03. Accounting Flashcards
List the line items in the cash flow statement.
The CFS is broken up into three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
In cash flow from operating, the key items are net income, depreciation and amortization, equity in earnings, non-cash stock compensation, deferred taxes, changes in working capital and changes in other assets and liabilities.
In cash flow from investing, the key items are capital expenditures and asset sales.
In cash flow from financing, the key items are debt raised and paid down, equity raised, share repurchases and dividends.
If you could have only two of the three main financial statements, which would it be?
The balance sheet and income statement because as long as I have the balance sheet from the beginning and end of the period as well as the end of period income statement, I would be able to generate a statement of cash flows.
If you could have only one of the three main financial statements, which would it be?
The IS is definitely inappropriate to pick. Income statements are full of non-cash items, which work fine for theoretical purposes, like matching revenue to expenses in appropriate time periods, but if none of it could be liquidated then company is worth nothing.
Most pick SCF, because cash is king in determining a company’s health. SCF because it gives you a true picture of how much cash the company is actually generating, independent of all the non-cash expense a company might have.
One interviewer selected BS because you can back out the main components of the cash flow statement (capex via PP&E and depreciation, net income via retained earnings, etc.). The BS is also helpful in distressed situations to determine the company’s liquidation value.
What is the link between the balance sheet and income statement?
The main link between the two is profits from the IS are added to the BS as retained earnings. Next, the interest expense on the IS is charged on the debt that is recorded on the BS. D&A is a capitalized expense from the IS that will reduce the PP&E on the asset side of the BS.
If a company has seasonal working capital, is that a deal killer?
Working capital (“WC”) is current assets less current liabilities. Seasonal working capital applies to firms whose business is tied to certain time periods. When current assets are higher than current liabilities, this means more cash is being tied up instead of being borrowed. For instance, UGG mostly manufactures snow boots. In the winter, demand is higher, so the firm must build up inventories to meet this demand at this time, increasing current assets. Since more cash is tied up, this can increase the liquidity risk. If UGGs suddenly go out of fashion, then the company is stuck holding the inventory. Also, if people frequently pay with credit for the company’s products, the amount is listed as accounts receivable (“AR”), which represents future profits but is noncash. Therefore, if the company cannot collect this owed cash in time to pay its creditors, it runs of the risk of bankruptcy. This is an issue to note and watch, but it is not a deal killer if you have an adequate revolver and can predict the seasonal WC requirements with some clarity. In general, any recurring event is fine as long as it continues to perform as planned. The one-time massive surprise event is what can kill an investment.
If a company issues a PIK security, what impact will it have on the three statements?
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.
If I increase AR by $10mm, what effect does that have on cash? Explain what AR is in layman terms.
There is no immediate effect on cash. AR is account receivable, which means the company received an IOU from customers. They should pay for the product or service at a later point in time. There will be an increase in cash of $10 million when the company collects on the account receivable.
Give examples of ways companies can inflate earnings.
(1) Switching from LIFO to FIFO. In a rising cost environment, switching from LIFO to FIFO will show higher earnings, lower costs and higher taxes.
* Or LIFO liquidation
(2) Switching from fair value to cash flow hedges. Changes in fair value hedges are in earnings, changes in cash flow hedges are in other comprehensive income. Having negative fair value hedges and then shifting them to cash flow hedges will increase earnings.
(3) Changing depreciation methods (e.g. useful life)
(4) Having a more aggressive revenue recognition policy. Accounts receivable will increase rapidly because they’re extending easier credit.
(5) Capitalizing interest or R&D that shouldn’t be capitalized, so you decrease expenses on the income statement
(6) Manipulating pre-tax or after-tax gains.
(7) Compensate employees with options rather than cash
(8) Asset sales or recognize one-time items on income statement
Is goodwill depreciated?
Not anymore. Accounting rules now state that goodwill must be tested once per year for impairment. Otherwise, it remains on the BS at its historical value. Note that goodwill is an intangible asset that is created in an acquisition, which represents the value between price paid and value of the company acquired.
What is a stock purchase and what is an asset purchase?
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.
Which structure (stock purchase vs asset purchase) does the seller prefer and why? What about the buyer?
A stock deal generally favors the seller because of the tax advantage. An asset 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.
Please note there are other, lesser-known legal advantages and disadvantages to both transaction structures.
What is a 10-K?
It’s a report similar to the annual report, except that it contains more detailed information about the company’s business, finances, and management. It also includes the bylaws of the company, other legal documents and information about any lawsuits in which the company is involved. All publicly traded companies are required to file a 10-K report each year to the SEC.
What is Sarbanes-Oxley and what are the implications?
Sarbanes-Oxley was a bill passed by Congress in 2002 in response to a number of accounting scandals. To reduce the likelihood of accounting scandals, the law established new or enhanced standards for publicly held companies. Those in favor of this law believe it will restore investor confidence by increasing corporate accounting controls. Those opposed to this law believe it will hinder organizations that do not have a surplus of funds to spend on adhering to the new accounting policies
What are the differences between extraordinary and special charges?
Extraordinary – unusual and infrequent; below the line after-tax (e.g. hurricane)
Special – unusual or infrequent; appear with income from continued operations pre-tax (e.g. employee layoffs, plant closing)
What is the definition of fair value?
Price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants
What is the LIFO method?
Last in, first out. Inventory costs are those which were incurred earlier in the period and are stale relative to the end of the period. Results in a more accurate income statement and less accurate balance sheet
What is the FIFO method?
First in, first out. Inventory costs are those which were incurred later in the period and are more current relative to the end of the period. Results in a more accurate balance sheet and less accurate income statement
What is LIFO liquidation?
Dramatic decrease in inventory on hand causes a dip into LIFO layers and an increase in net income
What is the LIFO reserve?
Contra asset account for the excess of FIFO over LIFO inventory
What are the effects of using LIFO vs FIFO assuming rising prices?
LIFO: results in a more current income statement based on fair value but a stale balance sheet with understated inventory assets (i.e. lower income taxes but lower assets)
-IS: leads to higher COGS, thus lower pre-tax income
-CF: leads to higher COGS, thus lower taxes paid, thus higher cash flows
-BS: leads to lower inventory balance
FIFO: results in a more current balance sheet based on fair value but a stale income statement with understated cost of goods sold (i.e. higher income taxes but higher assets)
-IS: leads to lower COGS, thus higher pre-tax income
-CF: leads to lower COGS, thus higher taxes paid, thus lower cash flows
-BS: leads to higher inventory balance
If you had to choose between the LIFO or FIFO method, which would you choose?
???
If had a choice beween the two – in some ways it doesn’t matter b/c it’s just a trade-off between which financial statement is misrepresented (and investors are savy), but LIFO seems less manipulative to earnings (and minimized taxes) so I’d go with it
What is the allowance method?
Bases bad debt expense on an estimate of uncollectible accounts
Dr: Bad debt expense (estimate)
Cr. Allowance for doubtful accounts
What is the direct method?
Write down accounts receivable when actual customer default occurs
Dr. Bad debt expense (write-off)
Cr. Accounts receivable
What is a trading security?
Trade for profit potential with unrealized gains and losses reported in net income. It is carried on the balance sheet at fair value. Used for debt or equity
What is a held-to-maturity security?
Debt securities for which a company has a positive intent to hold until maturity. It is carried on the balance sheet at amortized cost. There are no unrealized gains
What is an available-for-sale security?
-Neither HTM nor trading
-Carried at market value
-Unrealized gains/losses are presented net of tax in “Other Comprehensive Income”
Net Debt = Total Debt – Cash & Cash Equivalents
It represents the true amount of debt that a firm has, after it uses its existing cash to pay off current outstanding debt
What is net debt?
How are the three financial statements connected?
- Beginning cash balance on statement of cash flows comes from balance sheet; net income in operating cash flows comes from income statement
- Adjustments made to net income on statement of cash flows using balance sheet accounts
- Ending balance of cash appears on balance sheet and statement of cash flows
- Net income increases shareholders equity through retained earnings
Other connections: interest expense, depreciation, change in working capital
What is the link between the balance sheet and statement of cash flows?
- SCF starts with beginning cash balance, which comes from the previous period’s balance sheet
- Cash from operations is derived using the changes in NWC from the balance sheet
- Depreciation comes from PPE which affects OCF
- Any change in PPE due to purchase or sale will affect ICF
- Net increase in cash goes back onto next year’s balance sheet
What is the link between the balance sheet and the income statement?
- Net income generated in the income statement are added to shareholders’ equity on the balance sheet as retained earnings
- Debt on the balance sheet is used to calculate interest expense on the income statement
- PPE will be used to calculated depreciation
What is the difference between the income statement and statement of cash flows? How are the two financial statements linked?
- Income statement is a record of revenue and expenses while statement of cash flows records the actual cash that has either come into or left the company during that time period
- SCF has OCF, ICF and FCF
- Interestingly, a company can be profitable as shown on the income statement but still go bankrupt if it does not have the cash to meet its interest payments
- Both statements are linked by net income
What is goodwill?
- An intangible asset that can be found on a company’s balance sheet.
- Goodwill can often arise when one company is purchased by another company. In an acquisition, the amount paid for the company over book value usually accounts for the target firm’s intangible assets.
- Goodwill is seen as an intangible asset on the balance sheet because it is not a physical asset like buildings or equipment
- Goodwill typically reflects the value of intangible assets such as a strong brand name, good customer relations, good employee relations and any patents or proprietary technology.
How does goodwill affect the income statement?
- If an event occurs that diminishes the value of this intangible asset, the assets must be written down in a process called goodwill impairment
- Goodwill is then subtracted as a non-cash expense and therefore reduces net income
What are the components of the statement of cash flows?
Beginning cash
+Operating cash flow: cash generated from the normal operations of a company
+Investing cash flow: change in cash outside the scope of normal business (e.g. purchase of PPE and other investments not reflected in income statement); cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment.
+Financing cash flow: cash from changes in liabilities and shareholders’ equity including any dividends that were paid out to investors in cash (e.g. issuance of debt or equity, share repurchases)
=Ending Cash
Walk me through the major line items of the income statement.
Revenue -COGS =Gross Profit -SG&A -D&A =Operating Income (EBIT) -Interest Expense =Income before Taxes - Taxes =Net Income
What is a capital lease?
- Non-callable
- And either:
(1) ownership of the asset is transferred to lesee at end of lease
(2) “bargain purchase” option exists
(3) lease term is greater than or equal to 75% of the useful life of the asset
(4) at inception of the lease, the present value of minimum payments of the lease is greater than or equal to 90% of the estimated fair market value - Requires asset and liability to be recorded
- Treated as debt
What is meant by recovery value?
Amount an investor receives in bankruptcy liquidation from his investment in a particular financial instrument.
Recovery rate is the associated percentage
Could you ever end up with negative shareholders’ equity? What would this imply?
Yes, it is possible.
(1) Dividend Recap. Shareholders’ equity turns negative immediately after dividend recapitalization in an LBO situation. Means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative (2) Continuous losses. It can also happen if the company has been losing money consistently and therefore has declining retained earnings, which is a portion of shareholders’ equity
*Does not “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling
Why do companies report both GAAP and non-GAAP earnings?
These days, many companies have non-cash charges such as amortization of intangibles, stock-based compensation, deferred revenue write-downs on their income statement. Some argue that the income statement under GAAP no longer reflects how profitable a company is. Non-GAAP earnings are almost always higher because these expenses are excluded, which looks better to investors
What is a NINJA loan?
“No income, no job, no assets” – subprime loan, as it is typically made with little or no paperwork, generally to borrowers with less than average credit score
These types of loans were a sign of the impending subprime meltdown and deterioration of lending standards by banks and mortgage originators
These and other loans were packaged and sold as CDOs to investors. They were supposedly well diversified across different geographies, loan sizes, and income levels. The only way they would default is if there was a major collapse in the mortgage market due to oversupply and widespread economic slowdown
Under what circumstances would goodwill increase?
- If a company re-assesses its value and finds that it is worth more but that is rare
- What usually happens is:
(1) company gets acquired or bought out and goodwill changes as a result, since it is an account plug for the acquisition price
(2) company acquires another company and pays more than what its assets are worth, which is then reflected in goodwill
Why would goodwill be impaired and what does goodwill impairment mean?
- Usually happens when a company has been acquired and the acquirer re-assesses its intangible assets (e.g. brand, IP) and finds that they are not worth what they originally thought
- Buyer overpaid for the seller, which results in a large net loss (e.g. eBay / Skype)
How do you decide when to capitalize vs expense a purchase?
If the assets has a useful life over one year, it is capitalized on the balance sheet rather than expensed on the income statement. It is then depreciated (tangibles) or amortized (intangibles) over a certain number of years
PPE vs R&D
What is the difference between cash based and accrual based accounting?
Cash-Based Accounting:
- Recognize revenue and expenses when cash is actually received or paid out
- This delays revenue recognition
- There is a poor matching of true costs of generating revenue to the periods in which they are generated
Accrual-Based Accounting:
- Account for all transactions that economically occurred during a period
- Revenue principle: entity has delivered goods/services, evidence of arrangement for payment, price is fixed and collection of cash is reasonably assured
- Matching principle: revenue is matched with expense in the period in which they are incurred
*Most large firms use accrual accounting because paying with credit cards and lines of credit is so prevalent these days
