Accounting

Question 1

What are the 3 financial statements?

Answer 1

-IS, BS, CFS
IS:
shows a company’s revenue, expenses, and taxes paid over a period and ends with Net Income, which represents the company’s after-tax profits.
BS:
shows the company’s assets - its resources - as well as how it paid for those resources - its liabilities and equity - at a specific point in time. Assets = Liabilities + Equity
CFS: starts with NE, adjusts for non-cash expenses, and changes in working capital. Then it shows the company’s cash from investing and financing activities; the last lines show the net change in cash and the company’s ending balance
Why do we need them?
You need these statements because there is a big difference between a company’s Net Income and the cash it generates – the Income Statement alone doesn’t tell what its cash flow is.
The 3 financial statements let you estimate the “Cash Flow” part, which helps you value the company more accurately.

Question 2

How do the three statements link together?

Answer 2

To link the statements, make Net Income from the IS the top line of the CFS.
Then adjust this NE number for any non-cash items such as D&A.
Next reflect changes to operational Balance Sheet items, which increase or decrease the company’s cash flow depending on how they’ve changed.
This gives you CFO
Next, take into account investing and financing activities, and sum up Cash Flow from Op, Inv, and Fin to get net change in cash at the bottom

Link cash on the BS to the ending cash number on the CFS, and add NE to Ret Earn within the Equity category on the BS.

Link each non-cash adjustment to the appropriate asset or liability and do the same for items in CFI and CFF.

Now Assets should = L + E

Question 3

Most Important fin statement

Answer 3

CFS

• tells you how much CASH the company is generating
• IS is misleading because it includes non-cash revenye and expenses and excludes cash spending such as CapEx

Question 4

if you only had 2 statements, which would you pick?

Answer 4

IS and BS

• can create the CFS from these (assuming u have a copy of the BS at the start and end of the period)
• it would be much harder to make an IS from the BS and CFS

Question 5

How might the financial statements of a company in the UK or Germany be different from those of a company based in the US?

Answer 5

IS and BS tend to be similar across regions, but companies that use IFRS often start the CFS with something other than NE. There are also minor naming differences; IS could be named differently.

Question 6

What should you do if a company’s CFS starts with something other than NE?

Answer 6

For modeling and valuation purposes, you should convert this CFS into one that starts with NE and makes the standard adjustments.
Large companies should provide a reconciliation that shows you how to move from NE to CFO. If not, you might have to stick with the original format

Question 7

How do you know when a revenue or expense line item should appear on the IS?

Answer 7

• happened only during the period (this is why monthly rent shows up but not paying for a factory that will last for 10 years aka capex)
• is tax deductible (or affects the company’s taxes)

Question 8

How do you tell whether something should be an A, L, or Equity on the BS?

Answer 8

Asset: is an item that will generate future cash flow for the company or can be sold for cash
L: item that will cost the company cash in the future and cannot be sold (because it represents payments the company owes)
E: item similar to Liabilities because it represents funding sources for the company - but they will not result in future cash costs.

Question 9

How do you tell whether or not something appears on the CFS?

Answer 9

-has already appeared on the IS and affected NE, but it’s noncash, and you need to adjust for it to determine company’s true Cash Flow
OR
-It has not appeared on IS and it does affect company’s cash balance

Question 10

A company uses cash-based accounting rather than accrual.
A customer buys a TV from the company using a credit card. How would the company record this transaction differently from an accrual accounting firm?

Answer 10

Revenue would not show up until the company charges the customer’s credit card, receives authorization, and deposits the funds in its bank account. Rev show up as Cash on BS
Accrual ACC: sale would show up as revenue right away. it would go as AR in BS

Question 11

A company begins offering 12-month installment plans to customers so that they can pay $500 or $1000 courses over a year instead of all upfront. How will its cash flows change?

Answer 11

The first year, cash flow will decrease since they aren’t receiving up-front cash flow
So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on. This situation corresponds to Accounts Receivable: The Asset on the Balance Sheet that represents owed future payments from customers. The long-term impact depends on how much sales grow as a result of this change. If sales grow substantially and the company’s Revenue and Net Income increase, that might be enough to offset the reduced cash flow and make the company better off.

Question 12

A company decides to prepay its monthly rent - an entire year upfront - because it can save 10% by doing so. Will this prepayment boost cash flow?

Answer 12

Not in that year, an increase in an asset results in a decrease in cash flow
After that year, it will mean that the expense is paid so cash flow will increase

Question 13

Your friend is analyzing a company and says that you always have to look at the Cash Flow Statement to find the full amount of Depreciation.

Is he right? And if so, what are the implications?

Answer 13

Yes. This happens because companies often embed Dep within other line items such as COGS or OpEx on IS because portions of Dep might correspond to different functions in the company. There could be dep for sales and marketing, R&D, and cust support.

Question 14

A company mentions that it collects cash payments from customers for a monthly subscription service a year in advance. Why would a company do this, and what is the cash flow impact?

Answer 14

A company would collect cash payments for a monthly service long in advance if it has the market power do so.
It’s always better to get cash earlier rather than later because of the time value of money, so if the market and customers support this plan, any company would do it.
This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue will be a positive entry that boosts a company’s cash flow.

Question 15

Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?

Answer 15

AR corresponds to future cash payments that customers are expected to make. This means that this line items will generate cash in the future (aka an asset)

DR is a L because it will cost the company cash in the future. This is because the company has already received the cash from a good/service but not sent it out; when it does, it will need to incur the expenses and tax payments from it.

Question 16

How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?

Answer 16

Prepaid Expenses have already been paid out in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they do finally appear on the Income Statement, they’ll reduce the company’s future taxes, making them an Asset.
Accounts Payable have not yet been paid out in cash but have been incurred as expenses, so they have appeared on the Income Statement. When the company finally pays them in cash, Accounts Payable will reduce the company’s cash, making them a Liability. Accounts Payable and Accrued Expenses work in exactly the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), whereas Accrued Expenses is more for monthly, recurring items without invoices (e.g., utilities).

Question 17

Your CFO wants to start paying employees mostly in stock-based compensation, under the logic that it will reduce the company’s taxes, but not “cost it” anything in cash.
Is he correct? And how does Stock-Based Compensation impact the statements?

Answer 17

Partially. Yes, stock-based compensation is a non-cash expense that reduces a company’s taxes but gets added back on the CFS, similar to Depreciation.

However, unlike Depreciation or Amortization, stock-based compensation incurs a real cost to the company and its investors because it creates additional shares.

Question 18

A junior accountant in your department asks about the different ways to fund the company’s operations and how they impact the financial statements. What do you tell him?

Answer 18

The two main methods of funding a company’s operations are debt and equity. Debt is cheaper for most companies (see the previous lessons and guides on WACC and the Discount Rate), so most companies prefer to use debt… up to a reasonable level. Both equity and debt issuances show up on only the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company’s cash balance.
The only “after-effect” of equity is that the company’s share count increases. This happens because any investor who buys the company’s equity now owns a percentage of the company. With debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually pay back the full balance.

Question 19

Your company sells equipment for $85. The equipment was listed at $100 on your company’s Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement.

Why is this Loss considered a non-cash expense?

Answer 19

Because you have’t actually “lost” anything in cash in the current period. When you sell the equipment for $85, you get $85 in cash from the buyer. It’s not as if you’ve “lost” $15 in cash because you sold the equipment at a poor price. The “loss” refers to how you previously spent more than $85 to buy this equipment in some prior period.

Question 20

Your company owns an old factory that’s currently listed at $1,000 on its Balance Sheet. Why would it choose to “write down” this factory’s value, and what is the impact on the financial statements?

Answer 20

A company might write down an Asset if its value has declined substantially, and it’s no longer accurate to reflect it at the original value on the Balance Sheet.

An asset write-down is an expense on the US, but you add it back as a non-cash expense on CFS.
The result is that the company’s cash balance increases due to tax savings.
On the BS: cash is up; asset value is down, and RetEarn will balance the change

Question 21

The CFO of your firm recently unveiled plans to purchase short and long-term investments. Why would she want to do this, and how would this activity affect the statements?

Answer 21

A company might want to purchase investments if it has excess cash and cannot think of other ways to use it.
The initial purchase of these investments will show up only on the Cash Flow Statement and will reduce the company’s cash flow. Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company’s Pre-Tax Income, Net Income, and its Cash balance.

Question 22

Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean?

Answer 22

Yes,. if a company starts losing massive amounts of money, resulting in a negative NE. After a while, their ret earn would turn negative and exceed other line items in the equities section.
Another case where this might happen is if the company issues a huge dividend to its owners (like following an lbo) that turns its equity negative.
The meaning varies on what has happened, but most of the time negative equity is almost always a negative sign because it means the company has been unprofitable or has done something irresponsible with its dividends or share repurchases.

Question 23

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the BS. A junior accountant in your department asks you why the company did this - what do you tell him?

Answer 23

You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances. In an acquisition, you write down the seller’s Shareholders’ Equity and then combine its Assets and Liabilities with those of the acquirer. If you’ve paid exactly what the seller’s Shareholders’ Equity is worth – e.g., you paid $1,000 in cash and the seller has $1,000 in Equity, then there are no problems. The combined cash balance will decrease by $1,000, and so will the combined Equity

However, in real life, this almost never happens. Companies almost always pay premiums for companies they acquire, which means that the Balance Sheet will go out of balance. For example, if the seller here had $400 in Equity instead, the BS would go out of balance immediately because we wipe out $400 in Equity but spend $1,000 in cash. To fix that problem, you start by allocating value to the seller’s “identifiable intangible assets” such as patents, trademarks, intellectual property, and customer relationships. In this case, we allocated $200 to these items. If there’s still a gap remaining after that, you allocate the rest to Goodwill, which explains the $400 in Goodwill here.

Question 24

How do goodwill and other intangible assets change over time?

Answer 24

Goodwill is constant unless it is “impaired”

Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amort shows up on the IS and as a non-cash add back on the CFS. The balance decreases until it is amortized.

Question 25

Operating expenses increase by 100

Answer 25

IS: NE -60
CFS: -60
BS: Cash-60
RetEarn -60

Question 26

Dep increases by 10

Answer 26

IS: NE -6
CFS: -6 +10 = 4
BS: 
Cash +4
PP&E -10
RetEarn -6

Question 27

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.

Answer 27

IS:  EBIT: -20. NE -12
CFS: -12 +100
BS: Cash +88
PP&E -100
RetEarn -12

Question 28

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

Answer 28

IS: -20 NE -12
CFS: -12 + 120
BS: Cash +108
RetEarn -12 +120 (common stock & APIC) = 108

Question 29

Your company just acquired another one for $1,000 in cash. The other company’s Shareholders’ Equity was $500, and you identified $100 in Other Intangible Assets with a useful life of 5 years.

What happens on the 3 statements from just AFTER the acquisition closes to the end of the first year following the acquisition? Only factor in Goodwill and Other Intangible Assets.

In the second year, the acquisition goes horribly wrong, and your company realizes the acquired company is worth half of what it paid. So it decides to write down half the Goodwill created in the deal. how do the statements change?

Answer 29

In this scenario, the “gap” between the purchase price and the other company’s Shareholders’ Equity is $500. $100 in Other Intangible Assets and $400 in Goodwill will be created. Intangibles will amortize $20 per year over 5 years.

IS: Amort +20, NE -12
CFS: -12 + 20 = 8
BS: Cash 8
Other Intangible Assets -20 (due to amort)
RetEarn -12
------------------
IS: NE-120
CFS: -120+200=80
BS: Cash: 80
Goodwill -200
Ret Earn -120
Extra cash generated from tax relief from the asset being gone.

Question 30

Walk me through what happens on the statements when a customer orders a product for $100 but doesn’t pay for it in cash, and then what happens when the cash is finally collected

Answer 30

1)
IS: NE +60
CFS: +60 - 100 = -40
BS: Cash -40
AR: 100
Ret Earn +60
2) cash is collected
IS: no changes
CFS:AR decreases => +100 cash
BS: +100 cash
-100 AR

Question 31

A company prepays its rent ($20 per month) a 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 incurred.

Answer 31

Prepay:
IS nothing
CFS: prepaid is up => CFO -20
BS: Cash -20
Prepaid +20
----
Expense incurred
IS: NE -12
CFS: -12 +20 = 8
BS: Cash +8
Prepaid - 20
Ret Earn -12

Question 32

Wal-Mart buys $500 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.

Answer 32

1)
IS: nothing
CFS: -500 (asset increase)
BS: Cash -500
Inventories +500

2)
IS: +100 NE: +60
CFS: 60+500
BS: Cash 560
Inventory: -500
RetEarn+60

Question 33

Amazon.com decides to pay several key vendors on credit and make them wait for the cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash?

Answer 33

IS: -200 NE -120
CFS: -120 + 200 (AP increasing) = 80
BS: Cash +80
AP 200
RetEarn -120
-------------------------
IS: none
CFS: -200
BS: cash -200, AP-200

Question 34

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

Now what happens after one month has passed, and the company has delivered one month of service? Assume there are no associated COGS or Operating Expenses, and walk through what happens ONLY in this month.

Answer 34

IS: nothing
CFS: +1200 (from increasing deferred rev)
BS: Cash +1200
Def Rev +1200
-----------------------------------------
IS: Rev +100 NE +60
CFS: 60 - 100 (Def Rev decreasing) = -40
Cash: -40
Def Rev -100
Ret Earn +60

Question 35

Company issues $100 in stock to new investors to fund its operations. How do the statements change

This same company now realizes that it has too much cash, so it wants to issue dividends or repurchase shares. How do they impact the 3 statements differently? Assume $100 in dividends vs. $100 in shares repurchases.

Answer 35

IS: nothing
CFS: CFF +100
BS: Cash +100
Common Stock & APIC +100
----------------------------
Dividends:
IS nothing
CFS: CFF -100
BS Cash -100
Ret Earn -100
--------------------------------
Repurchase:
IS: nothing
CFS: CFF -100
BS: Cash -100
Treasury stock: -100

Question 36

A company has $1,000 in revenue, $200 in COGS, and $700 in operating expenses, and no other expenses. Walk through what happens on the 3 statements if half of the company’s Income Taxes shift from current to deferred.

Answer 36

First, you have to calculate the company’s total tax bill: $1,000 in revenue minus $200 in COGS minus $700 in operating expenses equals $100 in Pre-Tax Income and $40 in taxes at a 40% tax rate.
Income Statement: Nothing changes because you record BOTH current AND deferred taxes as part of the company’s Income Taxes here. So, there’s still $40 of Income Taxes.

Cash Flow Statement: Net Income stays the same, but now you have to add back $20 in the Deferred Income Tax line item because these taxes will be paid in some future period. Cash increases by $20 as a result.

Balance Sheet: Cash is up by $20, and so the Assets side is up by $20. On the L&E side, the Deferred Tax Liability will increase by $20 because of this deferral, so both sides increase by $20 and the Balance Sheet balances.

Question 37

A company buys a factory for $100 using 100 of debt. What happens initially on the statements?

One year later, company pays 10% interest and $10 dep. It also repays $20 of the loan. What happens?

Another year passes. Again the company pays 10% int based on the balance of the start of the year, and it depreciates $10 on the factory, with $20 loan principal repayment. At the very END of the year, company writes down the factory’s entire value and repay the remaining loan balance. Walk through beginning of yr 2 to the end.

Answer 37

IS: 0
CFS: CFI -100 CFF +100 = 0
BS: PP&E +100
Debt +100
------------------
IS: -10-10= -20 NE -12
CFS: -12 +10 CFF -20 = -22
BS: Cash -22
PPE -10
Debt -20
Ret Earn -12
--------------------
IS: -8-10-80 (PPE writedown) =-98, NE ~-59
CFS: NE:-59 +10+80 CFF -80 = -49
BS: Cash -49
PPE-90
debt -80
RetEarn -59

Question 38

Wal-Mart orderts $200 of Inventory but pays for it using debt. What happens on the statements immediately after this transaction?
A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process the orders. The company also pays 5% interest on its debt and repays 10% of the principal. What happens on the statements over the course of THIS one year?

Answer 38

IS: 0
CFS: -200
CFF: +200
BS: Inven +200
Debt +200
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unfinished