IBI Study Set

Question 1

How do I know if an item should hit / impact the income statement?

Answer 1

It boils down to two questions; first question relates to revenue and second question relates to expenses.

1. First question is will the company recognize the revenue during the period in question (under accrual-based accounting)? The answer is quite simple (excluding some special circumstances like the selling of inventory) - if 1) the revenue is realized or realizable (meaning that the customer has already paid or there is a high probability he will) and 2) the revenue is earned (i.e. the good have been transferred or the services rendered) during the period in question, then the company can and will recognize the revenue.
2. Second question is related to expenses, will the company recognize the expense during the period in question? The answer here is also quite straightforward. If the expense has been incurred (defined once again as the transfer of goods or the rendering of services), then the company will recognize the expense only to the extent that the company will not benefit from that good or service during future periods. For Revenue, the question to ask is if the revenue is realized or realizable and has the goods been transferred or services rendered; if the answer is yes, what does that imply? What if the answer is no?-If the answer is yes, then the item hits the Income Statement as Revenue. If the answer is no, then the item does not hit the Income Statement. For Expense, have the goods been transferred or the services rendered and is the current period the only period in which the company will benefit from the goods or service; if the answer is yes, what does that imply? What if the answer is no? If the answer is yes, then the item hits the Income Statement as Expense. If the answer is no, then the item does not hit the income Statement.

Question 2

In terms of clarifying why certain Assets are generated, what is Accounts Receivable and why does it exist?

Answer 2

Accounts Receivable is money owed for goods transferred or services rendered. In short, a company generates Accounts Receivable when the company has recognized the revenue from a product or service, but has not yet received the cash. Because the company is going to receive the cash in the future, there is clearly a future economic benefit and thus an asset is generated. An asset must also be generated in order to ensure that the balance sheet balances, but this topic will be covered later in this module.

Question 3

In terms of clarifying why certain Assets are generated, what is Inventory and why does it exist?

Answer 3

Inventory is made up of the raw materials, work-in-progress goods and completely finished goods that are ready or will be ready for sale. Because inventory will be used for future sales, it will clearly generate a future benefit and is therefore an asset. Moreover, the purchase of inventory is not an expense which hits the Income Statement (as the company will benefit from the goods in future periods). When the inventory is used to generate a sale, the inventory used in the sale is expensed and shows up on the Income Statement as Cost of Revenue.

Question 4

In terms of clarifying why certain Assets are generated, what is Prepaid Expenses and why does it exist?

Answer 4

Prepaid Expenses are, as the name clearly indicates, expenses which have been paid before they were due (incurred by the company). Using the example of insurance, assume that a company paid a $600K invoice (which relates to 1 year of insurance coverage ending on December 31st 2008) on January 30th 2008 (most invoices have 30-day terms, so it is not uncommon for companies to pay right around the due date). However, the company paying the invoice would have only incurred $50K of insurance expense at the end of January. So what happens to the other $550K? Since the company will receive $550K of insurance coverage in the future periods beyond the month of January, the $550K is clearly a future benefit and there is booked as an asset called Prepaid Expense.

Question 5

What are the different methodologies that tangible (fixed) assets can be depreciated?

Answer 5

There is straight-line schedule, double-declining method, modified accelerated cost recovery system (MACRS), etc., and it is important to understand that the depreciation of these assets is an expense. When a company purchases Tangible (Fixed) Assets, the purchase (as in the case with the purchase of inventory) of those assets is not an expense that hits the income statement as the company will benefit from the purchased goods (equipment) in future periods. However, once the company reduces/depreciates the value of Fixed Assets, then the company is acknowledging that it will no longer benefit from the portion of the asset which was depreciated. As a result, depreciation flows to the income statement in the form of an expense. Depreciation must also hit the Income Statement in order to ensure that the Balance Sheet balances.

Question 6

What is an Intangible Asset and Goodwill? How does their reduction in value over time gets recorded?

Answer 6

Intangible Assets include all assets we can’t touch or feel, includes patents, brands, trademarks, customer lists, and their value gets reduced over time with the vehicle by which they are reduced in value referred to as amortization (as opposed to depreciation for Tangible Assets). And similar to depreciation, amortization is an expense which impacts the Income Statement. Goodwill is by definition an Intangible Asset, however it is a special type of Intangible Asset and warrants special accounting treatment: Goodwill results when a company acquires another company and pays an amount for company ABC’s equity value that is in excess of company ABC’s book value or the value of equity on the Balance Sheet. Historically, the folks at the FASB were fine with the amortization of Goodwill, they soon realized that doing so was not only 1) inconsistent with the major tenet of the Balance Sheet (as assuming the value of an acquired company eventually goes to zero over some definite period of time was not only a flawed but illogical assumption), but also 2) causing negative externalities for the US government as the amortization of of goodwill (an expense) was creating a sizable tax shield for acquisitive companies, significantly reducing the tax revenue of the US government! As a result, in order to be consistent with the goal of the Balance Sheet and alleviate the strain on the government’s coffers, FASB changed the guidelines of the treatment of Goodwill in 2001. As a result of the changed, companies are no longer allowed to amortize Goodwill; instead, companies perform an impairment test - a valuation analysis performed at least once a year. If the value of Goodwill is determined to be impaired - meaning, the market value of the equity is less than that previously paid, the company records an impairment expense (which hits the Income Statement) in the amount by which the asset has been impaired. In addition, companies often times are required to reduce the carrying value of other assets like inventory, accounts receivable and investments when it is determined that such assets have been impaired. When this is the case, the reduction in value is typically referred to as an ‘asset write-down’.

Question 7

Give an example of a Goodwill Impairment taking place

Answer 7

Company XYZ purchased ABC resulting in $0.5M of Goodwill. If 6 months later XYZ determined that the market value of equity purchased from company ABC had decreased to $0.8M from $1.0M company XYZ would record an impairment expense of $0.2M ($1.0M minus $0.8M). However, if company XYZ concluded that the market value of equity purchased from company ABC had increased to $1.2M, would company XYZ be allowed to increase the value of Goodwill on its books to $0.7M? (The new valuation of $1.2M less the original book value of equity for company B of $0.5M). The answer is no! Companeis are required to mark down, or “impair”, the value of Goodwill, but they are not allowed to mark up the value of Goodwill.

Question 8

What is the vehicle for reducing value for Tangible (Fixed Assets), Intangible Assets, Goodwill and Other Assets (Unexpected)?

Answer 8

For Tangible (Fixed) Assets, Depreciation is used. For Intangible Assets, Amortization is used. For Goodwill, Impairment Test is used. For Other Assets (Unexpected), Asset Write-Down is used.

Question 9

In terms of clarifying why Certain Liabilities are generated, what is Accounts Payable and why does it exist?

Answer 9

Accounts Payable relates to goods which have been transferred or services which have been rendered but have not yet been paid for during the period in question. As a result, the company benefitting from the transferred goods or rendered services will have to pay for the transferred good or rendered service at some point in the future (typically within 30 days) and therefore carries a current liability.

Question 10

In terms of clarifying why Certain Liabilities are generated, what is Accrued Expenses and why does it exist?

Answer 10

Accrued Expenses relate to services which have been rendered but have not yet been paid for during the period in question. For example, assume company XYZ, by convention, pays its employees (in arrears, or for the previous 2 weeks of service) on the 1st and 15th of every month. At the end of each month, the company would have incurred expenses associated with salaries (as the services would have already been performed) since the 16th of each month; however, since the company will not pay those salaries until the 1st, company XYZ books a future obligation known as Accrued Expenses.

Question 11

In terms of clarifying why Certain Liabilities are generated, what is Deferred Revenue or Unearned Revenue and why does it exist?

Answer 11

Deferred Revenue results when a company receives payment for services that have not yet been rendered. Because of the payment, the company is obligated to provide services in the future and therefor carries the corresponding liability, which can be either current or long-term depending on how long the company is obligated to provide services in the future and therefore carries the corresponding liability, which can be either current or long-term depending on how long the company is obligated to provide services. Using the insurance example from the prior breakout for illustration purposes, and assuming the company XYZ paid the $600K invoice (which related to 1 year of insurance coverage), consider the Balance Sheet implications for the insurance company. Because the insurance company received $600K but had only provided $50K of insurance coverage at the end of January, the insurance company is on the hook (obligated) to provide $550K of additional insurance coverage and therefore records a (current in this case because the company is on the hook for another 11 months of insurance coverage) liability called deferred or unearned revenue.

Question 12

In terms of clarifying why Shareholder’s Equity is generated, what is Retained Earnings and why does it exist?

Answer 12

Retained Earnings is a cumulative concept which refers to the aggregate level of earnings (net income) which have been retained by the company as opposed to being distributed to the company’s owners as dividends. For example, if company XYZ earned Net Income of $60K for 2008 and distributed $20K in dividends to its shareholders, then XYZ’s Retained Earnings for 2008 would have been $40K. The Retained Earnings balance listed on the Balance Sheet at the end of 2008 would have equaled the Retained Earnings for 2008 ($40K) plus the previous Retained Earnings from all the previous years.

Question 13

In terms of clarifying why Shareholder’s Equity is generated, what is Contributed Equity Capital and why does it exist?

Answer 13

Contributed Equity Capital is quite simply the capital which has been invested in the company in the form of equity. Contributed Equity Capital consists of two elements: the aggregate par value of all the shares issued and the additional paid-in capital. The par value for a share is merely an accounting convention which assigns a starting value to shares. Most par values are between $0.10 and $0.001. Additional paid-in capital refers to the amount that investors pay for the shares in a company over and above the par value. For example, assume company XYZ ‘sells’ 4mn shares to its founders at a par value of $0.01 (par values exist to insure that individuals don’t receive shares for ‘free’, even if they are the ones starting the company). Further assume that the company sells an additional 2mn shares to Venture Capitalists in a Series A financing (the first round of capital where institutional investors like VCs participate) at a price of $1.00 share.

Question 14

Accounts Receivable increase of $50K indicates what?

Answer 14

Accounts Receivable increase of $50,000 - this indicates that the company recognized $50,000 of revenue, which therefore increased Net Income by the same amount, for which the company has not yet been paid. In short, the recognition of of $50,000 of Revenue preceded the receipt o the cash associated with that Revenue. As a result, since Net Income is the starting point for deriving CFO under the indirect method, and since Net Income is propped up by $50,000 in accrued revenue which has not yet resulted in cash, Net Income would need to be reduced by $50,000 when deriving CFO. Therefore the implication here is that a $50,000 increase in Accounts Receivable requires Net Income to be decreased by that amount in order to account for the timing difference.

Question 15

Prepaid Expenses decrease of $5K indicates what?

Answer 15

Prepaid Expenses decrease of $5,000 - this indicates that the $5K of services, for which the company previously paid, were fulfilled/provided during the year ended December 31, 2008. Since the services were rendered and since the company will not benefit from those services in future periods, the company receiving the services incurred an expense for the year ended December 31, 2008 equal to the $5K. Because an expense of $5K hit the Income Statement, Net Income was reduced by $5K. However, because the company previously paid for the service (the reason the Prepaid Expense asset was generated in the first place), Net Income would need to be increased by $5K when deriving CFO. In short, the recognition of the expense came after the distribution of cash. Therefore, the implication here is that a $5K decrease in Prepaid Expenses requires Net Income to be increased by $5K in order to account for the timing difference.

Question 16

Accounts Payable increase of $10K indicates what?

Answer 16

Accounts Payable increase of $10K - this indicates that the company incurred a $10K expense for which the company has not yet paid. In short, the recognition of $10K of expense preceded the payment of cash associated with that expense. And since Net Income is reduced by $10K in Accrued Expense which has not yet resulted in cash, Net Income would need to be increased by $10K when deriving CFO. Therefore, the implication here is that a $10L increase in Accounts Payable requires Net Income to be increased by $10K in order to account for the timing difference.

Question 17

Deferred Revenue increase of $10K indicates what?

Answer 17

Deferred Revenue increase of $10K - this indicates that the company received cash in advance of performing the services purchased with that cash. As a result, the company is unable to recognize the revenue associated with the cash payment. Therefore, the recognition of the revenue associated with the cash will come after the cash, which has already been received. Because the revenue has not yet been recognized for te period ended December 31, 2008, the Income Statement has not been impacted by this transaction. However, because the company has already received the cash, there is clearly a cash benefit that needs to be accounted for during the period. As a result, Net Income needs to be increased by $10K in order to account for the receipt of $10K in cash. Therefore, the implication here is that a $10K increase in Deferred Revenue requires Net Income to be increased by $10K in order to account for the timing difference.

Question 18

Why is an increase in Working Capital referred to as a ‘Use’ of Cash?

Answer 18

The adjustment to Net Income equals the negative change in Working Capital. Because the change in Working Capital is preceded by a negative sign, when there is an increase in Working Capital, this increase (a positive number) is multiplied by a negative sign resulting in a negative number. Because the resulting number is negative (when the change in Working Capital is positive), an increase in Working Capital is often times referred to as a use of cash. All this terminology is referring to is that in the derivation of CFO when using indirect method, an increase in Working Capital will be subtracted from Net Income. However, when there is a decrease in Working Capital, this decrease is multiplied by a negative sign resulting in a positive number. Because the resulting number is positive, a decrease in Working Capital is often times referred to as a source of cash as that positive number will be added to Net Income. An increase in a working capital asset results in an increase in Working Capital and an increase in Working Capital is a use of cash. A decrease in a Working Capital Asset results in a decrease in Working Capital, and a decrease in Working Capital is a source of cash. An increase in a Working Capital Liability results in a decrease in Working Capital, and a decrease in Working Capital is a source of Cash. A decrease in a Working Capital Liability results in an increase in Working Capital, and an increase in Working Capital is a use of cash.

Question 19

Assume that company XYZ pays a $600K invoice on January 30th, 2008 related to insurance services for a 12 month period (coverage ends December 30th, 2008). How would this transaction impact the company’s financial statements for the month ended January 31, 2008? Assume 0% tax rate.

Answer 19

On the Income Statement, the $50K related to the first month of insurance is expensed, which gives us -$50K Net Income. On the CF Statement, the -$50K from Net Income flows down to top of CFO and the increase in $550K Prepaid Expenses is a use of Cash so -$550K is the Prepaid Expenses impact on the Change in Working Capital. This gives us -$600K in CFO and that goes down to the bottom of the CF Statement. On the Balance Sheet, the -$600K in Cash shows up under Cash on the Assets side and the $550K increase in Prepaid Expense makes the Assets side equal to -$50K. On the Liabilities and Equities side, Liabilities is unchanged because there were no changes in Liabilities and on the Equities side, Net Income flows into Retained Earnings, so Retained Earnings is also equal to -$50K and both sides balance.

Question 20

Assume an insurance company bills company XYZ $600K in advance for insurance coverage for the year (12-months) ended December 31, 2008. If company XYZ pays the bill in full on January 30th, how would this transaction impact the insurance company’s financial statements for the month ended January 31st, 2008? Assume 0% tax rate.

Answer 20

On the Income Statement, the $50K related to the first completed month of insurance delivered is recorded as revenue, thus, Net Income is equal to $50K. On the CF Statement, Net Income of $50K flows to top of CFO. The increase in Deferred Revenue of $550K is a liability thus, the increase is a source of cash and causes the Change in Working Capital to be $550K. At the bottom, CFO is $600K which flows down to the bottom as the Net Change in Cash. On the Balance Sheet, the $600K in Cash shows up under Assets and Assets is shown as $600K. On the Liabilities and Equities side, the increase in Deferred Revenue is a Liability and as a result, Liabilities is increased by the amount of Deferred Revenue which is $550K. Then, Net Income flows into Retained Earnings which is $50K, now forcing the Liabilities and Equities side to be up $600K as well and both sides balance.

Question 21

Assume that company XYZ recorded $35K of depreciation expense in 2008 associated with the wear and tear of its truck and other equipment. How would this transaction impact the company’s financial statements for the year ended December 31, 2008? Assume 0% tax rate.

Answer 21

On the Income Statement, the $35K in Depreciation is recorded as an Expense, thus, Net Income equals -$35K. On the CF Statement, the -$35K in Net Income flows into the top of the CFO. Since Depreciation is a non-cash item it gets added back, thus, the add back of $35K in Depreciation causes the Net Change in Cash to be $0. On the Balance Sheet, the increase in Depreciation causes the PP&E to decrease by $35K. Thus, the Assets side is -$35K. On the Liabilities and Equities Side, no change in Liabilities. Then, Net Income of -$35K flows into the Retained Earnings and both sides balance.

Question 22

Assume that company XYZ purchases $100K of equipment (in cash) for the year ended December 31, 2008. How would this transaction impact the company’s financial statements? Assume 0% tax rate.

Answer 22

On the Income Statement, no changes occur. On the CF Statement, the CFO is not impacted, but the purchase of equipment is seen as an investment in PP&E since you’re purchasing equipment, thus, it’s CapEx and impacts CF Investing. Thus, the $100K purchase of equipment is a source of cash and CFI is down -$100K. The Net Change in Cash at the bottom is down -$100K. On the Balance Sheet, the Cash flows into Cash on the Assets side, thus, cash is at -$100K. Then the purchase of equipment means the company will benefit from equipment in future periods, thus, your PP&E is up $100K on the assets side which causes Assets to cancel each other out to $0K. There are no changes on the Liabilities and Equities side and both sides balance.

Question 23

Assume that company XYZ issues / sells 2M shares of common stock to Venture Capitalists at a price of $1.00 per share. How would this transaction impact the company’s financial statements? Assume 0% tax rate.

Answer 23

On the Income Statement, there are no changes. On the CF Statement, CFO and CFI are not impacted. The sale of $2M in shares is a source of cash, thus, CFF sees the issuance of 2m shares at $1.00/share price causing CFF to now be up $2M, thus, the Net Change in Cash at the bottom is up $2M. On the Balance Sheet, the cash at the top is up $2M. The Assets side is up $2M. On the Liabilities and Equities side, there are no changes to Liabilities, but on the Equities side, Retained Earnings is still $0 because of Net Income being $0 since Income Statement is unaffected, however, Contributed Equity is now up $2M since the Equity Issuance occured, causing Equity now to be up $2M as well, balancing both sides of the balance sheet.

Question 24

Explain why an increase in working capital is commonly referred to as a ‘use of cash’

Answer 24

An increase in working capital implies that more cash is invested in working capital and thus reduces cash flows. Firms with significant working capital requirements will find that their working capital grows as they do, and this working capital growth will reduce cash flows. Given this relationship and cash flows, firms which are more efficient about managing working capital, will have a higher value than an otherwise similar firm with greater working capital requirements. Firms should also think about the trade off between greater revenues and working capital requirements. As an example, granting credit may increase sales and profits, but it also increases working capital needs. The net effect can be positive or negative for value.

Question 25

What is the relationship between the Discount Rate in Working Capital Decisions?

Answer 25

Practitioners are unified in the use of cost of debt as the discount rate in working capital decisions. Let me try to present you my rationale for the use of the cost of capital and why I believe that the cost of debt is not the right discount rate. I come into this process as someone who is interested in the overall value of a firm. When valuing a firm, I discount free cash flows to the firm at the cost of capital, where free cash flow to firm is conventionally defined as FCFF = EBIT(1-Tax Rate)+Depreciation-CapEx-Change in Working Capital. Any action that increases working capital (such as granting longer credit terms) reduces my cash flow, and my value is reduced by the present value of these working capital changes, discounted back at the cost of capital. Thus, it seems to me fundamentally consistent to look at working capital changes through this prism and use the cost of capital as the discount rate. When I make this argument I hear two counter arguments. The first is that the firm borrows the money to finance the loosening of credit. This argument does not hold up, if this is a long term change in corporate strategy, rather than granting longer credit terms to one customer. If it is, in fact, a change in corporate strategy, the firm has to finance this premanent shift in working capital not with debt alone, but with the mix of debt and equity that the firm has chosen as its target capital structure. Otherwise, it will end up as over levered. The second is that working capital investments are somehow less risky than traditional capital expenditures - thus, the argument goes, the cost of capital is used for traditional projects but the cost of debt for working capital investments. This does not make sense to me either, working capital investments are not stand-alone projects but are investments that derive from other capital investments. Thus, the decision to grant credit to a customer who buys a product manufactured in a factory built by a firm cannot be separated from the primary investment in the factory. To argue that the investment in the factor is risky (and thus should have its cash flows discounted back at the cost of capital), but that the credit demands that flow from the factory are safer and should be discounted at the cost of debt is to me inconsistent. In fact, many of the CFOs that I talked to who use the cost of debt in discounting working capital decisions when made separately, used to cost of capital to discount cash flows in new project analysis, and these cash flows were after working capital changes. While I do not disagree with the fact that less risky cash flows should have lower discount rates, working capital does not fit the bill of less risky. I think that for a truly one-time decision on credit to a customer, it might be appropriate to use the cost of debt (using the default risk of the customer, in fact, in coming up with the cost of debt). For decisions that affect the broad cross section of customers over time, I still think that it is appropriate to use the cost of capital.

Question 26

Describe the benefits of the changes in working capital and how the pros use it.

Answer 26

The changes in working capital is included in CFO because companies typically increase and decrease their current assets and current liabilities to fund their ongoing operations. When a company increases its current assets, it’s a cash outflow: the company had to shell out money to buy the extra assets. Likewise, when a company increases its current liabilities, it’s a cash inflow: the added liabilities, such as short-term debt, provide money. Changes in working capital simply shows the net affect on cash flows of this. When changes in working capital is negative, the company is investing heavily in its current assets, or else drastically reducing its current liabilities. When changes in working capital is positive, the company is either selling off current assets or else raising its current liabilities. For many growing companies, changes in working capital is a little like capital spending: it’s money the company is investing - in things like inventory - in order to grow. To get a true picture of the cash a company is generating before investment, one can add back changes in working capital to cash flow from operations. Another point: a negative value for changes in working capital could mean the company is investing heavily in growth, or that something’s gone wrong. If a company is having trouble selling its goods, inventories will balloon and changes in working capital will turn sharply negative.