Accounting Questions - Basic

Question 1

Walk me through the 3 financial statements.

Answer 1

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.
1. The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement.
2. The Balance Sheet shows the company’s Assets – its resources – such as Cash, Inventory and PP&E, as well as its Liabilities – such as Debt and Accounts Payable – and Shareholders’ Equity. Assets must equal Liabilities plus Shareholders’ Equity.
3. The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company’s net change in cash.

Question 2

Can you give examples of major line items on each of the financial statements?

Answer 2

1. Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income.
2. Balance Sheet: Cash; Accounts Receivable; Inventory; Property, Plants & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.
3. Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

Question 3

How do the 3 statements link together?

Answer 3

To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders’ Equity. The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.

Question 4

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?

Answer 4

If stranded on a desert island with only one statement to review, the Cash Flow Statement is generally the best choice because it provides a clear view of the company’s cash generation and usage, which are crucial for assessing financial health and liquidity. Although the Income Statement shows the company’s profitability, it doesn’t provide insight into cash flow or liquidity. A company might report profits but still face cash flow problems. Similarly, while the Balance Sheet reveals the company’s financial position, it doesn’t show how cash is being managed or how the company generates cash.

Question 5

Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?

Answer 5

You would use the Income Statement and the Balance Sheet because you can create the Cash Flow Statement from them, assuming you have the “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking.

Question 6

Walk me through how Depreciation going up by $10 would affect the statements.

Answer 6

1. Starting with the Income Statement, a $10 increase in Depreciation would lower Operating Income by $10, causing Pre-Tax Income to drop by $10. Assuming a 40% tax rate, Net Income will decrease by $6.
2. On the Cash Flow Statement, Net Income would decrease by $6. The $10 Depreciation would get added back to Net Income since it’s a non-cash expense. As a result, Cash Flow from Operations would increase by $4. With no change in Cash Flow from Investing and Cash Flow from Financing, the Net Change in Cash would increase by $4.
3. On the Balance Sheet, under the Asset side, Cash and Cash Equivalents would increase by $4, but PP&E would decrease by $10, leading to a decrease of $6 in Total Assets. On the Liabilities & Equity side, Retained Earnings would decrease by $6, causing Total Liabilities & Equity to decrease by $6. The Balance Sheet balances.

Question 7

If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 7

Depreciation is tax-deductible, and since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Question 8

Where does Depreciation usually show up on the Income Statement?

Answer 8

It really depends on the company. Depreciation could show up as its own separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses.

Question 9

What happens when Accrued Compensation goes up by $10?

Answer 9

1. Assuming Accrued Compensation is now being recognized as an expense rather than just being reclassified (changing non-accrued to accrued compensation), a $10 increase would raise Operating Expenses by $10 on the Income Statement, causing a $10 decrease in Pre-Tax Income. Assuming a 40% tax rate, Net Income would decrease by $6.
2. On the Cash Flow Statement, Net Income is down by $6. However, Accrued Compensation, a non-cash expense, increases Cash Flow from Operations by $10, resulting in a net increase of $4 in Cash Flow from Operations, and causing the Net Change in Cash to go up by $4.
3. On the Balance Sheet, Cash increases by $4, leading to a $4 increase in Assets. On the Liabilities & Equity side, Liabilities increase by $10, while Retained Earnings decrease by $6 due to the lower Net Income, balancing the Balance Sheet.

Question 10

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Answer 10

The Income Statement would stay the same. On the Cash Flow Statement, since Inventory is an Asset, the $10 increase will decrease Cash Flow from Operations by $10, lowering the Net Change in Cash by $10. On the Balance Sheet, Inventory increases by $10 while Cash decreases by $10, canceling each other out, so the Total Assets remain unchanged.

Question 11

Why is the Income Statement not affected by changes in Inventory?

Answer 11

When it comes to Inventory, the expense is only recognized on the Income Statement when the goods associated with the Inventory are sold. If the goods are just sitting in a warehouse, they are not counted as Cost of Goods Sold (COGS) or Operating Expenses until the company manufactures them into a product and sells it.

Question 12

Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?

Answer 12

1. On the Income Statement, there wouldn’t be any changes as of yet.
2. On the Cash Flow Statement, the purchase of the factories would be recorded under Cash Flow from Investing, reducing cash by $100. However, the $100 worth of debt would be added under Cash Flow from Financing, which offsets the investment, resulting in no net change in cash.
3. On the Balance Sheet, there is an additional $100 worth of factories added to the PP&E line, increasing Assets by $100. On the Liabilities side, debt increases by $100, balancing both sides.

Question 13

Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

Answer 13

After a year has passed, Apple must pay the interest expense and record the depreciation of the factories.
1. Operating Income would decrease by $10 due to the 10% depreciation charge. The $10 in additional Interest Expense would further decrease Pre-Tax Income by a total of $20. Assuming a tax rate of 40%, Net Income would fall by $12.
2. On the Cash Flow Statement, Net Income is down by $12. Since depreciation is a non-cash expense, you add it back, resulting in Cash Flow from Operations being down by $2, and thus, Net Cash also being down by $2.
3. On the Balance Sheet, Cash would decrease by $2, and PP&E would decrease by $10 due to depreciation, resulting in a $12 decrease in Assets. On the Liabilities & Equity side, Shareholders’ Equity would decrease by $12 due to the drop in Net Income. The debt under Liabilities would remain unchanged since we’ve assumed none of the debt has been paid back.

Question 14

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

Answer 14

After two years, the value of the factories is now $80 if we assume 10% depreciation per year. This $80 will be written down in the three statements.
1. On the Income Statement, the $80 write-down appears on the Pre-Tax Income line. With a 40% tax rate, Net Income decreases by $48.
2. On the Cash Flow Statement, Net Income is down by $48, but the $80 write-down is added back as it’s a non-cash expense, resulting in a $32 increase in Cash Flow from Operations. There are no changes under Cash Flow from Investing. However, under Cash Flow from Financing, there is a $100 outflow for the loan repayment, reducing Cash Flow from Investing by $100. Overall, the Net Change in Cash decreases by $68.
3. On the Balance Sheet, Cash decreases by $68, and PP&E decreases by $80 due to the write-down, resulting in a total decrease of $148 in Assets. On the Liabilities & Shareholders’ Equity side, Debt decreases by $100 due to the loan repayment, and Shareholders’ Equity decreases by $48 because of the reduced Net Income. Total Liabilities & Shareholders’ Equity decreases by $148, balancing both sides.

Question 15

Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements?

Answer 15

The Income Statement would not change. On the Cash Flow Statement, an increase in inventory of $10 would result in a $10 decrease in Cash Flow from Operations, causing overall Cash to drop by $10. On the Balance Sheet, Inventory would increase by $10, and Cash would decrease by $10, resulting in no net change in the total Assets, thus leaving the Balance Sheet balanced.

Question 16

Now let’s say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 16

1. On the Income Statement, Revenue would increase by $20, and COGS would increase by $10, leading to a $10 increase in Gross Profit and Operating Income. Assuming a 40% tax rate, Net Income would increase by $6.
2. On the Cash Flow Statement, Net Income would be up by $6, and the decrease in Inventory of $10 would result in an additional $10 to Cash Flow from Operations. Thus, Cash Flow from Operations would increase by $16 overall, leading to a $16 increase in Net Cash.
3. On the Balance Sheet, Cash would increase by $16, and Inventory would decrease by $10, resulting in an overall increase in Assets of $6. On the Liabilities & Shareholders’ Equity side, Net Income is up by $6, so Shareholders’ Equity increases by $6, keeping the Balance Sheet balanced.

Question 17

Could you ever end up with negative shareholders’ equity? What does it mean?

Answer 17

Yes. It is common to see this in two scenarios:
1. Leveraged Buyouts with dividend recapitalizations - where a company takes on new debt to pay a special dividend to its shareholders or owners. This can result in negative shareholders’ equity if the company’s debt becomes greater than its equity due to the large dividend payments.
2. This can also happen if a company has been losing money consistently and has a declining Retained Earnings balance, which is a portion of shareholders’ equity.
3. It doesn’t necessarily “mean” anything, but it can signify that a company is struggling.

Question 18

What is working capital? How is it used?

Answer 18

Working Capital = Current Assets - Current Liabilities. If it’s positive, it means the company can pay off its short-term liabilities with its short-term assets. It’s often presented as a financial metric and it’s magnitude and sign can tell you how financially “sound” a company is. Bankers typically look at Operating Working Capital more often, which is defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt).

Question 19

What does negative Working Capital mean? Is that a bad sign?

Answer 19

Not necessarily. It depends on the type of company and the specific situation. For example:
1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.
3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy. Such as when customers aren’t paying quickly and upfront, or when the company is carrying a large amount of debt.

Question 20

Walk me through a $100 “bailout” of a company and how it affects the 3 statements.

Answer 20

First, confirm the type of bailout. Typically, a bailout involves an equity investment from the government, but it could also be in the form of debt or a combination of both. For this example, we’ll assume it’s an equity investment.
1. On the Income Statement, there would be no changes since the bailout is a financial injection rather than an operational expense.
2. On the Cash Flow Statement, Cash Flow from Financing would increase by $100 to reflect the government’s equity investment, resulting in a $100 increase in Net Change in Cash.
3. On the Balance Sheet, Cash would increase by $100, so Total Assets are up by $100. On the Liabilities & Equity side, Shareholders’ Equity would increase by $100 to reflect the new equity investment, ensuring that both sides of the Balance Sheet are balanced.

Question 21

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a write-down of $100.

Answer 21

1. When there’s a write-down of $100, the Income Statement will reflect a $100 reduction in Pre-Tax Income due to the write-down. With a 40% tax rate, this results in a $60 decrease in Net Income.
2. On the Cash Flow Statement, Net Income decreases by $60, but since the write-down is a non-cash expense, it is added back. This adjustment results in an increase of $40 in Cash Flow from Operations, leading to a $40 increase in Net Change in Cash.
3. On the Balance Sheet, Cash increases by $40, while the asset value decreases by $100, resulting in a net decrease of $60 in Total Assets. On the Liabilities & Equity side, the decrease in Net Income reduces Shareholders’ Equity by $60, ensuring that both sides of the Balance Sheet remain balanced.

Question 22

Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s balance sheet and how it affects the 3 statements.

Answer 22

1. When a liability is written down it is treated as a gain on the Income Statement. This results in a $100 increase in Pre-Tax Income. Assuming a 40% tax rate, Net Income would increase by $60.
2. On the Cash Flow Statement, Net Income is up by $60, but since the write-down is a non-cash gain, it is subtracted to adjust for cash flows, resulting in Cash Flow from Operations being down by $40. Thus, the Net Change in Cash is a decrease of $40.
3. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances.

Question 23

When would a company collect cash from a customer and not record it as revenue?

Answer 23

Three examples that come to mind are:
1. A web-based subscription software.
2. Cell-phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.
4. Any company that agrees to services in the future but collects cash upfront to ensure stable revenue.
5. Per the rules of GAAP, you can only record revenue once the product or service has been delivered to the customer.

Question 24

If cash collected is not recorded as revenue, what happens to it?

Answer 24

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement.

Question 25

What’s the difference between accounts receivable and deferred revenue?

Answer 25

Accounts receivable represents amounts that have not yet been collected in cash from customers, although the product or service has been delivered. Deferred revenue, on the other hand, has been collected, but the product or service has not yet been fully delivered. Accounts receivable shows how much revenue the company is waiting to collect, whereas deferred revenue represents how much revenue the company is waiting to record.

Question 26

How long does it usually take for a company to collect its accounts receivable balance?

Answer 26

This can vary depending on the company. Generally the accounts receivable days are in the 40-50 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.

Question 27

What’s the difference between cash-based and accrual accounting?

Answer 27

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out. Accrual accounting recognizes revenue when collection is reasonably certain and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because credit card transactions and lines of credit are common, while very small businesses may use cash-based accounting to simplify their financial statements.

Question 28

Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Answer 28

Under cash-based accounting, the revenue would not show up on the Income Statement right away. The company would have to charge the customer’s credit card, receive amortization, and deposit the funds into its bank account. Only then would it be recorded as Revenue on the Income Statement and as Cash on the Balance Sheet. In accrual accounting, it would show up as revenue right away, but it wouldn’t appear in Cash on the Balance Sheet. Instead, it would go to Accounts Receivable first and only show up in Cash once the funds have been deposited into the company’s bank account.

Question 29

How do you decide when to capitalize rather than expense a purchase?

Answer 29

The decision to capitalize or expense a purchase depends on the useful life of the asset. If the asset has a useful life of over a year, it is capitalized—recorded as an asset on the balance sheet rather than as an expense on the income statement. The asset is then depreciated (for tangible assets) or amortized (for intangible assets) over its useful life. Examples of such purchases include factories, equipment, and land. On the other hand, expenses like employee salaries, utilities, and the cost of manufacturing cover short-term periods of operations and are therefore recorded as normal expenses on the income statement.

Question 30

Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?

Answer 30

Under U.S. GAAP, income statements include non-cash charges such as depreciation, amortization, stock-based compensation, and deferred revenue. While these expenses are necessary for compliance with accounting standards, some argue that they do not fully reflect the company’s true profitability. Non-GAAP earnings typically exclude these non-cash expenses, resulting in higher reported earnings.

Question 31

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Answer 31

There are several possibilities:
1. EBITDA does not account for capital expenditures, so if a company has high CapEx, it might have negative cash flow even with positive EBITDA, potentially leading to bankruptcy.
2. EBITDA also does not include interest expenses. So if a company has significant debt and can no longer afford its interest payments, it may default and face bankruptcy.
3. If a large portion of the company’s debt is maturing soon, and it cannot refinance due to a credit crunch, it might be forced to use its cash reserves to pay off the debt, which could deplete its cash and lead to bankruptcy.
4. If a company incurs significant one-time charges, such as from litigation, and they are large enough, these charges could push the company into bankruptcy.

Question 32

Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?

Answer 32

A Goodwill impairment typically happens when a company is acquired and reassesses its intangible assets, finding them to be significantly less than originally thought. It can happen when a buyer overpays for the seller and can result in a large net loss on the Income Statement. It can also occur when a company discontinues part of its operations and must impair the associated goodwill.

Question 33

Under what circumstances would Goodwill increase?

Answer 33

Technically, goodwill can increase if a company reassesses its value and finds that it’s worth more, but this is rare. What usually happens is one of two scenarios:
1. The company gets acquired, and goodwill changes as a result.
2. The company acquires another company and pays more than the fair value of its identifiable assets and liabilities. This excess amount is then reflected in the goodwill number.