Accounting - Advanced Flashcards
(42 cards)
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.
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.
The most common way they occur is 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.
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.
Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?
Use estimates. For the revenue if you don’t have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years.
For the expenses, if you don’t have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.
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 employees 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.
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 + Stock Created by Option Exercises
If you’re calculating it, take the balance from last year, add this year’s stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.
What is the Statement of Shareholders’ Equity and why do we use it?
This statement shows everything we went through above – 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.
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.
How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?
Normally you make very simple assumptions here and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples:
- Accounts Receivable: % of revenue.
- Deferred Revenue: % of revenue.
- Accounts Payable: % of COGS.
- Accrued Expenses: % of operating expenses 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 & 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 capital expenditures 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, and then subtract that new Tax number from your old Pretax Income number (which should stay the same).
The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an 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.
How can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?
This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons.
For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets.
But they might also record accelerated Depreciation for tax purposes, but straight-line it for book purposes, which would result in a DTL in early years.
How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?
They are similar, but not the same exact idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the current year.
For example, if a company owes $300 in taxes at the end of each quarter during the year, on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months, at which point Income Taxes Payable would decrease once again.
By contrast, DTAs and DTLs tend to be longer-term and arise because of events that do NOT occur in the normal course of business.
What’s the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation? How do they impact the statements?
Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes).
Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they’ve saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it).
Neither one is a separate item on the Income Statement.
On the Cash Flow Statement, Excess Tax Benefits are subtracted out of Cash Flow from Operations and added to Cash Flow from Financing, effectively “re- classifying” them. Basically you’re saying, “We’ve gotten some extra cash flow from our share price increasing, so let’s call it what it is: a financing activity.”
Also on the CFS, you add back the Tax Benefits in Cash Flow from Operations.
You do that because you want them to accrue to Additional Paid-In Capital (APIC) on the Balance Sheet. You’re saying, “In addition to the additional value we created with this stock/option issuance, we’ve also gotten some value from the tax savings… so let’s make reflect that value along with the SBC itself under APIC.”
Let’s say you’re creating quarterly projections for a company rather than annual projections. What’s the best way to project revenue growth each quarter?
It’s best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example, in Quarter 1 of Year 2 you would look at how much the company has grown revenue by in Quarter 1 of previous years.
It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Quarter 1 over Quarter 4 in the previous year) because many companies are seasonal.
The same applies for expenses as well: always make sure you take into account seasonality with quarterly projections.
What’s the purpose of calendarizing financial figures?
“Calendarizing” means “Rather than using a company’s normal fiscal year figures, let’s use another year-long period during the year and calculate their revenue, expenses, and other key metrics for that period.”
For example, a company’s fiscal year might end on December 31 – if you calendarized it, you might look at the period from June 30 in the previous year to June 30 of this year rather than the traditional January 1 – December 31 period.
You do this most frequently with public comps (see the section on Valuation), because companies often have “misaligned” fiscal years. If one company’s year ends December 31, another’s ends June 30, and another’s ends September 30, you need to adjust and use the same period for all of them – otherwise you’re comparing apples to oranges because the financial figures are all from different time periods.
What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes, but straight-line Depreciation for book purposes?
If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because you’re paying less in cash taxes initially and need to make up for it later.
Then, as tax Depreciation switches and becomes lower in the later years, the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.
If you own over 50% but less than 100% of another company, what happens on the financial statements when you record the acquisition?
This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company’s statements to your own.
It’s similar to a 100% acquisition where you do the same thing, but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don’t own (e.g. if it’s worth $100 and you own 70%, you would list $30 here).
Just like with normal acquisitions, you also wipe out the other company’s Shareholders’ Equity when you combine its statements with yours, and you still allocate the purchase price (see the Merger Model section for more on that).
You also subtract Net Income Attributable to Noncontrolling Interests on the Income Statement – in other words, the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the Cash Flow Statement in the CFO section. That is just an accounting rule and has no cash impact.
On the Balance Sheet, the Noncontrolling Interest line item increases by that number (Net Income Attributable to Noncontrolling Interests) each year. Retained Earnings decreases by that same number each year because it reduces Net Income, so the Balance Sheet remains in balance.
What about if you own between 20% and 50% of another company? How do you record this acquisition and how are the statements affected?
This case refers to an Equity Interest (AKA Associate Company) – here, you do not consolidate the statements at all.
Instead, you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the Balance Sheet (Investments in Equity Interests). For example, if the other company is worth $200 and you own 30% of it, you record $60 for the Investments in Equity Interests line item.
You also add Other Company’s Net Income * Percentage Ownership to your own Net Income on the Income Statement, and then subtract it on the Cash Flow Statement because it’s a non-cash addition.
Each year, the Investments in Equity Interests line item increases by that number, and it decreases by any dividends issued from that other company to you. On the other side, Retained Earnings will also change based on the change in Net Income, so everything balances.
What if you own less than 20% of another company?
This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case, especially if they exert “significant influence” over the other company.
But sometimes they may also classify it as a simple Investment or Security on their Balance Sheet (see the next few questions), acting as if they have simply bought a stock or bond and ignoring the other company’s financials.
