Advanced Accounting Flashcards
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.
Wait a minute, then how can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?
This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons.
For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets.
But they might also record accelerated Depreciation for tax purposes, but straight-line it for book purposes, which would result in a DTL in early years.
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.
For a more complex method, you could start with each department of a company, the number of employees in each, the average salary, bonuses, and benefits, and then make assumptions for those going forward.
Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics.
Cost of Goods Sold should be tied directly to Revenue and each “unit” sold should incur an expense.
Other items such as rent, Capital Expenditures, and miscellaneous expenses are linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue in a simpler model.
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.
You can also project these metrics using “days,” e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365, assume that the days required to collect AR stays relatively the same each year, and calculate the AR number from that.
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.
Let’s take a step back… there’s usually a “simple” and “complex” way of projecting a company’s financial statements. Is there a real advantage to using the complex method? In other words, does it give us better numbers?
In short, no. The complex methods give you similar numbers most of the time – you’re not using them to get better numbers, but rather to get better support for those numbers.
If you just say, “Revenue grows by 10% per year!” there isn’t much evidence to back up that claim.
But if you create a bottoms-up revenue model by segment, then you can say, “The 10% growth is driven by a 5% price increase in this segment, a 10% increase in units sold here, 15% growth in units sold in this geography” and so on.
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 Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line,” then you do not add it back for the EBITDA / EBIT calculation. Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation when calculating EBITDA, but that these are not “non-recurring charges” because all companies have them every year – they’re just non-cash charges
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.
A lease is a capital lease if any one of the following 4 conditions is true:
1. If there’s a transfer of ownership at the end of the term.
2. If there’s an option to purchase the asset at a “bargain price” at the end of the term.
3. If the term of the lease is greater than 75% of the useful life of the asset.
4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.
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).
A more complex way to do this: 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 record the difference as an increase to the Deferred Tax Liability on the Balance Sheet.
This method reflects the fact that you’re saving on cash flow – since the DTL, a Liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.
What’s the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation? How do they impact the statements?
Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes).
Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they’ve saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it).
Neither one is a separate item on the Income Statement.
On the Cash Flow Statement, Excess Tax Benefits are subtracted out of Cash Flow from Operations and added to Cash Flow from Financing, effectively “re-classifying” them. Basically you’re saying, “We’ve gotten some extra cash flow from our share price increasing, so let’s call it what it is: a financing activity.”
Also on the CFS, you add back the Tax Benefits in Cash Flow from Operations.
You do that because you want them to accrue to Additional Paid-In Capital (APIC) on the Balance Sheet. You’re saying, “In addition to the additional value we created with this stock/option issuance, we’ve also gotten some value from the tax savings… so let’s make reflect that value along with the SBC itself under APIC.”
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.
It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Quarter 1 over Quarter 4 in the previous year) because many companies are seasonal.
The same applies for expenses as well: always make sure you take into account seasonality with quarterly projections.
What’s the purpose of calendarizing financial figures?
“Calendarizing” means “Rather than using a company’s normal fiscal year figures, let’s use another year-long period during the year and calculate their revenue, expenses, and other key metrics for that period.”
For example, a company’s fiscal year might end on December 31 – if you calendarized it, you might look at the period from June 30 in the previous year to June 30 of this year rather than the traditional January 1 – December 31 period.
You do this most frequently with public comps (see the section on Valuation), because companies often have “misaligned” fiscal years. If one company’s year ends December 31, another’s ends June 30, and another’s ends September 30, you need to adjust and use the same period for all of them – otherwise you’re
comparing apples to oranges because the financial figures are all from different time periods.
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.
