Basic Accounting Quiz

Question 1

What two conditions must be true for an expense to appear on the Income Statement

Answer 1

“It must correspond to the current period and it must be tax-deductible. It does NOT have to be related to the company’s operational activities because Gains and Losses on Assets sold appear on the Income Statement even though they are not operational in nature. It does NOT have to be a true cash expense as Depreciation shows up on the Income Statement but is a non-cash expense.
Debt principal repayment for example does NOT appear on the Income Statement as it relates to the current period but it is NOT tax-deductible. Whereas with interest expense, for example, both of these conditions are true as it IS tax-deductible and it IS corresponding to the current period, thus, interest expense DOES appear on the Income Statement. “

Question 2

Why is the Cash Flow Statement the most important financial statement?

Answer 2

The CFS is the most important because that’s what tells you whether or not the company is truly generating cash, i.e. after-tax, cash, profit, on an ongoing basis. The Income Statement is deceptive because it can include non-cash expenses and non-cash sources of revenue and can also exclude real cash expenses such as CapEx. And while the Balance Sheet tracks changes in cash, it doesn’t necessarily tell you how and why those changes occurred.

Question 3

“Which of the following items could NEVER be a Long-Term Liability?
1) Deferred Revenue; 2) Accounts Payable; 3) Debt; 4) Pension Obligations”

Answer 3

Deferred Revenue and Debt can both be Short-Term or Long-Term, so they can show up under both Current Liabilities and Long-Term Liabilities. Pension Obligations is a common Long-Term Liability, although many companies group it together with other items. So that leaves B as the only correct answer. Even if Accounts Payable are long overdue (i.e. over a year late), they are simply not listed as a Long-Term Liability - and in 99% of cases they are paid off in far less time than that.

Question 4

“Which of the following would NEVER show up in Cash Flow from Operations?
1) Add-Back for Stock-Based Compensation; 2) Add-Back for Depreciation & Amortization; 3) Add-Back for Cash Interest Expense; 4) Cash Flow Deduction for Increase in Accounts Receivable”

Answer 4

By definition, the CFO section is for adding back non-cash expenses that appeared on the IS, or for deducting true cash expenses that did NOT appear there – and the opposite for non-cash income and cash income sources. Both SBC and D&A qualify as non-cash expenses that should be added back. And AR counts as a non-cash source of income because you’ve recorded it as revenue but haven’t collected the cash yet. By contrast, cash interest expense is a true cash expense that appears on the IS, is tax-deductible, and does not need any type of adjustment on the Cash Flow Statement.

Question 5

What’s the difference between Accounts Payable and Accrued Expenses?

Answer 5

They work the same in terms of accounting mechanics - when they increase, you increase Income Statement expenses but then on the Cash Flow Statement you add them back because you haven’t paid anything in cash yet. And when they decrease, you leave the Income Statement alone but reduce the Balance Sheet line item and reduce cash on the other side of the Balance Sheet to reflect the cash payout. The difference lies in what they mean, as explained as “Accounts Payable is more common for one-time purchases, whereas Accrued Expenses is more common for recurring items like rent, utilities, and salaries.

Question 6

What’s the difference between Accounts Receivable and Deferred Revenue?

Answer 6

With Accounts Receivable the cash has not yet been collected but with Deferred Revenue it has already been collected in advance. With Accounts Receivable the service or product has already been delivered and with Deferred Revenue the company has not yet delivered the service or product.

Question 7

What’s the purpose of Income Taxes Payable?

Answer 7

To reflect taxes that have been accrued in the ordinary course of business and which will be paid out in cash in the near future (i.e. if the company pays taxes 4 times per year, for accrued taxes in the periods in between those dates).

Question 8

How do Prepaid Expenses and Accounts Payable differ from each other?

Answer 8

Prepaid Expenses have been paid out in cash in advance for products/services that will be delivered in the future, such as insurance. As the products/services get delivered, the corresponding expenses show up on the Income Statement according to the matching principle of accounting. With Accounts Payable, the service has already been delivered and the Income Statement expenses has already been recorded, bu the company has not yet paid it in cash. For example, it orders legal services from a law firm, records the expense on the IS, and receives the invoice but has not yet paid the invoice in cash.

Question 9

Name an example of an expense that should be capitalized rather than expensed.

Answer 9

Purchasing a new factory, since it will last for more than 1 year, this is a valid example because you always capitalize the purchase of long-term assets such as factories and label it “Capital Expenditures” or CapEx.

Question 10

Since Goodwill is no longer amortized, once a company acquires another company, pays a premium for it over its Book Value, and creates Goodwill, the Goodwill number on its Balance Sheet will never change. True or False? Why?

Answer 10

The company could always record a Goodwill Impairment and acknowledge that the acquired company’s vaue has declined. Goodwill rarely changes and is certainly not a predictable, recurring event, but it does happen. So it’s false to say that it “will never change” - it’s more accurate to say that “it will rarely change”.

Question 11

When you purchase Long-Term Securities, that’s classified under CF from Investing, but when you purchase Short-Term Securities, those go under CF from Operations since they relate to Current Assets, not Long-Term Assets. True or False?

Answer 11

Generally, yes, Cash Flow from Investing relates to Long-Term Assets… but not always. If a Current Asset is not operational in nature (i.e. Short-Term Equities or Fixed Income Investments), purchasing or selling it will still be classified as an investing activity. So you can’t use this rule of thumb for everything - you have to think about what the item means and whether it’s related to operations, investing, or financing.

Question 12

“Which of the following items would NEVER show up in the Changes in Working Capital (AKA Changes in Operating Assets and Liabilities) section of the Cash Flow Statement.
1) The Net Change in Cash; 2) Repayment of Short-Term Debt; 3) Purchases of Investments; 4) All over the above - i.e. NONE of these items would show up in this section”

Answer 12

You never list the change in cash here because you calculate that change in cash at the bottom of the CFS - doing it here would be double-counting it. Debt-related items never show up in this section either because they are related to the financing of the company and not its operations. Regardless of whether it’s Short-Term or Long-Term Debt, it never shows up here. Finally, purchases of investments, whether Short-Term or Long-Term, also never show up here because they are related to the company’s investing activities.

Question 13

What’s the purpose of Changes in Working Capital section of the Cash Flow Statement?

Answer 13

“To track the inflows and outflows from any Balance Sheet line items that haven’t been reflected on the Income Statement due to accrual accounting.

Changes to items like Accounts Receivables, Accounts Payables, and so on do not appear on the Income Statement due to accrual accounting. You CAN potentially have longer-term items here as well - for example, Long-Term Deferred Revenue will still show up in this section even if it is technically a ““Long-Term Liability””. So beware of sources that claim that it’s ONLY for Current Assets and Current Liabilities. That is not correct, and the distinction is more about operational vs. investing vs. financing activities than Short-Term vs. Long-Term. The impact of non-cash expenses on cash flow or shown in the section above the Changes in Working Capital.”

Question 14

A company has negative Operating Working Capital, meaning that (Current Assets Excluding Cash & Equivalents) Minus (Current Liabilities Excluding Debt) is a negative number. This will ALWAYS indicate that the business is suffering. Is this True or False?

Answer 14

Negative OWC may indicate this, but it could also be a sign of business efficiency - for example, a company collects cash upfront for services that get delivered later, so its Deferred Revenue balance is very high, and it has very low Accounts Receivable because it’s not waiting to receive cash from customers. So you have to analyze their business model and see what’s causing OWC to be negative before drawing conclusions. Not all Current Liabilities necessarily imply that the company will owe huge sums of money in the future.

Question 15

You see a Noncontrolling Interest (AKA Minority Interest) of $30 on a company’s Balance Sheet. What could this mean?

Answer 15

Noncontrolling Interests are for situations where one company owns more than 50% but less than 100% of another company. The line item itself reflects the value of the portion that they DO NOT own. So in this, if the other company is worth $100 and they own 70%, they DO NOT own 30%, which is worth $30.

Question 16

You see an Investments in Equity Interests (AKA Associate Companies) line item of $30 on the Assets side of a firm’s Balance Sheet. What does this mean?

Answer 16

Investments in Equity Interests (Associate Companies) represent scenarios where a company owns between 20% and 50% of another company. They belong on the assets side of the Balance Sheet and represent the value of the percentage ownership the company has. So it is straightforward: $30 means they could own 30% of another company worth $100 (or 3% of a company worth $1,000 etc.)

Question 17

Retained Earnings represents the saved up, after-tax earnings of a company after what they have distributed to shareholders in the form of Dividends. Why doesn’t CapEx impact the Retained Earnings?

Answer 17

“Because CapEx impacts the Net PP&E and Cash numbers on the Assets side - making it affect Retained Earnings would be double-counting it. Also because CapEx is a line item related ot the long-term assets and investments of a company as opposed to its financing activities, so linking anything in Shareholders’ Equity would not make sense.

Retained Earnings is ONLY impacted by Net Income and Dividends (and possible other accounting adjustments) and NOTHING ELSE. Retained Earnings doesn’t really ““mirror”” cash on the assets side and they’re not necessarily closely linked - they represent different concepts altogether. Cash is what the company as a whole has saved up, while Retained Earnings is more about what’s available to Shareholders!”

Question 18

Two companies have the same Net Income, but different Depreciation numbers. Which one will have the higher Cash Flow from Operations, assuming all else is equal?

Answer 18

“The one with the higher Depreciation number!
If Net Income is the same and everything else is also the same, the one with higher Depreciation will also have a higher Cash Flow from Operations since you add back the Depreciation on the Cash Flow Statement. Tax rates are irrelevant because we already know that Net Income is the same. And you add back the entire Depreciation number, not the tax-adjusted one, so we don’t need additional information to answer this.”

Question 19

Debt issuances and repayments are classified under CF from Financing on the CFS. Why don’t interest payments show up there?

Answer 19

“1) Because interest payments are tax-deductible and therefore appear on the IS, whereas debt issuances and repayments do not impact taxes and therefore don’t appear on the IS

2) Because interest payments are only for the current period, whereas issued debt may last for years and debt that is repaid may be due years into the future.
3) Because interest payments have already been reflected in Net Income and we don’t need to make further adjustments since they’re true cash expenses.

Everything above is the reasons stated. If an expense is tax-deductible, corresponds to the current period, and has already been reflected on the Income Statement, then you only reflect it on the Cash Flow Statement if it’s a non-cash expense such as Depreciation. But Interest Expense is a real cash expense so we don’t need to adjust anything. And it does not count as a financing activity because paying interest is simply dealing with the after-effects of financing activities. “

Question 20

A company needs to purchase additional Inventory to meet unexpectedly high demand for its products. What’s the most likely source of funding for this Inventory?

Answer 20

“Cash from Ordinary Business Operations.
Generally, you fund Current Assets with Current Liabilities or with Cash on-hand. Issuing Long-Term Debt or new Equity therefore doesn’t make much sense since both of those are long-term items. Those would be more likely if it’s an exceptionally large amount of inventory and no other funding source would suffice. While a Revolver is a current liability, generaly a company will not draw on debt to fund inventory unless it lacks the cash to do so and is truly facing an emergency.”

Question 21

Writing down OWED debt (the Liability) will produce a Gain on the Income Statement, and therefore result in a higher Pre-Tax Income and Net Income. If that’s the case, why don’t companies frequently write down their debt?

Answer 21

“Because lenders would stop trusting them to repay their debt and would make future borrowing difficult / impossible if they did this frequently.

Ultimately, it is all an issue of trust, credibility, and being able to borrow in the future. Yes, writing down a liability produces a Gain on the Income Statement (the opposite of writing down an asset) but that doesn’t mean it’s a good idea to do it all the time - it’s an accounting trick that will have a negative long-term impact on the company. So it is best used cautiously, and only when the market value of debt truly has fallen significantly.”

Question 22

Why do you add back the entire amount of each non-cash expense that affects the Income Statement on the Cash Flow Statement?

Answer 22

“Because you want to reflect that you save on taxes with these expenses, but that they don’t impact your cash balance aside from the tax saving.

It’s easiest to understand this with an example. Let’s say we have a Depreciation Expense of $10 and a tax rate of 40%, Depreciation is non-cash but it is tax-deductible, so we have $4 on taxes. On the Income Statement, our Net Income is also lower by $6 as a result. On the Cash Flow Statement, we then add back the entire amount of $10, meaning that our cash has now increased by $4, corresponding to the $4 in tax savings we achieved. That is the end result of any non-cash expense: your cash balance increases by the taxes you’ve saved, but nothing else changes. “

Question 23

“Which of the following scenarios would NOT necessarily result in an increase in Deferred Revenue?

1) Delivering a product to a customer, sending an invoice, and waiting on his payment.
2) Selling a 3-year cellular data plan to a customer, since the service will be delivered in the future.
3) Both of the above.
4) Neither of the above.”

Answer 23

The first option refers to Accounts Receivable - delivering something in advance but then waiting on the cash payment. With B, the possible change in Deferred Revenue depends on whether or not the customer has paid in advance. If the customer is going to pay each month over that 3-year period it would not count as Deferred Revenue. It would only count as Deferred Revenue if the customer pays for all 3 years upfront in cash. Therefore, the first option will definitely not result in Deferred Revenue increasing, and the second option will not necessarily result in Deferred Revenue increasing, so it is the third option, Both of the Above.

Question 24

Depreciation goes up by 10. How much does the cash balance change by (assume a 40% tax rate)?

Answer 24

“4
On the Income Statement, Pre-Tax Income is reduced by 10, and at a 40% tax rate Net Income is down by 6. On the CFS, Net Income is down by 6 at the top and you add back the Depreciation charge of 10, so cash at the bottom is up by 4. Then on the Balance Sheet, cash is up by 4 on the assets side, the PP&E balance is down by 10, and so the assets side is down by 6 overall. On the other side, Shareholders’ Equity is down by 6 due to the 6 reduction in Net Income. Intuition: Depreciation is a non-cash expense that reduces our tax bill but which we don’t have to actually pay for in cash, so that’s why cash increases.”

Question 25

You recognize an Accrued Expense of 10. How much does your cash balance change by (assume a 40% tax rate)?

Answer 25

“4
On the Income Statement, Pre-Tax Income is down by 10 and Net Income is down by 6 at a 40% tax rate. On the Cash Flow Statement, Net Income is down by 6. And since Accrued Expenses is a liability, the increase of 10 represents an increase of cash, so cash at the bottom of the CFS is up by 4. On the Balance Sheet, Cash is up by 4, Accrued Expenses on the other side is up by 10, and Shareholders’ Equity is down by 6 due to the Net Income reduction, so both sides are up by 4 and balance. Intuition: We’ve recognized the expense and have paid taxes on it but haven’t paid it out in cash yet… so we need to adjust our cash upward to reflect that we’ve only paid for the taxes on this expense.”

Question 26

You pay out an Accrued Expense of 10. If you do not take into account any previous Accrued Expense increases, how much does the cash balance change by (assume a 40% tax rate)?

Answer 26

“(10)
On the Income Statement, there are no changes. On the Cash Flow Statement, the change in Accrued Expenses in the CFO section is negative 10 because you pay it out in cash, and so the cash at the bottom decreases by 10. On the Balance Sheet, Cash is down by 10 on the assets side and Accrued Expenses is down by 10 on the other side. Intuition: We’ve already recognized this expense, so there are no Income Statement changes. All that changes is our cash position – we’re now paying it out in cold, hard cash. NOTE: This assumes we haven’t already made the changes outlined in question #2 – if we had, then the cash balance would decrease by 6 rather than 10 due to taxes.”

Question 27

You order 10 worth of inventory and pay for it with cash. You have not yet manufactured or sold any of the goods that this Inventory corresponds to. How much does Net Income change by?

Answer 27

“0
Inventory only affects the Income Statement when it’s manufactured into products and sold to customers. Otherwise, simply ordering Inventory has no impact. So nothing on the IS changes. On the CFS, the 10 addition to Inventory reduces cash by 10, so cash at the bottom is down by 10. On the Balance Sheet, Cash is down by 10 and Inventory is up by 10 and they’re both on the assets side, so the changes cancel out and the Balance Sheet balances. Intuition: See the preceding explanation – with changes like this always think, “Does it affect my revenue and/or expenses?” And if the answer is no, then it doesn’t belong on the Income Statement.”

Question 28

You order 10 worth of inventory and pay for it using Debt. How much does the cash balance change by immediately after we order the Inventory (assume a 40% tax rate)?

Answer 28

“0
Once again, there are no changes on the IS because no products have been sold yet, and no interest has been paid on the Debt yet. On the CFS, Inventory going up by 10 reduces cash by 10, but the Debt issuance shows up as a 10 addition to cash in Cash Flow from Financing. At the bottom, there are no net changes in cash. On the Balance Sheet, Cash has not changed but Inventory is up by 10 on the assets side and Debt is up by 10 on the other side so everything balances.

Intuition: Once again, simply ordering Inventory affects nothing on the IS until it is sold. And Debt also has no IS impact until the company starts paying interest on it.”

Question 29

Accounts Receivable increases by 10. By how much does the cash balance change (assume a 40% tax rate)?

Answer 29

“(4)
If AR “increases” by 10, that really means that we’ve recorded revenue of 10 but haven’t received it in cash yet. So on the IS, revenue is up by 10 and so is Pre-Tax Income, which means that Net Income is up by 6 assuming a 40% tax rate. On the CFS, Net Income is up by 6 but the AR increase is a reduction in cash, so we need to subtract the 10, which results in cash at the bottom being down by 4. On the Balance Sheet on the assets side, Cash is down by 4 and AR is up by 10, so the assets side is up by 6. On the other side, Shareholders’ Equity is up by 6 because Net Income has increased by 6. Intuition: When AR increases, it means that we’ve paid taxes on additional revenue but haven’t received any of that revenue in cash yet… so our cash balance decreases by the additional amount of taxes we’ve paid.”

Question 30

Accounts Receivable decreases by 10. If you do not take into account any previous AR increases, how much does the cash balance change by (assume a 40% tax rate)?

Answer 30

When AR “decreases” by 10 it means that we’ve collected cash from customers, and that the cash has already been recorded as revenue. So nothing on the Income Statement changes. On the CFS, a decrease in AR boosts cash, so cash is up by 10 and that’s the only change. On the BS, cash is up by 10 and AR is down by 10, so the changes cancel each other out and the Balance Sheet remains in balance. Intuition: See preceding explanation. A decrease in AR corresponds to a cash collection of revenue that has already been recorded, so cash changes with no impact on taxes. NOTE: Once again, if we had a previous increase of 10 here, then cash would only be up by 6.

Question 31

Prepaid Expenses increases by 10. How much does the cash balance change by (assume a 40% tax rate)?

Answer 31

“(10)
Prepaid Expenses refers to expenses that have been paid out in cash in advance, but which have not yet been recognized on the Income Statement. So there are no changes on the IS. On the CFS, since Prepaid Expenses is an asset, an increase of 10 reduces cash by 10, and with no other changes, cash at the bottom is down by 10. On the BS, Cash is down by 10 on the assets side and Prepaid Expenses is up by 10, also on the assets side, so the BS remains in balance. Intuition: See preceding explanation. An increase in Prepaid Expenses means that we pay out cash in advance with no corresponding IS expenses yet. One common example is paying for 1-2 years of an insurance policy upfront in cash and then recognizing the expense over time as it is delivered.”

Question 32

Prepaid Expenses decreases by 10. If you do not take into account any previous increases in Prepaid Expenses, how much does the cash balance change by (assume a 40% tax rate)?

Answer 32

“4
When Prepaid Expenses “decreases,” it means that some of these expenses are now recognized on the Income Statement. On the IS, Pre-Tax Income is therefore down by 10, and Net Income is down by 6. On the CFS, Net Income is down by 6 but since Prepaid Expenses is an asset, a decrease of 10 results in an increase of 10 in cash. At the bottom of the CFS, cash is up by 4 as a result. On the BS, on the assets side Cash is up by 4 and Prepaid Expenses is down by 10, so the assets side is down by 6 overall. On the other side, Shareholders’ Equity is down by 6 because of the Net Income Reduction so both sides balance. Intuition: Here, we’re losing Net Income and paying additional taxes… but oh, wait, we’ve already paid out these expenses in cash previously! So actually, our cash balance goes up rather than down, despite the additional expenses on the IS. NOTE: Once again, if we took into account the cumulative changes then cash would be down by 6 instead because when you initially increase Prepaid Expenses by 10, cash decreases by 10.”

Question 33

Deferred Revenue increases by 10. How much does the cash balance change by (assume a 40% tax rate)?

Answer 33

“10
When Deferred Revenue “increases,” that means that we’ve collected cash from a customer but haven’t recorded it as revenue yet. So there are no changes on the Income Statement. On the CFS, since DR is a liability, an increase of 10 will boost cash by 10, and so cash at the bottom is up by 10. On the BS, Cash is up by 10 on the assets side and Deferred Revenue is up by 10 on the other side so it remains in balance. Intuition: An increase in Deferred Revenue means that we’ve collected cash from a customer but haven’t recognized the revenue yet – so there’s no revenue, tax, or expense impact.”

Question 34

Deferred Revenue decreases by 10. If you do not take into account previous increases in Deferred Revenue, how much does cash change by (assume a 40% tax rate)?

Answer 34

“(4)
Now, we’re now recognizing the Deferred Revenue as real revenue. On the IS, revenue increases by 10, as does Pre-Tax Income at the bottom, and so Net Income is up by 6. On the CFS, Net Income is up by 6 but Deferred Revenue has decreased by 10, which makes cash decrease by 10. At the bottom, cash is down by 4. On the Balance Sheet on the assets side, Cash is down by 4, and on the other side, Deferred Revenue is down by 10 but Shareholders’ Equity is up by 6 because of the Net Income increase, so both sides are down by 4 and the Balance Sheet balances. Intuition: Here, we’ve already collected this cash… so in addition to paying more taxes on the IS, we also need to adjust for the fact that we haven’t received any new cash for this added revenue. Combined, those two changes push down the cash balance. NOTE: Once again, if you take into account the cumulative change and the initial 10 increase in cash, cash is up by 6.”

Question 35

Walk me through a PP&E write-down of 10, how does the cash balance change at the end (assume a 40% tax rate)?

Answer 35

“4
The PP&E write-down is a non-cash expense that shows up on the Income Statement, just like Depreciation. So it reduces Pre-Tax Income by 10 and it reduces Net Income by 6 assuming a 40% tax rate. On the CFS, Net Income is down by 6, but the write-down itself is a non-cash charge, so we add back the 10, and cash at the bottom is up by 4. On the Balance Sheet, cash is up by 4 on the assets side but PP&E is down by 10 because of the write-down, so the assets side is down by 6 overall. On the other side of the BS, Shareholders’ Equity is also down by 6 because of the Net Income reduction. Intuition: Mechanically, a PP&E write-down is no different from Depreciation – it saves you on taxes without costing any real cash. The difference, though, is that write-downs are unexpected and non-recurring items, whereas Depreciation follows a predictable schedule.”

Question 36

A company issues Dividends of 10. How much does Net Income change by (assume a 40% tax rate)?

Answer 36

“0
Dividends NEVER affect the Income Statement – they are a financing activity and they are not tax-deductible, so by definition they do not show up on the IS. On the CFS, there is a 10 reduction in cash flow in the Cash Flow from Financing section, so cash at the bottom is down by 10. On the Balance Sheet, Cash is down by 10 on the assets side, so the entire assets side is down by 10. On the other side, Shareholders’ Equity (Retained Earnings specifically) is down by 10, so both sides balance.”

Question 37

People often claim that there’s double taxation on Dividends - shouldn’t that be reflected in the taxes somewhere?

Answer 37

“Dividends are paid with after-tax profits, and then the shareholders that receive them are taxed individually as well – that is what’s meant by the “double tax.”

A company must pay corporate income taxes on its Pre-Tax Income before issuing Dividends. So effectively, you are always starting with Net Income before you can even think about Dividends – that’s tax #1. Then, after adjusting for non-cash charges, working capital, investing activities, and other items on the Cash Flow Statement, Dividends are deducted in the Cash Flow from Financing section. When individual shareholders receive the Dividends, they are then taxed on the proceeds, which is tax #2. The “double taxation” refers to how Dividends themselves come from after-tax profits, and how shareholders are also taxed when they receive them. There is one exception here for Real Estate Investment Trusts (REITs) – they do not pay corporate-level income taxes – but the description above is how Dividends work in all other cases. Answer C is true, but it doesn’t answer the whole question so it’s incorrect; D is completely false because Dividends are never tax-deductible, so that’s wrong.”

Question 38

Walk me through how Other Intangible Assets are amortized. Assume that there’s amortization of 10 in one year - how does cash change at the end of the year (assume a 40% tax rate)?

Answer 38

Amortization is a non-cash expense that shows up on the Income Statement. Pre-Tax Income is therefore reduced by 10, and Net Income falls by 6. On the CFS, Net Income is down by 6 but you add back the 10 of Amortization because it’s a non-cash expense, so cash at the bottom is up by 4. On the Balance Sheet, cash is up by 4 but Other Intangible Assets is down by 10, so the assets side is down by 6. The other side is also down by 6 because Shareholders’ Equity has been reduced by 6 due to the lower Net Income.

Question 39

A company goes into distress and we “bail it out” by purchasing 10 of additional Preferred Stock, similar to what government have done with banks in the past. What happens immediately after the company issues the Preferred Stock?

Answer 39

“No changes on the Income Statement; the Preferred Stock issuance results in additional cash at the bottom of the CFS, and on the BS there’s additional cash on the assets side and additional Preferred Stock to balance it on the other side.

Similar to issuing Debt, when you issue Preferred Stock there are no immediate changes on the IS because you don’t pay interest or Dividends right away. Preferred Stock is a part of Shareholders’ Equity on the Liabilities & Equity side of the BS, so that increases and cash increases on the other side. The Preferred Stock issuance itself also shows up as a cash inflow under Cash Flow from Financing on the CFS. Answer A is incorrect because there are no Preferred Stock Dividends yet and even when they are issued, they come from after-tax profits, just like normal Dividends. C is incorrect because Preferred Stock and Debt are not grouped together. And D is incorrect because Preferred Stock is always a visible, on-Balance Sheet item.”

Question 40

A company issues 10 worth of Stock-Based Compensation to employees. Walk me through how the 3 statements change, and state how cash is different afterward (assume a 40% tax rate).

Answer 40

Stock-Based Compensation is a non-cash expense that reflects the value of stock and options issued to employees. Since it is a non-cash expense, you reduce Pre-Tax Income on the IS and you add it back on the CFS. On the BS, it flows directly into Common Stock & APIC because those items reflect the market value of stock issued at the time that it was issued. It would not make sense to link Stock-Based Compensation to Retained Earnings because Retained Earnings is only affected by Net Income and Dividends.

Question 41

A company issues 100 shares of stock at $10 per share, recording an addition of $1000 to Common Stock & APIC and $1000 of Cash on the Assets side. Now the share price increases to $20 – how does the Balance Sheet change?

Answer 41

“It doesn’t change – you only reflect the price that a company’s stock was at when it issued shares.

Common Stock & APIC only reflects the value of the shares that were issued at the time they were issued. Subsequent stock price changes don’t affect anything, so B is incorrect. C is incorrect because no additional information is required – there are no changes whatsoever. Finally, D is incorrect because unrealized gains and losses are for the company’s investments in other assets / companies / entities, not its own shares.”

Question 42

A company repurchases $100 worth of its own shares. How do the 3 statements change immediately afterward?

Answer 42

“No changes on the IS; cash flow reduction of $100 in Cash Flow from Financing on the CFS, and cash on the assets side declines by $100, with Treasury Stock within Shareholders’ Equity on the other side also declining by $100 to balance it.

Nothing ever changes on the Income Statement immediately after you repurchase shares because Earnings Per Share (EPS) is not actually an official line item on the IS – Net Income is the “bottom line” and EPS is usually just shown for informational purposes. Also, EPS tracks what happens over a period of time so there would not be an “immediate change” there even if you do count it as an official IS line item. Repurchasing shares is a financing activity, so it’s a cash flow reduction in Cash Flow from Financing on the CFS, and you reduce Cash on the assets side and Treasury Stock on the other side to reflect the change. C is incorrect because the financial statements do change because you do reflect the value of the stock repurchased – just not the number of shares themselves. D is incorrect because share repurchases are always reflected in Treasury Stock, not Common Stock & APIC. Treasury Stock represents the shares that the company has “bought back” from the market and is now keeping internally.”

Question 43

A company has a factory valued at 100 on its Balance Sheet. It sells the factory for 120. How much does its Assets side change by immediately after it sells the factory (assume a 40% tax rate)?

Answer 43

“12

In this scenario, we sell PP&E for 100 and also record a Gain of 20 on the sale. The Gain of 20 shows up on the Income Statement and increases Pre-Tax Income by 20, also increasing Net Income by 12 as a result. On the CFS, Net Income is up by 12, but we subtract out the Gain of 20 in Cash Flow from Operations, so we’re down by 8 so far. Then, in Cash Flow from Investing, we record the sale of the factory for 120, which adds 120 to our cash flow. Cash is up by 112 at the bottom of the CFS. On the Balance Sheet, Cash is up by 112 on the assets side, but PP&E is down by 100 because we’ve sold the factory for 100, so overall we’re up by 12. On the other side, Retained Earnings is up by 12 because of the increased Net Income, so both sides are up by 12 and balance.”

Question 44

The cost of a company’s Inventory has been increasing each month. If the company wants to show a higher Net Income to shareholders, should it use Last-In-First-Out (LIFO) or First-In-First-Out (FIFO) to record its Cost of Goods Sold (COGS)?

Answer 44

“FIFO

Regardless of the system used, the Revenue and Operating Expenses stay the same – only COGS is different. If the costs of Inventory have been increasing, that means that the earlier amounts were less expensive. With FIFO, you start with the earliest costs first and so you are guaranteed to record a lower COGS number under FIFO if costs have been rising each month for the past year. Since COGS is lower, Pre-Tax Income and Net Income are both higher under FIFO. C is incorrect because you don’t need all the expense data – just a guarantee that expenses have been increasing each month. D is incorrect because a blended approach would make Net Income somewhere in the middle between the LIFO and FIFO approaches.”

Question 45

Let’s say that a company is currently using LIFO. Now it switches to FIFO – walk me through how Net Income, Inventory, and Cash all change.

Answer 45

“Notice how COGS is lower under FIFO because we’re using $100 + $120 + $150 + $170, as opposed to $120 + $150 + $170 + $200 under LIFO. Since COGS is lower for FIFO, Pre-Tax Income and Net Income are both higher. Therefore, we can rule out D as the correct answer. Now, what does the ending Inventory look like under each of these methods?
Inventory is higher under FIFO since the COGS expense is lower, so we can rule out B as the correct answer. Now, what about the change in Cash and the Balance Sheet? We’ll create a “mini Cash Flow Statement” first to track the change in Cash:

So Cash increases with both methods, but it’s a smaller increase under FIFO. Inventory increases under FIFO, whereas it stays the same under LIFO. Remember that on the Cash Flow Statement, an increase in Inventory reduces cash flow, which is why it’s negative at the top of the screenshot above. Under LIFO the assets side increases by $60; the other side also increases by $60 due to the $60 of additional Net Income. Under FIFO the assets side increases by $120, and Shareholders’ Equity on the other side also increases by $120.”

Question 46

“Let’s say that a company buys a factory worth 100, using 100 of debt with a 10% interest rate and 10% principal repayment each year. The factory also depreciates at 10% per year. How much does cash change by immediately after it purchases the factory (assume a 40% tax rate)?

Now let’s go a step further and look at what happens after the end of the first year. Walk me through what happens on the 3 financial statements- how much does cash change by after one year (assume a 40% tax rate)?

At the end of year 2, in addition to the Interest Expense and Depreciation for that year, the factory is sold off at Book Value and the Debt is repaid. What is the overall change in cash from the initial state in question 1 to the end of year 2 (assume a 40% tax rate)?”

Answer 46

“Immediately afterward, there are no Income Statement changes because there’s no Interest Expense or Depreciation yet. On the CFS, under Cash Flow from Investing there’s a cash reduction of 100 due to the factory purchase but under Cash Flow from Financing there’s an addition of 100 due to the debt, so the changes cancel each other out and there’s no net change in cash. On the Balance Sheet, PP&E is up by 100 and Debt is up by 100 on the other side to balance. There are no cash changes and no changes in revenue, expenses, or taxes yet.

On the Income Statement, there’s an additional Interest Expense of 10 and Depreciation of 10, so Pre-Tax Income is down by 20, and Net Income is down by 12 assuming a 40% tax rate. On the CFS, Net Income is down by 12 but we add back the Depreciation of 10, so Cash Flow from Operations is down by 2. There are no changes to Cash Flow from Investing, but under Cash Flow from Financing we repay 10 worth of debt due to the 10% principal repayment, so cash at the bottom, overall, is down by 12. On the Balance Sheet, cash is down by 12 but PP&E is down by 10 due to the Depreciation, so the assets side is down by 22. On the other side, Debt is down by 10 due to the principal repayment, and Shareholders’ Equity is down by 12 due to the reduced Net Income, so the liabilities & equity side is down by 22 and both sides balance.

We have an additional 9 of Interest Expense (since the starting Debt principal is now 90 rather than 100) and 10 of Depreciation on the Income Statement, which pushes Pre-Tax Income down by 19 and Net Income down by 11. On the CFS, Net Income is down by 11 and we add back the Depreciation of 10, so CFO is down by 1. We sell the factory for 80 under Cash Flow from Investing because it’s now only worth 80 after 2 years of Depreciation at 10 per year. So cash is up by 79. Under Cash Flow from Financing, we repay 10 worth of debt naturally over the course of the year, and then we repay the entire remaining balance of 80 at the end of the year. Cash Flow from Financing is down by 90 as a result, and so our cash at the bottom is down by 11. On the BS, cash is down by 11 and PP&E is down by 90 so we’re down by 101 overall. On the other side, Debt is down by 90 and Net Income is down by 11 so we’re also down by 101 and both sides balance. Remember, though, we want the cumulative change in cash: it was also down by 12 in year 1, so the net effect is that it’s down by 23 over that 2-year period.”

Question 47

“A company orders 100 worth of Inventory, using cash, and then sells 50 of the Inventory for revenue of 150, at a cost of 50. How much does cash change by at the end of this scenario (assume a 40% tax rate)?

The company has 50 in remaining Inventory – but auditors determine that it’s worth 0 because it has been sitting around too long. What is the cumulative change in cash following step 1 above AND this write-down (assume a 40% tax rate)?”

Answer 47

“10
Initially, there are no IS changes because they just order Inventory, so cash is down by 100 and Inventory is up by 100. When they sell the products, they record revenue of 150 and COGS of 50, so Pre-Tax Income is up by 100. At a 40% tax rate, Net Income is up by 60. On the CFS, Net Income is up by 60, but Inventory has decreased by 50, so we record that as an addition to cash. As a result, cash at the bottom is up by 110. On the BS, initially cash was down by 100 after the Inventory purchase and now it’s up by 110 – so cash is now up by 10. Inventory is down by 50 in this step, but overall it’s still up by 50 due to the previous order of 100. So the assets side is up by 60. On the other side, Shareholders’ Equity is also up by 60 because of the increased Net Income, so both sides balance. Intuition: This scenario reflects the fact that companies mark up the price of goods when they sell them. Here, we have a mark-up of 100 (150 in revenue – 50 in costs), which equates to 60 in additional after-tax profits.

10
A write-down of 50 reduces Pre-Tax Income by 50, also reducing Net Income by 30. On the CFS, Net income is down by 30 but the write-down was a non-cash charge, so we add it back and cash flow is now up by 20. At the bottom, cash is up by 20. On the BS, cash is up by 20 and Inventory is down by 50, so the assets side is down by 30. On the other side, Shareholders’ Equity is down by 30 due to the reduction in Net Income. However, remember that cash was up by 10 in the first step of this scenario. So now cash is up by another 20, which brings the total increase to 30. Intuition: This is a non-cash charge that reduces our tax bill, so we reflect the 40% tax savings on the write-down but nothing else.”

Question 48

“A company goes public and raises 100 by issuing shares to new investors. Immediately afterward, it also issues 10 in Stock-Based Compensation to its employees. How much does cash change by immediately afterward (assume a 40% tax rate)?

Now the company’s management decides that its shares are undervalued, and decides to repurchase 200 worth of shares. What is the cumulative change in cash after the IPO, Stock-Based Compensation, and now the Share Repurchase (assume a 40% tax rate)?”

Answer 48

“104
On the IS, the SBC reduces Pre-Tax Income by 10 and Net Income by 6. On the CFS, Net Income is down by 6 but SBC is a non-cash expense so we add it back, and Cash Flow from Operations is up by 4. Under Cash Flow from Financing, we record the 100 of proceeds from the IPO, so cash at the bottom is up by 104. On the BS, cash is up by 104 so the entire assets side is up by 104. On the other side, Common Stock & APIC goes up by 100 due to the IPO, and then goes up by 10 due to the Stock-Based Compensation. However, Retained Earnings falls by 6 due to the reduced Net Income, so overall Shareholders’ Equity is up by 104 and both sides balance.

(96)
Nothing on the IS changes as a result of the Share Repurchase. On the CFS, Cash Flow from Financing shows a reduction of 200, so cash at the bottom is down by 200. On the BS, cash is down by 200 on the assets side and Treasury Stock is down by 200 on the other side. But from our previous scenario, you know that cash was initially up by 104. 104 minus 200 = negative 96, meaning that our cash has decreased by 96 over this multi-step scenario.”

Question 49

Now the same company’s share price falls by 50%. What is the change in cash (assume a 40% tax rate)?

Answer 49

“0
For the umpteenth time, share prices changes after shares have already been issued or stock-based compensation has already been awarded do not make a difference on the financial statements. All that matters is the share price at the time of the issuance and how much capital traded hands as a result.”

Question 50

A company raises 100 worth of Debt, at 5% interest and 0% principal repayment, to buy 100 worth of Short-Term Securities, which have 15% interest (they’re extremely risky investments). How much does cash change by at the end of year 1 (assume a 40% tax rate)?

Answer 50

“6
On the Income Statement, we have 15 worth of Interest Income and 5 worth of Interest Expense, so Pre-Tax Income is up by 10 and Net Income is up by 6. On the CFS, Net Income is up by 6 and under Cash Flow from Investing we record a reduction of 100 in cash to reflect the securities purchased. Under Cash Flow from Financing, we record the 100 in additional cash flow from raising the debt. So at the bottom, cash is up by 6. On the BS, Cash is up by 6 and Short-Term Securities is up by 100 on the assets side, so the assets side is up by 106. On the other side, Debt is up by 100 and Shareholders’ Equity is up by 6 due to the increased Net Income. Therefore, both sides are up by 106 and balance. Intuition: This simply reflects the additional after-tax profits from 10 in Net Interest Income (Interest Income minus Interest Expense).”

Question 51

At the end of year 1, the company decides to sell the 100 of Short-Term Securities. However, they actually get a higher price and sell it for 110. What is the cumulative (also reflecting what happens in step 1) change in cash (assume a 40% tax rate)?

Answer 51

“106
This represents a Gain of 10, so Pre-Tax Income increases by 10 and Net Income increases by 6. On the CFS, Net Income is 6 higher but you have to subtract the Gain of 10, so CFO is down by 4. In Cash Flow from Investing, we show a cash inflow of 110 because of the sale of the Short-Term Securities. Overall, cash at the bottom is up by 106. On the BS, cash is up by 106 but Short-Term Securities is down by 100, so the assets side is up by 6. On the other side, Shareholders’ Equity is also up by 6 because of the increased Net Income. But remember that cash was initially up by 6 in the first step of this scenario. So now cash is up by 112 (increase of 6 + increase of 106). Intuition: This reflects the 6 in additional after-tax profits from step 1 as well as the 6 in after-tax profits from the Gain on the Sale of these securities.”