Accounting (basic)

Question 1

1. Walk me through the 3 financial statements.

Answer 1

1. Income Statement
   Shows performance over a period of time (e.g. quarter or year)
   Starts with Revenue, subtracts expenses (COGS, Opex, Depreciation, Interest, Taxes)
   Ends with Net Income – the company’s profit after all costs and taxes
   Key for understanding profitability
2. Balance Sheet
   Shows financial position at a specific point in time
   Follows the formula: Assets = Liabilities + Shareholders’ Equity
   Lists:
   Assets: Cash, Inventory, PP&E
   Liabilities: Debt, Payables
   Equity: Common Stock, Retained Earnings
   Key for understanding what the company owns vs owes
3. Cash Flow Statement
   Tracks actual cash movement during the same period as the Income Statement
   Split into 3 sections:
   Operating Activities – starts with Net Income, adjusts for non-cash items and working capital changes
   Investing Activities – e.g. buying/selling assets or CapEx
   Financing Activities – e.g. issuing/repaying debt, equity, dividends
   Ends in Net Change in Cash, which updates the cash line on the Balance Sheet

Question 2

2. Can you give examples of major line items on each of the financial statements?

Answer 2

1. Income Statement – Line Items:
   Revenue / Sales – income from selling goods or services
   Cost of Goods Sold (COGS) – direct cost to produce goods sold
   Gross Profit – Revenue minus COGS
   Operating Expenses – e.g. salaries, rent, marketing
   Depreciation & Amortisation – non-cash reduction in asset value
   Operating Income (EBIT) – profit before interest and tax
   Interest Expense – cost of debt
   Taxes – corporate tax payments
   Net Income – final profit after all expenses and taxes
2. Balance Sheet – Line Items:
   Assets
   Cash & Cash Equivalents – liquid funds
   Accounts Receivable – money owed by customers
   Inventory – goods held for sale
   Prepaid Expenses – payments made in advance
   PP&E – physical assets like land, buildings, machines
   Intangible Assets / Goodwill – brand value, patents, acquisitions
   Liabilities
   Accounts Payable – money owed to suppliers
   Accrued Expenses – salaries, utilities unpaid
   Deferred Revenue – cash received before earning it
   Short-term Debt – loans due within 12 months
   Long-term Debt – loans due in more than 12 months
   Shareholders’ Equity
   Common Stock – value of shares issued
   Retained Earnings – accumulated profits not paid as dividends
3. Cash Flow Statement – Line Items:
   Cash Flow from Operating Activities
   Net Income
   + Depreciation & Amortisation
   ± Change in Working Capital:
   Accounts Receivable
   Inventory
   Accounts Payable
   Cash Flow from Investing Activities
   Capital Expenditures (CapEx) – buying assets like equipment
   Sale of PP&E or investments
   M&A activity
   Cash Flow from Financing Activities
   Issuance / Repayment of Debt
   Issuance / Repurchase of Shares
   Dividends Paid

Question 3

3. How do the 3 statements link together?

Answer 3

Overview: The financial statements are interconnected, with changes in one affecting the others. The key link is Net Income, which connects the Income Statement to both the Cash Flow Statement and the Balance Sheet.
1. Net Income Links All Three
Starts on the Income Statement (final line)
Flows into:
Top of the Cash Flow Statement (Operating Activities section)
Retained Earnings in the Shareholders’ Equity section of the Balance Sheet
2. Cash Flow Statement Adjustments
Begins with Net Income
Adds back non-cash expenses (e.g. Depreciation, Amortisation)
Adjusts for changes in working capital (e.g. Inventory, Payables, Receivables)
Accounts for investing (e.g. CapEx) and financing (e.g. debt, equity)
Ends with Net Change in Cash
3. Balance Sheet Updates
Cash line is updated using the ending cash from the Cash Flow Statement
PP&E decreases due to Depreciation (from Income Statement, adjusted in Cash Flow)
Retained Earnings increases with Net Income (from Income Statement), minus dividends paid (from Financing section of Cash Flow)

Question 4

4. If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?

Answer 4

The Cash Flow Statement
It shows actual cash inflows and outflows, not just accounting profits
It’s the best measure of a company’s liquidity and solvency — whether it can survive, pay bills, and reinvest
Unlike the Income Statement, it’s not distorted by:
Non-cash items (e.g. depreciation, amortisation)
Revenue recognition timing
Unlike the Balance Sheet, it reflects performance over time, not just a snapshot

Question 5

5. Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?

Answer 5

The Income Statement and the Balance Sheet
Income Statement gives insight into:
Revenue growth, profit margins, and operating efficiency
Shows how well the business is performing over time
Key for understanding profitability trends
Balance Sheet provides a snapshot of:
Financial strength (liquidity, leverage, asset base)
Capital structure (debt vs equity)
Working capital (how well it can cover short-term obligations)
Together, they allow you to:
Calculate cash flow indirectly
Starting with Net Income from the Income Statement
Analyse changes in working capital and fixed assets from the Balance Sheet
Assess both performance and financial stability
Understand if the company is profitable and sustainable

Question 6

6. Walk me through how Depreciation going up by $10 would affect the statements.

Answer 6

1. Income Statement
   Depreciation Expense increases by $10
   Since depreciation is an expense, Operating Income (EBIT) drops by $10
   Assuming a tax rate of 25%, Net Income falls by $7.5 (i.e., $10 × (1 – 0.25)) – because lower profit will decrease tax paid, essentially saving $2.50
2. Cash Flow Statement
   Starts with Net Income ↓ $7.5
   But Depreciation is a non-cash expense, so it is added back in Operating Activities
   + $10 Depreciation
   → Net change in cash = +$2.5 (because the cash tax saving from the depreciation is real)
3. Balance Sheet
   Cash increases by $2.5 (from Cash Flow Statement)
   PP&E (a non-current asset) decreases by $10 (due to accumulated depreciation)
   So Total Assets decrease by $7.5
   On the Liabilities & Equity side,
   Retained Earnings decrease by $7.5 (due to lower Net Income)
   Balance Sheet remains balanced:
   Assets ↓ $7.5 = Equity ↓ $7.5

Question 7

7. If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 7

Depreciation reduces Net Income, which means it lowers the company’s reported accounting profit.
However, it’s a non-cash expense, meaning no cash actually leaves the company when you record it.
On the Cash Flow Statement, depreciation is added back under Operating Activities — because it reduced Net Income, but didn’t cost cash.
The result is a lower tax bill, since taxes are based on pre-tax profits (EBIT).
Paying less tax means keeping more cash → so cash increases as a result.
E.g.
Pre-depreciation profit = $100
Depreciation = $10
Tax rate = 25%
→ Taxable profit = $90
→ Tax = $22.5 (instead of $25)
→ You save $2.5 in real cash
That’s why depreciation affects cash balance, even though it’s not a cash cost.

Question 8

8. Where does Depreciation usually show up on the Income Statement?

Answer 8

Depreciation is typically included as part of Operating Expenses on the Income Statement.
More specifically, it is often grouped under:
Cost of Goods Sold (COGS) – if related to machinery used in production
Or under Selling, General & Administrative (SG&A) expenses – if related to office equipment, buildings, etc.
Some companies list it as a separate line, but more often it’s embedded in one of the above categories.

Question 9

9. What happens when Accrued Compensation goes up by $10?

Answer 9

Accrued compensation is an expense that is owed but not yet paid e.g. if employees have worked this month but get paid next month, this income becomes accrued compensation.
When accrued compensation goes up by $10:
1. Income Statement
No change at the moment the accrual increases (it was already recorded as an expense when earned, not when paid).
The compensation expense was already included in prior periods’ Net Income.
So: No new impact on Net Income now.
2. Cash Flow Statement
Cash hasn’t been paid yet, but the liability has increased.
On the Cash Flow from Operating Activities section:
The $10 increase in Accrued Compensation is treated as a source of cash (you’re deferring payment).
→ Cash increases by $10
3. Balance Sheet
Cash increases by $10 (from Cash Flow Statement)
Accrued Compensation (a liability) increases by $10
Assets ↑ $10 = Liabilities ↑ $10 → Balance Sheet stays balanced

Question 10

10. What happens when Inventory goes up by $10, assuming you pay for it with cash?

Answer 10

1. Income Statement
   No change
   Buying inventory is not an expense until it’s used or sold
   So: Net Income stays the same
2. Cash Flow Statement
   In Operating Activities, under Change in Working Capital, inventory increasing is a use of cash
   So: Cash decreases by $10
3. Balance Sheet
   Cash decreases by $10 (asset down)
   Inventory increases by $10 (asset up)
   Net effect: No change in total assets
   Liabilities and Equity are unchanged

Question 11

11. Why is the Income Statement not affected by changes in Inventory?

Answer 11

The Income Statement only reflects expenses related to goods that were sold, not goods you’ve purchased but haven’t used or sold yet.
Inventory that’s purchased but still sitting in storage is treated as an asset — not an expense.
Only when inventory is sold does its cost move from the Balance Sheet to the Income Statement, under Cost of Goods Sold (COGS).
So, simply increasing or decreasing inventory (without selling it) doesn’t impact revenue or expenses, and therefore doesn’t affect Net Income.

Question 12

12. Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?

Answer 12

Assumptions:
CapEx = $100 (used to buy factories)
Entirely funded by new debt (no equity or existing cash used)
No depreciation yet, and no revenue or expenses yet — it’s the start of Year 1
1. Income Statement
No impact yet
No depreciation (hasn’t started)
No operations, no revenue, no interest payments yet
So: Net Income stays the same
2. Cash Flow Statement
Cash from Operating Activities: No changes (no income, no expenses yet)
Cash from Investing Activities: –$100 → CapEx to buy factories (cash out)
Cash from Financing Activities: +$100 → Cash in from debt raised
Net change in cash = $0
3. Balance Sheet
Assets:
PP&E ↑ $100 (you now own the new factories)
Cash = no change (cash in from debt = cash out for factories)
Liabilities:
Debt ↑ $100
Equity:
No change (no Net Income or retained earnings movement yet)
Balance Sheet remains balanced:
Assets ↑ $100 = Liabilities ↑ $100

Question 13

13. Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

Answer 13

1. Income Statement
   Depreciation Expense: 10% of $100 = $10
   Interest Expense: 10% of $100 debt = $10
   EBIT (Operating Profit) ↓ $10 from depreciation
   EBT (Earnings Before Tax) ↓ $20 (depreciation + interest)
   Assume 25% tax rate: Tax = $5
   Net Income ↓ by $15
2. Cash Flow Statement
   Cash from Operating Activities:
   Start with Net Income = –$15
   Add back Depreciation = +$10 (non-cash)
   → Operating Cash Flow = –$5
   Cash from Investing Activities:
   No CapEx this year → No changes
   Cash from Financing Activities:
   No debt repayment
   No equity activity → No changes
   Net change in cash = –$5
3. Balance Sheet
   Assets:
   Cash ↓ by $5 (from cash flow)
   PP&E ↓ by $10 (due to depreciation)
   Liabilities:
   Debt = unchanged (no repayments)
   Equity:
   Retained Earnings ↓ by $15 (Net Income)
   Assets ↓ $15 = Equity ↓ $15 → Balance Sheet balances

Question 14

14. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

Answer 14

1. Income Statement
   Write-down of $90 (non-cash, treated like an expense)
   This reduces EBIT by $90
   No interest expense anymore (debt is being repaid now — assume happens at end of period)
   EBT = –$90
   Tax = +$22.5 (a tax shield) → 25% of $90
   Net Income = –$67.5
2. Cash Flow Statement
   Cash from Operating Activities:
   Start with Net Income = –$67.5
   Add back $90 write-down (non-cash)
   → Operating cash = +$22.5
   Cash from Investing Activities:
   No new activity → No changes
   Cash from Financing Activities:
   Repay $100 of debt → Cash outflow of –$100
   Net change in cash = –$77.5
3. Balance Sheet
   Assets:
   Cash ↓ by $77.5
   PP&E ↓ by $90 (write-down to $0)
   Liabilities:
   Debt ↓ by $100 (fully repaid)
   Equity:
   Retained Earnings ↓ by $67.5 (Net Income)
   Assets ↓ $167.5 = Liabilities ↓ $100 + Equity ↓ $67.5 → Balanced

Question 15

15. Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements?

Answer 15

1. Income Statement
   No impact
   The inventory hasn’t been used or sold yet → so no revenue or COGS
   Net Income remains unchanged
2. Cash Flow Statement
   Cash from Operating Activities:
   Inventory increases by $10
   That’s a use of cash (working capital outflow)
   Cash decreases by $10
3. Balance Sheet
   Assets:
   Inventory increases by $10
   Cash decreases by $10
   → Total assets remain unchanged
   Liabilities and Equity:
   No changes (no income, no debt)
   Balance Sheet stays balanced

Question 16

16. Now let’s say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 16

1. Income Statement
   Revenue = $20
   COGS (cost of goods sold) = $10 (from inventory)
   Gross Profit = $10
   No other expenses mentioned, so assume that’s also Operating Profit (EBIT) = $10
   Tax (25%) = $2.5
   Net Income = $7.5
2. Cash Flow Statement
   Cash from Operating Activities:
   Start with Net Income = $7.5
   Add back COGS of $10? No! COGS is a real cash expense — already included in Net Income
   But we do have a working capital change:
   Inventory decreases by $10 (because it’s sold)
   That’s a source of cash
   Net cash increase = $7.5 + $10 = $17.5
   Cash from Investing / Financing:
   No other changes mentioned
   Net change in cash = +$17.5
3. Balance Sheet
   Assets:
   Cash increases by $17.5
   Inventory decreases by $10
   Net Assets ↑ $7.5
   Equity:
   Retained Earnings ↑ $7.5 (from Net Income)
   Balance Sheet remains balanced

Question 17

17. Could you ever end up with negative shareholders’ equity? What does it mean?

Answer 17

Yes – negative shareholders’ equity is possible.
It means the company’s liabilities exceed its assets. In other words:
Assets – Liabilities = Shareholders’ Equity → if liabilities > assets, equity becomes negative
Causes of Negative Shareholders’ Equity:
Accumulated losses over time
If a company has repeated Net Losses, its Retained Earnings (part of equity) shrink and can go negative
Large dividend payouts
If a company pays dividends greater than its retained earnings, equity can turn negative
Write-downs or impairments
Big asset impairments reduce total assets
Leveraged Buyouts (LBOs)
Companies acquired with large amounts of debt often start with negative equity due to high liabilities
Is it always bad?
Not always.
For a high-growth tech company, negative equity might just reflect reinvestment and accounting losses
But for a mature company, it can signal financial distress

Question 18

18. What is working capital? How is it used?

Answer 18

Working Capital = Current Assets – Current Liabilities
It measures a company’s short-term liquidity — its ability to cover day-to-day operating costs and short-term obligations.
Typical Formula (used in IB/finance):
Operating Working Capital (OWC) = (Accounts Receivable + Inventory – Accounts Payable)
Excludes cash, debt, and interest-related items (because those relate to financing, not operations)
How it’s used:
Liquidity indicator:
Positive working capital = company can pay short-term bills
Negative = may struggle with short-term obligations
Cash flow impact:
If working capital increases, cash goes down (you’ve tied up cash in receivables/inventory)
If working capital decreases, cash goes up (you’ve collected receivables or delayed payments)
Operational efficiency:
Well-managed working capital means tight control over inventory, receivables, and payables
Examples:
A supermarket may have negative working capital (they collect cash quickly but pay suppliers later) → not a bad thing!
A manufacturer may need positive working capital to hold inventory and allow credit sales

Question 19

19. What does negative Working Capital mean? Is that a bad sign?

Answer 19

Working Capital = Current Assets – Current Liabilities
So, Negative Working Capital means Current Liabilities > Current Assets
Is it a bad sign?
It depends on the business model.
When Negative Working Capital Can Be a Good Thing
Retailers, fast food chains, supermarkets
These companies often collect cash from customers immediately (e.g. card sales)
But they have long payment terms with suppliers (e.g. 30–60 days)
So they operate with negative working capital and still have strong cash flow
Examples: Amazon, Walmart, McDonald’s
When Negative Working Capital Can Be a Bad Thing
If a business:
Struggles to collect receivables
Has a liquidity crisis
Relies too heavily on delaying payments
Then negative working capital might indicate:
Cash flow problems
Inability to cover short-term obligations
Supplier risk
How to Evaluate It
Compare against industry norms
Look at trends over time — consistent deterioration may signal deeper issues
Analyse alongside operating cash flow
Conclusion
Negative working capital isn’t inherently bad. It can reflect operational efficiency or financial stress — context is key.

Question 20

20. Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a write-down of $100.

Answer 20

A write-down happens when a company realises that something it owns is now worth less than it thought. So, the company lowers the value of that item in its accounting records.
This may because the asset is damaged/lost, has lost market value, or won’t generate as much future benefit as expected
1. Income Statement
A write-down of $100 is treated as a non-cash expense.
It reduces Pre-Tax Income (EBT) by $100.
Assuming a 25% tax rate, the company saves $25 in taxes.
Net Income decreases by $75.
2. Cash Flow Statement
Operating Activities:
Start with Net Income: –$75
Add back the $100 write-down (non-cash)
Operating cash flow increases by $25
Investing and Financing Activities:
No impact (unless related to a specific transaction, which is not stated here)
Net change in cash: +$25
3. Balance Sheet
Assets:
The asset being written down (e.g., Goodwill, a loan, or other intangible) decreases by $100
Cash increases by $25 (from the tax savings)
Net asset change: –$75
Equity:
Retained Earnings decreases by $75 (from Net Income)
Balance Sheet balances: Assets decrease by $75 = Equity decreases by $75

Question 21

21. Walk me through a $100 “bailout” of a company and how it affects the 3 statements.

Answer 21

Assumption:
Let’s assume the bailout is a cash injection of $100 from the government or an investor. The company receives $100 in equity financing — it’s not a loan and doesn’t need to be repaid.
1. Income Statement
No effect at the time of the bailout
It’s not revenue, and it doesn’t affect expenses
So Net Income remains unchanged
2. Cash Flow Statement
Cash from Financing Activities: Cash increases by $100 (new money raised)
Cash from Operating and Investing Activities: No change
Net change in cash = +$100
3. Balance Sheet
Assets:
Cash increases by $100
Liabilities:
No change
Shareholders’ Equity:
Equity increases by $100 (e.g. common stock or additional paid-in capital)
Balance Sheet balances: Assets ↑ $100 = Equity ↑ $100

Question 22

22. Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s balance sheet and how it affects the 3 statements.

Answer 22

the debt (for example, in a restructuring or partial settlement). So the company no longer has to pay it back — it’s written off. This creates a gain for the company, because a debt is cancelled.
1. Income Statement
The company records a gain of $100 under “Other Income” or a similar line.
Assuming a 25% tax rate: Tax = $25
Net Income increases by $75
2. Cash Flow Statement
Cash from Operating Activities:
Start with Net Income = +$75
This gain is non-cash (you didn’t receive $100 in cash — you just don’t have to pay it back)
But no adjustment is needed here because it’s not like depreciation — it’s real benefit
Cash stays the same
3. Balance Sheet
Liabilities:
Debt ↓ $100 (liability removed)
Equity:
Retained Earnings ↑ $75 (Net Income)
Assets:
No change (cash didn’t increase)
Balance Sheet balances: Liabilities ↓ $100 = Equity ↑ $75 → Net Assets ↓ $25
(which works because total liabilities + equity still balances assets)
That decrease is from Deferred Tax Asset (DTA) ↓ $25 (reflecting the loss of future tax benefit, since you’re no longer making a tax-deductible interest payment)

Question 23

23. When would a company collect cash from a customer and not record it as revenue?

Answer 23

When the company is paid in advance for a product or service it hasn’t delivered yet.
This is called deferred revenue or unearned revenue.
Examples:
A customer prepays for a 1-year subscription (e.g. Spotify, The Economist)
A customer places a non-refundable deposit for future delivery (e.g. Tesla preorders)
A software company sells a multi-year license and gets full payment upfront
Why is it not recorded as revenue?
Under accrual accounting, revenue can only be recognised when:
It is earned, and
The product or service has been delivered
If the company hasn’t fulfilled its obligation yet, it can’t recognise the cash as revenue — even if it has the money in the bank.
Where does it go instead?
It shows up as a liability on the Balance Sheet under Deferred Revenue
It reflects the company’s obligation to provide goods/services in the future

Question 24

24. If cash collected is not recorded as revenue, what happens to it?

Answer 24

The cash is recorded as an increase in cash (asset) on the Balance Sheet
At the same time, the company records a liability called Deferred Revenue
This reflects the company’s obligation to deliver a product or service in the future
Once the company delivers the good or service, it will:
Reduce Deferred Revenue
Recognise actual revenue on the Income Statement

Question 25

25. What’s the difference between accounts receivable and deferred revenue?

Answer 25

Accounts Receivable = You’ve earned the revenue but haven’t been paid yet So the customer owes you money, the product/service has been delivered, and it is recorded as an asset (money to be received) on the balance sheet, revenue already recorded on the income statement Deferred Revenue = You’ve been paid, but haven’t earned the revenue yet So you owe the customer a service/product, the product/service has not yet been delivered, and it is recorded as a liability (obligation to deliver) on the balance sheet, revenue is not yet recorded on the income statement

Question 26

26. How long does it usually take for a company to collect its accounts receivable balance?

Answer 26

It depends on the industry and company, but typically 30 to 90 days This is often referred to as the “Days Sales Outstanding” (DSO) Formula for DSO: DSO = (Accounts Receivable / Revenue) × Number of Days This tells you, on average, how many days it takes to collect payment after a sale. A high DSO means slower collections, which may hurt cash flow A low DSO means efficient collections and better working capital

Question 27

27. What’s the difference between cash-based and accrual accounting?

Answer 27

The key difference is timing — specifically, when revenue and expenses are recorded. 1. Cash-Based Accounting Revenue is recorded only when cash is received Expenses are recorded only when cash is paid Think: "Money changes hands" = record it Used by: Small businesses Individuals (e.g. freelancers) 2. Accrual Accounting Revenue is recorded when earned, even if cash hasn’t been received Expenses are recorded when incurred, even if cash hasn’t been paid Think: "Work is done" = record it Used by: Nearly all large businesses Required under GAAP and IFRS Accrual accounting gives a more accurate picture of a company’s financial performance It matches revenue and expenses to the correct period, which is crucial for understanding profitability

Question 28

28. Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Answer 28

1. Cash-Based Accounting Revenue is recorded only when cash is received So the company waits until the money actually hits the bank (e.g. 2–3 days later) Until then: no revenue shown 2. Accrual Accounting Revenue is recorded immediately, because the TV has been delivered The company sets up an Accounts Receivable entry for the amount owed by the credit card processor When the cash is received, Accounts Receivable decreases, and Cash increases

Question 29

29. How do you decide when to capitalize rather than expense a purchase?

Answer 29

When a company spends money, does it record the full amount as a cost now (expensing), or does it spread the cost over time (capitalising)? The decision depends on whether the item will provide a future economic benefit beyond the current accounting period (1 year) 1. What does it mean to “expense” something? You record the full cost immediately on the Income Statement It reduces profit right away Use this when something is used up quickly — within a few weeks or months Simple examples: Wages, Rent, Electricity, Office supplies You pay for it, you use it, and it’s gone — so you count it as an expense now. 2. What does it mean to “capitalise” something? You record it as an asset on the Balance Sheet Then, you slowly turn it into an expense over time (this is called depreciation or amortisation) You use this when the thing you buy will help the business for a long time — usually more than 1 year Simple examples: A new delivery van, A building, Factory equipment (depreciated) Software development costs (amortised) These are all long-term investments. You still spend cash today, but you don’t count it as a full expense right away — instead, you spread out the cost over a few years.

Question 30

30. Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?

Answer 30

What is GAAP? GAAP stands for Generally Accepted Accounting Principles It’s the official rulebook companies must follow when preparing their financial statements GAAP earnings include all required expenses, even if they are non-cash, one-time, or unusual What is non-GAAP (or Pro Forma)? Non-GAAP earnings remove certain items that the company thinks don’t reflect its normal, ongoing performance It’s not audited and not standardised — companies define it themselves Why do companies report both? 1. GAAP earnings show the full picture (good and bad) They include everything required by the accounting rules — like: Stock-based compensation Restructuring charges Asset write-downs Legal settlements These items can distort results in the short term but are required for transparency 2. Non-GAAP earnings help investors focus on “core” performance Companies argue that some expenses are one-time or non-cash and don’t reflect how the business is really doing So they adjust earnings to show what they believe is a more “normal” view

Question 31

31. A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Answer 31

EBITDA only tells you part of the story — it shows earnings before interest, taxes, depreciation, and amortisation, but ignores critical cash outflows and financial obligations. So even with positive EBITDA, a company can go bankrupt if it’s struggling in other areas. Reasons why a company with positive EBITDA might go bankrupt: 1. High interest expense EBITDA ignores interest payments If the company has a lot of debt, it might not generate enough real cash to cover interest and loan repayments 2. Capital-intensive business EBITDA excludes CapEx (capital expenditures) If the company needs to spend heavily on equipment, buildings, or infrastructure, it may run out of cash even with strong EBITDA 3. Working capital problems EBITDA doesn’t account for cash tied up in receivables or inventory If customers delay payments or inventory builds up, the company might face short-term cash shortages 4. One-off liabilities Legal fines, lawsuits, tax bills, or regulatory costs may suddenly hit These don’t show up in EBITDA but can drain cash quickly 5. Poor cash flow Ultimately, EBITDA is not cash flow A company might be profitable on paper but still unable to pay suppliers, repay debt, or fund operations

Question 32

32. Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?

Answer 32

What is Goodwill? Goodwill is an intangible asset that arises when one company acquires another for more than the fair value of its net assets It reflects things like: Brand reputation Customer relationships Skilled workforce Expected future profits Example: If Company A buys Company B for $500 million, and B’s net assets are only worth $400 million, the extra $100 million is recorded as Goodwill on the Balance Sheet Why does Goodwill stay constant? Unlike other assets, Goodwill isn’t amortised or depreciated It sits unchanged on the Balance Sheet unless there’s a reason to believe it’s no longer worth what you paid What is Goodwill Impairment? Goodwill Impairment happens when the company tests its Goodwill and finds that the business it bought is now worth less than expected So it reduces the value of Goodwill on the Balance Sheet and records a loss on the Income Statement Why would it happen? The acquired company is underperforming Market conditions have worsened The deal was overvalued or based on over-optimistic forecasts Competitors gained an edge What happens on the financial statements? Income Statement: Records a non-cash loss called “Goodwill Impairment” → Net Income decreases Cash Flow Statement: The loss is added back because it’s non-cash Balance Sheet: Goodwill decreases, and Retained Earnings decrease by the same amount

Question 33

33. Under what circumstances would Goodwill increase?

Answer 33

Goodwill increases only when a company acquires another company and pays more than the fair value of its identifiable net assets. In other words, Goodwill goes up when an acquisition is made at a premium. How does it work? Formula for Goodwill: Goodwill = Purchase Price – Fair Value of Net Identifiable Assets So if: Company A buys Company B for $500 million The fair value of B’s net assets (assets – liabilities) is $400 million → Then Goodwill = $100 million This is recorded as a new intangible asset on Company A’s Balance Sheet When else could it change? Goodwill can only increase when a new acquisition occurs It does not increase from internal growth, branding, or improved performance Goodwill does not accumulate organically — it must come from a purchase transaction Important to know: Goodwill can increase: Only via acquisitions Goodwill can decrease: Through impairment, when an acquisition underperforms It is never amortised, but is tested for impairment annually