Multi Step Accounting Flashcards
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?
Income Statement: At the start of “Year 1,” there are no changes yet.
Cash Flow Statement: The $100 worth of Capital Expenditures 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 in Cash Flow from Investing, canceling out the investment activity. So the cash number stays the same, for now.
Balance Sheet: There is now an additional $100 worth of factories, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, Debt is up by $100, so the entire other side is up by $100 and both sides balance
Now let’s go out one 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 now?
Assume that we have already factored in the changes from Part 1 and are only tracking what happens AFTER those have taken place.
After a year has passed, Apple must pay Interest Expense and must record the Depreciation.
Income Statement: Operating Income decreases by $10 due to the 10% Depreciation charge each year, and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income falls by $12.
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.
Balance Sheet: On the Assets side, Cash is down by $2 and PP&E is down by $10 due to the Depreciation, so overall the Assets side is 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 that the Debt number itself does not change since we’ve assumed that nothing is paid back.
At the end of Year 2, the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements ONLY from the start of Year 2 to the end of Year 2.
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 on the 3 statements. Also, don’t forget about the Interest Expense – it still needs to be paid in Year 2.
Income Statement: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense, so Pre-Tax Income is down by $100. Net Income is down by $60 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but the Write-Down and Depreciation are both non-cash expenses, so we add them back and cash flow is up by $30 so far.
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 Financing falls by $100.
Overall, cash at the bottom decreases by $70.
Balance Sheet: Cash is now down by $70, and PP&E has decreased by $90, so the Assets side is down by $160.
On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $60, Shareholders’ Equity is down by $60. Both sides are down by $160 and balance.
NOTE: Be very careful with this type of question because there are many variations – when in doubt, always ask to clarify before you begin answering.
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?
Income Statement: No changes.
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.
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.
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.
Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit, Operating Income, and Pre-Tax Income are all up by $10. 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 CFS, so cash at the bottom is up by $16.
Balance Sheet: Cash is up by $16 and Inventory is down by $10, so the Assets side 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.
Intuition: This simply reflects the sale of products at a certain cost, and the after-tax profit from that. The only tricky part is how Cash increases by $16, not $6 – that just reflects the “release” you get from selling off the Inventory.
A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.
Income Statement: No changes yet.
Cash Flow Statement: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under Cash Flow from Investing, and the $100 Debt raise shows up as a $100 increase under Cash Flow from Financing. Cash at the bottom is unchanged.
Balance Sheet: Short-Term Securities on the Assets side is up by $100, and Debt on the Liabilities side is up by $100 so both sides balance.
Now walk me through what happens at the end of Year 1, after the company has earned interest, paid interest, and paid back some of the debt principal
Income Statement: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%), so Pre-Tax Income increases by $5, and Net Income increases by $3 assuming a 40% tax rate.
Cash Flow Statement: Net Income is up by $3. In Cash Flow from Financing, we repay $10 worth of debt ($100 * 10%), so cash at the bottom is down by $7.
Balance Sheet: Cash on the Assets side is down by $7, so the Assets side is down by $7. On the other side, Debt is down by $10 due to the repayment and Shareholders’ Equity (Retained Earnings) is up by $3 due to the Net Income, so this side is also down by $7 and the Balance Sheet balances.
Now let’s say that at the end of year 1, the company sells the $100 of Short-Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining Debt.
Walk me through the statements after ONLY these changes.
Income Statement: You record a Gain of $10 ($110 – $100), so Pre-Tax Income is up by $10 and Net Income is up by $6 with a 40% tax rate.
Cash Flow Statement: Net Income is up by $6 but you subtract the Gain of $10, so Cash Flow from Operations is down by $4.
Under Cash Flow from Investing, you record the $110 sale as an addition to cash flow, so cash is up by $106 so far.
Then, under Cash Flow from Financing, you pay off $90 worth of Debt, which reduces cash by $90. Overall, Cash at the bottom is up by $16.
Balance Sheet: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100, so the Assets side is down by $84.
On the other side, Debt is down by $90 but Shareholders’ Equity (Retained Earnings) is up by $6 due to the Net Income increase, so that side is also down by $84 and both sides balance.
