Financial Accounting - Basic

Question 1

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

Answer 1

These days, many companies have “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements.

• As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.

Question 2

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

Answer 2

Several possibilities:

1. The company is spending too much on Capital 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 it is unable to refinance it 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 3

Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s balance sheet and how it affects the 3 statements.

Answer 3

• This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60.
• On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40.
• On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances.

If this seems strange to you, you’re not alone – see this Forbes article for more on why writing down debt actually benefits companies accounting-wise: http://www.forbes.com/2009/07/31/fair-value-accounting-markets-equities-fasb.html

Question 4

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

Answer 4

This is a common interview mistake – incorrectly stating that Working Capital changes show up on the Income Statement.

• In the case of Inventory, the expense 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 Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Question 5

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

Answer 5

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases.

Question 6

1. Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements?

2. Now let’s say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 6

1.

• No changes to the Income Statement.
• Cash Flow Statement – Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10.
• On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.

2.

• Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6.
• Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPads), which is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16.
• On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders’ Equity is up by $6 and both sides balance.

Question 7

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a writedown of $100.

Answer 7

• First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60.
• On the Cash Flow Statement, Net Income is down by $60 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40.
• On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it’s not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders’ Equity is also down by $60 – and both sides balance.

Question 8

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Answer 8

• No changes to the Income Statement.
• On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
• On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.

Question 9

1. Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?

2. Go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

3. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

Answer 9

1.

• At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet).
• On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same.
• On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

2. After a year has passed, Apple must pay interest expense and must record the depreciation.

• Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12.
• On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
• On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.

Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back.

3.

• After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48.
• On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68.
• On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance.

Question 10

What does negative Working Capital mean? Is that a bad sign?

Answer 10

Not necessarily. It depends on the type of company and the specific situation – here are a few different things it could mean:

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – 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 efficiency.
3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance).

Question 11

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?

Answer 11

• You would use the Cash Flow Statement 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 – its cash flow.

Question 12

What’s the difference between accounts receivable and deferred revenue?

Answer 12

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it has already collected in cash but is waiting to record as revenue.

Question 13

Could you ever end up with negative shareholders’ equity? What does it mean?

Answer 13

Yes. It is common to see this in 2 scenarios:

1. Leveraged Buyouts with dividend recapitalizations – it means that the owner of the company has taken out 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 portion of Shareholders’ Equity. It doesn’t “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario).

Note: Shareholders’ equity never turns negative immediately after an LBO – it would only happen following a dividend recap or continued net losses.

Question 14

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

Answer 14

Three examples come to mind:

1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.

Companies that agree to services in the future often collect cash upfront to ensure stable revenue – this makes investors happy as well since they can better predict a company’s performance. Per the rules of accounting, you only record revenue when you actually perform the services – so the company would not record everything as revenue right away.

Question 15

Under what circumstances would Goodwill increase?

Answer 15

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare.

What usually happens is 1 of 2 scenarios:

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

Question 16

Walk me through how Depreciation going up by $10 would affect the statements.

Answer 16

• Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6.
• Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.
• Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6 and both sides of the Balance Sheet balance.

Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.

Question 17

Where does Depreciation usually show up on the Income Statement?

Answer 17

• It could be in a separate line item, or it could be embedded in Cost of Goods Sold 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 18

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

Answer 18

In cash-based accounting, the revenue would not show up until the company charges the customer’s credit card, receives authorization, and deposits the 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. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” Cash.

Question 19

Walk me through the 3 financial statements.

Answer 19

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.

The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement.

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 Liabilities plus Shareholders’ Equity. The Cash Flow Statement begins 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 company’s net change in cash.

Question 20

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

Answer 20

• Cash-based accounting recognizes revenue and expenses when cash is actually received 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 than when they are paid out in cash
• Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

Question 21

Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?

Answer 21

• Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.
• It often happens in acquisitions where the buyer “overpaid” for the seller and can result in a large net loss on the Income Statement (see: Microsoft/Skype).
• It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

Question 22

Can you give examples of major line items on each of the financial statements?

Answer 22

• Income Statement: Revenue; Cost of Goods Sold; SG&A; Operating Income; Pretax Income; Net Income.
• Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment; Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.

Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

Question 23

What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

Answer 23

• LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2 different ways of recording the value of inventory and the Cost of Goods Sold (COGS).
• With LIFO, you use the value of the most recent inventory additions for COGS
• With FIFO you use the value of the oldest inventory additions for COGS
• Here’s an example: let’s say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4. You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40 * $30 or $1,200 for the annual revenue. The difference is that in LIFO, you would use the 40 most recent inventory purchase values – $120 + $150 + $170 + $200 – for the Cost of Goods Sold, whereas in FIFO you would use the 40 oldest inventory values – $100 + $120 + $150 + $170 – for COGS. As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending inventory value would be $100 higher under FIFO and $100 lower under FIFO.
• In general if inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending inventory values and vice versa if inventory is getting cheaper to purchase.

Question 24

What happens when Accrued Compensation goes up by $10?

Answer 24

For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation).

• Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
• On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4.
• On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

Question 25

How do the 3 statements link together?

Answer 25

• To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement.
• Changes to 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 Cash Flow Statement.

Question 26

How long does it usually take for a company to collect its accounts receivable balance?

Answer 26

Generally the accounts receivable days are in the 30-60 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.

Question 27

How do you decide when to capitalize rather than expense a purchase?

Answer 27

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment 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 28

Walk me through a $100 “bailout” of a company and how it affects the 3 statements.

Answer 28

• First, confirm what type of “bailout” this is – Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here’s what happens:
• No changes to the Income Statement.
• On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government’s investment, so the Net Change in Cash is up by $100.
• On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders’ Equity would go up by $100 to make it balance.

Question 29

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

Answer 29

• Depreciation is a non-cash expense
• Depreciation is tax-deductible
• Taxes are a cash expense
• Depreciation affects cash by reducing the amount of taxes you pay

Question 30

Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?

Answer 30

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

Question 31

What is Working Capital? How is it used?

Answer 31

Working Capital = Current Assets – Current Liabilities.

• If it’s positive, it means a company can pay off its short-term liabilities with its shortterm assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.”
• Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt).
• The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation.