BIWS Accounting Questions

Question 1

Describe the three financial statements, listing major items on each

Answer 1

The Income Statement shows a company’s profit and loss and includes Revenue and expenses such as COGS (variable costs), SG&A (fixed costs), D&A, Other Income/Expense, Interest Expense and Tax Expense. Profit figures included Gross Margin, EBITDA, EBIT, EBT and finally Net Income.

Balance Sheet: Lists a company’s Assets, Liabilities and Shareholders’ Equity. Assets and liabilities are broken out into current and non-current. Current Assets include Cash, A/R and Inventory. Long-term Assets include PP&E and Goodwill. Current Liabilities include Current Portion of Debt and A/P. Long-Term Liabilities include Debt. Shareholders’ Equity includes Retained Earnings, Treasury Stock, APIC and AOCI.

Cash Flow Statement: Shows a company’s change in cash for the period. Begins with Cash from Operations, which includes Net Income, non-cash expense add-backs (e.g. D&A and SBC) and changes in working capital. Next Cash from Investing includes CapEx. Finally Cash from Financing includes debt activities and dividends paid to shareholders.

Source: BIWS Guide pg. 76-77 (Q1&2)

Question 2

How do the three statements link together?

Answer 2

1) Net Income links from the bottom of the Income Statement to the top of the Cash Flow Statement.
2) We calculate Change in Cash and Ending Cash Balance at the bottom of the Cash Flow Statement, and this links to the top of the Balance Sheet.
3) Net Income also links from the bottom of the Income Statement to Shareholders’ Equity. To complete Shareholders’ Equity we should also subtract common and preferred dividends paid (generally linked from Cash from Financing on the Cash Flow Statement).

Other Links: Non-cash expenses are added back under Cash from Operations. Changes in Working Capital linking from the Balance Sheet to the Cash Flow Statement under Cash From Operations and CapEx and D&A linking from the Cash Flow Statement to the PP&E account on the Balance Sheet. Debt is linked, generally from a supplemental schedule, to the balance sheet, cash flow statement, and income statement (because of interest expense).

Source: BIWS Guide pg. 77 (Q3)

Question 3

If you have one financial statement to assess a business, what would you choose?

Answer 3

Cash Flow Statement “ ultimately the company’s ability to generate cash will be the most important factor driving its valuation

Source: BIWS Guide pg. 77 (Q4)

Question 4

If you have two financial statements to assess a business, what would you choose?

Answer 4

Income Statement and Balance Sheet because you can use these to create a Cash Flow Statement and you’ll then have a complete picture of the company

Source: BIWS Guide pg. 77 (Q5)

Question 5

How does a non-cash, pre-tax expense (e.g. D&A or SBC) going up by $10 affect the three financial statements?

+ the opposite, what if D&A goes down by $10?

Answer 5

Income Statement: Pre-Tax Income decreases by $10. Taxes also decrease by $10 * tax rate - if we assume 40% tax rate, taxes decrease by $4. Overall, Net Income decreases by $6.

Cash Flow Statement: Net Income is reduced by $6 but we add back $10 of non-cash D&A expense. Therefore, cash is increased by $4 (due to tax savings).

Balance Sheet: Change in cash flows from the SCF goes up by $4 (+A), PP&E is linked from the Balance Sheet and is reduced by $10 (-A). The net effect is a reduction in assets by $6. Retained Earnings, under Shareholders’ Equity, flows from Net Income and is reduced by $6 (-SE), so the Balance Sheet balances.

Source: BIWS Guide pg. 77-78 (Q6)

Question 6

How does a cash, pre-tax expense (e.g. COGS or SG&A) going up by $10 affect the three financial statements?

Answer 6

Income Statement: Pre-Tax Income decreases by $10. Taxes also decrease by $10 * tax rate - if we assume 40% tax rate, taxes decrease by $4. Overall, Net Income decreases by $6.

Cash Flow Statement: Net Income is reduced by $6 since we’re dealing with a cash expense, there is no add-back and cash is also reduced by $6.

Balance Sheet: Cash flows from the SCF and is reduced by $6, Net Income flows from the Income Statement and reduces Retained Earnings by $6, so the Balance Sheet Balances.

Source: Self-made

Question 7

Do non-cash expenses affect our cash balance?

Answer 7

Yes, because they decrease tax expense, which saves the company cash.

Source: BIWS Guide pg. 78 (Q7)

Question 8

Where can we find Depreciation on the Income Statement? Where can we always find the complete number?

Answer 8

On the Income Statement, depreciation may be included in either COGS or SG&A or both, or it may be broken out as its own line item. Depreciation can always be found on the Cash Flow Statement as a non-cash add-back under Cash from Operations.

Source: BIWS Guide pg. 78 (Q8)

Question 9

What happens when Inventory goes up by $10? (assume we buy the inventory with cash). Then explain what happens when the inventory is sold for $20?

Answer 9

When the inventory is bought/manufactured:
The Income Statement is not affected. On the cash flow statement, Inventory is an asset so an increase in Inventory is recorded as a reduction in cash of $10 under CFO.On the Balance Sheet, cash falls by $10 and Inventory increases by $10.
When the inventory is sold:
Revenue increases by $20, We recognize $10 of COGS, Pre-Tax Income increases by $10, taxes increase by $4, and Net Income increases by $6. On the SCF, Net Income is up by $6 and Inventory is down by $10, so we recognize a change in Cash of $16 (b/c this is the new cash that has flowed in and we already paid cash for the inventory in our prior entry). On the Balance Sheet, cash increaes by $16 (+A), Inventory decreases by $10 (-A) and Retained Earnings increases by $6 (+SE). The net efffect is an increase in both cash and Retained Earnings by $6.

Source: BIWS Guide pg. 79 (Q10), pg. 81 (Q15) & pg. 82 (Q16)

Question 10

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

Answer 10

Since no good or service has been provided to the customer, we don’t record any expense for the Inventory when it is bought. When the inventory is sold, we will simultaneously recoginze revenue from the sale and expense the cost of the inventory in COGS.

Source: BIWS Guide pg. 79 (Q11)

Question 11

Let’s say Apple buys/constructs $100 of factories using debt. How are all of the financial statements affected during Year 1?

Answer 11

Income Statement is not affected. On SCF, CapEx increases by $100 under CFI. Debt also increases by $100 under CFF. The net change in cash is $0. On the Balance Sheet, PP&E increases by $100 (+A) and Debt increases by $100 (+L).

Source: BIWS Guide pg. 79 (Q12)

Question 12

During Year 2, let’s assume that interest on the debt is repaid at a 10% rate (bullet, not amortizing, so no principal repayment). Also assume the factories depreciate at 10%… What is the effect on the financial statements?

Answer 12

Income Statement: Interest expense and D&A both increase by $10, so expenses go up by $20. Taxes are reduced by $8. Net Income is reduced by $12.
Cash Flow Statement: Net Income has fallen by $10 but depreciation of $10 is added back. The net effect on cash is -$2 ($10 of interest expense + $8 of tax savings).
Balance Sheet: Cash decreases by $2 (-A), PP&E falls by $10 (-A) and Retained Earnings falls by $12 (-SE).

Source: BIWS Guide pg. 80 (Q13)

Question 13

During Year 3, the factories break down and their value is written down to $0. The loan also matures… What is the effect on the financial statements?

Answer 13

At the beginning of year 3, the value of the factories on the Balance Sheet is $80 because they have been depreciated for two years. The value of the loan is still $100.
On the Income Statement: We record a $80 pre-tax asset write-down/impairment. Taxes fall by $80 x .4 = $32. Therefore, Net Income is down by $80 - $32 = $48.
On the Cash Flow Statement: Net Income falls by $48 but we add back $80 since this is a non-cash write-down. Overall, CFO is catually up by $32 (the tax savings). Under CFF, we see a $100 cash outflow to pay back the pincipal on the loan. Cash falls by $100 - $32 = $68.
On the Balance Sheet: Cash is down by $68 (-A). PP&E falls by $80 (-A). So total assets fall by $148. Retained Earnings falls by $48 (-SE). Debt falls by $100 (-L). So total L + SE falls by $148 as well.

Source: BIWS Guide pg. 81 (Q14)

Question 14

Can we end up with negative Shareholders’ Equity? Describe two cases

Answer 14

Yes.

1) LBO’s that are structured as a recapitalization. In this case the accounting leads to negative Shareholders’ Equity.
2) If a company has had negative Net Income for many years, Retained Earnings may turn severely negative and lead to negative Shareholders’ Equity.

Source: BIWS Guide pg. 82 (Q17)

Question 15

Give two definitions of “Working Capital”… Which do we tend to use?

Answer 15

1) Working Capital = Current Assets - Current Liabilities
2) Operating Working Capital = Non-Cash Current Assets - Non-Debt Current Liabilities
* BIWS notes that “we look at Operating Working Capital” more commonly in models

Source: BIWS Guide pg. 82-83 (Q18)

Question 16

Discuss a $100 asset write-down/impairment and how it affects the financial statements

Answer 16

Income Statement: The $100 write-down/impairment is recorded as a pre-tax expense. Taxes are reduced by $40, so Net Income declines by $60.
Cash Flow Statement: Net Income falls by $60. We add back the expense because the write-down/impairment is a non-cash charge. Therefore, cash is actually up by $40 (our tax savings).
Balance Sheet: Cash is up by $40 (+A) and our PP&E falls by $100 (-A). The net change in assets is -$60. Retained Earnings also falls by $60 (-SE), so the balance sheet balances.

Source: BIWS Guide pg. 83 (Q20)

Question 17

Give three cases where we collect cash but don’t yet record revenue? What asset/liability is created in this case?

Answer 17

1) Web-based subscription software (we sell an annual subscption and then only recognize cash as the software is used)
2) Cell phone carriers (with annual contracts)
3) Magazine publishers (subscription based)

In this case, we create a “Deferred Revenue” liability

Source: BIWS Guide pg. 85 (Q23&24)

Question 18

What is a common number for accounts receivable days? How is it affected by product price point?

Answer 18

Generally 40-50 days. Generally longer for companies selling high-end items and may be shorter for companies selling smaller, less-expensive items.Source: BIWS Guide pg. 83 (Q20)

Source: BIWS Guide pg. 85 (Q26)

Question 19

What is the difference between cash-based and accrual accounting? Give one simple example

Answer 19

Under cash-based accounting, we simply recognize revenue and expenses when the cash is either received or paid out. Under accrual accouting, we recognize revenue when a good or service has been provided and it is reasonably certain cash will be collected, and we recognize expenses when they are incurred rather than when they are paid out in cash.
One example is selling on credit - under accrual accounting, revenue is recognized when the good is sold and an accrued revenue/A/R account is created. Under cash accoutning, revenue wouldn’t be recognized until cash was collected by the company.

Source: BIWS Guide pg. 85-86 (Q27-28)

Question 20

How do we decide whether to capitalize or expense a purchase?

Answer 20

We capitalize purchases of assets with a useful life of > 1 year and expense purchases of assets with a useful life of <1 year. Note this is NOT refering to Inventory, but mostly other assts.

Source: BIWS Guide pg. 86 (Q29)

Question 21

A company has had postive EBITDA for the last 10 years, but just went bankrupt. Give 4 reasons why this might happen?

Answer 21

1) The company is spending too much on CapEx and has run out of cash
2) The company has a severe debt load and can no longer serve its debt (remember EBITDA is pre-interest expense)
3) The company’s debt all matures at once and it expeiences a “credit crunch”
4) The company has significant one-time chages (e.g. litigation charges)

Source: BIWS Guide pg. 87 (Q31)

Question 22

Name two ways in which GAAP accouting is different from tax accounting…

Answer 22

1) GAAP accounting is accrual-based while tax accounting is cash-based
2) GAAP may use a number of depreciation methods (most often straight-line) while tax accounting depreciation is accelerated

Source: BIWS Guide pg. 89 (QA1)

Question 23

Name two methods to create a revenue model for a company. Which is generally more common/credible?

Answer 23

1) Bottom-up approach: Build the revenue model based on the smallest unit that you can reasonably forecast - this may be stores, oil rigs, product line sales, etc. Make assumptions about key future inputs (e.g. same store sales and square footage) and build up revenue on a unit-by-unit basis.
2) Top down approach: We generally estimate the overall market size and then teh company’s future market share.
Bottom-up is more common/credible because estimating market size and future share can be very challenging.

Source: BIWS Guide pg. 89 (QA3)

Question 24

How do we build an expense model for a company?

Answer 24

Generally we break costs down into the smallest unit possible - e.g. COGS might be assigned a cost on a unit-sold basis, and SG&A might be broken down on an employee by employee basis. Using the historical numbers and our revenue projections, we create our expense build. LAST STEP : ALWAYS check your margins aginst the historical numbers!!

Source: BIWS Guide pg. 90 (QA4)

Question 25

Discuss 5 major items in Shareholders’ Equity…

Answer 25

1) Retained Earnings: Includes accumulated Net Income less Dividends paid out
2) Common Stock: The par value of however much stock the company has issued
3) APIC (Additional Paid in Capital): Includes 1) the amount over par value of stock issued, stock-based compensation and new stock from employees exercising options
4) Treasury Stock: Dollar amount of stock the company has bought back (a NEGATIVE account)
5) AOCI (Accumulated Other Comprehensive Income): Effect of FX rates

Source: BIWS Guide pg. 90 (QA6)

Question 26

What is the equation for Retained Earnings?

Answer 26

Retained Earnings = Last Year’s Retained Earnings + Net Income - Dividends Issued (Common & Preferred)

Source: BIWS Guide pg. 91 (QA7)

Question 27

What is the equation for APIC? State the logic for each link that you describe

Answer 27

APIC = Last year’s APIC + Stock Based Compensation + Stock Created by Option Exercise

Stock Based Comp: SBC is a non-cash expense. Let’s say SBC on the Income Statement is $10. Taxes fall by $4 and Net Income falls by $6. On the cash flow statement, Net Income falls by $6 and we add back SBC as a non-cash expense, so Cash increases by $4 (the tax savings). On the Balance Sheet, Cash increases by $4 (+A), Retained Earnings falls by $6 (-SE) so we have to increase APIC by $10 to balance (+SE).

Stock from Opetion Exercises: When the company issues stock, it receives cash (noted as CFF on the Cash Flow Statement). To balance the increase in cash (+A) we have to increase APIC (+SE).

Source: BIWS Guide pg. 91 (QA8)

Question 28

What is the fourth financial statement? What does it do? When might we use it?

Answer 28

The Statement of Shareholders’ Equity. It shows changes in the Shareholders’ Equity line items. It may be useful in helping us understand how a company is linking items to their Shareholders’ Equity section.

Source: BIWS Guide pg. 91 (QA9)

Question 29

Name two types of adjustments we must make to EBIT to calculate EBITDA. Name specific examples within each category

Answer 29

1) Add back non-cash expenses: D&A and SBC (sometimes)
2) Add back non-recurring items: Restructuring, Goodwill Impairment and Asset Write-Downs, Legal Expenses, Change in Accounting Policies (LIAR - legal, accounting, impairment, restructuring)

Source: BIWS Guide pg. 92 (QA10)

Question 30

How do we project the major working capital line items? Name the 5 most common and describe

Answer 30

A/R: Use DSO (tied to revenue)
Invntory: Use DIH (tied to COGS)
Deferred Revenue: % of revenue
A/P: Use DPO (tied to COGS)
Accrued Expenses: % of SG&A

Source: BIWS Guide pg. 92 (QA11)

Question 31

How would you project D&A?

Answer 31

1) % of revenue
2) Build a PP&E schedule that splits out different assets by their useful lives and assumes straight-line depreciation. Project new CapEx based on historical CapEx

Source: BIWS Guide pg. 92-3 (QA12)

Question 32

How do you project CapEx?

Answer 32

% of revenue

Source: BIWS Guide pg. 92-3 (QA12)

Question 33

Why would the D&A number on the Income Statement differ from the D&A number on the Cash Flow Statement? Which should be added back to get EBITDA?

Answer 33

The D&A number on the Income Statement may differ if D&A is also embedded in other line items. Always use the D&A number on the Cash Flow Statement as it should be more complete

Source: BIWS Guide pg. 93-4 (QA15)