Accounting Flashcards
What happens when Accrued Compensation goes up by $10?
For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation).
Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation 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.
On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.
Why is the Income Statement not affected by changes in Inventory?
This is a common interview mistake – incorrectly stating that Working Capital changes show up on the Income Statement.
- In the case of Inventory, the expense is only recorded when the goods associated with it are sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.
What does negative Working Capital mean? Is that a bad sign?
Not necessarily. It depends on the type of company and the specific situation – here are a few different things it could mean:
Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.
In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance).
What’s the difference between cash-based and accrual accounting?
Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out
Accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash
Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.
Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?
These days, many companies have “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements.
- As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
Several possibilities:
The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative.
The company has high interest expense and is no longer able to afford its debt.
The company’s debt all matures on one date and it is unable to refinance it due to a “credit crunch” – and it runs out of cash completely when paying back the debt.
It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.
Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges – and all of these could end up bankrupting the company.
Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?
Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.
It often happens in acquisitions where the buyer “overpaid” for the seller and can result in a large net loss on the Income Statement (see: Microsoft/Skype).
It can also happen when a company discontinues part of its operations and must impair the associated goodwill.
Under what circumstances would Goodwill increase?
Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare.
What usually happens is 1 of 2 scenarios:
The company gets acquired or bought out and Goodwill changes as a result, since it’s an accounting “plug” for the purchase price in an acquisition.
The company acquires another company and pays more than what its assets are worth – this is then reflected in the Goodwill number.
What are deferred tax assets/liabilities and how do they arise?
They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.
-) Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet;
-) Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.
*** They’re most common with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset
How is GAAP accounting different from tax accounting?
- GAAP is accrual-based but tax is cash-based.
- GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
- GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.
Walk me through how you create a revenue model for a company.
There are 2 ways you could do this: a bottoms-up build and 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 sales and sale values to tie everything together.
- Tops-Down: Start with “big-picture” metrics like overall market size, 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.
Walk me through how you create an expense model for a company.
- To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on 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” produced should incur an expense.
- Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.
Walk me through the major items in Shareholders’ Equity.
Common items include:
- Common Stock – Simply the par value of however much stock the company has issued.
- Retained Earnings – How much of the company’s Net Income it has “saved up” over time.
- Additional Paid in Capital – This keeps track of how much stock-based compensation has been issued and how much new stock emplo yees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering.
- Treasury Stock – The dollar amount of shares that the company has bought back.
- Accumulated Other Comprehensive Income – This is a “catch-all” that includes other items that don’t fit anywhere else, like the effect of foreign currency exchange rates changing.
What is the Statement of Shareholders’ Equity and why do we use it?
The major items that comprise Shareholders’ Equity, and how we arrive at each of them using the numbers elsewhere in the statement. You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.
Walk me through what flows into Retained Earnings.
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.
Walk me through what flows into Additional Paid-In Capital (APIC).
APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises
Take the balance from last year, add this year’s stock-based compensation number, and then add in the value of new stock created by employees exercising options this year.
What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?
- Restructuring Charges
- Goodwill Impairment
- Asset Write-Downs
- Bad Debt Expenses
- Legal Expenses
- Disaster Expenses
- Change in Accounting Procedures
Note that to be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges “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 for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges.
Bad Debt Expenses
Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off.
Bad debt expenses refer to the amount of money a company writes off as a loss because it is unable to collect payment from its customers. This is typically a result of customers defaulting on their payments or becoming insolvent.
How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?
Normally you make very simple assumptions and assume these are % of Revenue, % of OpEx, or % of COGS… Here are examples:
- Accounts Receivable: % of Revenue
- Deferred Revenue: % of Revenue
- Accounts Payable: % of COGS
- Accrued Expenses: % of OpEx or SG&A
- Then you either carry the same percentages across in future years or assume slight changes depending on the company
How should you project Depreciation and Capital Expenditures?
- The simple way:
— Project each one as a % of Revenue or previous PP&E balance - The more complex way:
— Create a PP&E schedule that splits out different Assets by their useful lives, assumes Straight-Line Depreciation over each Asset’s useful life, and then assumes CapEx based on what the company has invested historically
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
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
-) Subtract that new Tax number from your old Pretax Income number (which should stay the same).
The way you should do this:
-) Create Book Tax vs. Cash Tax schedule where you calculate the Taxable Income based on NOLs
-) Look at what you would pay in taxes without the NOLs
-) Book the difference as a 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.
What’s the difference between Capital Leases and Operating Leases?
-) 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:
- If there’s a transfer of ownership at the end of the term.
- If there’s an option to purchase the asset at a bargain price at the end of the term.
- If the term of the lease is greater than 75% of the useful life of the asset.
- If the present value of the lease payments is greater than 90% of the asset’s fair market value.
Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement?
-) This happens if D&A is embedded in other Income Statement line items.
-) When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A.
What do you do if you understated depreciation by $100 and discovered the error in a period after the statements are issued (assuming 30% tax)
- Net Income decreases by $70. There is a $100 decrease by taking out the extra $100 in depreciation, but there is a corresponding depreciation tax shield of $30 that partially offsets the decrease.
- Shareholder’s Equity decreases by $70 due to the decrease in Net Income. Net PPE decreases by $100 due to the increase in depreciation. The Accounting Equation (A = Liability + Shareholders’ Equity) is balanced by creating a Deferred Tax Asset of $30.
- Cash flow remains the same as this is a non-cash transaction.Net Income is reduced by $70, $100 in depreciation is added back, and $30 in changes to deferred tax is subtracted, resulting in no change.
HOW DO YOU CAPITALIZE AN OPERATING LEASE?
Take the following steps:
1.Calculate the present value of the minimum operating lease payments at the current balance sheet date
2.Add the leasehold asset and leasehold obligation to the balance sheet
3.Remove rent expense from the income statement
4.Replace it with amortization and interest expense
5.Adjust cash flows by removing rent expense and adding back interest and amortization. Classify the repayment on the obligation as financing.
Where woud you put a convertible bond on the BS?
Under Long Term Liabilities
Why might a bond’s cash payment and interest expense be different during a given period?
If a bond is issued at a premium or discount then the rates (coupon calculation) will be different from what you would normally calculate looking at the face value of the bond.
Fish & Chips restaurant: Sale of a hamburger?
- Debit: Account receivable or cash
- Credit: Fish & Chips inventory
- Debit: COGS
- Credit: Sales
If $10 of accounts receivable is left out, how would you modify the financial statements? (assuming everything balanced prior)
Account receivable will increase by $10 and the adjustment we need to make for this change is increase sales by $10 (assuming no tax-net profit will increase by $10 which will go through retained earnings on the equity on B/S)
What is the formula for cash conversion?
Vergleich OCF / CFO vor Zinsen und Steuern mit EBITDA
In LBO scenarios and when conducting credit analyses, analysts typically use the following formula to calculate the CCR:
Cash Conversion Ratio = FCF / EBITDA
