New Accounting

Question 1

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

Answer 1

Income Statement: Operating Income and Pre-Tax 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 & Equity side is down by $6 and both sides of the Balance Sheet balance.
Intuition: We save on taxes with any non-cash charge, including Depreciation.

Question 2

What happens when Accrued Expenses increases by $10?

Answer 2

For this question, remember that Accrued Expenses are recognized on the Income Statement but haven’t been paid out in cash yet. So this could correspond to payment being set aside for an employee, but not actually the employee in cash yet.
Income Statement: Operating Income and Pre-Tax Income fall by $10, and Net Income falls by $6 (assuming a 40% tax rate).
Cash Flow Statement: Net Income is down by $6, and the increase in Accrued Expenses 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.
Balance Sheet: Cash is up by $4 as a result, so Assets is up by $4. On the Liabilities & Equity side, Accrued Expenses is a Liability so Liabilities is up by $10 and Shareholders’ Equity(Retained Earnings) is down by $6 due to the Net Income decrease, so both sides balance.
Intuition: We record an additional expense and save on taxes with it… but that expense hasn’t been paid in cash yet, so our cash balance is actually up.

Question 3

3. What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do not take into account cumulative changes from previous increases in Accrued Expenses.

Answer 3

Income Statement: There are no changes.
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.
Balance Sheet: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side, so it balances.
Intuition: This is a simple cash payout of previously recorded expenses.

Question 4

Accounts Receivable increases by $10. Walk me through the 3 statements.

Answer 4

If AR “increases” by $10, it means that we’ve recorded revenue of $10 but haven’t received it in cash yet. For example, a customer has ordered a $10 product from us and we’ve delivered it, but we are still waiting on cash payment.
Income Statement: 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.
Cash Flow Statement: Net Income is up by $6 but the AR increase is a reduction in cash (since we don’t have the cash yet), so we need to subtract $10, which results in cash at the bottom being down by $4.
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. Both sides balance.
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 5

Prepaid Expenses decreases by $10. Walk me through the statements. Do not take into account cumulative changes from previous increases in Prepaid Expenses

Answer 5

When Prepaid Expenses “decreases,” it means that expenses are now recognized on the Income Statement. For example, we’ve previously paid for an insurance policy in cash and have now recognized that same expense on the IS.
Income Statement: Pre-Tax Income is down by $10, and Net Income is down by $6.
Cash Flow Statement: 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.
Balance Sheet: 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 thereduced Net Income, 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 our Cash balance goes up rather than down, despite the additional Income Statement expenses.

Question 6

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

Answer 6

This really just means, “Walk me through what happens on the statements when you purchase $10 worth of Inventory with cash.”
Income Statement: No changes.
Cash Flow Statement: Inventory is an Asset so that reduces Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
Balance Sheet: On the Assets side, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Equity.
Intuition: We’ve spent cash to buy Inventory, but haven’t manufactured or sold anything yet.

Question 7

A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change.

Answer 7

Income Statement: You record a Gain of $20 ($120 – $100), which boosts Pre-Tax Income by $20. At a 40% tax rate, Net Income is up by $12.
Cash Flow Statement: Net Income is up by $12, but you need to subtract out that Gain of $20, so Cash Flow from Operations is down by $8.Then, in Cash Flow from Investing, you record the entire amount of proceeds from the sale – $120 – so that section is up by $120. At the bottom of the CFS, cash is therefore up by $112.
Balance Sheet: Cash is up by $112, but PP&E is down by $100 since we’ve sold it, so the Assets side is up by $12. The other side is up by $12 as well, since Shareholders’ Equity is up by $12 due to the Net Income increase.
Intuition: Gains and Losses are not non-cash, but they are re-classified on the CFS. The cash increase here simply reflects the after-tax profit from the Gain – if we had sold the PP&E at its Balance Sheet value, there would be no change on the IS.

Question 8

Walk me through what happens on the 3 statements when there’s an Asset Write-Down of $100.

Answer 8

Income Statement: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate, Net Income declines by $60.
Cash Flow Statement: Net Income is down by $60 but the Write-Down is a non-cash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Cash at the bottom is up by $40.
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 it). 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.
Intuition: The same as any other non-cash charge: we save on taxes, so our Cash goes up, and something on the Balance Sheet changes in response

Question 9

Explain what happens on the 3 statements when a company issues $100 worth of shares to investors

Answer 9

Income Statement: No changes (since this doesn’t affect taxes and since the shares will be around for years to come).
Cash Flow Statement: Cash Flow from Financing is up by $100 due to this share issuance, so cash at the bottom is up by $100.
Balance Sheet: Cash is up by $100 on the Assets side and Shareholders’ Equity (Common Stock & APIC) is up by $100 on the other side to balance it.
Intuition: This one does not affect taxes and does not correspond to the current period, so it doesn’t show up on the IS – just like similar items, all that changes is Cash and then something else on the Balance Sheet.

Question 10

Let’s say we have the same scenario, but now instead of issuing $100 worth of stock to investors, the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?

Answer 10

Income Statement: You need to record this as an additional expense because it’s now a tax-deductible and a current expense – Pre-Tax Income falls by $100 and Net Income falls by $60 assuming a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but you add back the SBC of $100 since it’s a non-cash charge, so cash at the bottom is up by $40.
Balance Sheet: Cash is up by $40 on the Assets side. On the other side, Common Stock & APIC is up by $100 due to the Stock-Based Compensation, but Retained Earnings is down by $60 due to the reduced Net Income, so Shareholders’ Equity is up by $40 and both sides balance.
Intuition: This is a non-cash charge, so like all non-cash charges it impacts the IS and affects one Balance Sheet item in addition to Cash and Retained Earnings – in this case, it flows into Common Stock & APIC because that one reflects the market value of stock at the time the stock was issued. The cash increase here simply reflects the tax savings.

Question 11

A company decides to issue $100 in Dividends – how do the 3 statements change?

Answer 11

Income Statement: No changes. Dividends count as a financing activity and are not tax-deductible, so they never appear on the IS.
Cash Flow Statement: Cash Flow from Financing is down by $100 due to the Dividends, so cash at the bottom is down by $100.
Balance Sheet: Cash is down by $100 on the Assets side, and Shareholders’ Equity (Retained Earnings) is down by $100 on the other side so both sides balance.
Intuition: This is another non-operational CFS / BS item, so it is a simple use of cash and nothing else changes.

Question 12

A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid, in cash, in the current period. Now we change it and only $90 of it is paid in cash, with $10 being deferred to future periods. How do the statements change?

Answer 12

Income Statement: Nothing changes. Both Current and Deferred Taxes are recorded simply as “Taxes” and Net Income remains the same. Net Income changes only if the total amount of taxes changes.
Cash Flow Statement: Net Income remains the same but we add back the $10 worth of Deferred Taxes in Cash Flow from Operations – no other changes, so cash at the bottom is up by $10.
Balance Sheet: Cash is up by $10 and so the entire Assets side is up by $10. On the other side, the Deferred Tax Liability is up by $10 and so both sides balance.
Intuition: Deferred Taxes save us on cash in the current period, at the expense of additional cash taxes in the future.

Question 13

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

Answer 13

Income Statement: No changes.
Cash Flow Statement: Cash Flow from Financing goes up by $100 to reflect this new investment, so the Net Change in Cash is up by $100.
Balance Sheet: Cash is up by $100 so the Assets side is up by $100; on the other side, Shareholders’ Equity goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred).
Intuition: It’s the same as a normal stock issuance: no Income Statement changes because nothing affects the company’s taxes.

Question 14

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 14

This one is counter-intuitive. When a Liability is written down you record it as an addition on the Income Statement (with an asset write-down, it’s a subtraction).
Income Statement: Pre-Tax Income goes up by $100, and assuming a 40% tax rate, Net Income is up by $60.
Cash Flow Statement: Net Income is up by $60, but we need to subtract that Debt Write-Down because it was non-cash – so Cash Flow from Operations is down by $40, and Cash is down by $40 at the bottom.
Balance Sheet: Cash is down by $40 so the Assets side is 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 both sides balance.
Intuition: One way to think about this is that writing down Assets is “bad” for us because it reduces our ability to generate future cash flow, but writing down Liabilities is “good” because it reduces our future expenses… sort of. I don’t recommend presenting it like that in an interview.

Question 15

Wait a minute – if writing down Liabilities boosts Net Income, why don’t companies just do it all the time? It helps them out!

Answer 15

This is like asking, “If declaring bankruptcy helps you relieve your obligations, why not do it whenever you rack up debt?!”
And the answer is similar: Because it may help in the short-term, but in the long-term it hurts the company’s credibility and ability to borrow in the future. If a company continually writes down its Liabilities, investors will stop trusting it – and the inability to borrow again will hurt it far more than a reduced Net Income would.

Question 16

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

Answer 16

First, note that this question does not apply to you if you’re outside the US because IFRS does not permit the use of LIFO. But you may want to read this anyway because it’s good to know in case you ever work with US-based companies.
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, but 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 LIFO.
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 17

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?

Answer 17

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.

Question 18

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?

(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?)

Answer 18

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.

Question 19

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.

(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?

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?)

Answer 19

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

Question 20

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?

Answer 20

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.

Question 21

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 21

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.

Question 22

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.

Answer 22

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.

Question 23

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.

(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.)

Answer 23

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.

Question 24

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

(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)

Answer 24

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.

Question 25

Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?

Answer 25

A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future – in other words, you’ve underpaid on taxes and need to make up for it in the future. A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future – you’ve paid too much before, and now you get to save on taxes in the future. Both DTLs and DTAs arise because of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes. You see them most often in 3 scenarios: 1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes). 2. When Assets get written up for book, but not tax purposes, in M&A deals. 3. When pension contributions get recognized differently for book vs. tax purposes.

Question 26

Wait a minute, then how can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?

Answer 26

This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons. For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets. But they might also record accelerated Depreciation for tax purposes, but straight-line it for book purposes, which would result in a DTL in early years.

Question 27

How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?

Answer 27

They are similar, but not the same exact idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the current year. For example, if a company owes $300 in taxes at the end of each quarter during the year, on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months, at which point Income Taxes Payable would decrease once again. By contrast, DTAs and DTLs tend to be longer-term and arise because of events that do NOT occur in the normal course of business.

Question 28

Walk me through how you project revenue for a company.

Answer 28

The simplest way to do it is to assume a percentage growth rate – for example, 15% in year 1, 12% in year 2, 10% in year 3, and so on, usually decreasing significantly over time. To be more precise, you could create a bottoms-up build or a tops-down build: • Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in customers / transactions and customer / transaction values to tie everything together. • Tops-Down: Start with “big-picture” metrics like overall market size, and then estimate the company’s market share and how that will change in coming years and multiply to get to their revenue. Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible.

Question 29

Walk me through how you project expenses for a company.

Answer 29

The simplest method is to make each Income Statement expense a percentage of revenue and hold it fairly constant, maybe decreasing the percentages slightly (due to economies of scale), over time. For a more complex method, you could start with each department of a company, the number of employees in each, the average salary, bonuses, and benefits, and then make assumptions for those going forward. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. Cost of Goods Sold should be tied directly to Revenue and each “unit” sold should incur an expense. Other items such as rent, Capital Expenditures, and miscellaneous expenses are linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue in a simpler model.

Question 30

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses over several years in a 3-statement model?

Answer 30

Normally you assume that these are percentages of revenue or expenses, under the assumption that they’re all linked to the Income Statement: • Accounts Receivable: % of Revenue. • Prepaid Expense: % of Operating Expenses. • Inventory: % of COGS. • Deferred Revenue: % of Revenue. • Accounts Payable: % of Operating Expenses. • Accrued Expenses: % of Operating Expenses. Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company. You can also project these metrics using “days,” e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365, assume that the days required to collect AR stays relatively the same each year, and calculate the AR number from that.

Question 31

How should you project Depreciation and Capital Expenditures?

Answer 31

You could use several different approaches here: • Simplest: Make each one a % of revenue. Alternative: Make Depreciation a % of revenue, but for CapEx average several years of previous CapEx, or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year). • Complex: Create a PP&E schedule, where you estimate a CapEx increase each year based on management’s plans, and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added, using the same approach.

Question 32

Let’s take a step back… there’s usually a “simple” and “complex” way of projecting a company’s financial statements. Is there a real advantage to using the complex method? In other words, does it give us better numbers?

Answer 32

In short, no. The complex methods give you similar numbers most of the time – you’re not using them to get better numbers, but rather to get better support for those numbers. If you just say, “Revenue grows by 10% per year!” there isn’t much evidence to back up that claim. But if you create a bottoms-up revenue model by segment, then you can say, “The 10% growth is driven by a 5% price increase in this segment, a 10% increase in units sold here, 15% growth in units sold in this geography” and so on.

Question 33

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing its financial statements?

Answer 33

``` Restructuring Charges • Goodwill Impairment • Asset Write-Downs • Bad Debt Expenses • One-Time Legal Expenses • Disaster Expenses • Changes in Accounting Policies ``` Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line,” then you do not add it back for the EBITDA / EBIT calculation. Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation when calculating EBITDA, but that these are not “non-recurring charges” because all companies have them every year – they’re just non-cash charges.

Question 34

What’s the difference between capital leases and operating leases? How do they affect the statements?

Answer 34

Operating Leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as Operating Expenses on the Income Statement and impact Operating Income, Pre-Tax Income, and Net Income. Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate, incur Interest Expense, and are counted as Debt. A lease is a capital lease if any one of the following 4 conditions is true: 1. If there’s a transfer of ownership at the end of the term. 2. If there’s an option to purchase the asset at a “bargain price” at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.

Question 35

How do Net Operating Losses (NOLs) affect a company’s 3 statements?

Answer 35

The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pre-Tax Income number (which should stay thesame). Then you can deduct whatever you used up from the NOL balance (which should be a part of the Deferred Tax Asset line item). A more complex way to do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you record the difference as an increase to the Deferred Tax Liability on the Balance Sheet. This method reflects the fact that you’re saving on cash flow – since the DTL, a Liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.

Question 36

What’s the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation? How do they impact the statements?

Answer 36

Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes). Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they’ve saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it). Neither one is a separate item on the Income Statement. On the Cash Flow Statement, Excess Tax Benefits are subtracted out of Cash Flow from Operations and added to Cash Flow from Financing, effectively “re-classifying” them. Basically you’re saying, “We’ve gotten some extra cash flow from our share price increasing, so let’s call it what it is: a financing activity.” Also on the CFS, you add back the Tax Benefits in Cash Flow from Operations You do that because you want them to accrue to Additional Paid-In Capital (APIC) on the Balance Sheet. You’re saying, “In addition to the additional value we created with this stock/option issuance, we’ve also gotten some value from the tax savings… so let’s make reflect that value along with the SBC itself under APIC.”

Question 37

Let’s say you’re creating quarterly projections for a company rather than annual projections. What’s the best way to project revenue growth each quarter?

Answer 37

It’s best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example, in Quarter 1 of Year 2 you would look at how much the company has grown revenue by in Quarter 1 of previous years. It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Quarter 1 over Quarter 4 in the previous year) because many companies are seasonal. The same applies for expenses as well: always make sure you take into account seasonality with quarterly projections.

Question 38

What’s the purpose of calendarizing financial figures?

Answer 38

“Calendarizing” means “Rather than using a company’s normal fiscal year figures, let’s use another year-long period during the year and calculate their revenue, expenses, and other key metrics for that period.” For example, a company’s fiscal year might end on December 31 – if you calendarized it, you might look at the period from June 30 in the previous year to June 30 of this year rather than the traditional January 1 – December 31 period. You do this most frequently with public comps (see the section on Valuation), because companies often have “misaligned” fiscal years. If one company’s year ends December 31, another’s ends June 30, and another’s ends September 30, you need to adjust and use the same period for all of them – otherwise you’re comparing apples to oranges because the financial figures are all from different time periods.

Question 39

What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes, but straight-line Depreciation for book purposes?

Answer 39

If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because you’re paying less in cash taxes initially and need to make up for it later. Then, as tax Depreciation switches and becomes lower in the later years, the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.

Question 40

If you own over 50% but less than 100% of another company, what happens on the financial statements when you record the acquisition?

Answer 40

This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company’s statements to your own. It’s similar to a 100% acquisition where you do the same thing, but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don’t own (e.g. if it’s worth $100 and you own 70%, you would list $30 here). Just like with normal acquisitions, you also wipe out the other company’s Shareholders’ Equity when you combine its statements with yours, and you still allocate the purchase price (see the Merger Model section for more on that). You also subtract Net Income Attributable to Noncontrolling Interests on the Income Statement – in other words, the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the Cash Flow Statement in the CFO section. That is just an accounting rule and has no cash impact. On the Balance Sheet, the Noncontrolling Interest line item increases by that number (Net Income Attributable to Noncontrolling Interests) each year. Retained Earnings decreases by that same number each year because it reduces Net Income, so the Balance Sheet remains in balance.

Question 41

What about if you own between 20% and 50% of another company? How do you record this acquisition and how are the statements affected?

Answer 41

This case refers to an Equity Interest (AKA Associate Company) – here, you do not consolidate the statements at all. Instead, you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the Balance Sheet (Investments in Equity Interests). For example, if the other company is worth $200 and you own 30% of it, you record $60 for the Investments in Equity Interests line item. You also add Other Company’s Net Income * Percentage Ownership to your own Net Income on the Income Statement, and then subtract it on the Cash Flow Statement because it’s a non-cash addition. Each year, the Investments in Equity Interests line item increases by that number, and it decreases by any dividends issued from that other company to you. On the other side, Retained Earnings will also change based on the change in Net Income, so everything balances.

Question 42

What if you own less than 20% of another company?

Answer 42

This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case, especially if they exert “significant influence” over the other company But sometimes they may also classify it as a simple Investment or Security on their Balance Sheet (see the next few questions), acting as if they have simply bought a stock or bond and ignoring the other company’s financials.

Question 43

What are the different classifications for Securities that a company can use on its Balance Sheet? How do they differ?

Answer 43

Trading: These Securities are very short-term and you count all Gains and Losses on the Income Statement, even if they’re unrealized (i.e. you haven’t sold the Securities yet). • Available for Sale (AFS): These Securities are longer-term and you don’t report Gains or Losses on the Income Statement – they appear under Accumulated Other Comprehensive Income (AOCI). The Balance Sheet values of these Securities also change over time because you mark them to market. • Held-to-Maturity (HTM): These Securities are even longer-term, and you don’t report unrealized Gains or Losses anywhere. Gains and Losses are only reported when they’re actually sold.

Question 44

You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated. Walk me through how you would recognize Net Income Attributable to Noncontrolling Interests, and how it affects the 3 statements.

Answer 44

Income Statement: You show a line item for “Net Income Attributable to Noncontrolling Interests” near the bottom. You subtract $3 (Other Company Net Income of $10 * 30% You Don’t Own) to reflect the 30% of the other company’s Net Income that does not “belong” to you. At the bottom of the Income Statement, the “Net Income Attributable to Parent” line item is down by $3. Cash Flow Statement: Net Income is down by $3 as a result, but you add back this same charge because you do, in fact, receive this Net Income in cash when you own over 50% of the other company. So cash at the bottom of the CFS remains unchanged. Balance Sheet: There are no changes on the Assets side. On the other side, the Noncontrolling Interests line item (included in Shareholders’ Equity) is up by $3 due to this Net Income, but Retained Earnings is down by $3 because of the reduced Net Income at the bottom of the Income Statement, so this side doesn’t change and the Balance Sheet remains in balance.

Question 45

Let’s continue with the same example, and assume that this other company issues Dividends of $5. Walk me through how that’s recorded on the statements. (You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated. Walk me through how you would recognize Net Income Attributable to Noncontrolling Interests, and how it affects the 3 statements)

Answer 45

Income Statement: There are no changes because Dividends never show up on the Income Statement. Cash Flow Statement: There’s an additional Dividend of $5 under Cash Flow from Financing on the CFS, so cash is down by $5. Balance Sheet: The Assets side is down by $5 as a result and Shareholders’ Equity (Retained Earnings) is also down by $5. Remember that the other company’s financial statements are consolidated with your own when you own over 50% – you only split out Net Income separately. So there’s no need to multiply by ownership percentages or anything when factoring in the impact of Dividends, or really any item other than Net Income.

Question 46

Now let’s take the opposite scenario and say that you own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to.

Answer 46

Here, nothing has been consolidated because we own less than 50% of the other company. So nothing on the statements yet reflects this other company. Income Statement: We create an item “Net Income from Equity Interests” (or something similar) below our normal Net Income at the bottom, which results in our real Net Income (Net Income Attributable to Parent) increasing by $6 ($20 * 30%). Cash Flow Statement: Net Income is up by $6, but we subtract this $6 of additional Net Income because we haven’t really received it in cash when we own less than 50% - it’s not as if we control the other company and can just “take it.” Cash remains unchanged. Balance Sheet: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this Net Income, so the Assets side is up by $6. On the other side, Shareholders’ Equity (Retained Earnings) is up by $6 to reflect the increased Net Income, so both sides balance.

Question 47

Now let’s assume that this 30% owned company issues Dividends of $10. Taking into account the changes from the last question, walk me through the 3 statements again and explain what’s different now. (You own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to)

Answer 47

Income Statement: It’s the same: Net Income is up by $6 at the bottom. Cash Flow Statement: Net Income is up by $6 and we then subtract out the $6 that’s attributable to the Equity Interests… And then we ADD $3 ($10 * 30%) in the Cash Flow from Operations section to reflect the Dividends that we receive from these Equity Interests. So cash at the bottom is up by $3. Balance Sheet: Cash is up by $3 on the Assets side, and the Investments in Equity Interests line item is up by $6… but it falls by $3 due to those Dividends, so the Assets side is up by $6 total. On the other side, Net Income is up by $6 so Shareholders’ Equity (Retained Earnings) is up by $6 and both sides balance. The Investments in Equity Interests line item is like a “mini-Shareholder’s Equity” for companies that you own less than 50% of – you add however much Net Income you can “claim,” and then subtract your portion of the Dividends. Remember that only the Dividends the parent company itself issues show up in the Cash Flow from Financing section – Dividends received from other companies (such as what you see in this example) do not.

Question 48

What if you now only own 10% of this company? Would anything change? (Dividends and Net Income)

Answer 48

In theory, yes, because when you own less than 20%, the other company should be recorded as a Security or Short-Term Investment and you would only factor in the Dividends received but not the Net Income from the Other Company. In practice, however, treatment varies and some companies may actually record this scenario the same way, especially if they exert “significant influence” over the 10% owned company.

Question 49

Walk me through what happens when you pay $20 in interest on Debt, with $10 in the form of cash interest and $10 in the form of Paid-in-Kind (PIK) interest.

Answer 49

Income Statement: Both forms of interest appear, so Pre-Tax Income falls by $20 and Net Income falls by $12 at a 40% tax rate. Cash Flow Statement: Net Income is down by $12 but you add back the $10 in PIK interest since it’s non-cash, so Cash Flow from Operations is down by $2. Cash at the bottom is also down by $2 as a result. Balance Sheet: Cash is down by $2 so the Assets side is down by $2. On the other side, Debt increases by $10 because PIK interest accrues to Debt, but Shareholders’ Equity (Retained Earnings) falls by $12 due to the reduced Net Income, so this side is also down by $2 and both sides balance. PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the Balance Sheet – in this case, that’s the existing Debt number.

Question 50

Due to a high issuance of Stock-Based Compensation and a fluctuating stock price, a company has recorded a significant amount of Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation. Assume that it records $100 in Tax Benefits from SBC, with $40 of Excess Tax Benefits from SBC, and walk me through the 3 statements. Ignore the original Stock-Based Compensation issuance.

Answer 50

Income Statement: No changes Cash Flow Statement: You add back the $100 in Tax Benefits from SBC in Cash Flow from Operations, and subtract out the $40 in Excess Tax Benefits, so CFO is up by $60. Then, under Cash Flow from Financing, you add back the $40 in Excess Tax Benefits, so Cash at the bottom is up by $100. Balance Sheet: Cash is up by $100, so the Assets side is up by $100. On the other side, Common Stock & APIC is up by $100 because Tax Benefits from SBC flow directly into there. The rationale: Essentially we’re “re-classifying” the Tax Benefits OUT of Cash Flow from Operations and saying that they should accrue to the company’s Shareholders’ Equity. And we are also saying that Excess Tax Benefits (which arise due to share price increases) should be counted as a Financing activity but should not impact cash, since they’re already a part of the normal Tax Benefits.

Question 51

A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3. Walk me through what happens on the BOOK financial statements in Year 1.

Answer 51

Income Statement: On the Book Income Statement you list the Book Depreciation number, so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate. On the Tax Income Statement, Depreciation was $15 so Net Income fell by $9 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $85. Book Taxes were $36 and Cash Taxes were $34, so Book Taxes fell by $4 and Cash Taxes fell by $6). Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you add back $2 worth of Deferred Taxes – that represents the fact that Cash Taxes were lower than Book Taxes in Year 1. At the bottom, Cash is up by $6. Balance Sheet: Cash is up by $6 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $4. On the other side, the Deferred Tax Liability increases by $2 due to the Book / Cash Tax difference, but Shareholders’ Equity (Retained Earnings) is down by $6 due to the lower Net Income, so both sides are down by $4 and balance.

Question 52

Now let’s move to Year 2. What happens? (A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3. Walk me through what happens on the BOOK financial statements in Year 1.)

Answer 52

This one’s easy, because now Book and Tax Depreciation are the same. Income Statement: Pre-Tax Income is down by $10 so Net Income falls by $6. Cash Flow Statement: Net Income is down by $6 and you add back the $10 of Depreciation on the CFS, but there are no changes to Deferred Taxes because Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4. Balance Sheet: Cash is up by $4 but PP&E is down by $10, so the Assets side is down by $6. The other side is also down by $6 because Shareholders’ Equity (Retained Earnings) is lower due to the reduced Net Income.

Question 53

And finally, let’s move to Year 3 – walk me through what happens on the statements now. (A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3. Walk me through what happens on the BOOK financial statements in Year 1.)

Answer 53

Income Statement: On the Book Income Statement, you use the Book Depreciation number so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate. On the Tax Income Statement, Depreciation was $5 so Net Income fell by $3 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $95. Book Taxes were $36 and Cash Taxes were $38, so Book Taxes fell by $4 and Cash Taxes fell by $2). Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you subtract out $2 worth of additional Cash Taxes – that represents the fact that Cash Taxes were higher than Book Taxes in Year 1 (meaning that you’re now paying extra to make “catch-up payments”). At the bottom, Cash is up by $2. Balance Sheet: Cash is up by $2 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $8. On the other side, the Deferred Tax Liability decreases by $2 due to the Book/Cash Tax difference and Shareholders’ Equity (Retained Earnings) is down by $6 due to the reduced Net Income, so both sides are down by $8 and balance

Question 54

A company you’re analyzing records a Goodwill Impairment of $100. However, this Goodwill Impairment is NOT deductible for cash tax purposes. Walk me through how the 3 statements change.

Answer 54

Income Statement: You still reduce Pre-Tax Income by $100 due to the Impairment, so Net Income falls by $60 at a 40% tax rate – when it’s not tax-deductible, you make that adjustment via Deferred Tax Liabilities or Deferred Tax Assets. On the Tax Income Statement, Pre-Tax Income has not fallen at all and so Net Income stays the same… which means that Cash Taxes are $40 higher than Book Taxes. Cash Flow Statement: Net Income is down by $60, but we add back the $100 Impairment since it is non-cash. Then, we also subtract $40 from Deferred Taxes because Cash Taxes were higher than Book Taxes by $40 – meaning that we’ll save some cash (on paper) from reduced Book Income Taxes in the future. Adding up all these changes, there are no net changes in Cash. Balance Sheet: Cash is the same but Goodwill is down by $100 due to the Impairment, so the Assets side is down by $100. On the other side, the Deferred Tax Liability is down by $40 and Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides are down by $100 and balance. Intuition: When a charge is not truly tax-deductible, a firm pays higher Cash Taxes and either “makes up for” owed future tax payments or gets to report lower Book Taxes in the future. Remember that DTLs get created when additional future cash taxes are owed – when additional future cash taxes are paid, DTLs decrease

Question 55

How can you tell whether or not a Goodwill Impairment will be tax-deductible?

Answer 55

There’s no way to know for sure unless the company states it, but generally Impairment on Goodwill from acquisitions is not deductible for tax purposes. If it were, companies would have a massive incentive to start writing down the values of their acquisitions and saving on taxes from non-cash charges – which the government wouldn’t like too much. Goodwill arising from other sources may be tax-deductible, but it’s rare to see significant Impairment charges unless they’re from acquisitions.

Question 56

A company has Net Operating Losses (NOLs) of $100 included in the Deferred Tax Asset (DTA) line item on its Balance Sheet because it has been unprofitable up until this point. Now, the company finally turns a profit and has Pre-Tax Income of $200 this year. Walk me through the 3 statements and assume that the NOLs can be used as a direct tax deduction on the financial statements.

Answer 56

Income Statement: The company can apply the entire NOL balance to offset its Pre-Tax Income, so Pre-Tax Income falls by $100 and Net Income falls by $60 at a 40% tax rate. Cash Flow Statement: Net Income is down by $60 but the company hasn’t truly lost anything – it has just saved on taxes. So you add back this use of NOLs and label it “Deferred Taxes” – it should be a positive $100, which means that Cash at the bottom is up by $40. Balance Sheet: Cash is up by $40 and the Deferred Tax Asset is down by $100, so the Assets side is down by $60. On the other side, Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides balance.

Question 57

You’re analyzing a company’s financial statements and you need to calendarize the revenue, EBITDA, and other items. The company has earned revenue of $1000 and EBITDA of $200 from January 1 to December 31, 2050. From January 1 to March 31, 2050, it earned revenue of $200 and EBITDA of $50. From January 1 to March 31, 2051, it earned revenue of $300 and EBITDA of $75. What are the company’s revenue and EBITDA for the Trailing Twelve Months as of March 31, 2051?

Answer 57

Trailing Twelve Months (TTM) = New Partial Period + Twelve-Month Period – Old Partial Period So in this case, TTM Revenue = $300 + $1000 – $200 = $1100 and TTM EBITDA = $75 + $200 – $50 = $225.

Question 58

A company acquires another company for $1000 using 50% stock and 50% cash. Here’s what the other company looks like: • Assets of $1000 and Liabilities of $800. Using that information, combine the companies’ financial statements and walk me through what the Balance Sheet looks like IMMEDIATELY after the acquisition

Answer 58

The acquirer has used $500 of cash and $500 of stock to acquire the seller, and the seller’s Assets are worth $1000, with Liabilities of $800 and therefore Equity of $200. In an M&A deal the Equity of the seller gets wiped out completely. So you simply add the seller’s Assets and Liabilities to the acquirer’s – the Assets side is up by $1000 and the Liabilities side is up by $800. Then, you subtract the cash used, so the Assets side is up by $500 only, and the other side is up by $1300 due to the $800 of Liabilities and the $500 stock issuance. Our Balance Sheet is out of balance… and that’s why we need Goodwill. Goodwill equals the Purchase Price Minus the Seller’s Book Value, so in this case it’s equal to $1000 – $200, or $800. That $800 of Goodwill gets created on the Assets side, and so both sides are now up by $1300 and the Balance Sheet balances.

Question 59

You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Available-for-Sale (AFS) Securities. The market value for these securities increases to $110. Walk me through what happens on the 3 statements.

Answer 59

Income Statement: Since these are AFS securities, you do not reported Unrealized Gains and Losses on the Income Statement. There are no changes. Cash Flow Statement: There are no changes because no cash accounts change. Balance Sheet: The Short-Term Investments line item increases by $10 on the Assets side and Accumulated Other Comprehensive Income (AOCI) increases by $10 on the other side under Shareholders’ Equity, so the Balance Sheet balances.

Question 60

Now let’s say that these were classified as Trading Securities instead – walk me through the 3 statements after their value increases by $10. (You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Available-for-Sale (AFS) Securities.)

Answer 60

With Trading Securities, you do show Unrealized Gains and Losses on the Income Statement. Income Statement: Both Operating Income and Pre-Tax Income increase by $10, and so Net Income increases by $6 at a 40% tax rate. Cash Flow Statement: Net Income is up by $6, but you subtract the Unrealized Gain of $10 because it’s non-cash, so Cash at the bottom is down by $4. Balance Sheet: Cash is down by $4 on the Assets side and Short-Term Investments is up by $10, so the Assets side is up by $6 overall. On the other side, Shareholders’ Equity (Retained Earnings) is up by $6 due to the increased Net Income. Intuition: We’ve paid taxes on a non-cash source of income, so cash is down. However, the paper value of our Assets has increased.

Question 61

What happens when accrued compensation goes up by $10?

Answer 61

IS: Opex +10; pre-tax income -10; Net Income -6 (40% tax rate) CFS: NI -6; Accrued Comp +10; Cash +4 BS: Cash +4; Assets +4. Accrued Comp +10; Liabilities +10. Retained earnings -6.

Question 62

What happens when inventory goes up by $10 when you pay for it with cash?

Answer 62

IS: No changes CFS: Inventory Up = Cash down 10 BS: Cash down 10; Inventory up 10

Question 63

What is working capital?

Answer 63

Current assets - current liabilities If positive, company can pay off short term liabilities with short term assets

Question 64

What happens if revenue is not counted as revenue?

Answer 64

Deferred revenue under liabilities; over time converted to revenue on IS

Question 65

What are deferred tax assets/liabilities and how do they arise?

Answer 65

Differences btwn what a company can deduct for tax purposes and for book purposes DTA/DTL = difference between what you show on the income statement versus what you pay in cash In M&A, an asset write-up = DTL and DTA = asset write-down

Question 66

What is the difference btwn capital and operating leases?

Answer 66

Operating leases are for short-term leases of equipment/property, don't involve ownership, show up on income statement Capital leases are longer-term leases, confer ownership rights, depreciate and incur interest payments, counted as debt 4 Conditions for capital leases: 1) transfer ownership at the end of the term 2) Option to purchase asset at low price at the end of the term 3) Term of the lease is >75% of useful life 4) PV of lease payments is >90% of FMV

Question 67

What happens is D&A on income statement is different from the number on the cash flow statement?

Answer 67

It means D&A is embedded in other line items on the IS. When this happens use the CFS number to arrive at EBITDA

Question 68

Walk me through what flows into Retained Earnings.

Answer 68

Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends

Question 69

Walk me through what flows into Additional Paid-In Capital (APIC).

Answer 69

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises If you’re calculating it, take the balance from last year, add this year’s stock-based compensation number, and then add in however much new stock was created by employees exercising options this year

Question 70

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?

Answer 70

``` Restructuring Charges • Goodwill Impairment • Asset Write-Downs • Bad Debt Expenses • Legal Expenses • Disaster Expenses • Change in Accounting Procedures ```

Question 71

How do Net Operating Losses (NOLs) affect a company’s 3 statements?

Answer 71

The “quick and dirty” way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same). The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet. This method reflects the fact that you’re saving on cash flow – since the DTL, a liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.

Question 72

What’s the difference between capital leases and operating leases?

Answer 72

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement. Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt. A lease is a capital lease if any one of the following 4 conditions is true: 1. If there’s a transfer of ownership at the end of the term. 2. If there’s an option to purchase the asset at a bargain price at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.

Question 73

If a company issues a PIK security, what impact will it have on the three statements?

Answer 73

PIK stands for “paid in kind,” another important non-cash item that refers to interest or dividends paid by issuing more of the security instead of cash. This can mean compounding profits for the lenders and flexibility for the borrower. For instance, a mezzanine bond of $100 million and 10 percent PIK interest will be added to the BS as $100 million as debt on the right side, and cash on the left side. On the CFS, cash flow from financing will list an increase of $100 million as debt raised. When the PIK is triggered and all else is equal, interest on the IS will be increased by $10 million, which will reduce net income by $6 million (assuming a 40 percent tax rate). This carries over onto the CFS where net income decreases by $6 million and the $10 million of PIK interest is added back (since it is non-cash), resulting in a net cash flow of $4 million. On the BS, cash increases by $4 million, debt increases by $10 million (the PIK interest accretes on the balance sheet as debt) and shareholders equity decreases by $6 million.

Question 74

What is a stock purchase and what is an asset purchase? Which structure does the seller prefer and why? What about the buyer?

Answer 74

A stock purchase refers to the purchase of an entire company so that all the outstanding stock is transferred to the buyer. Effectively, the buyer takes the seller’s place as the owner of the business and will assume all assets and liabilities. In an asset deal, the seller retains ownership of the stock while the buyer uses a new or different entity to assume ownership over specified assets deal for a C corporation causes the seller to be double-taxed; once at the corporate level when the assets are sold, and again at the individual level when proceeds are distributed to the shareholders/owners. In contrast, a stock deal avoids the second tax because proceeds transfer directly to the seller. In non-C corporations like LLCs and partnerships, a stock purchase can help the seller pay transaction taxes at a lower capital gains rate (there is a capital gains and ordinary income tax difference at the individual level, but not at a corporate level). Furthermore, since a stock purchase transfers the entire entity, it allows the seller to completely extract itself from the business. A buyer prefers an asset deal for similar reasons. First, it can pick and choose which assets and liabilities to assume. This also decreases the amount of due diligence needed. Second, the buyer can write up the value of the assets purchased—known as a “step-up” in basis to fair market value over the historical carrying cost, which can create an additional depreciation write-off, becoming a tax benefit.

Question 75

What's the difference between the Face Value, Book Value, and Market Value of Debt?

Answer 75

Face Value represents the amount the company initially issues and pays interest on; it’s affected only by principal issuances, repayments/maturities, and Paid-in-Kind (PIK) Interest. Book Value is the amount shown on the company’s Balance Sheet. It’s affected by issuance fees, debt discounts and premiums, amortization of these items, and principal issuances, repayments/maturities, and PIK Interest. Market Value is how much someone else would pay for the Debt in the secondary market; it’s affected by prevailing yields on similar Debt and the company’s credit quality.

Question 76

Why might a company issue Debt with an Original Issue Discount (OID), and how is it recorded on the statements?

Answer 76

A company would issue Debt with an Original Issue Discount if the Market Value of the Debt, upon initial issuance, is different from its Face Value. For example, yields on similar bonds in the market are 5%, but this company is offering only 4%, so it issues the Debt at a discount to incentivize investors to buy the issuance. The OID means that investors can buy the bond for less than its Face Value, so they might be able to buy it for $95 if the Face Value is $100 (for example). This discount is deducted from the Book Value of Debt on the Balance Sheet, and it amortizes over time so that the Book Value increases each year until maturity. Upon maturity, Book Value = Face Value.

Question 77

Why might a company continually record "Losses on Debt Extinguishment" on its statements?

Answer 77

Losses on Debt Extinguishment can come from several sources, but the most common one is the early repayment of Debt principal when the Debt still has unamortized issuance fees or an unamortized original issue discount. If a company repays Debt early – e.g., it repays 50% of the remaining principal in Year 3 even though the Debt only matures in Year 5 – then it must write down 50% of the unamortized OID and 50% of the unamortized issuance fees, both of which show up in this line item. Losses on Debt Extinguishment are non-cash expenses on the Income Statement that get reversed on the Cash Flow Statement and flow into the Book Value of Debt on the Balance Sheet.

Question 78

How does a company record the initial issuance of a Convertible Bond on the statements?

Answer 78

Under IFRS, the initial Convertible Bond issuance is always split into Liability and Equity components, with the Liability Component equal to the Present Value of future interest payments plus future principal repayments, at a Discount Rate equal to the coupon rate on equivalent, non-convertible Debt. For example, if the Convertible Bond has a very low coupon rate of 0.5%, but the company would have to pay 4.0% on non-convertible Debt, you would use 4.0% for the Discount Rate. The Equity Component equals the Face Value of the Convertible Bond at issuance minus the Liability Component. Under U.S. GAAP, this Liability / Equity split happens only if there’s a “cash-settlement” option, but that option usually exists.

Question 79

What's the accounting treatment if a Convertible Bond converts into shares before its maturity date?

Answer 79

If there’s a conversion into shares before maturity, the company must record a Loss on Debt Extinguishment for the remaining, unamortized issuance fees. The Equity Component and Liability Component (i.e., the Book Value of Debt, after the Amortization of Issuance Fees and the Amortization of the Debt Discount and the Losses on Debt Extinguishment) both get “transferred” into Common Shareholders’ Equity. So, Common Shareholders’ Equity increases, and both these separate components go to 0.

Question 80

Explain the equity method of accounting (for equity investments or associate companies).

Answer 80

The equity method is used when one company has “significant influence” but not control over another company, which usually means a 20% to 50% ownership stake (technically, just under 50%). The Parent Co. records its Ownership Percentage * Sub Co.’s Net Income toward the bottom of its Income Statement, which increases the “Net Income to Parent” that appears at the very bottom. Nothing else changes, so there is no consolidation of Sub Co.’s full financials. On the Cash Flow Statement, Parent Co. reverses this line item (“Equity Investment Earnings” or “Equity Investment Net Income” or something similar) and records a positive cash inflow for its Ownership Percentage * Sub Co.’s Dividends. Both these items link into Equity Investments on the Assets side of the Balance Sheet, with Equity Investment Earnings increasing this line item and Equity Investment Dividends decreasing it.

Question 81

Explain consolidation accounting (for noncontrolling interests).

Answer 81

Consolidation accounting is used when one company owns >= 50%, but less than 100%, of another company. In this scenario, the financial statements of both companies are consolidated 100%, i.e., all the items from the Parent Co. and the Sub Co. are added together. Parent Co. then makes adjustments for Sub Co.’s Net Income and Dividends. On the Income Statement, it subtracts (1 – Ownership Percentage) * Sub Co.’s Net Income (“Net Income Attributable to Noncontrolling Interests”), and on the Cash Flow Statement, it reverses this. Then, it also records a positive cash inflow for Ownership Percentage * Sub Co.’s Dividends. Further down on the Cash Flow Statement, it records deductions for 100% of the Dividends from both Parent Co. and Sub Co. On the Balance Sheet, Net Income Attributable to Noncontrolling Interests (the reversal of the deduction on the IS), 100% of Sub Co.’s Dividends, and Ownership Percentage * Sub Co.’s Dividends all flow into the Noncontrolling Interests (NCI) line item within Equity. The net effect is that the NCI increases by the Net Income that’s attributable to other shareholders, and it decreases by the Dividends that go to other shareholders.

Question 82

What happens on the financial statements when employees finally receive their shares from Stock-Based Compensation, and it becomes Cash-Tax Deductible to the company? Follow the U.S. GAAP treatment.

Answer 82

If the SBC’s value has changed (e.g., it was granted at $20 but it’s now worth $50), then the initial amount (the $20) reduces the company’s Cash Taxes and shows up as a positive adjustment in Deferred Income Taxes on the Cash Flow Statement. On the Balance Sheet, the Deferred Tax Asset that was initially created when the SBC was issued now goes back to $0. On the Income Statement, there’s an additional line item for “Excess Tax Benefits / (Deficiencies)” in between Pre-Tax Income and Net Income, equal to Change in Value of SBC * Tax Rate. If the SBC’s value has increased, this line item reduces the company’s taxes; if it has decreased, it increases the tax burden. In this example, it’s ($50 – $20) * 25% = $7.5, so the company’s Income Taxes fall by $7.5.

Question 83

How is this treatment for Stock-Based Compensation different under IFRS? Just give a high-level overview.

Answer 83

The main difference under IFRS is that as the value of the SBC changes, the Deferred Tax Asset associated with the initial issuance keeps changing. It’s still created in the same way and still goes to $0 when the SBC finally becomes Cash-Tax Deductible. The initial “Tax Benefits” from the SBC, e.g., Tax Rate * Initial SBC Value, are recorded on the Income Statement in between Pre-Tax Income and Net Income, but the Excess Tax Benefits do not appear there. Instead, they reduce Cash Taxes in the year the deduction is finally allowed, there’s a positive adjustment in Deferred Income Taxes on the CFS, and the DTA drops to $0.

Question 84

How are Unrealized Gains and Losses recorded differently for Trading / Fair Value Through Profit & Loss (FVPL), Available for Sale (AFS) / Fair Value Through Other Comprehensive Income (FVOCI), and Held to Maturity (HTM) / Amortized Cost securities?

Answer 84

First, note that all Equity securities now use the Trading/FVPL treatment, so the AFS/FVOCI and HTM/Amortized Cost ones are only available for Debt. With the Trading/FVPL treatment, Unrealized Gains and Losses appear directly on the Income Statement but do not affect the company’s Cash Taxes, so the Deferred Tax line item on the CFS changes, which affects the DTA or DTL on the Balance Sheet. The impact on the DTA or DTL reverses when the company finally sells the Trading securities and records a Realized Gain or Loss. With AFS or FVOCI securities, Unrealized Gains and Losses affect the Balance Sheet line item and Accumulated Other Comprehensive Income within Common Shareholders’ Equity on the other side, but do not appear on the IS or CFS. Finally, Unrealized Gains and Losses do not appear on the statements at all for HTM or Amortized Cost securities, which is the treatment used for most Debt investments

Question 85

How are the LIFO, FIFO, and Moving Average Weighted Cost methods for Inventory and COGS different?

Answer 85

With the LIFO (“Last-In, First-Out”) method, the company uses the cost of the latest items purchased for its Cost of Goods Sold on the Income Statement. For example, if Inventory prices increased from $10 per unit to $20 per unit over a year, the company kept purchasing Inventory the whole time, and now it sells 10 units, it records $20 * 10 = $200 for COGS. With FIFO (“First-In, First-Out”), the company uses the cost of the earliest items purchased for COGS, so it records $10 * 10 = $100. With the Moving Average Weighted Cost method, the company calculates the average unit cost in each period, which keeps changing, and it uses Most Recent Average Unit Cost * Units Sold for COGS. Under IFRS, only FIFO and the Average method are allowed; U.S. GAAP allows those as well as LIFO. If Inventory costs are rising, FIFO tends to produce higher Net Income but lower Cash Flow, while LIFO does the opposite.

Question 86

For a Defined-Benefit Pension plan, how do the Pension Asset and Pension Liability change over time?

Answer 86

The Pension Asset changes based on the return the company earns (the Actual Return), how much the company contributes (Employer Contributions), and how much it pays out to employees (Benefit Payments). There may also be “Other Adjustments” and plan contributions from employees. The Pension Liability, or Pension Benefit Obligation, changes based on the Service Cost (the additional amount the company owes based on employees working longer or earning more), the Interest Cost (the PV of the Liability increasing due to the passage of time), the Experience (Gain) / Loss (actuarial estimates changing), and Benefit Payments. Again, there may also be “Other Adjustments” and plan contributions from employees.

Question 87

Why does the Pension Expense on the Income Statement consist of mostly non-cash expenses?

Answer 87

The main components of the Pension Expense on the Income Statement are the Service Cost, the Interest Cost, the Expected Return on Plan Assets, the Amortization of Net Losses, Gains, and Prior Service Costs, and “Other Adjustments.” (Under IFRS, the Amortization of Net Losses and Gains does not appear, but the other items do.) The logic behind these items is that the company attempts to “smooth out” its gains and losses over time because the returns on Pension Assets are often volatile, so it uses various Amortization line items to do that. None of these items represent upfront cash expenses – they represent hypothetical returns, the passage of time, or the amortization of Expected vs. Actual returns. Even the Service Cost, which qualifies as “operational,” is not a cash expense – it’s the accrual of future expenses because of salary increases or employees working additional years. On the Cash Flow Statement, most companies add back all, or a significant portion, of this Income Statement expense and then show a cash outflow for the Employer Contributions into the plan.

Question 88

Explain the links between the Pension Expense on the Income Statement, the Pension Plan Asset, the Pension Plan Liability, and the Pension items on the Cash Flow Statement

Answer 88

Most, or all, of the Pension Expense on the Income Statement is added back on the Cash Flow Statement, and the company records its Employer Contributions as a cash outflow there. Also, there’s a Deferred Tax impact, depending on which items are Cash-Tax Deductible (e.g., just the Service Cost, the entire IS Pension Expense, just the Employer Contributions, etc.). Of these line items, only the Employer Contributions from the CFS directly affect the Pension Asset; it also changes based on Actual Returns (i.e., Unrealized Gains/Losses) and Benefit Payments. With the Pension Liability, the Service Cost and Interest Cost flow in from the Income Statement and increase it. Actuarial Gains and Benefit Payments also affect it (neither one is shown on the IS or CFS). Finally, under U.S. GAAP, the Amortization of Expected vs. Actual Returns appears on the Income Statement and is influenced by the Actual Returns that flow into the Pension Asset. Under IFRS, the difference between Expected and Actual Returns each year goes into AOCI within Equity on the Balance Sheet.

Question 89

Walk me through the financial statements when there's a $100 Face Value Debt issuance with $5 in Issuance Fees, amortized over 5 years, but the Debt is repaid early – at the end of Year 3. Assume a 5% coupon rate and no principal repayments until maturity, and explain just the changes in Year 3.

Answer 89

Initially, the Debt is recorded at a Book Value of $95 on the Balance Sheet, and it increases by $1 per year as the Issuance Fees amortize. On the Income Statement in Year 3, there’s $1 in Finance Fee Amortization, and the remaining $2 is written down and shown as a Loss on Debt Extinguishment. There’s also $5 in Interest Expense. Pre-Tax Income is down by $8, so at a 25% Tax Rate, Net Income is down by $6. On the CFS, Net Income is down by $6, and you add back the $3 in Amortization plus the Loss on Debt Extinguishment. Within Cash Flow from Financing, there’s a negative $100 cash outflow for the Debt Principal Repayment, so Cash at the bottom is down by $103. On the Balance Sheet, Cash on the Assets side is down by $103; on the other side, Debt is down by $97, and CSE is down by $6 due to the reduced Net Income, so both sides are down by $103 and balance.

Question 90

Walk me through the financial statements when there's a $100 Face Value Convertible Bond issued with a Liability Component of $80 and $5 in Issuance Fees. Assume straight-line amortization over 5 years and a coupon rate of 1.0%.

Answer 90

Initially, the company records $80 – $5 = $75 for the Book Value of Debt and $20 for the Equity Component, so the L&E side is up by $95. On the Assets side, Cash is up by $95 because the company had to pay the $5 in Issuance Fees in cash. Each year after that, the company records $100 * 1.0% = $1 in Interest Expense, $5 / 5 = $1 in Amortization of Financing Fees, and $20 / 5 = $4 for the Amortization of the Debt Discount. They’re all classified within Interest Expense on the Income Statement, so Net Income falls by $6 * 75% = $4.5 at a 25% tax rate. On the CFS, Net Income is down by $4.5, and you add back the $5 of Amortization, so Cash at the bottom is down by $0.5. On the Assets side, Cash is down by $0.5, so Total Assets are down by $0.5 On the L&E side, the Book Value of Debt increases by $5 due to both Amortization lines, but Common Shareholders’ Equity is down by $4.5 due to the reduced Net Income, so the L&E side is also down by $0.5, and both sides balance.

Question 91

What happens if this same Convertible Bond converts into common shares at the end of Year 3?

Answer 91

The company must write down the remaining unamortized Issuance Fees, which appears as a Loss on Debt Extinguishment on the Income Statement (along with the normal Cash Interest Expense and Amortization line items). On the Cash Flow Statement, Net Income is down, and the Loss and Amortization line items are added back. The conversion into shares makes no cash impact, so it’s usually not shown directly on the CFS. On the Balance Sheet, the Debt Component and the Equity Component of the Convertible Bond are both transferred into Common Shareholders’ Equity At the end of Year 3, the $20 Equity Component is the same, and the Liability Component equals the Face Value of $100 minus the remaining unamortized Debt Discount, which means $100 – $8 = $92. So, Common Shareholders’ Equity increases by $112, the Equity Component decreases by $20, and the Liability Component decreases by $92

Question 92

Walk me through the financial statements over a year when a company has issued a $100 Face Value bond with 5% Cash Interest and 5% PIK Interest. Ignore the Issuance Fees.

Answer 92

Initially, Cash on the Assets side increases by $100, and Debt on the L&E side also increases by $100. In Year 1, the company records $100 * 10% = $10 of Interest Expense on the Income Statement, so its Pre-Tax Income falls by $10, and its Net Income falls by $7.5 at a 25% tax rate. On the CFS, Net Income is down by $7.5, but you add back the $5 of PIK Interest, which is non-cash, so Cash at the bottom is down by $2.5. On the BS, Cash is down by $2.5, so the Assets side is down by $2.5. On the L&E side, Debt is up by $5 from the PIK Interest, and CSE is down by $7.5 due to the reduced Net Income, so both sides are down by $2.5 and balance.

Question 93

Walk me through the statements when a Parent Co. already owns a 30% stake in Sub Co., and the Sub Co. earns $100 in Net Income and issues $40 in Dividends.

Answer 93

Parent Co. records 30% * $100 = $30 in Equity Investment Earnings on its Income Statement, which boosts its Net Income by $30. On the CFS, Net Income is up by $30, but then Parent Co. reverses these Equity Investment Earnings and records $40 * 30% = $12 in Dividends Received from Equity Investments. At the bottom, Cash is up by $12. On the Balance Sheet, Cash is up by $12 on the Assets side. The Equity Investments line item is up by $30 from the Equity Investment Earnings and down by $12 from the Dividends, so the Assets side is up by $30. The L&E side is also up by $30 because CSE is up by $30 due to the Net Income increase, so both sides are up by $30 and balance.

Question 94

Walk me through the Balance Sheet combination when Parent Co. goes from a 30% stake to an 80% stake in Sub Co., using 100% Cash for the purchase price. Assume that Sub Co.'s Market Cap is $200 and that it has $200 in Total Assets and $50 in Total Liabilities

Answer 94

If Parent Co. has 30% * $200 = $60 in Equity Investments to represent its current 30% stake, then: Parent Co. creates Goodwill based on the purchase price for 100% of Sub Co. minus Sub Co.’s Common Shareholders’ Equity, which is $150 based on these numbers ($200 of Total Assets – $50 of Total Liabilities). New Goodwill = $200 – $150 = $50. On the Assets side, Parent Co. deducts the (80% – 30%) * $200 = $100 in Cash used to make this acquisition, and it removes the $60 in Equity Investments. Then, it adds the $50 of new Goodwill and the $200 of Sub Co.’s Total Assets, so the Assets side is up by $90. On the L&E side, Parent Co. adds Sub Co.’s $50 of Liabilities and creates a $40 Noncontrolling Interest for the 20% of Sub Co. that it does not own (20% * $200 = $40). So, the L&E side is up by $90, and both sides balance.

Question 95

Now, walk me through what happens in Year 1 following the deal when Parent Co. maintains its 80% stake in Sub Co. Assume that Parent Co.'s Net Income is $100, with $20 of Dividends, and that Sub Co.'s Net Income is $20, with $5 of Dividends.

Answer 95

Parent Co. has $100 of Net Income, and Sub Co. has $20, so the total Net Income is $120. At the bottom of the Income Statement, Parent Co. deducts 20% * Sub Co. Net Income, or 20% * $20 = $4. So, Net Income to Parent is up by $116. On the CFS, Net Income to Parent is up by $116, but Parent Co. then reverses the deduction from the Income Statement and adds back this $4 in Net Income Attributable to NCI. Then, it records 80% * $5 = $4 of Dividends Received from Sub Co. In Cash Flow from Financing, Parent Co. deducts its $20 of Dividends and Sub Co.’s $5 of Dividends. So, Cash at the bottom is up by $116 + $4 + $4 – $20 – $5 = $99. On the Balance Sheet, Cash on the Assets side is up by $99, so Total Assets are up by $99. On the L&E side, the NCI increases by Net Income to Noncontrolling Interests (+$4), increases by Dividends Received from Sub Co. (+$4), and decreases by Sub Co.’s Total Dividends (–$5). So, it is up by $3 here. Common Shareholders’ Equity increases by the $116 Net Income to Parent and decreases by the $20 in Dividends it issues, so it’s up by $96 here. Therefore, the L&E side is up by $99 because the NCI is up by $3, and CSE is up by $96. Both sides are up by $99 and balance

Question 96

At a high level (no numbers), explain what happens if Parent Co. sells its entire 80% stake in Sub Co. after a few years.

Answer 96

Parent Co. has to deconsolidate the financial statements by removing all of Sub Co.’s Assets and Liabilities, the new Goodwill that was created in the deal to acquire the 80% stake, and the Noncontrolling Interests. Also, Parent Co. has to record the Gain or Loss on the sale within Common Shareholders’ Equity and the total Cash it receives on the Assets side. The Gain or Loss is based on (Market Value of Stake Sold + Market Value of New Equity Investment, If Any + Book Value of Noncontrolling Interests) – Sub Co.’s Net Assets Including Goodwill. This Gain or Loss is taxed, and the total Cash proceeds equal the Cost Basis Recovered plus the After-Tax Gain or Loss.

Question 97

Walk me through the statements under U.S. GAAP when employees receive $40 of Stock-Based Compensation and then exercise their options and receive shares once the SBC’s value has increased to $140 in a future year.

Answer 97

Initially, the $40 of SBC is not Cash-Tax Deductible, so a Deferred Tax Asset of $40 * 25% = $10 gets created. If the SBC’s value increases to $140 in a future year, first, the ($140 – $40) * 25% = $25 is recorded as an “Excess Tax Benefit” on the Income Statement that reduces Income Taxes and increases Net Income by $25. On the Cash Flow Statement, Net Income is up by $25, and now the company can take the Cash-Tax Deduction on the original $40 of SBC, which produces a positive $10 in Deferred Taxes. At the bottom of the CFS, Cash is up by $35. On the Balance Sheet, Cash is up by $35 on the Assets side, and the DTA is down by $10, so the Assets side is up by $25. On the L&E side, Common Shareholders’ Equity is up by $25 due to the increased Net Income, so both sides are up by $25 and balance.

Question 98

Walk me through the statements when a company has $100 of Equity Securities classified as Trading or FVPL, and it records an Unrealized Gain of $40 on them

Answer 98

The Unrealized Gain shows up on the Income Statement and boosts Pre-Tax Income by $40, resulting in a $30 increase in Net Income at a 25% tax rate. On the CFS, Net Income is up by $30, and the Unrealized Gain of $40 is reversed. The company does not pay an extra $10 in Cash Taxes from this, so it also records a positive $10 in Deferred Income Taxes. At the bottom, Cash is unchanged. On the Balance Sheet, Cash is unchanged, the Equity Securities are up by $40, and the Deferred Tax Asset is down by $10, so Total Assets are up by $30. On the L&E side, Common Shareholders’ Equity is up by $30 due to the increased Net Income, so both sides are up by $30 and balance.

Question 99

A company records $40 in Pension Service Costs and $40 in Pension Interest/Finance Costs, as well as $100 in Employer Contributions into the plan. Assume that the Income Statement expenses are NOT Cash-Tax Deductible, but that the Employer Contributions are, and walk through the financial statements.

Answer 99

On the Income Statement, Pre-Tax Income is down by $80, so Net Income is down by $60 at a 25% tax rate On the Cash Flow Statement, Net Income is down by $60, but you add back the entire $80 Pension Expense from the Income Statement. This $80 Pension Expense is not Cash-Tax Deductible, but the $100 Employer Contributions are, so the company’s Cash Taxes are lower than its Book Taxes by ($100 – $80) * 25% = $5. This is shown as a positive $5 in Deferred Taxes, and the $100 in Employer Contributions are negative, so Cash is down by $75, since –$60 + $80 + $5 – $100 = –$75. On the Balance Sheet, Cash is down by $75, the Pension Assets are up by $100 from the Employer Contributions, and the Deferred Tax Asset is down by $5, so Total Assets are up by $20. On the L&E side, the Pension Liability is up by $80 because of the Pension Expense added back on the CFS, and Common Shareholders’ Equity is down by $60 due to the reduced Net Income. So, both sides are up by $20 and balance.

Question 100

Walk me through the financial statements when a company’s Operating Expenses increase by $100.

Answer 100

Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by $100, and Net Income is down by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $75. There are no other changes, so Cash at the bottom is down by $75. • Balance Sheet: Cash is down by $75, so the Assets side is down by $75, and CSE on the L&E side is down by $75 due to the reduced Net Income, so both sides balance. • Intuition: Nothing; it’s a simple cash expense

Question 101

company’s Depreciation increases by $20. What happens to the financial statements?

Answer 101

Income Statement: Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate. • Cash Flow Statement: Net Income is down by $15, but you add back the $20 in Depreciation since it’s non-cash, so Cash at the bottom is up by $5. Balance Sheet: Cash is up by $5, but PP&E is down by $20 due to the Depreciation, so the Assets side is down by $15. The L&E side is also down by $15 because Net Income falls by $15, which reduces CSE, so both sides balance. • Intuition: This non-cash expense does not “cost” the company anything, but it reduces the company’s taxes

Question 102

A company runs into financial distress and needs Cash immediately. It sells a factory that’s listed at $100 on its Balance Sheet for $80. What happens to the statements?

Answer 102

Income Statement: You record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $15, but you add back the $20 Loss since it’s non-cash. You also show the full proceeds received, $80, in Cash Flow from Investing, so cash at the bottom is up by $85. • Balance Sheet: Cash is up by $85, and PP&E is down by $100, so the Assets side is down by $15. The L&E side is also down by $15 because CSE falls by $15 due to the Net Income decrease, so both sides balance. • Intuition: The company gets the $80 in Cash proceeds, but it also gets $5 in tax savings from the Loss, so its Cash goes up by $85 rather than $80.

Question 103

A company decides to CHANGE a key employee’s compensation by offering the employee stock options instead of a cash salary. The employee’s cash salary was $100, but she will receive $120 in stock options now. How do the statements change?

Answer 103

Operating Expenses go up by $20, but the company also records $120 in non-cash expenses that are not Cash-Tax Deductible: • Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15 at a 25% tax rate. Cash Flow Statement: Net Income is down by $15, but you add back the $120 in SBC as a non-cash expense. However, this SBC is not truly Cash-Tax deductible, so there’s a Deferred Tax adjustment for ($30), since ($120) * 25% = ($30). The company did not reduce its Cash Taxes with this SBC. Cash at the bottom is up by $75. • Balance Sheet: Cash is up by $75, and the Net DTA is up by $30 because of the Deferred Tax adjustment, so the Assets side is up by $105. On the L&E side, CSE is down by $15 because of the reduced Net Income, but it’s also up by $120 because of the SBC, so the L&E side is up by $105, and both sides balance. • Intuition: The company increases its Cash balance by switching the employee to Stock-Based Compensation, but it doesn’t realize any Cash-Tax savings from doing that – so, Cash is up by $75 rather than $120, $90, or some other, larger number. If you don’t feel comfortable with the tax part, you could skip the Deferred Tax adjustment and just say that Cash, rather than the Net DTA, increases by $30.

Question 104

Walk me through the financial statements when a customer orders a product for $100 but doesn’t pay for it in cash. Then, walk through the cash collection, combining it with the first step.

Answer 104

The first step corresponds to Accounts Receivable increasing by $100, and the second step represents AR decreasing by $100. Here’s what happens when it increases: • Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100, and Net Income is up by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is up by $75, but the increase in AR reduces cash flow by $100, so Cash at the bottom is down by $25. • Balance Sheet: Cash is down by $25, but AR is up by $100, so the Assets side is up by $75. On the L&E side, CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and balance. • Intuition: The company has to pay taxes on Revenue it hasn’t yet collected in cash, so its Cash balance falls by $25. And when the AR is collected, combining it with the first step: Income Statement: The Net Income is still up by $75, and there are no other changes. • Cash Flow Statement: Net Income is still up by $75, but now the AR increase reverses, so the Change in AR is $0. Therefore, Cash at the bottom is up by $75. • Balance Sheet: Cash is now up by $75, and AR goes back to its original level, so the Assets side is up by $75. The L&E side is still up by $75 because of the CSE increase due to the increased Net Income in the first step, so both sides balance. • Intuition: This is a simple cash collection of a $100 payment owed to the company. Cash goes from being down by $25 in the first step to being up by $75 to reflect this.

Question 105

A company prepays $20 in utilities one month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is recognized, combined with the first step.

Answer 105

This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the increase: • Income Statement: No changes. • Cash Flow Statement: The $20 increase in Prepaid Expenses reduces the company’s cash flow by $20, so Cash at the bottom is down by $20. • Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains balanced. • Intuition: This is a simple cash payment for expenses that have not yet been incurred. And then when Prepaid Expenses decrease, combining it with the first step: • Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate. • Cash Flow Statement: Net Income is down by $15, but the increase in Prepaid Expenses now reverses, and there are no other changes, so Cash at the bottom is down by $15. Balance Sheet: Cash is down by $15, and Prepaid Expenses return to their original level, so the Assets side is down by $15. The L&E side is also down by $15 due to the reduced Net Income that flows into CSE, so both sides balance. • Intuition: Cash decreases by $15 because this represents the payment and recognition of a simple $20 cash expense, which reduces taxes by $5.

Question 106

Walmart buys $400 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600, combining it with the first step.

Answer 106

The first step is a simple Inventory purchase. In the second step, the company has to record COGS and the Revenue associated with the product sales. Here’s the first step: • Income Statement: No changes. • Cash Flow Statement: The $400 Inventory increase reduces the company’s cash flow, so Cash at the bottom is down by $400. • Balance Sheet: Cash is down by $400, but Inventory is up by $400, so the Assets side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains in balance. • Intuition: This is a simple cash purchase for an expense that has not yet been incurred. And then here’s the second step, combining it with the changes in the first one: • Income Statement: Revenue is up by $600, but COGS is up by $400, so Pre-Tax Income is up by $200, and Net Income is up by $150 at a 25% tax rate. • Cash Flow Statement: Net Income is up by $150, the Inventory increase now reverses because the Inventory has been sold, and there are no other changes, so Cash at the bottom is up by $150. • Balance Sheet: Cash is up by $150, and Inventory returns to its original level, so the Assets side is up by $150. The L&E side is also up by $150 because Net Income increases by $150 and flows into CSE, so both sides balance.

Question 107

Amazon decides to pay several key vendors $200 on credit and says it will pay them in cash in one month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash? Combine the second step with the first one.

Answer 107

This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and then decreasing by $200 when they’re finally paid out in cash. • Income Statement: Operating Expenses increase by $200, so Pre-Tax Income is down by $200, and Net Income is down by $150, assuming a 25% tax rate. • Cash Flow Statement: Net Income is down by $150, but AP increasing by $200 results in higher cash flow since it means the expenses haven’t been paid in cash yet. So, Cash at the bottom is up by $50. • Balance Sheet: Cash is up by $50, so the Assets side is up by $50. On the L&E side, AP is up by $200, but CSE is down by $150 due to the reduced Net Income, so the L&E side is up by $50, and both sides balance. • Intuition: This expense is “non-cash” at this point because it reduces the company’s taxes but doesn’t cost anything in cash. Cash is up because of the reduced taxes. And then here’s the second step, combined with the first step: • Income Statement: Net Income is still down by $150. No other changes. • Cash Flow Statement: Net Income is still down by $150, but now the AP increase reverses, so the Change in AP becomes $0. As a result, Cash at the bottom is down by $150. • Balance Sheet: Cash is down by $150, so the Assets side is down by $150. On the other side, AP returns to its original level, and CSE is down by $150 because of the reduced Net Income, so both sides are down by $150 and balance. • Intuition: From beginning to end, this is a simple $200 cash expense; Cash decreases by $150 rather than $200 due to the tax savings in the first step.

Question 108

Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens to the statements?

Answer 108

This scenario corresponds to Deferred Revenue increasing because the company collects the Cash, but cannot yet recognize it as Revenue. The payment for the entire year is $1,200. • Income Statement: No changes. • Cash Flow Statement: DR increasing by $1,200 boosts the company’s cash flow, so Cash at the bottom is up by $1,200. • Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance. • Intuition: This is a simple $1,200 cash inflow, with no taxes, for services the company has not yet delivered.

Question 109

What happens after one month has passed, and the company has delivered one month of service for $100? Assume that there are $20 in Operating Expenses associated with the delivery of the service for this one month. Combine this step with the previous one.

Answer 109

Income Statement: Revenue is up by $100, but Operating Expenses are up by $20, so Pre-Tax Income is up by $80, and Net Income is up by $60 at a 25% tax rate. • Cash Flow Statement: Net Income is up by $60, and part of the DR increase now reverses, so the increase in DR is now $1,100 rather than $1,200. Cash at the bottom is up by $1,160. • Balance Sheet: Cash is up by $1,160, so the Assets side is up by $1,160. On the L&E side, Deferred Revenue is now up by $1,100 instead of $1,200, and CSE is up by $60 due to the increased Net Income, so both sides are up by $1,160 and balance. • Intuition: Cash is up by less than it was in the previous step because the company must pay expenses and taxes when part of the cash inflow is now recognized as Revenue.

Question 110

A company issues $100 in common stock to new investors to fund its operations. How do the statements change?

Answer 110

Income Statement: No changes. • Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from Financing, and there are no other changes, so Cash at the bottom goes up by $100. • Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common Shareholders’ Equity on the other side goes up by $100, so the L&E side is up by $100, and both sides balance. • Intuition: This is a simple cash inflow that doesn’t impact the company’s taxes at all.

Question 111

This same company now realizes that it has too much Cash, so it wants to issue Dividends or repurchase common shares. How do they impact the three statements differently? Compare $100 in Dividends with a $100 Stock Repurchase.

Answer 111

These changes both make a similar impact; the main difference is that Dividends do not reduce the common shares outstanding, but a Stock Repurchase does. • Income Statement: No changes. • Cash Flow Statement: Both of these show up as negative $100 entries in Cash Flow from Financing, reducing the Cash at the bottom of the CFS by $100. • Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E side, Dividends reduce Retained Earnings within CSE by $100, while a Stock Repurchase reduces Treasury Stock within CSE by $100. But in either case, CSE is down by $100, so the L&E side is down by $100, and both sides balance. • Intuition: These are simple cash outflows that don’t affect the company’s taxes at all. We can’t determine how the common shares outstanding change without information on the share price at which the Stock Repurchase takes place.

Question 112

A company that follows U.S. GAAP signs a 10-year, $1,000 Operating Lease on January 1 and pays a total of $100 in Rent throughout the year. Assume a 6% Discount Rate, and walk me through the financial statements over this entire year in a single step.

Answer 112

Initially, the company records the Operating Lease Assets and Liabilities on its Balance Sheet ($1,000 on both sides), and then it records the Rental Expense on the Income Statement. The 6% Discount Rate means that the initial “Interest Expense” is 6% * $1,000 = $60, so the “Depreciation” equals $100 – $60 = $40. Since the lease payments are constant, the “Lease Principal Repayment” equals the “Depreciation” here: • Income Statement: Operating Expenses are up by $100 due to the Rent, so Pre-Tax Income falls by $100, and Net Income falls by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $75, but Operating Lease Assets and Liabilities increase by $1,000, which offset each other. But then they both decrease by $40, which is also an offset. So, Cash is down by $75 at the bottom. • Balance Sheet: On the Assets side, Cash is down by $75, and Operating Lease Assets are up by $960, so Total Assets are up by $885. On the L&E side, the Operating Lease Liabilities are up by $960, and CSE is down by $75, so this side is up by $885, and both sides balance. • Intuition: Cash is down by $75 because this is a simple $100 cash expense with $25 in tax savings, and the Lease Asset and Lease Liability change by the same amounts.

Question 113

A company that follows IFRS now signs a 10-year, $1,000 Operating Lease with a cash Rental Expense of $100 per year. Assume a 6% Discount Rate and walk me through the statements over the entire year.

Answer 113

Under IFRS, the company records Depreciation of $1,000 / 10 = $100 per year and an initial Interest Expense of $1,000 * 6% = $60. The Lease Principal Repayment = Cash Rental Expense – Interest Expense = $100 – $60 = $40. • Income Statement: Depreciation is up by $100, and the Interest Expense is up by $60, so Pre-Tax Income is down by $160, and Net Income falls by $120 at a 25% tax rate. Cash Flow Statement: Net Income is down by $120, but you add back the $100 of Depreciation and record the $1,000 additions to the Finance Lease Assets and Liabilities (which offset each other). Also, you record a negative $40 for the Lease Principal Repayment. Cash is down by $60 at the bottom. • Balance Sheet: Cash is down by $60, and the Finance Lease Assets are up by $900 due to the initial $1,000 increase and the $100 of Depreciation, so Total Assets are up by $840. On the other side, the Finance Lease Liabilities are up by $960, and Common Shareholders’ Equity is down by $120, so both sides are up by $840 and balance. • Intuition: Cash is down by $60 because there’s a total of $200 in new Lease Expenses, but $100 of them are non-cash, and $160 of them reduce the company’s taxes. So, ($200) + $100 + $160 * 25% = ($60).

Question 114

For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records $40 in Depreciation. Walk me through the financial statements

Answer 114

You don’t need to walk through the Tax Schedule for this type of change because the numbers are simple: • Income Statement: The $20 in increased Depreciation reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate, so the company saves $5 in taxes. • Cash Flow Statement: Net Income is down by $15, and you add back the $20 in Depreciation as a non-cash expense. However, the company recorded $40 of Depreciation for Cash-Tax purposes, so it actually reduced its Cash Taxes by $10, not $5. You record this additional $5 as a positive in the Deferred Income Taxes line on the CFS. Cash at the bottom is up by $10. • Balance Sheet: Cash is up by $10 on the Assets side, and Net PP&E is down by $20, so the Assets side is down by $10. On the L&E side, the Deferred Tax Liability is up by $5, and CSE is down by $15 due to the reduced Net Income, so the L&E side is also down by $10, and both sides balance. • Intuition: Cash is up by $10 rather than $5 or $0 because the company’s actual Cash-Tax savings equals $40 * 25% = $10.

Question 115

A company has a factory shown at $200 on its Balance Sheet, but a hurricane hits the factory and destroys part of it, so the company records a $100 PP&E Write-Down. Walk me through the statements.

Answer 115

Normally, PP&E Write-Downs are not Cash-Tax deductible, so the “correct” treatment is: • Income Statement: The $100 PP&E Write-Down reduces Pre-Tax Income by $100, and Net Income falls by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $75, but you add back the $100 Write-Down as a non-cash expense. In reality, however, the company saved nothing in Cash Taxes, so you also record a negative $25 in Deferred Income Taxes, and Cash at the bottom is unchanged. • Balance Sheet: Cash does not change, but the Deferred Tax Asset increases by $25, and Net PP&E decreases by $100, so the Assets side is down by $75. The L&E side is also down by $75 because CSE falls due to the reduced Net Income, so both sides balance. • Intuition: Cash does not change because Write-Downs are typically not Cash-Tax deductible, so the DTA, rather than Cash, increases.

Question 116

A company buys a factory for $200 using $200 of Debt. What happens INITIALLY on the statements?

Answer 116

Income Statement: No changes. • Cash Flow Statement: There’s no net change in cash because the $200 factory purchase counts as CapEx, which reduces cash flow, and the $200 Debt issuance is a cash inflow. • Balance Sheet: PP&E is up by $200, so the Assets side is up by $200, and Debt is up by $200, so the L&E side is up by $200, and the Balance Sheet stays balanced. • Intuition: An Asset increases and a Liability increases to balance it, and there are no tax effects.

Question 117

One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the factory. It also repays 5% of the Debt principal. What happens on the statements in this first year?

Answer 117

10% interest rate means $20 in Interest Expense, the 10% depreciation means $200 * 10% = $20 of Depreciation, and 5% * $200 = $10 of the Debt principal is repaid. So: • Income Statement: You record $20 in Interest and $20 in Depreciation, so Pre-Tax Income falls by $40, and Net Income falls by $30 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $30, but you add back the $20 of Depreciation and record $10 in Debt Principal Repayments, so Cash at the bottom is down by $20. • Balance Sheet: Cash is down by $20, and Net PP&E is down by $20, so the Assets side is down by $40. On the L&E side, Debt is down by $10 due to the principal repayment, and CSE is down by $30 due to the reduced Net Income, so both sides are down by $40 and balance. • Intuition: Cash declines because of the Interest Expense and Debt Principal Repayment, offset by the tax savings from the Interest and Depreciation.

Question 118

At the end of this first year, the company sells its factories for $220 and uses the proceeds to repay its remaining Debt principal, after realizing there is little demand for its products. Walk through this step SEPARATELY from the previous two. Assume that the Net PP&E balance is $180, and the Debt is $190 because of changes in the previous step.

Answer 118

The Net PP&E selling price is $220, and its Book Value is $180, so we record a Gain of $40: • Income Statement: The Realized Gain of $40 increases Pre-Tax Income by $40 and Net Income by $30 at a 25% tax rate. • Cash Flow Statement: Net Income is up by $30, but the $40 Gain is non-cash, so it’s reversed in the CFO section. Then, in Cash Flow from Investing, the full sale proceeds of $220 are recorded as a cash inflow. In Cash Flow from Financing, the $190 Debt repayment is shown as a negative. So, Cash at the bottom is up by $20. • Balance Sheet: Cash is up by $20, and Net PP&E is down by $180, so Total Assets are down by $160. On the L&E side, Debt is down by $190, and CSE is up by $30 because of the increased Net Income, so both sides are down by $160 and balance. • Intuition: Cash is up because of the Gain, which boosts Cash by $30 after taxes. However, the full $30 does not flow into Cash because the Debt Repayment exceeds the reduction in Net PP&E by $10. As a result, Cash is up by $20 instead of $30

Question 119

Walmart orders $200 of Inventory and pays for it using Debt. What happens on the statements immediately after this initial transaction?

Answer 119

Income Statement: No changes. • Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but the Debt issuance boosts cash flow by $200, so Cash at the bottom stays the same. • Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E side is also up by $200 because Debt is up by $200, so both sides balance Intuition: This is a simple cash payment for an expense not yet incurred, combined with a Debt issuance that offsets the cash outflow.

Question 120

A year passes, and Walmart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process and deliver the orders (counted as OpEx). The company also pays 4% interest on its Debt and repays 10% of the principal. What happens on the statements over this year? Combine this step with the previous one and explain the changes from beginning to end.

Answer 120

This question is the standard “Sell Inventory for a certain amount of Revenue” one, but there are a few twists. For one, there’s also $100 in additional Operating Expenses. Also, you need to factor in the $8 Interest Expense on the Debt ($200 * 4%) and the $20 Debt Principal Repayment ($200 * 10%). • Income Statement: Revenue is up by $400, but COGS is up by $200, and OpEx is up by $100, so Operating Income is only up by $100. There’s $8 in Interest Expense as well, so Pre-Tax Income is up by $92. At a 25% tax rate, Net Income is up by $69 (mental math: $100 * 75% = $75, and $8 * 75% = $6, so take $75 and subtract $6). • Cash Flow Statement: Net Income is up by $69. But now we reverse the previous increase in Inventory, so the Change in Inventory is $0 once again. The $200 cash inflow for Debt still exists, but now there’s also a $20 Debt Principal Repayment so Cash at the bottom is up by $249. • Balance Sheet: Cash is up by $249, and Inventory returns to its original level, so the Assets side is up by $249. On the L&E side, Debt is up by $180, and CSE is up by $69 due to the increased Net Income, so both sides are up by $249 and balance. • Intuition: The company has bought goods, turned them into finished products, and recorded $75 in after-tax profits from the sale. However, its Cash balance increases by only $49 due to the Interest Expense on the Debt it used to purchase this Inventory as well as the Debt Principal Repayment.

Question 121

Walk through the same scenario, but assume that Walmart purchases the $200 of Inventory on credit (i.e., Accounts Payable), sells it for $400, and still records $100 in additional OpEx. Assume that it pays the suppliers in the second step of this process.

Answer 121

Remember that Accounts Payable is not necessarily linked to a specific Income Statement line item in a case like this! It could just correspond to the company paying for Inventory on credit. In the first step: • Income Statement: No changes. • Cash Flow Statement: Accounts Payable increases, increasing cash flow by $200, and Inventory also increases, reducing cash flow by $200; the changes offset each other, and Cash at the bottom stays the same. • Balance Sheet: Inventory on the Assets side is up by $200, and Accounts Payable on the L&E side is up by $200, so both sides are up by $200 and balance. • Intuition: The company receives the parts and materials, but has not paid for them in cash yet, so the Balance Sheet changes but Cash stays the same. And then in the second step: • Income Statement: Revenue is up by $400, COGS is up by $200, and OpEx is up by $100, so Pre-Tax Income is up by $100. Net Income is up by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is up by $75, and the Change in Inventory and Change in Accounts Payable both reverse now, so Cash at the bottom is up by $75. • Balance Sheet: Cash is up by $75 on the Assets side, and Inventory returns to its original level, so Total Assets are up by $75. On the L&E side, AP returns to its original level, and CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and balance. • Intuition: From beginning to end, this is a simple increase of $100 in Pre-Tax Income, so the company’s Cash balance goes up by $75 due to taxes.

Question 122

A company issues $200 in Preferred Stock to buy $200 in Financial Investments. The Preferred Stock has a coupon rate of 8%, and the Financial Investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase?

Answer 122

Income Statement: No changes. • Cash Flow Statement: The purchase of the Financial Investments counts as an Investing Activity and reduces cash flow by $200, but the Preferred Stock issuance boosts cash flow by $200 within CFF, so there’s no net change in cash. • Balance Sheet: Financial Investments is up by $200, so the Assets side is up by $200, and Preferred Stock on the other side is up by $200, so the L&E side is up by $200, and both sides balance. • Intuition: This is a simple cash purchase of investments funded by a Preferred Stock issuance, and neither event affects the company’s taxes.

Question 123

What happens on the statements after a year? Combine this step with the previous one, so that you factor in the increases in Financial Investments and Preferred Stock.

Answer 123

Although you subtract Preferred Dividends from Net Income to calculate Net Income to Common, the Preferred Dividends are NOT tax-deductible: • Income Statement: The company records 10% * $200 = $20 in Interest Income from the Financial Investments, so Pre-Tax Income is up by $20, and Net Income is up by $15 at a 25% tax rate. The Preferred Dividends equal 8% * $200 = $16, so Net Income to Common is down by $1 after subtracting these. • Cash Flow Statement: Net Income to Common is down by $1, and the Financial Investment and Preferred Stock increases still appear on the CFS and offset each other, so Cash at the bottom is down by $1. • Balance Sheet: Cash is down by $1, and Financial Investments are up by $200, so the Assets side is up by $199. On the L&E side, Preferred Stock is still up by $200, and CSE is down by $1 because of the reduced Net Income to Common, so both sides are down by $199 and balance. Intuition: The point of this question is that the tax treatment of funding sources can make a significant impact on the statements. Since the Preferred Dividends are not tax-deductible, the company’s Cash balance falls; if they had been tax-deductible, its Cash balance would have risen. Also, note that Preferred Dividends do not reduce Preferred Stock – they reduce Common Shareholders’ Equity!

Question 124

A company wants to boost its EPS artificially, so it decides to issue Debt and use the proceeds to repurchase common shares. Initially, the company has 1,000 shares outstanding at $1.00 per share and a Net Income of $300. What happens IMMEDIATELY after the company raises $200 in Debt and uses it to repurchase $200 in common stock?

Answer 124

Repurchasing $200 in stock at a share price of $1.00 per share means that the company repurchases 200 shares, so its share count drops from 1,000 to 800. Its EPS before this move was $300 / 1,000, or $0.30. For the first step: • Income Statement: No changes. • Cash Flow Statement: The $200 Debt issuance boosts cash flow by $200, but the $200 stock repurchase reduces it by $200, so there’s no net change in cash. • Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by $200, but Treasury Stock within CSE is down by $200, so there’s no net change, and the BS remains in balance. • Intuition: These are simple cash inflows and outflows that cancel each other out and make no impact on the company’s taxes.

Question 125

What happens after a year passes if the company pays 4% interest on the Debt? Combine this with the first step and explain the EPS impact.

Answer 125

This question is a twist on the standard 3-statement accounting questions because you also have to calculate the change in EPS: Income Statement: The company records 4% * $200 = $8 in Interest Expense, so Pre-Tax Income is down by $8, and Net Income is down by $6 at a 25% tax rate. Net Income is now $294 rather than $300, and the Share Count decreased from 1,000 to 800 in Step 1. Therefore, EPS increases because the EPS numerator falls by 2%, but the denominator falls by 20% (it’s a $0.07 increase, but you can just say, “EPS increases”). • Cash Flow Statement: Net Income is down by $6, and the Debt Issuance and Stock Repurchase still offset each other, so Cash at the bottom is down by $6. • Balance Sheet: Cash is down by $6, so the Assets side is down by $6. On the L&E side, Debt is still up by $200, CSE is down by $200 due to the Stock Repurchase, and then it drops by another $6 due to the reduced Net Income, so the L&E side is also down by $6, and both sides balance. • Intuition: Companies can artificially inflate their EPS with these tactics, so they may “look better” even if their cash flow and Cash balances both decrease. Don’t trust EPS!

Question 126

Your company decides to acquire another company for $500, using 50% Debt and 50% Common Stock. The other company has $300 in Assets, no Liabilities, and $300 in Common Shareholders’ Equity. Assume that the purchase premium is distributed 50/50 between Goodwill and Other Intangible Assets. What happens to your company’s financial statements immediately after this acquisition takes place?

Answer 126

You combine the other company’s Assets and Liabilities with your company’s, and you write down the seller’s Common Shareholders’ Equity: • Income Statement: No changes. • Cash Flow Statement: You record a negative $500 for “Acquisitions” in Cash Flow from Investing and a positive $250 for Debt Issuances and positive $250 for Common Stock Issuances under Cash Flow from Financing. Cash at the bottom is unchanged. • Balance Sheet: Cash stays the same, but you add the $300 in Acquired Assets, as well as the $100 in Goodwill and $100 in Other Intangible Assets, so the Assets side is up by $500. On the other side, Debt is up by $250, and CSE is up by $250, so the L&E side is also up by $500, and both sides balance. • Intuition: Immediately after the deal closes, the main changes take place on the Balance Sheet; Cash does not change because the acquisition was funded completely with Debt and a Stock Issuance.

Question 127

Now, walk through what happens on the statements in the one year following this acquisition. The acquired company contributes $200 in Revenue and $100 in OpEx, and the Interest Rate on Debt is 8%. Assume that the Other Intangible Assets have a useful life of 5 years. Walk through ONLY THIS STEP, and do not worry about tracking the cumulative changes with the previous one.

Answer 127

Income Statement: Revenue is up by $200, but OpEx is up by $100, and there’s now $100 / 5 = $20 of Amortization of Intangibles and $250 * 8% = $20 of Interest Expense. So, Pre-Tax Income is up by $100 – $20 – $20 = $60. At a 25% tax rate, Net Income is up by $45. • Cash Flow Statement: Net Income is up by $45, and we add back the $20 of Amortization of Intangibles since it was non-cash. However, we also make an adjustment of ($5) in Deferred Income Taxes because this Amortization is not Cash-Tax Deductible. So, Cash at the bottom is up by $45 + $20 – $5 = $60. • Balance Sheet: Cash is up by $60, Other Intangibles are down by $20 due to the Amortization, and the Net DTA is up by $5 due to the Deferred Income Tax adjustment, so the Assets side is up by $45. On the L&E side, CSE is up by $45 due to the increased Net Income, so both sides are up by $45 and balance. • Intuition: The acquired company contributes $100 in Operating Income, but it’s not a straight $75 increase to Cash because of the new Amortization and Interest Expense, which make it to a $45 increase instead.

Question 128

On December 31 of Year 1, this same company now decides that this acquired company is worth far less than expected, so it writes down the entire $100 balance of Goodwill.

Answer 128

This one is a simple non-cash expense that is also not Cash-Tax Deductible: • Income Statement: Record a $100 Goodwill Impairment, which reduces Pre-Tax Income by $100 and Net Income by $75 at a 25% tax rate. • Cash Flow Statement: Net Income is down by $75, and you add back the $100 Goodwill Impairment. Also, since it was not Cash-Tax Deductible, record a ($25) adjustment in Deferred Income Taxes. Cash at the bottom is unchanged. • Balance Sheet: Cash is unchanged, Goodwill is down by $100, and the Net DTA is up by $25, so Total Assets are down by $75. On the L&E side, CSE is down by $75 due to the reduced Net Income, so both sides are down by $75 and balance. • Intuition: Impairments and write-downs are rarely, if ever, Cash-Tax deductible. So, when they occur, they increase the company’s DTA or Net DTA rather than increasing its Cash balance.

Question 129

What is Free Cash Flow (FCF), and what does it mean if it's positive and increasing?

Answer 129

There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations (CFO) minus CapEx. FCF represents a company’s “discretionary cash flow” – how much cash flow it generates from its core business after also paying for the cost of its funding sources, such as interest on Debt. It’s defined this way because most items in CFO are required to run the business, while most of the CFI and CFF sections are optional or non-recurring (except for CapEx). It’s generally a good sign if FCF is positive and increasing, as long as it’s driven by the company’s sales, market share, and margins growing (rather than creative cost-cutting or reduced re-investment into the business). Positive and growing FCF means the company doesn’t need outside funding sources to stay afloat, and it could spend its cash flow in different ways: hiring more employees, re-investing in the business, acquiring other companies, or returning money to the shareholders with Dividends or Stock Repurchases.

Question 130

What does FCF mean if it's negative or decreasing?

Answer 130

You have to find out why FCF is negative or decreasing first. For example, if FCF is negative because CapEx in one year was unusually high, but it’s expected to return to normal levels in the future, negative FCF in one year doesn’t mean much. On the other hand, if FCF is negative because the company’s sales and operating income have been declining each year, then the business is in trouble. If FCF decreases to the point where the company runs low on Cash, it will have to raise Equity or Debt funding ASAP and restructure to continue operating. Short periods of negative FCF, such as for early-stage startups, are acceptable, but if a company continues to generate negative cash flow for years or decades, stay away!

Question 131

Why might you have to adjust the calculation for FCF if you’re analyzing a company that follows IFRS rather than U.S. GAAP?

Answer 131

The simple definition (Cash Flow from Operations minus CapEx) assumes that Cash Flow from Operations has deductions for the Net Interest Expense, Preferred Dividends (if applicable), Taxes, and all Lease Expenses. That is almost always the case under U.S. GAAP because CFO usually starts with Net Income (to Common), but under IFRS, the presentation of the Cash Flow Statement varies widely. So, if a company starts CFO with Operating Income or Pre-Tax Income instead, you’ll have to make adjustments to ensure that the proper items have been deducted. Also, you should not add back the Depreciation element of the Lease Expense in the non-cash adjustments section of CFO.

Question 132

What is Working Capital?

Answer 132

The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the more useful definition is: Working Capital = Current Operational Assets – Current Operational Liabilities “Operational” means that you exclude items such as Cash, Investments, and Debt that are related to the company’s capital structure, not its core business. This version is sometimes called Operating Working Capital instead. You may also include Long-Term Assets and Liabilities that are related to the company’s business operations (Long-Term Deferred Revenue is a good example). Working Capital tells you whether a company needs more in Operational Assets or Operational Liabilities to run its business, and how big the difference is. But the Change in Working Capital (see below) matters far more for valuation purposes.

Question 133

Should Changes in Operating Lease Assets and Liabilities be included in the Change in Working Capital? What difference does it make if they are included or not included?

Answer 133

Different companies set up their statements differently, so some companies list these items within the Change in WC, others list them outside of the Change in WC but within Cash Flow from Operations, and others do not list them on the CFS at all. Under U.S. GAAP, the exact treatment makes almost no difference because the Change in Operating Lease Assets tends to be very close to the Change in Operating Lease Liabilities, so changes to these items usually offset each other. Under IFRS, only increases in Operating Lease Assets and Liabilities could potentially appear within the Change in Working Capital because the Depreciation and Lease Principal Repayment parts are shown separately. Even though the Lease Assets and Liabilities decrease by different amounts each year under IFRS, they should increase by about the same amount. Therefore, the cash flows usually offset each other, and these items’ exact positions do not matter.

Question 134

A A company's Working Capital has increased from $50 to $200. You calculate the Change in Working Capital by taking the new number and subtracting the old number, so $200 – $50 = positive $150. But on its Cash Flow Statement, the company records the Change in Working Capital as negative $150. Is the company wrong? No, the company is correct. On the Cash Flow Statement, the Change in Working Capital equals Old Working Capital – New Working Capital.

Answer 134

Pretend that that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to $200, that will reduce the company’s cash flow because it means the company has spent Cash to purchase Inventory. Therefore, the Change in Inventory should be ($150) on the CFS, and if that’s the only component of Working Capital, the Change in WC should also be ($150). When a company’s Working Capital INCREASES, the company USES cash to do that; when Working Capital DECREASES, it FREES UP cash.

Question 135

What does the Change in Working Capital mean?

Answer 135

The Change in Working Capital tells you if the company needs to spend in ADVANCE of its growth, or if it generates more cash flow as a RESULT of its growth. It’s also a component of Free Cash Flow and gives you an indication of how much “Cash Flow” will differ from Net Income, and in which direction. For example, the Change in Working Capital is often negative for retailers because they must spend money on Inventory before being able to sell products. But the Change in Working Capital is often positive for subscription companies that collect cash from customers far in advance because Deferred Revenue increases when they do that, and increases in Deferred Revenue boost cash flow. The Change in Working Capital increases or decreases Free Cash Flow, which directly affects the company’s valuation.

Question 136

What does it mean if a company's FCF is growing, but its Change in Working Capital is more and more negative each year?

Answer 136

It means that the company’s Net Income or non-cash charges are growing by more than its Change in WC is declining, or that its CapEx is becoming less negative by more than the Change in WC is declining. If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher non-cash charges or artificially reduced CapEx are boosting FCF, both are negative.

Question 137

How do you calculate Return on Invested Capital (ROIC), and what does it tell you?

Answer 137

ROIC is defined as NOPAT / Average Invested Capital, where NOPAT (Net Operating Profit After Taxes) = EBIT * (1 – Tax Rate), and Invested Capital = Equity + Debt + Preferred Stock + Other Long-Term Funding Sources. It tells you how efficiently a company is using its capital from all sources (both external and internal) to generate operating profits. Among similar companies, ones with higher ROIC figures should, in theory, be valued more highly because all the investor groups earn more for each $1.00 invested into the company

Question 138

What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring company performance?

Answer 138

These metrics all measure how efficiently a company is using its Equity, Assets, or Invested Capital to generate profits, but the nuances are slightly different. ROE and ROA are both affected by capital structure (the company’s Cash and Debt and Net Interest Expense) because they use Net Income (to Common) in the numerator. However, they’re also “closer to reality” because Net Income (to Common) is an actual metric that appears on companies’ financial statements and affects the Cash balance. By contrast, since NOPAT is a hypothetical metric that doesn’t appear on the statements, ROIC is further removed from the company’s Cash position, even though it has the advantage of being capital structure-neutral. In terms of ROE vs. ROA, ROA tends to be more useful for companies that depend heavily on their Assets to generate Net Income (e.g., banks and insurance firms), while ROE is more of a general-purpose metric that applies to many industries.

Question 139

A company seems to be boosting its ROE artificially by using leverage to fuel its growth. Which metrics or ratios could you look at to see if this is true?

Answer 139

Companies can artificially boost their ROE by continually issuing Debt rather than Equity because Debt doesn’t affect the denominator, and the Interest Expense from Debt only makes a small impact on the numerator (Net Income). And this small impact is usually outweighed by the additional Operating Income the company generates from the assets it buys with the proceeds from the Debt issuances. To see if this is happening, you could check the company’s Debt / EBITDA and EBITDA / Interest ratios and see how they’ve been trending. If Debt / EBITDA keeps increasing while EBITDA / Interest keeps decreasing, the company may be relying on leverage to boost its ROE.

Question 140

What does it say about a company if its Days Receivables Outstanding is ~5, but its Days Payable Outstanding is ~60?

Answer 140

It tells you that the company has quite a lot of market power to collect cash from customers quickly and to delay supplier payments for a long time. Examples might be companies like Amazon and Walmart that dominate their respective markets and that often make suppliers “offers they can’t refuse.”

Question 141

What is the Cash Conversion Cycle (CCC), and what does it mean if, among a group of similar companies, one company’s CCC is 5, and another’s is 30?

Answer 141

The Cash Conversion Cycle is defined as Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO), and it tells you how much time it takes a company to convert its Inventory and other short-term Assets, such as Accounts Receivable, into Cash. Lower is better for this metric because it means the company “converts” these items into cash flow more quickly, so a CCC is 5 is better than a CCC of 30.This one also depends heavily on the industry: the CCC is often low (under 10) for large retailers, but it may be over 100 (or more!) in an industry like spirits, where Inventory may sit on the Balance Sheet for months, years, or decades