IB Accounting Questions

Question 1

What is the primary purpose of US GAAP?

Answer 1

In the US, the Securities and Exchange Commission (“SEC”) authorizes the Financial
Accounting Standards Board (“FASB”) to determine the set of accounting rules followed by publicly traded companies.
Under FASB, financial statements are required to be prepared in accordance with US Generally Accepted Accounting Principles (“US GAAP”). Through the standardization of financial reporting and ensuring all financials are presented
on a fair, consistent basis – the interests of investors and lenders are protected.

Question 2

What are the main sections of a 10-K?

Answer 2

Three core financial statements: the income statement, cash flow statement,
and balance sheet. There’ll also be a statement of shareholders’ equity, a statement of comprehensive income,
and supplementary data and disclosures to accompany the financials. (Main sections of a 10-k: Business overview, MD&A, Notes

Question 3

What is the difference between the 10-K and 10-Q?

Answer 3

10-K is the annual report required to be filed with the SEC (audit required, filed within 60-90 days after the fiscal year) vs 10-Q refers to the quarterly report required to be filed with the SEC (only reviewed by CPAs, left unaudited, submitted 40-45 days after the quarter ends)

Question 4

Walk me through the three financial statements.

Answer 4

Income Statement (“IS”): The income statement shows a company’s “profitability over a specified period”, typically quarterly and annually. The beginning line item is revenue and upon deducting various costs and expenses, the ending line item is net income.

Balance Sheet (“BS”): The balance sheet is a snapshot of a company’s resources (assets)
and sources of funding (liabilities and shareholders’ equity) “at a specific point in time”, such as the end of a quarter or fiscal year.

Cash Flow Statement (“CFS”): Under the indirect approach, the starting line item is net income, which will be adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from operations. Cash from investing and financing activities are then added to cash from operations to arrive at the net change in cash, which represents the “actual cash inflows/(outflows) in a given period”.

Question 5

Walk me through the balance sheet

Answer 5

Assets Section: Organized in the order of liquidity. “Current Assets” being assets that can be converted into cash within a year, such as cash itself, along with
marketable securities, accounts receivable, prepaid expenses, and inventories. “Long-Term Assets” include property, plant, and equipment (PP&E), intangible assets, goodwill, and long-term investments.
Liabilities Section: Liabilities are listed in the order of how close they’re to coming due. “Current

Liabilities: How close they’re to coming due. “Current Liabilities” include accounts payable, accrued expenses, and short-term debt, while “Long-Term Liabilities” include items such as long-term debt, deferred revenue, and deferred income taxes.

SHE: The equity section consists of common stock, additional paid-in capital (APIC), treasury stock, and retained earnings.

Question 6

What do assets, liabilities, and equity each represent?

Answer 6

Assets: Resources with economic value that can be sold for money or bring positive monetary benefits in the future. - Inflow

Liabilities: Unsettled obligations to another party in the future and represent the external sources of capital from third-parties, which help fund the company’s assets (e.g., debt capital, payments owed to suppliers/vendors). - Outflow

Equity: Capital invested in the business and represents the internal sources of capital that helped fund its assets.

Question 7

Walk me through the cash flow statement (indirect approach)

Answer 7

Cash from Operations: The cash from operations section starts with net income and adds back non-cash expenses such as depreciation & amortization and stock-based
Statement compensation, and then makes adjustments for changes in working capital.

2. Cash from Investing: Next, the cash from investing section accounts for capital expenditures (typically
   the largest outflow), followed by any business acquisitions or divestitures.
3. Cash from Financing: In the third section, cash from financing shows the net cash impact of raising capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of debt.
   The cash outflows from the payout of dividends to shareholders will be reflected here as well.

Together = Net Change in Cash for the Period

Question 8

How are the three financial statements connected?

Answer 8

IS ↔ CFS: Connected through net income, as net income is the starting line on the cash flow statement.

CFS ↔ BS: CF is connected as it tracks
the changes in the balance sheet’s working capital (current assets and liabilities). The
impact from capital expenditures (PP&E), debt or equity issuances, and share buybacks (treasury stock) are also reflected on the balance sheet. In addition, the ending cash balance from the bottom of the cash flow statement will flow to the balance sheet as the cash balance for the current period.

IS ↔ BS: The income statement is connected to the balance sheet through retained earnings. Net income minus dividends issued during the period will be added to the prior period’s retained earnings balance to
calculate the current period’s retained earnings. Interest expense on the income statement is also calculated off the beginning and ending debt balances on the balance sheet, and PP&E on the balance sheet
is reduced by depreciation, which is an expense on the income statement.

Question 9

If you have a balance sheet and must choose between the income statement or cash flow
statement, which would you pick?

Answer 9

Assuming that I would be given both the beginning and end of period balance sheets, I would choose the income statement since I could reconcile the cash flow statement using the balance sheet’s year-over-year
changes along with the income statement.

Question 10

Which is more important, the income statement or the cash flow statement?

Answer 10

The cash flow statement is arguably more important because it reconciles net income, (the accrual-based bottom line on the income statement) to what is actually occurring to cash. This means the actual movement of cash during the period is reflected on the cash flow statement. Thus, the
cash flow statement brings attention to liquidity-related issues and investments and financing activities that
don’t show up on the accrual-based income statement.

Question 11

If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?

Answer 11

Cash is king. The cash flow statement would be chosen since the cash flow statement reflects a company’s true liquidity and is not prone to the same discretionary accounting conventions used in accrual accounting.

Question 12

Why is the income statement insufficient to assess the liquidity of a company?

Answer 12

A company can consistently show positive net income yet struggle to
collect sales made on credit. The company’s inability to retrieve payments from
customers would not be reflected on its income statement.

The solution to the shortcomings of the income statement is the cash flow statement, which reconciles net
income based on the real cash inflows/(outflows) to understand the true cash impact from operations,
investing, and financing activities during the period.

Question 13

What are some discretionary management decisions that could inflate earnings (7)?

Answer 13

Extending asset useful lives: Overestimating capital expenditure lifespans reduces annual depreciation, boosting net income.

LIFO to FIFO switch: During rising inventory costs, FIFO lowers COGS, increasing reported profits.

Delaying asset write-downs: Avoiding impairment charges preserves equity and prevents income reduction.

Capitalizing vs. expensing: Classifying costs as long-term assets (e.g., software) spreads expenses over time, inflating short-term earnings.

Share buybacks: Reducing outstanding shares artificially raises EPS without operational improvement.

Deferring capex/R&D: Postponing investments temporarily enhances current-period profitability and cash flow.

Aggressive revenue recognition: Recognizing revenue prematurely inflates income by relaxing performance obligations.

Question 14

Tell me about the revenue recognition and matching principle used in accrual accounting.

Answer 14

Revenue Recognition Principle: Revenue is recorded in the same period the good or service was delivered (and therefore “earned”), whether or not cash was collected from the customer.

Matching Principle: The expenses associated with the production/delivery of a good or service must be recorded in the same period as when the revenue was earned.

Question 15

What is the difference between cost of goods sold and operating expenses?

Answer 15

Cost of Goods Sold: COGS represents the “direct costs associated with the production of the goods sold or the delivery of services to generate revenue”. Examples include direct material and labor costs.

Operating Expenses: Operating expenses such as SG&A and R&D are “not directly associated with the production of goods or services offered”. Often called indirect costs, examples include rent, payroll, wages,
commissions, meal and travel expenses, advertising, and marketing expenses.

Question 16

When do you capitalize vs. expense items under accrual accounting?

Answer 16

The factor that determines whether an item gets capitalized as an asset or gets expensed in the period incurred
is its useful life (i.e., estimated timing of benefits).

Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for more than one year need to be capitalized and expensed over time. For example, PP&E such as a building can provide benefits for 15+ years and is therefore depreciated over its useful life.

Expensed: When the benefits received are short-term, the related expenses should be incurred in the same period. For example, inventory cycles out fairly quickly within a year and employee wages
should be expensed when the employee’s services were provided.

Question 16

If depreciation is a non-cash expense, how does it affect net income?

Answer 16

While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax-
deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already
occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.

Question 17

Do companies prefer straight-line or accelerated depreciation?

Answer 17

For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation
will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation.

Question 18

What is the relationship between depreciation and the salvage value assumption?

Answer 18

Most companies will use a salvage value assumption in which the remaining value of the asset is zero by the
end of the useful life. The difference between the cost of the asset and residual value is known as the total
depreciable amount. If the salvage value is assumed to be zero, the depreciation expense each year will be
higher and the tax benefits from depreciation will be fully maximized.

Question 19

How would a $10 increase in depreciation flow through the financial statements?

Answer 19

IS: When depreciation increases by $10, EBIT would decrease by $10.
Assuming a 30% tax rate, net income will decline by $7.
CFS: At the top of the cash flow statement, net income has decreased by $7, but
the $10 depreciation will be added back since it’s a non-cash expense. The net
impact on the ending cash balance will be a positive $3 increase.
BS: PP&E will decrease by $10 from the depreciation, while cash will be up by
$3 on the assets side. On the L&E side, the $7 reduction in net income flows
through retained earnings. The balance sheet remains in balance as both sides
went down by $7.

(The depreciation expense will decrease the earnings, with a portion of this being the tax expense, which saved us $3, therefore the net effect is 7 net income, but then on the cash flow statement we then add back the depreciate, resulting in a ending cash balance of $3.)

Question 20

A company acquired a machine for $5 million and has since generated $3 million in accumulated
depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value
of that PP&E on the balance sheet?

Answer 20

The short answer is $2 million. Except for certain liquid financial assets that can be written up to reflect their
fair market value (“FMV”), companies must carry the value of assets at their net historical cost.
Under IFRS, the revaluation of PP&E to fair value is permitted. Even though permitted, it’s not widely used and
thus not even well known in the US. Don’t voluntarily bring this up in an interview on your own.

Question 21

What is the difference between growth and maintenance capex?

Answer 21

Growth Capex: The discretionary spending of a business to facilitate new growth plans, acquire more customers, and expand geographically. Throughout periods of economic expansion, growth capex tends to increase across most industries (and the reverse during an economic contraction).

Maintenance Capex: The required expenditures for the business to continue operating in its current state
(e.g., repair broken equipment).

Question 22

Which types of intangible assets are amortized?

Answer 22

Customer lists, copyrights, trademarks,
and patents, which all have a finite life and are thus amortized over their useful life.

Question 23

What is goodwill and how is it created?

Answer 23

Goodwill is the
excess premium
paid over the fair
value, and is created
to “plug” this gap for
the balance sheet to
remain in balance.

“Buys a company for a $500 million purchase price with a fair
market value of $450 million. In this hypothetical scenario, goodwill of $50 million
would be recognized on the acquirer’s balance sheet.”

Question 24

Can companies amortize goodwill?

Answer 24

Assumed to have an indefinite life, similar to land. Instead, goodwill must be tested annually for impairment.

Question 25

What is the “going concern” assumption used in accrual accounting?

Answer 25

Companies are assumed to continue operating into the foreseeable future and remain in existence indefinitely. The assumption has broad valuation implications, given the expectation of continued cash flow generation from the assets belonging to a company, as opposed to being liquidated.

Question 26

Explain the reasoning behind the principle of conservatism in accrual accounting.

Answer 26

For any revenue or expense to be recognized, there must be evidence of occurrence with a measurable monetary amount.

Question 27

Why are most assets recorded at their historical cost under accrual accounting?

Answer 27

An asset's value on the balance sheet must reflect the initial purchase price. This represents the most consistent measurement method since there's no need for constant revaluations and markups, thereby reducing market volatility.

Question 28

What role did fair-value accounting have in the subprime mortgage crisis?

Answer 28

In the worst-case scenario, sudden drops in asset values could cause a domino effect in the market. An example was the subprime mortgage crisis, in which the meltdown's catalyst is considered to be FAS-157. This mark-to- market accounting rule mandated financial institutions to update their pricing of illiquid securities. Soon after, write-downs in financial derivatives, most notably credit default swaps ("CDS") and mortgage-backed securities ("MBS"), ensued from commercial banks, and it was all downhill from there.

Question 29

Why are the values of a company's intangible assets not reflected on its balance sheet?

Answer 29

The objectivity principle of accrual accounting states that only verifiable, unbiased data can be used in financial filings, as opposed to subjective measures. For this reason, internally developed intangible assets such as branding, trademarks, and intellectual property will have no value recorded on the balance sheet because they cannot be accurately quantified and recorded. Companies are not permitted to assign values to

Question 30

If the share price of a company increases by 10%, what is the balance sheet impact?

Answer 30

There would no change on the balance sheet as shareholders’ equity reflects the book value of equity (Total Assets – Total Liabilities) vs Equity value, also known as the "market capitalization," represents the value of a company’s equity based on supply and demand in the open market. In contrast, the book value of equity is the initial historical amount shown on the balance sheet for accounting purposes. This represents the company's residual value belonging to equity shareholders once all of its assets are liquidated and liabilities are paid off.

Question 31

Do accounts receivable get captured on the income statement?

Answer 31

No accounts receivable line item on the income statement, but it gets captured, if only partially, indirectly in revenue. (The cash flow statement will reconcile revenue to cash revenue, while the absolute balance of accounts receivable can be observed on the balance sheet.)

Question 32

Why are increases in accounts receivable a cash reduction on the cash flow statement?

Answer 32

Increases in working capital assets are cash outflows, whereas increases in working capital liabilities are cash inflows.

Question 33

What is deferred revenue?

Answer 33

Is cash payment was received upfront and the benefit to the customer will be delivered on a later date, i.e. gift card

Question 34

Why is deferred revenue classified as a liability while accounts receivable is an asset?

Answer 34

Deferred Revenue (liability): Unfulfilled obligations to the customers that paid in advance A/R (asset): Already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit.

Question 35

Why are increases in accounts payable shown as an increase in cash flow?

Answer 35

cash is currently still in the company's possession. The due payments will eventually be made, but the cash belongs to the company for the time being and is not restricted from being used. Thus, an increase in accounts payable is reflected as an inflow of cash on the cash flow statement.

Question 36

Which section of the cash flow statement captures interest expense?

Answer 36

The cash flow statement doesn't directly capture interest expense. However, interest expense is recognized on the income statement and then gets indirectly captured in the cash from operations section since net income is the starting line item on the cash flow statement.

Question 37

What happens to the three financial statements if a company initiates a dividend?

Answer 37

IS: When a company initiates a dividend, there'll be no changes to the income statement. However, a line below net income will state the dividend per share ("DPS") to show the amount paid. CFS: On the cash flow statement, the cash from financing section will decrease by the dividend payout amount and lower the ending cash balance at the bottom. BS: The cash balance will decline by the dividend amount on the balance sheet, and the offsetting entry will be a decrease in retained earnings since dividends come directly out of retained earnings.

Question 38

Do inventories get captured on the income statement?

Answer 38

Gets indirectly captured, if only partially, in cost of goods sold (or operating expenses). For a specific period, regardless of whether the associated inventory was purchased during the same period, COGS may reflect a portion of the inventory used up. The two other financial statements would be more useful for assessing inventory as the cash flow statement shows the year-over-year changes in inventory, while the balance sheet shows the beginning and end-of-period inventory balances.

Question 39

How should an increase in inventory get handled on the cash flow statement?

Answer 39

An increase in inventory reflects a use of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement.

Question 40

What is the difference between LIFO and FIFO, and what are the implications on net income?

Answer 40

FIFO and LIFO are two inventory accounting methods to estimate the value of inventory sold in a period, effected by the change in inventory costs over time. First In, First Out ("FIFO"): Under FIFO accounting, the goods that were purchased earlier would be the first ones to be recognized and expensed on the income statement. Last In, First Out ("LIFO"): Alternatively, LIFO assumes that the most recently purchased inventories are recorded as the first ones to be sold first.

Question 41

What is the average cost method of inventory accounting?

Answer 41

Total costs of production in a period are summed up and divided by the total number of items produced. Each product cost is treated equally and inventory costs are spread out evenly,

Question 42

How do you calculate retained earnings for the current period?

Answer 42

Current Period Retained Earnings = Prior Retained Earnings + Net Income – Dividends

Question 43

What does the retention ratio represent and how is it related to the dividend payout ratio?

Answer 43

Represents the proportion of net income retained by the company, net of any dividends paid out to shareholders. Retention Ratio =(Net Income − Dividends)/Net Income Dividend Payout Ratio = Dividends Paid/Net Income (The greater the retention ratio, the lower the dividend payout ratio.)

Question 44

What are the two ways to calculate earnings per share (EPS)?

Answer 44

Basic EPS: Determines a company's earnings on a per-share basis, but allocable to only the basic shares outstanding (otherwise known as "common shares"). Basic EPS = (Net Income − Dividends on Preferred Stock)/Basic Weighted Average Shares Outstanding Diluted EPS: Compares a company's earnings relative to its shares outstanding on a per-share basis but considers the impact of potentially dilutive securities such as options, warrants, and convertible securities. If an option is "in-the-money," the option holder can become a common shareholder at their choosing. Thus, diluted EPS is a more accurate depiction of ownership value per share. Diluted EPS = (Net Income − Dividends on Preferred Stock)/Diluted Weighted Average Shares Outstanding

Question 45

Where can you find the financial reports of public companies?

Answer 45

SEC EDGAR, SEDAR database, Companies house (UK)

Question 46

What is a proxy statement?

Answer 46

The proxy statement, formally known as "Form 14A," is required to be filed before a shareholder meeting to solicit shareholder votes. The document must disclose all relevant details regarding the matter for shareholders to make an informed decision. In addition, the board of directors' compensation and other notable announcements such as changes to the company’s articles of incorporation are included.

Question 47

What is an 8-K and when is it required to be filed?

Answer 47

When a company undergoes a materially significant event and must disclose the details. Examples: Plans for a new acquisition, disposal of assets, bankruptcy, a tender offer, the resignation of a senior-level manager or member of the board of directors, or disclosure that the company is under SEC investigation for alleged wrongdoing.

Question 48

Why has understanding the differences between US GAAP and IFRS financial reporting become increasingly important? (5)

Answer 48

Globalization: As economies converge, pressure mounts for a unified global accounting standard, though immediate US adoption of IFRS remains unlikely. Geographic Investment Diversification: Investors are expanding their portfolios internationally, including emerging markets, necessitating familiarity with different accounting standards. Cross-Border M&A: Multinational companies engage in cross-border mergers and acquisitions to enter new markets and diversify revenue sources, requiring understanding of varied accounting practices. Dual Reporting Challenges: Companies operating in multiple jurisdictions may need to navigate both US GAAP and IFRS, highlighting the importance of understanding key differences. Stakeholder Confidence: With increasing concerns about financial reporting clarity, understanding these differences is crucial for maintaining investor and regulator trust.

Question 49

What are some of the most common margins used to measure profitability?

Answer 49

Gross margin, operating margin, net profit margin,EBITDA margin (are are over revenue)

Question 50

What do the phrases “above the line” and “below the line” mean?

Answer 50

Above line: reflects a company's operational performance before non-operational items such as interest and taxes. Below line: Have adjusted operating income for non-operating income and expenses, which are items classified as discretionary and unrelated to the core operations of a business. An example would be net income, since interest expense, non-operating income/(expenses), and taxes have all been accounted for in its ending value.

Question 51

Is EBITDA a good proxy for operating cash flow?

Answer 51

EBITDA remains the most widely used proxy for operating cash flow in practice. While EBITDA does add back D&A, typically the largest non-cash expense, it doesn't capture the full cash impact of capital expenditures ("capex") or working capital changes during the period. EBITDA also doesn't adjust for stock-based compensation, although an increasingly used “adjusted EBITDA” metric does add-back SBC.

Question 52

What are some examples of non-recurring items?

Answer 52

Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs, or asset impairments. Often called "scrubbing" the financials, the act of adjusting for these non-recurring items is meant to normalize the cash flows and depict a company's true operating performance.

Question 52

When adjusting for non-recurring expenses, are litigation expenses always added back?

Answer 52

Whether an expense is non-recurring depends on the industryExpenses. Litigation might not be added back for a research and development (R&D) oriented pharma company, given the prevalence of lawsuits in the industry.

Question 53

What is the difference between organic and inorganic revenue growth?

Answer 53

Organic growth is the optimization of a business from the internal efforts of management and their employees.

Question 53

Inorganic Growth

Answer 53

Inorganic Growth: Once the opportunities for organic growth have been maximized, a company may turn to inorganic growth, which refers to growth driven by M&A. Inorganic growth is often considered faster and more convenient than organic growth. Post-acquisition, a company can benefit from synergies, such as having new customers to sell to, bundling complementary products, and diversification in revenue.

Question 54

How does the relationship between depreciation and capex shift as companies mature?

Answer 54

As a company begins to mature and its growth stagnates, a greater proportion of its total capex will shift towards maintenance.

Question 55

What is working capital?

Answer 55

Measures a company's liquidity and ability to pay off its current obligations using its current assets. Working Capital = Current Assets − Current Liabilities Assets>liabilities = lower the liquidity risk Working capital = Resources that can be turned into cash within the year - payments that a company needs to make within the year

Question 56

Why are cash and debt excluded in the calculation of net working capital (NWC)?

Answer 56

Cash and other short-term investments (e.g., treasury bills, marketable securities, commercial paper) and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded when calculating working capital because they're non-operational and don't directly generate revenue. Net Working Capital (NWC) = Operating Current Assets − Operating Current Liabilities

Question 57

Classify in the cashflow statement: Cash & cash equivalents vs debt

Answer 57

Investing activities since the company can earn a slight return (~0.25% to 1.5%) through interest income, whereas debt is classified as financing. Neither is operations-related, and both are thereby excluded in the calculation of NWC.

Question 58

Is negative working capital a bad signal about a company's health?

Answer 58

Negative working capital can result from being efficient at collecting revenue, quick inventory turnover, and delaying payments to suppliers while efficiently investing excess cash into high-yield investments. vs Negative working capital could signify impending liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company would need to find external financing as early as possible to stay afloat.

Question 59

What does change in net working capital tell you about a company's cash flows?

Answer 59

The change in net working capital is important because it gives you a sense of how much a company's cash flows will deviate from its accrual-based net income. Change in Net Working Capital = NWC Prior Period − NWC Current Period If a company's NWC has increased year-over-year, its operating assets have grown and/or its operating liabilities have shrunk from the prior year. Since an increase in an operating asset is a cash outflow, it should be intuitive why an increase in NWC means less cash flow for a company (and vice versa).

Question 60

What ratios would you look at to assess working capital management efficiency?

Answer 60

Days Inventory Held ("DIH"), Days Sales Outstanding ("DSO"), Days Payable Outstanding ("DPO")

Question 61

What is the cash conversion cycle?

Answer 61

Measures the number of days it takes a company to convert its inventory into cash from sales. Cash Conversion Cycle = DIO + DSO – DPO

Question 62

How would you forecast working capital line items on the balance sheet (working capital forecast)?

Answer 62

A/R, inventories, prepaid expenses, other current assets, A/P, accrued expenses, deferred revenue, other current liabilities.

Question 63

How would you forecast capex and D&A when creating a financial model?

Answer 63

D&A can be projected as either a percentage of revenue or CAPEX, while capex is forecasted as a percentage of revenue. Re-investments such as capex directly correlate with revenue growth, thus historical trends, management guidance, and industry norms should be closely followed. Alternatives: Depreciation Waterfall Schedule: Requires granular data on existing PP&E (in-use assets, remaining useful life for each). Depends on management’s future Capex plans and useful life assumptions for new purchases. Separately tracks depreciation from old vs. new Capex, improving transparency. Amortization Projections: Relies on useful life assumptions for intangible assets (e.g., patents, trademarks). Assumptions often disclosed in financial report footnotes under accounting policies. This approach enables precise modeling of asset depreciation/amortization timelines and aligns with operational planning.

Question 64

How would you forecast PP&E and intangible assets?

Answer 64

When forecasting PP&E, the end of period balance will be calculated using the roll-forward schedule shown below. Note, capex will input as a negative, meaning the PP&E balance should increase. Other factors that could affect the end-of-period PP&E balance are asset sales and write-downs. PP&E Roll-Forward Current Assets EOP PP&E = BOP PP&E + Capex − Depreciation To forecast intangible assets, management guidance becomes necessary as unlike capex, there's usually no clear historical pattern that can be followed as these purchases tend to be inconsistent. In most cases, it's best to rely on management if available, but in the absence of guidance, it's recommended to assume no purchases. Intangible Assets Roll-Forward EOP Intangibles = BOP Intangibles + Intangibles Purchases – Amortization

Question 65

What is the difference between the current ratio and the quick ratio?

Answer 65

Current Ratio: A current ratio greater than 1 implies that the company is financially healthy in terms of liquidity and can meet its short-term obligations. (checking a pulse) Quick Ratio (only for highly liquid assets, convertible into cash in less than 90 days): Otherwise known as the acid-test ratio, the quick ratio measures short-term liquidity, but uses stricter policies on what classifies as a liquid asset.

Question 66

How can a profitable firm go bankrupt?

Answer 66

To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it cannot get favorable terms from suppliers and must pay cash for all inventories and supplies, the company can suffer from liquidity problems due to the timing mismatch of cash inflows and outflows. E.g. Profitable companies with these types of working capital issues can usually secure financing, but if financing suddenly becomes unavailable (e.g., 2008 credit crisis), the company could be forced to declare bankruptcy. or a profitable company that took on far too much debt in its capital structure and could not service the interest payments may also default on its debt obligations.

Question 66

Give some examples of when the current ratio might be misleading?

Answer 66

The cash balance used includes the minimum cash amount required for working capital needs – meaning operations could not continue if cash were to dip below this level. Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose. Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low liquidity, cannot sell without a substantial discount). Accounts receivable could include “bad A/R", but management refuses to recognize it as such.

Question 67

Is it bad if a company has negative retained earnings (two cases)?

Answer 67

Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses than profits, payout of dividends and share repurchases, contributing to lower or even negative retained earnings. Case 1: Startups and early-stage companies investing heavily to support future growth (e.g., high capex, sales & marketing expenses, R&D spend). or Case 2: Negative retained earnings mean the company has returned more capital to shareholders than taken in.

Question 68

What does return on assets (ROA) and return on equity (ROE) each measure?

Answer 68

How effective a company’s management team is at utilizing the resources it has on-hand (assets or equity). Return on Assets: ROA measures asset utilization and how efficiently a company's assets are used to generate earnings. Return on Equity: The ROE ratio gives insight into how efficiently a management team has been using the capital shareholders have contributed.

Question 69

What is the relationship between return on assets (ROA) and return on equity (ROE)?

Answer 69

The relationship between ROA and ROE is tied to the use of leverage. In the absence of debt in the capital structure, the two metrics would be equal. But if the company were to add debt to its capital structure, its ROE would rise above its ROA due to increased cash, as total assets would rise while equity decreases.

Question 70

If a company has a ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE?

Answer 70

Imagine a company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.

Question 71

When using metrics such as ROA and ROE, why do we use averages for the denominator?

Answer 71

Because the denominator comes from the balance sheet. The income statement covers a specific period, whereas the balance sheet is a snapshot at one particular point in time. Thus, the average between the beginning and ending balance of the denominator is used to adjust for this mismatch in timing.

Question 72

What are some shortcomings of the ROA and ROE metrics for comparison purposes?

Answer 72

ROA and ROE ratios are most useful when compared to a peer group of companies with similar: - Growth rates - Margin profiles - Risks

Question 73

What is the return on invested capital (ROIC) metric used to measure?

Answer 73

"How much in returns is the company earning for each dollar invested?" ROIC over its cost of capital (WACC) suggests the management team has been allocating capital efficiently (i.e., investing in profitable projects or investments) and if sustained over the long-run, this indicates a competitive advantage. ROCI = NOPAT/Invested capital

Question 74

What does the asset turnover ratio measure?

Answer 74

"How many dollars in revenue does the company generate per dollar of assets?" (How efficiently a company uses its assets to generate sales.) Higher the better, suggests the company is generating more revenue per dollar of an asset owned

Question 75

What does inventory turnover measure and how does it differ from days inventory held (DIH)?

Answer 75

Inventory turnover ratio: How often a company has sold and replaced its inventory balance throughout a specified period (i.e., the number of times inventory was "turned over"). VS DIH is the average number of days it takes for a company to turn its inventory into revenue.

Question 76

What does accounts payables turnover measure and is a higher or lower number preferable?

Answer 76

Measures how quickly a company pays its vendors. Generally, longer credit terms provide a company with more flexibility as it means the company has more cash-on-hand. A higher A/P turnover means the company pays off its A/P balance quickly, meaning the cash outflows occur faster.

Question 77

What does accounts receivables turnover measure?

Answer 77

Measure the number of times per year that a company can collect its average accounts receivable from customers. The higher the turnover ratio, the better as it indicates the company is efficient at collecting its due payments from customers that paid on credit.

Question 78

What are some ratios you would look at to perform credit analysis?

Answer 78

Liquidity ratio (current, quick, cash) Leverage/solvency ratios Coverage ratios Profitability ratios.

Question 79

What are the two types of credit ratios used to assess a company's default risk?

Answer 79

Leverage ratios, interest coverage ratios

Question 80

How do you calculate the debt service coverage ratio (DSCR) and what does it measure?

Answer 80

A measure of creditworthiness that tests a company’s ability to pay its current debt obligations using its current cash flows. DSCR greater than 1.0 shows the company is generating sufficient cash flows to pay down its debt.

Question 81

How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean?

Answer 81

Assess if a company's earnings can cover its fixed charges, which can include rent, utilities, and interest expense. The higher the ratio, the better the creditworthiness.

Question 82

How would raising capital through share issuances affect earnings per share (EPS) (primary effects of share issuances on EPS, emphasizing the dilutive impact and potential scenarios.)?

Answer 82

Raising capital through share issuances affects EPS in the following ways: Dilution: Increased share count directly decreases EPS. Interest income: Cash from issuances may generate minimal interest, slightly offsetting EPS reduction. Acquisition scenarios: Using stock for acquisitions can impact EPS: Acquired company's earnings added to acquirer's Result can be accretive or dilutive to EPS Overall impact: Generally negative on EPS due to dilution outweighing potential benefits. Share count effect: New issuances increase outstanding shares, reducing each share's claim on earnings. Market perception: Can signal company's need for capital, potentially affecting stock price.

Question 83

How would a share repurchase impact earnings per share (EPS)?

Answer 83

Share repurchase is a reduced share count, which increases EPS. However, there would be an impact on net income, assuming the share repurchase was funded using excess cash. The interest income that would have otherwise been generated on that cash is no longer available, causing net income and EPS to decrease. But the impact would be minor since the returns on excess cash are low, and would not offset the positive impact the repurchase had on EPS from the reduced share count.

Question 84

What is the difference between the effective and marginal tax rates?

Answer 84

Effective Tax Rate: The effective tax rate represents the percentage of taxable income corporations must pay in taxes. (Taxes paid/EBT) Marginal Tax Rate: The marginal tax rate is the taxation percentage on the last dollar of a company’s taxable income (tiers).

Question 85

Why is the effective and marginal tax rate often different?

Answer 85

Differ because the effective tax rate calculation uses pre-tax income from the accrual-based income statement.

Question 86

Could you give specific examples of why the effective and marginal tax rates might differ?

Answer 86

Effective tax rate reflects deductions/credits and timing differences, while marginal rate applies only to top-tier income. Depreciation Methods, NOL Carryforwards, Bad Debt Write-Offs, Progressive Tax Brackets

Question 87

What are deferred tax liabilities (DTLs)?

Answer 87

Temporary timing differences in book and tax accounting lead to the creation of DTAs/DTLs, which will gradually unwind to a balance of zero. Definition: Tax expenses recognized in GAAP statements but not yet paid to IRS, expected to be paid in future. Common cause: Depreciation methods Tax: Accelerated depreciation GAAP: Straight-line depreciation Early years: Higher tax depreciation creates DTLs Inflection point: Tax depreciation becomes lower than GAAP depreciation Cumulative effect: Total depreciation equal over asset's life for both methods Balance sheet impact: DTLs represent future tax obligations due to current timing differences

Question 88

What are deferred tax assets (DTAs)?

Answer 88

Definition: Financial assets representing future tax benefits due to temporary differences between GAAP and tax accounting. Creation: Arise when GAAP tax expense is lower than actual tax payments to IRS. Key source: Net Operating Losses (NOLs) carried forward against future income. Example: $10 million pre-tax loss creates DTA for future tax benefit, not immediate refund. GAAP treatment: Tax benefit recognized immediately on income statement, captured in DTAs. Reversal: DTAs decrease as company uses NOLs to reduce future tax liabilities. Other causes: Differences in revenue recognition between book (accrual) and tax (cash) rules. Balance sheet: Listed as non-current assets, representing potential future tax savings. Valuation: Based on expected future tax rates when the DTA will be utilized. Expiration: DTAs don't expire but reverse when timing differences end.

Question 89

Difference between DTA and DTL

Answer 89

Key difference: DTAs represent future tax benefits (lower future taxes), while DTLs indicate future tax obligations (higher future taxes) NOL, warranty provisions vs depreciation, instalment sales

Question 90

Does a company truly not incur any costs by paying employees through stock-based compensation rather than cash?

Answer 90

Stock-based compensation is a non-cash expense that reduces a company’s taxable income and is added-back on the cash flow statement. SBC incurs an actual cost to the issuer by creating additional shares for existing equity owners. The issuing company, due to the dilutive impact of the new shares, becomes less valuable on a per-share basis to existing shareholders.

Question 91

Could you define contra-liability, contra-asset, and contra-equity with examples of each?

Answer 91

Contra-Liability: Definition: Liability account with a debit balance, reducing the paired liability. Example: Financing fees in M&A amortized over debt maturity, lowering tax burden. Contra-Asset: Definition: Asset account with a credit balance, reducing the paired asset’s value. Example: Accumulated depreciation reduces fixed asset carrying value while offering tax benefits. Contra-Equity: Definition: Equity account with a debit balance, reducing total shareholders’ equity. Example: Treasury stock decreases equity and appears as a negative on the balance sheet.

Question 92

What is an allowance for doubtful accounts on the balance sheet?

Answer 92

Estimates the percentage of uncollectible accounts receivable (a contra asset) Reduces the A/R balance on the balance sheet, providing a more realistic view of collectible amounts. This bad debt reserve represents management's estimate of likely unpaid customer debts, aligning with the matching principle by recognizing potential losses in the same period as related revenues. The ADA helps prevent sudden A/R decreases by anticipating potential defaults, thus offering a more conservative and accurate picture of a company's financial health. It's typically calculated using methods like percentage of sales or A/R aging analysis, allowing businesses to present a more prudent view of their expected cash inflows

Question 93

What is the difference between a write-down and a write-off?

Answer 93

Write-down: Value of the asset is decreased to reflect its true value on the balance sheet. Write-Offs: Reduces an asset's value to zero, meaning the asset has been determined to hold no current or future value (and should therefore be removed from the balance sheet).

Question 94

How would a $100 inventory write-down impact the three financial statements?

Answer 94

Affect is the same as if it were depreciation. Only change is on the BS, cash is up 30 (thanks to lower tax) with inventory down by 70, offset by a decrease in RE by 70 since NI dropped by that amount.

Question 95

How does buying a building impact the three financial statements?

Answer 95

IS: Initially, there'll be no impact on the income statement since the purchase of the building is capitalized. CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance. BS: The cash balance will go down by the purchase price of the building, with the offsetting entry to the cash reduction being the increase in PP&E. Throughout the purchased building's useful life, depreciation is recognized on the income statement, which reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible).

Question 96

How does selling a building with a book value of $6 million for $10 million impact the three financial statements?

Answer 96

IS: If I sell a building for $10 million with a book value of $6 million, a $4 million gain from the sale would be recognized on the income statement, which will increase my net income by $4 million. CFS: Since the $4 million gain is non-cash, it'll be subtracted from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. BS: The $6 million book value of the building is removed from assets while cash increases by $10 million, for a net increase of $4 million to assets. On the L&E side, retained earnings will increase by $4 million from the net income increase, so the balance sheet remains balanced. However, the gain on sale will result in higher taxes, which will be recognized on the income statement. This lowers retained earnings by $1 million and be offset by a $1 million credit to cash on the asset side.

Question 97

If a company issues $100 million in debt and uses $50 million to purchase new PP&E, walk me through how the three statements are impacted in the initial year of the purchase and at the end of year 1. Assume a 5% annual interest rate on the debt, no principal paydown, straight-line depreciation with a useful life of five years and no residual value, and a 40% tax rate.

Answer 97

IS: Since the capex amount was $50 million with a useful life assumption of five years (straight-line to a residual value of zero), the annual depreciation will be $10 million. Next, the interest expense will be equal to the $100 million in debt raised multiplied by the 5% annual interest rate, which comes out to $5 million in annual interest expense. The pre-tax income will be down by $15 million and assuming a 40% tax rate, net income will be down $9 million. CFS: Net income will be down $9 million, but the non-cash depreciation of $10 million will be added back, making the ending cash balance increase by $1 million. BS: On the assets side, cash is up by $1 million and PP&E will decrease by $10 million because of the depreciation. Since equity is also down $9 million due to net income, both sides will remain in balance.

Question 97

For long-term projects, what are the two methods for revenue recognition?

Answer 97

Percentage of Completion Method: Revenue is recognized based on the percentage of work completed during the period. Completed Contract Method: Recognizes revenue once the entire project has been completed.

Question 98

If a company has continuously incurred goodwill impairment charges, what do you take away from seeing this in their financials?

Answer 98

History of overpaying for assets or their inability to integrate new acquisitions.

Question 99

What is restricted cash and could you give me an example?

Answer 99

cash reserved for a specific purpose and not available for the company to use (Disclosed separately on the BS and said why) E.g. Agreement to receive a line of credit, but the lender required the borrower to maintain 10% of the total loan amount at all times (i.e., “bank loan requirement”).

Question 100

What is the accounting treatment for finance leases?

Answer 100

Finance lease accounting treats leases as if the lessee owns the asset, recognizing both an asset and a liability on the balance sheet. The initial recognition is based on the present value of future lease payments. Over the lease term, the asset is depreciated, and the liability accrues interest. On the income statement, instead of recording rent expense, the lessee records depreciation expense for the asset and interest expense for the liability. This approach provides a more transparent representation of a company's lease obligations and assets on financial statements

Question 101

What is the accounting treatment for operating leases?

Answer 101

Lease accounting changed significantly in 2019 for both US GAAP and IFRS, with US GAAP retaining the distinction between operating and finance leases. For operating leases under US GAAP, the initial balance sheet impact is the same as finance leases, with the lease recognized as a liability and the corresponding asset as a right-of-use asset. The income statement treatment differs, with operating leases simply recording the lease payment as an operating expense, while the cash flow statement reflects the lease payment through the net income line in the cash from operations section

Question 102

What are the three different types of intercompany investments?

Answer 102

Investment in securities (passive investments): company invests in another company's equity, but the ownership percentage is less than 20%. Equity investment method: When a company owns between 20-50% of another company, this is considered a significant level of influence. Under the equity method, an investment is initially measured at the acquisition price and recorded as an “Investment in Affiliate” (or “Investment in Associate”) on the assets side Consolidation method: When the parent company has majority control over 50% ownership, the consolidation method is used. The target company’s balance sheet is consolidated with the acquirer.

Question 103

What is Non-Controlling Interests” (NCI)

Answer 103

To reflect that the acquirer owns less than 100% of the consolidated assets and liabilities, a new equity line titled “Non-Controlling Interests” (NCI) is created, which captures the value of equity in the consolidated business held by non-controlling (minority) interests (other third parties).

Question 104

What are the three sub-classifications of investment securities?

Answer 104

Trading securities: Debt or equity investments intended to generate short-term profits. Unrealized gain/(loss) will be recorded on the income statement throughout the holding period until the realized gain/(loss) when sold. Available-for-Sale Securities ("AFS"): Debt or equity securities held for the long-term but sold before maturity. (current or non current). Recorded as AOCI on the balance sheet. Held-to-Maturity Securities ("HTM"): Long-term investments in debt securities held until the end of their term. Applies only to debt instruments, typically government bonds, certificates of deposit (CDs), and investment-grade corporate bonds, as they have fixed payment schedules and maturity dates. Original cost is recorded on the balance sheet (reported at amortized cost). However, the value of the investment is not adjusted following changes in its FMV due to the HTM classification.

Question 105

Could you name an example of an asset that's exempt from the cost principle rule?

Answer 105

Mark-to-market accounting would record the asset at its current fair market value and then adjust the value to reflect what an asset would sell for today (except marketable securities, which are highly liquid and traded on stock exchanges.)

Question 106

What is trapped cash and what benefit does it provide to companies?

Answer 106

Refers to the accumulation of cash overseas by multinational companies. While not illegal, companies keep this cash offshore to avoid certain repatriation taxes if brought back to the US.

Question 107

When can a company capitalize software development costs under accrual accounting?

Answer 107

The application development stage for software intended for internal use such as coding The stage when the software’s “technological feasibility” has been reached and can be marketed

Question 108

What is PIK interest?

Answer 108

PIK (Payment-in-Kind) Interest: This refers to interest that is added to the principal balance of a loan instead of being paid in cash. The borrower essentially defers the interest payment by increasing the outstanding debt

Question 109

What is a PIK toggle note?

Answer 109

This is a more flexible instrument that allows the issuer to choose between paying interest in cash or as PIK for each interest period. If the PIK option is chosen, it typically comes with a higher interest rate The key difference is that PIK interest always adds to the principal, while a PIK toggle note gives the issuer the option to pay in cash or add to the principal, providing greater flexibility in managing cash flow

Question 110

If a company has incurred $100 in PIK interest, how would the three-statements be impacted?

Answer 110

IS: On the income statement, interest expense will increase by $100, which causes EBIT to decrease by $100. Assuming a 30% tax rate, net income will decrease by $70. CFS: On the cash flow statement, net income will be down by $70, but the $100 non-cash PIK interest will be added back. The ending cash balance will increase by $30. BS: On the assets side of the balance sheet, cash will be up $30. Then on the liabilities side, the debt balance will be up $100 (since the PIK accrues to the debt’s ending balance), and net income is down $70. Therefore, both sides are up by $30, and the balance sheet balances.

Question 111

What is the purpose of the original issue discount feature of debt?

Answer 111

An original issue discount (OID) is a feature of debt financing where bonds are issued at a price below their face value, making them more attractive to investors by offering higher returns. This discount is essentially a form of interest that is realized at maturity, when the investor receives the full face value of the bond. OID bonds are often used to entice investors, especially in cases where the issuer might face challenges raising capital due to credit concerns or market conditions An original issue discount ("OID") is a feature of debt meant to make the issuance more appealing to investors as a “deal sweetener.” Typically, the reduction is 1-2% of the debt issuance.

Question 112

Why are circularities created in financial models?

Answer 112

Circularities in financial models are created when a cell's calculation depends on its own output, either directly or indirectly. The most common example is the calculation of interest expense and income: Interest expense is calculated using the average debt balance, which includes the beginning and ending balances. The ending debt balance is affected by cash flow, which in turn is impacted by interest expense. This creates a loop where interest expense affects the debt balance, which then affects the interest expense calculation. This interdependence between variables leads to a circular reference, making the model challenging to resolve without special techniques or Excel settings

Question 113

How would you forecast a company's basic and diluted share count?

Answer 113

The number of share issuance and repurchases can be calculated using the formula shown below: Basic Share Count EOP = Basic Share Count BOP + (Shares issued/est share price)-(Share repurchases/est share price) The estimated share price used above can be approximated using the formula below: Share Price Estimate = Prior Period Share Price × (1 + Current Period Consensus EPS Growth Rate) To calculate the impact of dilutive securities:, Take the difference between the basic and diluted share count in historical periods can be looked at and this amount can be straight-lined into the future Serves as a decent proxy for how potentially dilutive securities such as options, warrants, and convertible debt will impact the diluted share count.

Question 114

How can you forecast a company's implied share price using its EPS?

Answer 114

Take the forecasted EPS figure and then multiplying it by a P/E ratio assumption. This estimated share price can be sanity checked by using the consensus EPS annual growth rate as a proxy for share price growth.