Redbook accounting Flashcards
(107 cards)
What is the primary purpose of US GAAP?
US GAAP is established by FASB who is under the authorization of the SEC
Standardizes financial reporting and ensure all financials are presented on a fair and consistent basis to protect the interests of investors and lendors
What are the main sections of a 10-K?
Business Overview: Overview of a company’s business divisions, strategy, products/services, key risks
Management Discussion & Analysis: Commentary and summarized analysis of the company’s fiscal year from the management team
Financial Statements: 3 big statements and other 2 (statement of comprehensive income, statement of shareholders equity)
Notes: Supplementary disclosure to the financial statements that provide more details about a company’s recent financial performance
What is the difference between a 10-K and a 10-Q?
10-K: Annual, comprehensive, audited, due ~60-90 days after FY end.
10-Q: Quarterly, condensed, unaudited just reviewed by CPAs, due ~40-45 days after quarter end.
Walk me through the three financial statements.
Income Statement: Shows profitability over time (revenue to net income). First line item is revenue and upon deducting costs/expenses, the ending line item is net income
Balance Sheet: Snapshot of a company’s resources (assets) and source of fundings (Liabilities and shareholder’s equity) at a POINT IN TIME
Cash Flow Statement:
Under the commonly used indirect approach:
- Starting line item is net income which is then adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from operations
- Cash from investing and Cash from financing activities are then added to the FO to arrive at the net change in cash
- Net change in cash represents the actual cash inflows/outflows in a given period
Walk me through the income statement.
- Revenue → Less: COGS → Gross Profit → Less: SG&A → Less: R&D → EBITDA → Less: D&A → Operating Income/EBIT → Less: Interest → Pre-tax Income → Less: Taxes → Net Income.
Walk me through the balance sheet.
Show’s a company’ assets liabilities, and equity sections at a specific point in itme. The fundamental accounting equation is: Assets = Liabilities + Shareholders equity
Assets belonging to a company must have been funded somehow, so assets will always be equal to the sum of liabilities and equity
Could you give further context on what assets, liabilities, and equity each represent?
Asset: resources with economy value that can be sold for money or bring positive monetary benefits in the future (E.g., cash and marketable securities can be invested to earn interest/resturns, Ars are payments due from customers, PP&E is used to generate cash flows in the future)
Liabilities: unsettled obligations to another party in the future and present the external sources of capital from third-parties, which help fund the company’s assets. Represent future outflows of cash (E.g., debt capital, payment sowed to supplies/vendors)
Equity: Capital invested in the business and represents the internal sources of capital that helped fund its assets. Th providers of capital could range from being self-funded to outside institutional investors.
Additionally, the accumulated net profits will be shown here as retained earnings.
What are the typical line items you might find on the balance sheet?
Assets: Cash, securities, AR, inventory, prepaid expenses, PP&E, intangibles, goodwill.
Liabilities: AP, accrued expenses, ST debt, deferred revenue/taxes, LT debt, leases.
Equity: Common stock, APIC, preferred stock, treasury stock, retained earnings, OCI (e.g., , gain on AFS securities, currency adjustments)
Walk me through the cash flow statement.
Via the indirect method:
CFO: Starts with NI an adds back non-cash expenses such as D&A and stock-based comp and then makes adjustments for working capital
CFI: Accounts for CapEx and M&A.
CFF: Net cash impact of raising capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of debt. Also reflects dividend payouts.
Together the sum of the three sections will be the net change in cash for the period. This figure will then be added to the beginning-of-period cash balance to arrive at the ending cash balance
How are the three financial statements connected?
Income Statement → Cash Flow Statement
The net income at the bottom of the income statement is the starting point of the cash flow statement.
Cash Flow Statement → Balance Sheet
The cash flow statement explains changes in key balance sheet items such as:
* Working capital (e.g., inventory, A/R, A/P)
* CapEx (affects PP&E)
* Debt/equity changes (affects long-term liabilities or equity)
The ending cash on the cash flow statement becomes the cash balance on the balance sheet.
Income Statement → Balance Sheet
* Net income flows into retained earnings (after subtracting dividends).
* Depreciation (an income statement expense) reduces PP&E on the balance sheet.
* Interest expense is calculated based on debt levels from the balance sheet.
If you have a balance sheet and must choose between the income statement or cash flow statement, which would you pick?
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
Which is more important, the income statement or the cash flow statement?
The income statement and cash flow statement are both necessary, and any in-depth analysis would require using both. However, 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
If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?
Cash flow statement, because ‘cash is king.’ It shows a company’s ability to meet obligations and reinvest. CFS is not subject to accounting discretion via accrual accounting like the income statement. However, for unprofitable companies who maintain negative net net income, CFO and FCF, the income statement may be better for valuation based on a revenue multiple.
Why is the income statement insufficient to assess the liquidity of a company?
The income statement can be misleading from a liquidity/solvency perspective, as a company can report net income while struggling to collect cash. Accrual accounting allows for discretion like early revenue recognition and D&A assumptions that affect reported earnings and potentially mislead depiction of performance.
What are some discretionary management decisions that could inflate earnings?
Using longer asset useful lives, switching inventory methods (LIFO to FIFO), avoiding write-downs, repurchasing shares to boost EPS, capitalizing costs instead of expensing, deferring CapEx or R&D, and aggressive revenue recognition.
Tell me about the revenue recognition and matching principle used in accrual accounting.
Revenue is recorded when the good or service was delivered (and therefore “earned), whether or not cash is received. Expenses must be matched to the same period as when the revenue was earned.
How does accrual accounting differ from cash-basis accounting?
Accrual: Revenue and expenses are recorded when earned/incurred. Cash-basis: Only when cash is received/spent, regardless whether the product/service was delivered.
What is the difference between cost of goods sold and operating expenses?
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.
When do you capitalize vs. expense items under accrual accounting?
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. (E.g., PP&E such as a building can provide benefits for 15+ years and is therefore depreciated over its useful life.)
Expensed: In contrast, when the benefits received are short-term, the related expenses should be incurred in the same period. (E.g., inventory cycles out fairly quickly within a year and employee wages should be expensed when the employee’s services were provided.)
If depreciation is a non-cash expense, how does it affect net income?
While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is taxdeductible 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.
Do companies prefer straight-line or accelerated depreciation?
They usually prefer straight-line for GAAP because it results in higher net income and EPS in early years, which is better for reporting. Eventually, the accelerated approach will show lower depreciation into an asset’s life than the straight-line method. However, companies still prefer straight-line depreciation because of the timing, as many companies are focused more on near-term earnings.
“What is the relationship between depreciation and the salvage value assumption?”
“Do companies depreciate land?”
