Basic Accounting

Question 1

What are the 3 financial statements?

Answer 1

The Income statement
The Balance Sheet
The statement of Cash Flows

Question 2

What Does the Income Statement do?

Answer 2

The income statement gives the companies revenue and expenses and goes down to net income, the final line on the statement.

Question 3

What does the Balance Sheet do?

Answer 3

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 liabilites + Shareholders Equity.

Question 4

What does the Cash Flow Statement do?

Answer 4

The Cash Flow statement begins with Cash flows from operations and starts 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 companies net change in cash.

Question 5

Can you give examples of major line items on the Income Statement?

Answer 5

Revenue, COGS, (Selling, General & Administrative Expenses); Operating Income; Pre Tax Income; Net Income

Question 6

Can you give examples of major line items on the Balance Sheet?

Answer 6

Cash, Accounts Recievable; Inventory;PP&E, Accounts payable, Accrued expenses, Debt; Shareholders equity.

Question 7

Can you give examples of major line items on the CF Statement?

Answer 7

Net Income; Depreciation and Amortization, Stock- Based Compensation; changes in operating assets& liabilites; Cash Flow from operations; Capital expenditures. Cash Flow from investing ; Sale/Purchase of securities; Dividends Issued; Cash Flow from financing

Question 8

How do the 3 statements link together?

Answer 8

To tie the statements together , Net Income from the income statement flows into Shareholders Equity on the on the balance sheet and into the top line of the Cash Flow Statement

Changes to the 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 CF statement

Question 9

If I were stranded on a desert Island and only had one statement to review the overall health of a company which statement would I use and why?

Answer 9

You would use the statement of Cash Flows because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that’s the #1 thing you care about when analyzing the overall financial health of any business is it’s cash flow

Question 10

Lets say I could only look at two statements to asess a companies prospects- which 2 would I use and why?

Answer 10

You would use the Income Statement and the Balance Sheet because you can create the CF statement from both of those (assuming that you have “before and after” versions of the Balance sheet that correspond to the same period the income statement is tracking.)

Question 11

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

Answer 11

Although depreciation is a non cash expense , it is tax deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Question 12

Where does depreciation usually show up on the income statement?

Answer 12

It could be in a seperate line item, or it could be embedded in COGS or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same Depreciation always reduces Pre-Tax income

Question 13

Why is the income statement not affected by changes in Inventory?

Answer 13

Expense in the case of the inventory,is only recorded when the goods associated with it are sold- so if it’s just sitting in a warehouse, it does not count as a COGS or Operating expense until the company manufactures it into the product and sells it.

Question 14

Could you ever end up with negative Share holders equity?

Answer 14

Yes in two cases

1. LBO’s with dividend recapitalizations - it means that the owner of the company has taken our a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has a declining retained earnings balance, which is a porton of the SE

Question 15

What is Working Capital and how is it used?

Answer 15

Working Capital = Current Assets - Current Liabilities

If it is positive it means a company can pay off its short term liabilites with its short term assets. it is often presented as a financial metric and its magnitude and sign tells you whether the company is sound.

Question 16

What is Operating Working Capital?

Answer 16

Current Assets - (Cash & Cash Equivalents) - (Current Liabilites - Debt)

Question 17

What does negative working capital mean?

Answer 17

It could mean a few things

1. Some companies with subscriptions or longer term contracts usually have negative WC because of high deferred revenue balances.
2. Retail and restaurants companies like Amazon, Wal-Mart, and Mcdonalds often have negative WC because customers pay up front - 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 efficency.
3. In other cases negative WC could point to financial trouble or possible bankruptcy ( for example, when customers don’t pay quickly and up front and the company is carrying a high debt balance)

Question 18

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

Answer 18

1. Web Based Subscription software
2. Cell phone carriers annual contracts
3. Magazine publishers

Companies that agree to services in the future often collect cash up front to ensure stable revenue - this makes investors happy as well since they can better predict a company’s performance.

Per the rules of GAAP , you only record revenue when you actually perform the sevice - so the company would not record everything as a revenue right away.

Question 19

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

Answer 19

Usually it goes into deferred revenue balance on the balance sheet under liabilites.

Over time as the services are performed, the deferred revenue balance turns into real revenue on the income statement.

Question 20

What is the difference between accounts recievable and deferred revenue?

Answer 20

Accounts Recievable has not yet been collected in cash from customers whereas deferred revenue has been. Accounts recievable represents how much revenue the company is waiting on whereas deferred revenue represents how much is waiting to record as a revenue.

Question 21

How long does it take for a company to collect it’s accounts recievable balance?

Answer 21

Generally the accounts recievable days are in the 40-50 day range, though its higher for companies selling high end items and it might be lower for samller , lower transaction- value companies.

Question 22

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

Answer 22

Cash Based accounting recognizes revenue and expenses when cash is actually recieved or paid out;

accrual accounting recognizes revenue when collection is reasonably certain (i.e after a customer has ordered the product) and recognizes expenses when they are incurred rather when they are paid out in cash

Most large companeis use accrual accounting becayse paying with credit cards and lines of credit is so prevalent these days; very small busnesses may use cash - based accounting to simplify their financial statements.

Question 23

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

Answer 23

In cash based accounting the revenue would not show up until the company charges the customers credit cards, recieved authorization and deposits funds in its bank account- at which point it would show up as both revenue on the income statement and Cash on the balance sheet.

Question 24

What would a customer paying for a TV with a credit card look like in accrual accounting?

Answer 24

It would show up as a revenue right away but instead of appearing in cash on the balance sheet it would gointo accounts recievable at first. Then once the cash is actually deposited in the companies bank account, it would turn into cash.

Question 25

How do you decide when to captitalize a purchase?

Answer 25

If the asset has a useful life of over 1 year it is capitalized (meaning put on the balance sheet rather than shown as an expense on the income statement) Then its depreciated (tangible assets) or amortized (intangible assets) over a certain number of years.

Question 26

How do you decide when to expense a purchase?

Answer 26

Purchases like factories equiptment and land all last longer than a year and therefore show up on the balance sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the income statement as normal expenses instead.

Question 27

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

Answer 27

These days many companies have “non cash” charges such as amortization of the intangibles, stock based compensation, and deferred revenue write down in their income statments. As a result some argue that income statments under gap no longer reflect how profitable most companies truly are. Non -Gaap earnings are almost always higher because these expenses are excluded.

Question 28

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

Answer 28

1. The comoany is spending too much on Captial Expenditures - these are not reflected at all in EBITDA, but it could still be Cash Flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company’s debt all matures on one date and its unable to refinance due to a credit crunch and it runs out of cash completely when paying back the debt.
4. It has significant one time charges (from litigation, for example) and those are high enough to bankrupt the company.

Remember, EBITDA excludes investment in and depreciation of) long term assets, interest and one time charges - and all of these could end up bankrupting the company.

Question 29

Normally Goodwill remains constant on the Balance sheet - why would it be impaired and what does goodwill impairment mean ?

Answer 29

Usually this happens when a company has been acquired and the acquirer re-assess its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth signficantly less than they origianlly thought.

It often happens in acquisitons where the buyer overpaid for the seller and can result in a large net loss on the income statement

It can also happen when a company discontinues part of its operations and must impair that associated goodwill

Question 30

Under what circumstances would goodwill increase?

Answer 30

Technically goodwill can increase if the company re-asses its value and finds that it is worth more, but that is rare. What usually happens is :

1. The company gets acquired or bought out and goodwill changes as a result, since its an accounting “plug” for the purchase price in an acquisiton.
2. The company acquires another company and pays more than what its assets are worth - this is reflected in the goodwill number.