, in Quarter 1 of Year 2 you would look at how much the company has grown revenue by in Quarter 1 of previous years.
What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes, but straight-line Depreciation for book purposes?
If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because you’re paying less in cash taxes initially and need to make up for it later.
Then, as tax Depreciation switches and becomes lower in the later years, the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.
If you own over 50% but less than 100% of another company, what happens on the financial statements when you record the acquisition?
This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company’s statements to your own.
It’s similar to a 100% acquisition where you do the same thing, but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don’t own (e.g. if it’s worth $100 and you own 70%, you would list $30 here).
Just like with normal acquisitions, you also wipe out the other company’s Shareholders’ Equity when you combine its statements with yours, and you still allocate the purchase price (see the Merger Model section for more on that).
You also subtract Net Income Attributable to Noncontrolling Interests on the Income Statement – in other words, the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the Cash Flow Statement in the CFO section. That is just an accounting rule and has no cash impact.
On the Balance Sheet, the Noncontrolling Interest line item increases by that number (Net Income Attributable to Noncontrolling Interests) each year. Retained Earnings decreases by that same number each year because it reduces Net Income, so the Balance Sheet remains in balance.
What about if you own between 20% and 50% of another company? How do you record this acquisition and how are the statements affected?
This case refers to an Equity Interest (AKA Associate Company) – here, you do not consolidate the statements at all.
Instead, you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the Balance Sheet (Investments in Equity Interests). For example, if the other company is worth $200 and you own 30% of it, you record $60 for the Investments in Equity Interests line item.
You also add Other Company’s Net Income * Percentage Ownership to your own Net Income on the Income Statement, and then subtract it on the Cash Flow Statement because it’s a non-cash addition.
Each year, the Investments in Equity Interests line item increases by that number, and it decreases by any dividends issued from that other company to you. On the other side, Retained Earnings will also change based on the change in Net Income, so everything balances.
What if you own less than 20% of another company?
This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case, especially if they exert “significant influence” over the other company.
But sometimes they may also classify it as a simple Investment or Security on their Balance Sheet (see the next few questions), acting as if they have simply bought a stock or bond and ignoring the other company’s financials.
