Advanced Changes and Scenarios Flashcards
You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
Walk me through how you would recognize Net Income Attributable to Noncontrolling Interests, and how it affects the 3 statements.
Income Statement: You show a line item for “Net Income Attributable to Noncontrolling Interests” near the bottom. You subtract $3 (Other Company Net Income of $10 * 30% You Don’t Own) to reflect the 30% of the other company’s Net Income that does not “belong” to you.
At the bottom of the Income Statement, the “Net Income Attributable to Parent” line item is down by $3.
Cash Flow Statement: Net Income is down by $3 as a result, but you add back this same charge because you do, in fact, receive this Net Income in cash when you own over 50% of the other company.
So cash at the bottom of the CFS remains unchanged.
Balance Sheet: There are no changes on the Assets side. On the other side, the Noncontrolling Interests line item (included in Shareholders’ Equity) is up by $3 due to this Net Income, but Retained Earnings is down by $3 because of the reduced Net Income at the bottom of the Income Statement, so this side doesn’t change and the Balance Sheet remains in balance.
Let’s continue with the same example, and assume that this other company issues Dividends of $5. Walk me through how that’s recorded on the statements.
Income Statement: There are no changes because Dividends never show up on the Income Statement.
Cash Flow Statement: There’s an additional Dividend of $5 under Cash Flow from Financing on the CFS, so cash is down by $5.
Balance Sheet: The Assets side is down by $5 as a result and Shareholders’ Equity (Retained Earnings) is also down by $5.
Remember that the other company’s financial statements are consolidated with your own when you own over 50% – you only split out Net Income separately.
So there’s no need to multiply by ownership percentages or anything when factoring in the impact of Dividends, or really any item other than Net Income.
Now let’s take the opposite scenario and say that you own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to.
Here, nothing has been consolidated because we own less than 50% of the other company. So nothing on the statements yet reflects this other company.
Income Statement: We create an item “Net Income from Equity Interests” (or something similar) below our normal Net Income at the bottom, which results in our real Net Income (Net Income Attributable to Parent) increasing by $6 ($20 * 30%).
Cash Flow Statement: Net Income is up by $6, but we subtract this $6 of additional Net Income because we haven’t really received it in cash when we own less than 50% - it’s not as if we control the other company and can just “take it.” Cash remains unchanged.
Balance Sheet: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this Net Income, so the Assets side is up by $6. On the other side, Shareholders’ Equity (Retained Earnings) is up by $6 to reflect the increased Net Income, so both sides balance.
Now let’s assume that this 30% owned company issues Dividends of $10. Taking into account the changes from the last question, walk me through the 3 statements again and explain what’s different now.
Income Statement: It’s the same: Net Income is up by $6 at the bottom.
Cash Flow Statement: Net Income is up by $6 and we then subtract out the $6 that’s attributable to the Equity Interests…
And then we ADD $3 ($10 * 30%) in the Cash Flow from Operations section to reflect the Dividends that we receive from these Equity Interests.
So cash at the bottom is up by $3.
Balance Sheet: Cash is up by $3 on the Assets side, and the Investments in Equity Interests line item is up by $6… but it falls by $3 due to those Dividends, so the Assets side is up by $6 total.
On the other side, Net Income is up by $6 so Shareholders’ Equity (Retained Earnings) is up by $6 and both sides balance.
The Investments in Equity Interests line item is like a “mini-Shareholder’s Equity” for companies that you own less than 50% of – you add however much Net Income you can “claim,” and then subtract your portion of the Dividends.
Remember that only the Dividends the parent company itself issues show up in the Cash Flow from Financing section – Dividends received from other companies (such as what you see in this example) do not.
What if you now only own 10% of this company? Would anything change?
In theory, yes, because when you own less than 20%, the other company should be recorded as a Security or Short-Term Investment and you would only factor in the Dividends received but not the Net Income from the Other Company.
In practice, however, treatment varies and some companies may actually record this scenario the same way, especially if they exert “significant influence” over the 10% owned company.
Walk me through what happens when you pay $20 in interest on Debt, with $10 in the form of cash interest and $10 in the form of Paid-in-Kind (PIK) interest.
Income Statement: Both forms of interest appear, so Pre-Tax Income falls by $20 and Net Income falls by $12 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $12 but you add back the $10 in PIK interest since it’s non-cash, so Cash Flow from Operations is down by $2. Cash at the bottom is also down by $2 as a result.
Balance Sheet: Cash is down by $2 so the Assets side is down by $2. On the other side, Debt increases by $10 because PIK interest accrues to Debt, but Shareholders’ Equity (Retained Earnings) falls by $12 due to the reduced Net Income, so this side is also down by $2 and both sides balance.
PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the Balance Sheet – in this case, that’s the existing Debt number
Due to a high issuance of Stock-Based Compensation and a fluctuating stock price, a company has recorded a significant amount of Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation
Assume that it records $100 in Tax Benefits from SBC, with $40 of Excess Tax Benefits from SBC, and walk me through the 3 statements. Ignore the original Stock-Based Compensation issuance.
Income Statement: No changes.
Cash Flow Statement: You add back the $100 in Tax Benefits from SBC in Cash Flow from Operations, and subtract out the $40 in Excess Tax Benefits, so CFO is up by $60.
Then, under Cash Flow from Financing, you add back the $40 in Excess Tax Benefits, so Cash at the bottom is up by $100.
Balance Sheet: Cash is up by $100, so the Assets side is up by $100. On the other side, Common Stock & APIC is up by $100 because Tax Benefits from SBC flow directly into there.
The rationale: Essentially we’re “re-classifying” the Tax Benefits OUT of Cash Flow from Operations and saying that they should accrue to the company’s Shareholders’ Equity. And we are also saying that Excess Tax Benefits (which arise due to share price increases) should be counted as a Financing activity but should not impact cash, since they’re already a part of the normal Tax Benefits.
A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3. Walk me through what happens on the BOOK financial statements in Year 1.
Income Statement: On the Book Income Statement you list the Book Depreciation number, so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.
On the Tax Income Statement, Depreciation was $15 so Net Income fell by $9 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $85. Book Taxes were $36 and Cash Taxes were $34, so Book Taxes fell by $4 and Cash Taxes fell by $6).
Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you add back $2 worth of
Deferred Taxes – that represents the fact that Cash Taxes were lower than Book Taxes in Year 1.
At the bottom, Cash is up by $6.
Balance Sheet: Cash is up by $6 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $4.
On the other side, the Deferred Tax Liability increases by $2 due to the Book / Cash Tax difference, but Shareholders’ Equity (Retained Earnings) is down by $6 due to the lower Net Income, so both sides are down by $4 and balance.
A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3. Now let’s move to Year 2. What happens?
This one’s easy, because now Book and Tax Depreciation are the same.
Income Statement: Pre-Tax Income is down by $10 so Net Income falls by $6.
Cash Flow Statement: Net Income is down by $6 and you add back the $10 of Depreciation on the CFS, but there are no changes to Deferred Taxes because Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4.
Balance Sheet: Cash is up by $4 but PP&E is down by $10, so the Assets side is down by $6. The other side is also down by $6 because Shareholders’ Equity (Retained Earnings) is lower due to the reduced Net Income.
And finally, let’s move to Year 3 – walk me through what happens on the statements now
Income Statement: On the Book Income Statement, you use the Book Depreciation number so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.
On the Tax Income Statement, Depreciation was $5 so Net Income fell by $3 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $95. Book Taxes were $36 and Cash Taxes were $38, so Book Taxes fell by $4 and Cash Taxes fell by $2).
Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you subtract out $2 worth of additional Cash Taxes – that represents the fact that Cash Taxes were higher than Book Taxes in Year 1 (meaning that you’re now paying extra to make “catch-up payments”).
At the bottom, Cash is up by $2.
Balance Sheet: Cash is up by $2 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $8.
On the other side, the Deferred Tax Liability decreases by $2 due to the Book/Cash Tax difference and Shareholders’ Equity (Retained Earnings) is down by $6 due to the reduced Net Income, so both sides are down by $8 and balance.
A company you’re analyzing records a Goodwill Impairment of $100. However, this Goodwill Impairment is NOT deductible for cash tax purposes. Walk me through how the 3 statements change
Income Statement: You still reduce Pre-Tax Income by $100 due to the Impairment, so Net Income falls by $60 at a 40% tax rate – when it’s not tax-deductible, you make that adjustment via Deferred Tax Liabilities or Deferred Tax Assets.
On the Tax Income Statement, Pre-Tax Income has not fallen at all and so Net Income stays the same… which means that Cash Taxes are $40 higher than Book Taxes.
Cash Flow Statement: Net Income is down by $60, but we add back the $100 Impairment since it is non-cash.
Then, we also subtract $40 from Deferred Taxes because Cash Taxes were higher than Book Taxes by $40 – meaning that we’ll save some cash (on paper) from reduced Book Income Taxes in the future. Adding up all these changes, there are no net changes in Cash.
Balance Sheet: Cash is the same but Goodwill is down by $100 due to the Impairment, so the Assets side is down by $100.
On the other side, the Deferred Tax Liability is down by $40 and Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides are down by $100 and balance.
Intuition: When a charge is not truly tax-deductible, a firm pays higher Cash Taxes and either “makes up for” owed future tax payments or gets to report lower Book Taxes in the future.
Remember that DTLs get created when additional future cash taxes are owed – when additional future cash taxes are paid, DTLs decrease.
How can you tell whether or not a Goodwill Impairment will be tax-deductible?
There’s no way to know for sure unless the company states it, but generally Impairment on Goodwill from acquisitions is not deductible for tax purposes.
If it were, companies would have a massive incentive to start writing down the values of their acquisitions and saving on taxes from non-cash charges – which the government wouldn’t like too much.
Goodwill arising from other sources may be tax-deductible, but it’s rare to see significant Impairment charges unless they’re from acquisitions.
A company has Net Operating Losses (NOLs) of $100 included in the Deferred Tax Asset (DTA) line item on its Balance Sheet because it has been unprofitable up until this point.
Now, the company finally turns a profit and has Pre-Tax Income of $200 this year. Walk me through the 3 statements and assume that the NOLs can be used as a direct tax deduction on the financial statements.
Income Statement: The company can apply the entire NOL balance to offset its Pre-Tax Income, so Pre-Tax Income falls by $100 and Net Income falls by $60 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but the company hasn’t truly lost anything – it has just saved on taxes. So you add back this use of NOLs and label it “Deferred Taxes” – it should be a positive $100, which means that Cash at the bottom is up by $40.
Balance Sheet: Cash is up by $40 and the Deferred Tax Asset is down by $100, so the Assets side is down by $60. On the other side, Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides balance.
You’re analyzing a company’s financial statements and you need to calendarize the revenue, EBITDA, and other items.
The company has earned revenue of $1000 and EBITDA of $200 from January 1 to December 31, 2050. From January 1 to March 31, 2050, it earned revenue of $200 and EBITDA of $50. From January 1 to March 31, 2051, it earned revenue of $300 and EBITDA of $75.
What are the company’s revenue and EBITDA for the Trailing Twelve Months as of March 31, 2051?
Trailing Twelve Months (TTM) = New Partial Period + Twelve-Month Period – Old Partial Period
So in this case, TTM Revenue = $300 + $1000 – $200 = $1100 and TTM EBITDA = $75 + $200 – $50 = $225.
A company acquires another company for $1000 using 50% stock and 50% cash. Here’s what the other company looks like:
• Assets of $1000 and Liabilities of $800.
Using that information, combine the companies’ financial statements and walk me through what the Balance Sheet looks like IMMEDIATELY after the acquisition.
The acquirer has used $500 of cash and $500 of stock to acquire the seller, and the seller’s Assets are worth $1000, with Liabilities of $800 and therefore Equity of $200.
In an M&A deal the Equity of the seller gets wiped out completely. So you simply add the seller’s Assets and Liabilities to the acquirer’s – the Assets side is up by $1000 and the Liabilities side is up by $800.
Then, you subtract the cash used, so the Assets side is up by $500 only, and the other side is up by $1300 due to the $800 of Liabilities and the $500 stock issuance.
Our Balance Sheet is out of balance… and that’s why we need Goodwill. Goodwill equals the Purchase Price Minus the Seller’s Book Value, so in this case it’s equal to $1000 – $200, or $800.
That $800 of Goodwill gets created on the Assets side, and so both sides are now up by $1300 and the Balance Sheet balances.
