Accounting Questions (BASIC)

Question 1

What are the three major financial statements?

Answer 1

The three major financial statements are the Income Statement, the Balance Sheet, and the Cash Flow Statement.

Question 2

What does the Income Statement indicate?

Answer 2

The Income Statement indicates the profitability of a company and works from revenues and expenses down to net income.

Question 3

What does the Balance Sheet show?

Answer 3

The Balance Sheet shows a company’s assets or resources and the sources of funding for those assets, which are made up of shareholder’s equity and liabilities.

Question 4

What is the key equation for the Balance Sheet?

Answer 4

The key equation for the Balance Sheet is that assets must equal liabilities plus shareholder’s equity.

Question 5

What does the Cash Flow Statement reconcile?

Answer 5

The Cash Flow Statement reconciles from net income to the actual ending cash balance by adjusting for non-cash expenses and working capital changes.

Question 6

What are major line items on the Income Statement?

Answer 6

Major line items on the Income Statement include revenues, cost of goods sold, selling, general, and administrative expenses, operating income, pretax income, and net income.

Question 7

What are major line items on the Balance Sheet?

Answer 7

Major line items on the Balance Sheet include cash, accounts receivable, inventory, property, plants, and equipment, accounts payable, accrued expenses, debt, and shareholder’s equity.

Question 8

What are major line items on the Cash Flow Statement?

Answer 8

Major line items on the Cash Flow Statement include net income, depreciation and amortization, stock-based compensation, changes in operating assets and liabilities, cash flow from operations, capital expenditures, cash flow from investing, sale and purchase of securities, dividends issued, and cash flow from financing.

Question 9

How do the three statements link together?

Answer 9

Net income from the Income Statement flows into shareholder’s equity on the Balance Sheet and into the top line of the Cash Flow Statement.

Question 10

If stranded on a desert island, which statement would you use to review a company’s health?

Answer 10

I would use the Cash Flow Statement because it gives a true picture of how much cash a company is generating independent of non-cash expenses.

Question 11

If you could only look at two statements to assess a company’s prospects, which would you use?

Answer 11

I would look at the Income Statement and the Balance Sheet because you can reconcile from net income to the actual ending cash balance.

Question 12

How does a $10 increase in depreciation affect the three statements?

Answer 12

A $10 increase in depreciation lowers operating income and pre-tax income by $10, resulting in a $6 decrease in net income after tax. The Cash Flow Statement adds back the $10 depreciation, resulting in a $4 increase in ending cash. The Balance Sheet shows a $6 decrease in assets and a $6 decrease in retained earnings.

Question 13

Why does depreciation affect cash balance if it’s a non-cash expense?

Answer 13

Depreciation is tax-deductible, reducing the amount of taxes paid, which affects cash.

Question 14

Where does depreciation usually show up on the Income Statement?

Answer 14

Depreciation could be in a separate line item or embedded in cost of goods sold or operating expenses.

Question 15

What happens when accrued compensation goes up by $10?

Answer 15

Accrued compensation increases operating expenses by $10, resulting in a $6 decrease in net income. This flows to the Cash Flow Statement, increasing cash from operations by $10, resulting in a $4 increase in ending cash.

Question 16

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

Answer 16

There will be no changes to the Income Statement. The Cash Flow Statement will show a $10 decrease in cash from operations, and the Balance Sheet will reflect a $10 increase in inventory and a $10 decrease in cash.

Question 17

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

Answer 17

The expense is recorded only when the goods are sold, due to the matching principle.

Question 18

What happens when Apple buys $100 worth of new iPod factories with debt?

Answer 18

The Income Statement is unaffected. The Cash Flow Statement shows a $100 decrease in cash from investing and a $100 increase in cash from financing, resulting in no net change. The Balance Sheet shows a $100 increase in PP&E and a $100 increase in debt.

Question 19

What happens at the start of Year 2 after Apple buys new factories?

Answer 19

Depreciation expense of $10 decreases operating income, and interest expense increases by $10, resulting in a $20 decrease in pre-tax income and a $12 decrease in net income. The Cash Flow Statement shows a $2 net decrease in cash. The Balance Sheet reflects a $12 decrease in assets and a $12 decrease in shareholder’s equity.

Question 20

What happens when the factories break down and are written down to $0?

Answer 20

The write-down decreases pre-tax income by $80, net income by $48, and cash from operations increases by $32. Cash from financing decreases by $100. The Balance Sheet shows a total decrease of $148 in assets and a corresponding decrease in liabilities and shareholder’s equity.

Question 21

What happens when Apple orders $10 of additional iPod inventory using cash?

Answer 21

There will be no changes to the Income Statement. Cash from operations decreases by $10, and on the Balance Sheet, cash decreases by $10 while inventory increases by $10.

Question 22

What happens when Apple sells iPods for revenue of $20 at a cost of $10?

Answer 22

Revenues increase by $20 and expenses by $10, resulting in a $10 increase in pre-tax income and a $6 increase in net income. The Cash Flow Statement shows a $16 increase in cash. The Balance Sheet reflects a $6 increase in assets.

Question 23

Can you end up with negative shareholders’ equity?

Answer 23

Yes, negative shareholders’ equity can occur due to leveraged buyouts or consistent losses leading to declining retained earnings.

Question 24

What is working capital?

Answer 24

Working capital is equal to current assets minus current liabilities.

Question 25

What does negative working capital mean?

Answer 25

Negative working capital is not necessarily bad; it can indicate efficiency in companies with upfront payments or may signal financial trouble.

Question 26

What happens when there’s a writedown of $100?

Answer 26

The writedown results in a $100 expense, decreasing pre-tax income and net income by $60. The Cash Flow Statement shows a $40 increase in cash. The Balance Sheet reflects a $60 decrease in assets and equity.

Question 27

What happens during a $100 bailout of a company?

Answer 27

If it’s an equity investment, the Income Statement is unaffected, cash from financing increases by $100, and the Balance Sheet shows a $100 increase in assets and equity.

Question 28

What happens during a $100 write-down of debt?

Answer 28

Pre-tax income increases by $100, net income by $60. The Cash Flow Statement shows a $40 decrease in cash. The Balance Sheet reflects a $40 decrease in assets and a $40 decrease in liabilities and equity.

Question 29

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

Answer 29

Companies can only record revenues when they perform services, leading to deferred revenues for cash collected upfront.

Question 30

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

Answer 30

It goes into the deferred revenue balance on the Balance Sheet under liabilities.

Question 31

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

Answer 31

Accounts receivable represents cash not yet collected for delivered services, while deferred revenue represents cash collected for services not yet performed.

Question 32

What happens to cash collected if it is not recorded as revenue?

Answer 32

Usually, it goes into the deferred revenue balance on the balance sheet under liabilities. As the services are performed, the deferred revenue balance ‘turns into’ real revenue on the income statement.

Question 33

What is the difference between accounts receivable and deferred revenue?

Answer 33

Accounts receivable represents cash that has not been collected from customers for a product or service that has been delivered, while deferred revenue represents cash that has been collected from customers for a product or service that has not yet been delivered.

Question 34

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

Answer 34

Generally, the accounts receivable days are in the forty to fifty day range, but it can be higher for companies selling high-end items and lower for smaller, lower transaction value companies.

Question 35

What is the difference between cash-based and accrual accounting?

Answer 35

Cash-based accounting recognizes revenues and expenses when cash is actually received or paid out, while accrual accounting recognizes revenue when collection is reasonably certain and recognizes expenses when they are incurred.

Question 36

How does a customer paying for a TV with a credit card look under cash-based versus accrual accounting?

Answer 36

In cash-based accounting, the revenue would not show up until the company charges the customer’s credit card and receives authorization. In accrual accounting, it would show up as revenue right away but go into accounts receivable at first.

Question 37

When do you decide to capitalize rather than expense a purchase?

Answer 37

If the asset has a useful life of over one year, it is capitalized and depreciated or amortized over a certain number of years. Purchases like factories and equipment show up on the balance sheet, while employee salaries are normal expenses.

Question 38

Why do companies report both GAAP and non-GAAP (‘Pro Forma’) earnings?

Answer 38

Many companies have ‘non-cash’ charges on their income statements, leading some to argue that GAAP does not reflect true profitability. Non-GAAP earnings are usually higher as they exclude these expenses.

Question 39

How could a company with positive EBITDA go bankrupt?

Answer 39

This could happen due to high capital expenditures, high interest expenses, debt maturing without refinancing options, or significant one-time charges.

Question 40

Why would Goodwill be impaired?

Answer 40

Goodwill is usually impaired when a company is acquired and the acquirer reassesses its intangible assets, finding them worth significantly less than originally thought.

Question 41

Under what circumstances would Goodwill increase?

Answer 41

Goodwill can increase if the company reassesses its value and finds it worth more, but this is rare. Usually, it increases due to acquisitions where the purchase price exceeds the value of the assets.