OE - Advanced Accounting Flashcards
How do you get from net income to CFO?
Net Income gets added to the top line of CFO. D&A and other non-cash charges are added back to CFO. Pretax gains from asset sales are subtracted and pretax losses are added back to CFO. Working capital adjustments are made such that year-over-year changes in current assets are subtracted and changes in current liabilities are added.
What section of the cash flow statement could you do without and still complete a valuation?
You can do without the cash flow from financing section. You can complete a DCF by using just the cash flows from operating and cash flow from investing. You can use the cash flow from operating (which includes the added depreciation and subtraction of net working capital) and then subtract the capital expenditure found on the cash flow from investing statement to get the FCF to then perform a DCF.
How do you get NOPAT from EBITDA?
Net Operating Profit After Taxes = (EBITDA - D&A) x (1-tax rate)
(Note: NOPAT is the common name for EBI.)
Is increasing working capital a cause for concern?
Not necessarily, but it would require further analysis. Working capital gives investors can idea of the company’s underlying operational efficiency. An increase in working capital indicates that the business has either increased current assets or has decreased current liabilities. This could be because the firm is investing more in inventories in preparation for greater sales in some future period.
Discuss different accounting treatments for different types of securities (trading, available for sale, held to maturity)
Trading securities are characterized by active buying and selling with the intent of generating a profit. Typically, only financial institutions hold these types of highly liquid securities. Trading securities are shown on the balance sheet at fair market value and unrealized gains / losses pass through the income statement.
BS: Market to market, classified as current assets - marketable securities
IS: Recognize dividend and interest revenues as well as unrealized gains / losses
SCF: CFO: Interest / dividend receipt; CFI: Proceeds from purchases and sales
S/E: Effect on equity through impact on NI
Available for sale securities are an intermediate class of securities that are typically held for a specific cash need. Available for sale securities are shown on the balance sheet at fair market value, however unrealized gains / losses pass through other comprehensive income on the income statement, and are recorded in an equity account (accumulated other comprehensive income) and are only realized in income upon disposition.
BS: Shown at market value; classified as current or non-current asset; unrealized gains / losses recorded as “Other Comprehensive Income”
IS: Dividend and interest revenue reported. Gains / Losses only hit IS when security is sold
SCF: CFO: interest and dividend receipt; CFI: proceeds from purchases, sales and maturation of securities
S/E: Impact from changes to NI; unrealized gains / losses hit OCI
Held to maturity securities are securities for which a firm has both the intent and ability to hold to maturity. They are shown on the balance sheet at the amortized cost. The impact of temporary fluctuations in the fair value of debt securities is not reflected in the company’s financial statements.
BS: Shown at the amortized cost
IS: Interest revenue
SCF: CFO: Deduct change in interest received and amortization of discount; CFI: Proceeds from purchases, sales, and maturation of securities
Discuss how investments are handled depending on ownership level.
There are three main types of investments: 1) minority passive 2) minority active 3) majority active
Minority passive investments require less than 50% ownership where the investing firm cannot or does not influence the decisions of the owned firm (generally less than 20%). The initial investment is recorded at cost, according to one of the financial investment classification groups.
Minority active investments typically involve ownership of 20-50% with the remainder of voting ownership split. The equity method of accounting is required in which the initial acquisition is recorded at cost, and in each period the investing firm records its proportionate share of the firm’s net income. Dividends reduce the value of the investment on the balance sheet, and the investment’s net income increases the balance sheet value.
When a parent firm owns more than 50% of another entity, the financial statements are consolidated and the portion not owned by the parent is called the non-controlling interest. Non-controlling interest income is subtracted on the income statement and is an equity account on the balance sheet.
What are deferred revenues? Give me an example of a firm that would have deferred revenues and why.
Deferred revenues are previously recorded liabilities that occur when cash is received before the good / service has been provided. Take your WSJ subscription, for example. The liability to provide service to you will be recognized on their income statement as that liability is fulfilled since the cash has been collected.
What is a Deferred Tax asset (DTA) and Deferred Tax liability (DTL)?
Deferred tax liabilities traditionally occur because of the timing differences in reporting of revenues and expenses on the accounting books vs. the tax books. More specifically, DTLs typically occur due to use of accelerated depreciation schedules for tax accounting but not for GAAP, which push tax payments into the future. DTAs typically occur due to net operating loss carry-forwards, which allow corporations to offset future taxable gains with past losses. DTAs thus are a direct reduction of future taxes.
Are dividends tax deductible?
No. Dividends paid on common stock are taxable on two levels in the U.S. At the firm level, dividends come out of the net income after taxes. Shareholders are also taxed on dividends in either at the ordinary income tax level or the qualified dividend tax rate depending on factors determined by IRS tax code.
How do you calculate interest coverage?
Divide EBIT or EBITDA by the total interest expense?
What is the difference between an expense and an expenditure?
An expense is reported immediately on the business’s income statement. Capital expenditures are subject to depreciation. Depreciation and amortization exist to allow for a capitalized expense to be recognized over time.
If a firm pays out 100% of their earnings as dividends, is their free cash flow to the firm negative?
Not necessarily. Free cash flow to the firm is calculated before dividends or other payments to capital providers.
Where do pension liabilities fall on the balance sheet?
Pension liabilities are reported as “accrued liabilities” under long-term liabilities. Actuarial gains or losses and prior service costs that arise during the period are recognized as components of “accumulated or other comprehensive income” under shareholders’ equity.
Suppose a company buys a new factory building for $100 funded by 50% debt and 50% stock. What is the effect on the 3 financial statements? Assume 10-year straight line depreciation and 10% pre-tax interest with PIK payments.
Now (Year 0)
On income statement: No impact.
On cash flow statement: Cash outflow in the investing section of $100 (CAPEX). Cash inflow in the financing section of $50 (Debt) and $50 (Equity).
On balance sheet: PP&E increases by $100. Debt increases by $50. Shareholders equity increases by $50.
Year 1
On income statement: Depreciation expense of $10 per year, Interest expense of $5 (10% x $50 debt), therefore net income is $12 lower per year (assuming 20% tax rate)
On cash flow statement: Depreciation of $10 and PIK interest of $5 (non-cash expenses) are added back to net income (-$12) in the calculation of cash flow from operations. Cash flow from operations is thus $3 per year higher than it would have been without the investment (tax savings from depreciation).
On balance sheet: Cash increases by $3, net PP&E decreases by $10, so assets are down by $7. On the L&SE side, debt increases by $5 (PIK interest is added to the loan principal) retained earnings decreases by $12 because of the decrease in net income, so L&SE is down by $7 and both sides balance.
Year 2
On income statement: Depreciation expense of $10 per year, Interest expense of $5.5 (10% x $55 debt - includes the additional capitalized interest), therefore net income is $12.4 lower per year (assuming 20% tax rate)
On cash flow statement: Depreciation of $10 and PIK interest of $5.5 (non-cash expenses) are added back to net income (-$12.4) in the calculation of cash flow from operations. Cash flow from operations is thus $3.1 per year higher than it would have been without the investment (tax savings from depreciation).
On balance sheet: Cash increases by $3.1 net PP&A decreases by $10, so assets are down by $6.9. On the LS&E side, debt increases by $5.5 (PIK interest is added to the loan principal) retained earnings decreases by $12.4 because of the decrease in net income, so L&SE is down by $6.9 and both sides balance.
