OE - Basic Accounting

Question 1

How do the 3 financial statements relate to each other? Which items are on all three statements?

Answer 1

Links between the income statement and balance sheet: The profits generated on the income statement after any payment of dividends are added to shareholder’s equity on the balance sheet under retained earnings. Debt on the balance sheet is used to calculate interest expense on the income statement. Property, plant and equipment on the balance sheet is used to calculate depreciation expense on the income statement.

NI is the first line item on the cash flow statement, under CFO.

Links between the statement of cash flows and balance sheet: Beginning cash on the statement of cash flows comes from the prior time period’s balance sheet. Cash from operations is derived primarily from changes in balance sheet accounts, net working capital (current assets minus current liabilities) and depreciation come from PP&E on the balance sheet. Investments in PP&E come from the balance sheet and are accounted for under cash flows from investing. Ending cash goes back onto the balance sheet.

Question 2

Run me through an income statement. Define Operating Income?

Answer 2

The income statement gives us information related to recognized revenues and expenses within a given period. Revenue less all expenses gets us to net income of profit. The top line is revenues. COGS are subtracted off to get to gross profit. Subtracting SG&A gets us to operating income or EBIT. Removing interest expense gets us profit before taxes or EBT. Taxes are then removed, leading to net income. Finally, net income is divided by basic shares outstanding and diluted shares outstanding to get basic and diluted earnings per share or EPS.

Operating income is revenue less COGS less operating expenses, and should be listed before financial expenses (interest expense) and capital expenses. It is often referred to as EBIT.

Exceptions: Operating leases (financial expense) and R&D (capital expense) are both categorized as operating expenses.

To adjust operating leases to bring on balance sheet: take the present value of operating lease commitments using pre-tax cost of debt of the firm as the discount rate and treat the PV as debt. The operating income has to be adjusted by adding back the operating lease expense and subtracting out the depreciation created by operating leases.

Question 3

What are the three main sections of the statement of cash flows?

What goes into cash flow from operations? (CFO) Give me an example of a source / use of cash.

Answer 3

Cash flow from operating, cash flow from investing, and cash flow from financing

Net income +/- non-cash operating items: Depreciation and amortization, gain / loss on sale of assets, change in working capital accounts, etc.

OR

CFO = Net Income + depreciation + amortization + remaining non-cash charges - change in non-cash current assets (inventory / AR) + change in non-debt current liabilities (A/P, deferred revenues)

= Net income + depreciation + amortization + remaining non-cash charges - change in non-cash working capital

Question 4

You sell PP&E for $20 with a book value of $10. How does this affect the three financial statements?

Answer 4

This transaction results in a gain of $10 which hits the income statement. Assume a 20% tax rate. On the income statement, pretax income increases by $10 and net income increases by $8 (we pay $2 in taxes). The $8 increase in net income flows to the operating section of the cash flow statement. The $10 gain on sale of assets is subtracted from cash flow from operations (CFO), so the net change in CFO is (-$2). CFI increases by $20 (proceeds from sale of asset). No change in CFF, so net change in cash is $18. On the balance sheet, cash increases by $18 and PP&E decreases by $10 (book value), so net change in assets is $8. There is no change in liabilities and shareholders’ equity increases by $8 through retained earnings (due to increase in net income).

(Practice this question with different sales prices, book values, and tax rates to test both gains and losses.)

Question 5

What is EBITDA? Why is it important?

Answer 5

EBITDA = Earnings before interest, taxes, depreciation, and amortization and is a commonly used proxy for cash flow. EBITDA can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. However, this is a non-GAAP measure that allows a greater amount of discretion as to what is (and is not) included in the calculation. This also means that companies often change the items included in their EBITDA calculation from one reporting period to the next.

Question 6

Why do we prefer EBITDA over net income to gauge the strength / weakness of the firm?

Answer 6

• Starting with the basics, it is important to define EBITDA = Earnings before interest, taxes, depreciation and amortization.

EBITDA = Operating Income + Depreciation + Amortization = EBIT + D + A = Net Income + Income Tax Expense (T) + Interest Expense (I) + Depreciation (D) + Amortization (A)

• Next, there are several reasons we would prefer to look at EBITDA over net income:

1) In general, it is a much stronger indicator of ongoing operational strength for the firm.
2) Taxes are considered “non-operational” in a sense because they can be affected by a variety of accounting and tax conventions. These have no bearing on the ongoing operational strength of the firm. Companies with significant losses in the past will have “artificially” low effective tax rates once they become profitable, due to tax reliefs received in the form of NOLs, or Net Operating Losses (eg biotechs, technology companies).
3) Interest expense is a function of leverage, not operations. Companies in any given industry will have varying degrees of interest expense based on the debt load they incur, which is independent of their operational strength.
4) Depreciation expense is based on the PP&E of the firm. Again, it has no bearing on the ongoing operational strength of the firm except in the sense that high capital expenditures can limit investment in operations. Firms with high capital requirements (manufacturing, autos, retail, aircraft builders, airlines, transports) will have very high depreciation expense due to the nature of the assets they hold. We need to take deprecation “out” in order to see how the firm’s operations actually performed in a given year.
5) Amortization expense is another accounting convention dealing with the amortization of intangibles. Because it is an accounting convention, we want to take it “out” also. Companies with significant intangible assets on their balance sheets could have material amortization expenses reducing operational income. These usually result from acquisitions.
6) EBITDA measures recurring earnings, and excludes one-time charges (legal fees, restructuring expenses, impairments, etc.) It is thus a better indicator of ongoing operational performance of the firm.

Question 7

How would a $50 gain on sale of equipment with a book value of $25 flow through the financial statements?

Answer 7

A $50 gain on sale of equipment with a $25 book value means we sold the equipment for $75 total.

On income statement: $50 pre-tax gain from sale, therefore net income is $40 higher (after tax effect assuming a 20% tax rate)

On cash flow statement: The $40 increase in net income flows to the top of CFO. We then subtract the $50 gain so on net CFO is decreased by $10 (the tax expense on the gain). CFI is increased by the full sales price of $75 so the net increase in cash is $65

On balance sheet: Cash is increased by$65, PP&E has decreased by $25, so on net assets are up by $40. On the L&SE side there is no change to liabilities but retained earnings has increased by $40.

Question 8

If Starbucks invests $10mm in coffee machines and uses straight line depreciation for 10 years, what is the effect on the three financial statements? What happens if the machines break down after five years?

Answer 8

If no breakdown occurs:

Now (Year 0)
On income statement: No impact
On cash flow statement: Cash outflow in the investing section of $10mm (CAPEX)
On balance sheet: Cash decreases by $10mm. PP&E increases by $10mm

Years 1-10
On income statement: Depreciation expense of $1mm per year, therefore net income is $0.8mm lower per year (assuming 20% tax rate)
On cash flow statement: Depreciation of $1mm is added back to net income (-$0.8mm) in the calculation of cash flow from operations. Cash flow from operating is thus $0.2mm per year higher than it would have been without the investment (tax savings from depreciation).
On balance sheet: Cash increases by $0.2mm, net PP&E decreases by $1mm, so assets are down by $0.8mm. On the L&SE side, retained earnings decreases by $0.8mm because of the decrease in net income.

If breakdown after 5 years:
Now (Year 0)
On income statement: No impact
On cash flow statement: Cash outflow in the investing section of $10mm (CAPEX)
On balance sheet: Cash decreases by $10mm. PP&E increases by $10mm

Years 1-4
On income statement: Depreciation expense of $1mm per year, therefore net income is $0.8mm lower per year (assuming 20% tax rate)
On cash flow statement: Depreciation of $1mm is added back to net income (-$0.8mm) in the calculation of cash flow from operations. Cash flow from operations is thus $0.2mm per year higher than it would have been without the investment (tax savings from depreciation).
On the balance sheet: Cash increases by $0.2mm, net PP&E decreases by $1mm, so assets are down by $0.8mm. On the LS&E side, retained earnings decreases by $0.8mm because of the decrease in net income.

Year 5 (machines break down)
On income statement: $5mm pre-tax expense from asset impairment, therefore net income is $4mm lower (assuming 20% tax rate)
On cash flow statement: NI of (-$4mm) is the top line of CFO. Add back the $5mm impariment (non-cash expense affecting a non-operating BS account), thus CFO is increased by $1mm (from the tax shield provided by the loss).
On the balance sheet: Cash is increased by $1mm because of the tax shield, PP&E is decreased by the full $5mm so on net Assets are down by $4mm. No change in liabilities and retained earnings is decreased by $4mm (due to flow through of net income).

Question 9

What is working capital? Why is it important?

Answer 9

Working capital represents the assets and liabilities a business needs for its daily operations. It is a measure of both a company’s efficiency and its short-term financial health. Businesses need some amount of cash on hand to operate, but typically bankers exclude cash from working capital. Net working capital is equal to short term non financial assets less short term non financial liabilities. Financial assets and liabilities are those that are interest bearing. Net working capital is calculated as:

Working Capital = Current Assets minus Current Liabilities

Positive working capital means that the company is able to pay off its short term liabilities. Negative working capital means that a company currently is unable to meet its short term liabilities with its current assets (cash, accounts receivable, and inventory)

Question 10

Why do we need cash flow from operations when we already have EBITDA?

Answer 10

The key operational distinction between EBITDA and CFO / OCF is the change in net working capital. CFO / OCF are also burdened by taxes and interest expense since it begins from Net Income. Both will usually exclude the non-cash, one-time items.

There are many operational factors that come into account in the change in net working capital:

1. Deferred Revenue: There are certain products and services a company can sell which will not show up in the traditional revenue account on the income statement. As a result, EBITDA and net income could be significantly understated. If we want to know operational and cash flow performance for a given time period, this matters. The remainder of this deferred revenue typically shows up in the operating section of the cash flow statement.
2. Operational Efficiency: One example is inventory management. If a company needs more inventory, then that will require spending cash that could be put to other uses. This means that current asset - inventory - goes up and “uses” cash. Another example is credit policy. What would be preferable - a company that only takes cash or one that allows you to push off payment for a year at 0% interest? If a company records $100 of revenue but doesn’t collect cash, then accounts receivable (current asset) will rise and “use” cash.

Question 11

Where do you find shares outstanding?

Answer 11

Can be found on balance sheet or first page / cover of 10K or 10Q.

Question 12

How do dividends appear in the financial statements?

Answer 12

Income Statement: Dividends declared to common shareholders are not typically reported on the income statement since they do not represent an expense. However, dividends declared to preferred shareholders are subtracted from net income to report the earnings available to common shareholders.

Cashflow statement: Once the declared dividends are paid it will appear as a cash outflow in the cash flow from financing section.

Balance Sheet: Dividends declared are subtracted from net income in the retained earnings account of shareholders equity. When these dividends are declared, but before they are paid, they will appear as a current liability (dividends payable) on the balance sheet. Once they are paid, cash will fall and the liability will be removed.

Question 13

What are typical one-time, non-recurring items?

Answer 13

Some examples of one-time items include: adjustments to inventory due to a change in value, change in accounting treatment of an item, gains / losses from an unusual lawsuit / settlement, impairments / write-downs / write-offs, gains / losses on disposal of assets, etc. You would adjust net income for these non-recurring items in order to arrive at normalized (or recurring) earnings.

Question 14

How do you derive Free Cash Flow (FCF)?

Answer 14

Ideally you should be able to walk from any income statement item or from Cash Flow from Operation (CFO) to FCF, some of these examples are shown below.

Free cashflow to the firm (FCFF):

FCFF represents the cash flows available to ALL investors after mandatory cash outflows for business needs have been taken out (including taxes)

FCFF (top down) = (EBITDA - D&A) * (1-tax rate) + D&A - CAPEX - Change in Working Capital

FCFF = NI + Interest*(1-tax rate) + D&A - Change in Working Capital - CAPEX

Free cashflow to the equity (FCFE):

FCFE represents the cash flows that are available only to Equity investors.

FCFE = NI + D&A - Change in Working Capital - CAPEX - Net Payments of Debt Principal

FCFE = FCFF - Interest * (1-tax rate) - Net Payments of Debt Principal

Question 15

What is the difference between OCF and FCF and why would you use one over the other?

Answer 15

The reason we look at FCF instead of EBITDA and OCF is the CAPEX adjustment. Any capital-intensive company (eg manufacturing, autos, retail, aircraft builders, airlines, transports) will be spending money on a regular basis to buy / modify / upgrade / replace their fixed assets (stores, machines, equipment, airplanes). CAPEX can represent a significant ongoing reduction in cash flow for many of these companies. Look at the cash flow statement for any of the airlines to see the impact. In these cases, CAPEX is an ongoing operational cash outflow that must be considered.

Question 16

Can a firm have negative earnings and positive free cash flow?

Answer 16

Yes. The focus of this question should be that there are many non-cash expenses that reduce net income but have a positive impact on free cash flow (why?) Think of a large D&A expense for a firm reducing net income (NI) but having a positive cash impact due to the tax shield effect.

Question 17

If accounts receivable increases, how does that impact free cash flow? What other items impact free cash flow?

Answer 17

This would increase working capital, thus reducing FCFF. Intuitively, we have recognized revenue but haven’t actually received the cash - so we need to adjust our cash flows downward. Other items affecting FCFF include depreciation & amortization, any other working capital changes, and CAPEX.

Question 18

What is goodwill? How do you calculate it?

Answer 18

Goodwill is an accounting term used to reflect the portion of the purchase price of a business entity not directly attributable to its net assets; it normally arises only in case of an acquisition. Goodwill is considered an intangible asset.

First we calculate the net tangible assets on the balance sheet as assets less existing target goodwill less liabilities. We then bring those net tangible assets to their fair market value based on any write ups or write downs of the net assets. Finally, we subtract the purchase price from the fair market value of the net assets to find new goodwill:

Net Tangible Assets = Assets - Target’s Existing Goodwill - Liabilities

Fair Market Value of Net Assets = Net Tangible Assets + Write-up of Net Assets

Goodwill = Purchase Price - Fair Market Value of Net Assets

Question 19

Explain the difference between FIFO and LIFO accounting on a high level

Answer 19

FIFO and LIFO are methods of accounting for changes in inventory. They differ in terms of timing. One way to think about inventory is to think of a box of inventory in which each piece of inventory has a slightly different cost. First In-First Out (FIFO) assumes that the first unit making its way into inventory is the first sold. To put it another way, you would pull the inventory from the bottom of the pile. Last In-First Out (LIFO) assumes that the last unit making its way to inventory (the top of the pile) is sold first.

Question 20

In an inflationary environment, which would give you a higher Net Income, FIFO or LIFO?

Answer 20

In a world of rising prices, FIFO provides a more accurate indication of the value of the ending inventory on the balance sheet, but it also increases net income (and therefore taxes paid). On the other hand, LIFO is not a good indicator of the ending value of inventory because the remaining inventory is recorded at lower (and possibly outdated) prices, but it is a good indicator of COGS expenses because it uses the most recent prices. LIFO results in lower net income (and thus lower taxes) because COGS is higher.

Question 21

You have two companies. One uses LIFO to account for inventories and the other uses FIFO. Which of these companies will have higher net income?

Answer 21

FIFO assumes first unit made (or added to inventory) is the first unit sold. LIFO assumes last unit made is the first unit sold. Therefore, assuming costs are increasing, FIFO results in a higher net income because the cost of goods sold is lower.

While a higher net income is nice for reporting purposes, it is really just the result of an accounting decision - it doesn’t actually impact cashflows. What does affect cashflows are the taxes paid. Companies typically want to minimize their tax burden to minimize cashflows and will often choose LIFO in a rising price environment since it gives them a higher cost of goods sold and thus less earnings that can be taxed by the government.

Question 22

Assume that your GAAP depreciation uses the straight line method and is $100 this year while your depreciation expense for tax purposes uses MACRS and is $200. Does this create a DTL or a DTA and by how much? Walk me through the three financial statements of how this expense would flow? Assume a 20% tax rate.

Answer 22

Since your income is lower for tax purposes than stated on your GAAP books, you have fewer taxes payable this year than stated tax expense and this creates a Deferred Tax Liability. In other words, the cash taxes you paid to the tax authorities are lower than what you have stated on your GAAP books and therefore you will owe the IRS more taxes in the future when the MACRS depreciation schedule creates a lower depreciation expense than the straight line method. The Deferred Tax Liability created is in the amount of ($200-$100)*20%. The way this would flow through the three statements.

Income Statement:
Pre-Tax Income: -100
After-Tax Income: (-100*.8)=-80

Cash Flow Statement: 
Start with Net Income: -80 
Add Back Depreciation: +100
Subtract the Change in a Current Liability (Change in OWC): +20 
Net Change to CFO: +40 
Net Change to CFI: 0 
Net Change to CFF: 0
Net Cash Flow: $40 (Effect of the cash savings form the depreciation and the creation of the DTL) 

Balance Sheet: 
Cash: Increase by $40 
PPE: Decreases by $100 
Deferred Tax Liability: Increases by $20 
Shareholders' Equity: Decreases by $80 

Your balance sheet now balances as Assets go down by 60 and L+SE goes down by 60 as well.

Question 23

What kind of account is “Treasury Stock” on the balance sheet and what happens to it when the company repurchases its shares for $100 and then sells it for $200.

Answer 23

Treasury stock is typically the most common contra-Shareholder’s equity account and if a company resells its shares in its Treasury Stock for a profit then the excess proceeds go into the Paid-In Capital account.

Question 24

Assume a company sells a $50 gift card. Walk me through how this affects the three statements.

Answer 24

When the company initially sells the $50 gift card, there is no impact on the income statement. In the cash flow statement, you have an increase in the deferred revenue account, which is a decrease in “Net Working Capital”. Since you subtract changes in NWC in the cash flow statement, you subtract (-$50) and therefore there is an increase of $50 in CFO. Total Cash Flow increases by $50. The $50 increases the company’s cash balance by $50 and also increases its deferred revenue by $50. Therefore the balance sheet balances.

When the gift card is redeemed, the company then books the $50 on the income statement. Assuming COGS of $20, and a 20% tax rate, net income is $24. The $24 Net Income flows to the top of the Cash Flow statement. There is also a decrease in deferred revenue, which increases NWC by $50, and a decrease in inventory which decreases NWC by $20. Therefore there is a -$30 reconciliation in the Cash Flow from Operations and total CFO is -$6. The -$6 then flows to the balance sheet. Cash is reduced by $6, inventory is reduced by $20 so total assets are reduced by $26. Deferred revenue is reduced by $50, Retained earnings is increased by $24. Therefore the balance sheet balances.

Note: The -$6 reflects the cash that is paid to the IRS.

Question 25

Company A acquires Company B for $200mm Equity Value. Total assets on company B’s books are $170mm while existing goodwill is $50mm. Liabilities are $80mm. The fair value of identifiable assets is $30mm higher than the book value. What is the new goodwill that will be on Company A’s books?

Answer 25

The total goodwill on Company A’s books is $130mm. First we need to determine net identifiable assets. We take the $170mm in assets on the balance sheet and add the $30mm in adjustments to bring the assets to their fair value of $200mm. We then subtract off existing goodwill of $50mm. This leads to $150mm in identifiable assets. From there the $80mm in liabilities is subtracted to get net identifiable assets of $70mm. These net identifiable assets are subtracted from the $200mm purchase price to get $130mm in new goodwill that will be added to the Company A’s books.