IB Interview Red Accounting

IF CONVERTIBLE DEBT IS CONVERTED, WHAT IS THE IMPACT ON THE BALANCE SHEET?

Shareholder equity will increase, and debt will decrease.

WHAT LINE ITEM IS USUALLY FOUND ON ALL THREE FINANCIAL STATEMENTS?

Net Income

USING THE INDIRECT METHOD, WHAT ARE THE FOUR MAJOR ADJUSTMENTS YOU MAKE TO NET INCOME TO ARRIVE AT CASH FLOW FROM OPERATIONS?

- Add depreciation - Subtract net increases in Accounts Receivable - Subtract net increases in Inventory - Add net increases in Accounts Payable

SAY YOU LOOK AT THE FINANCIAL STATEMENTS OF A FIRM FOR TWO CONSECUTIVE YEARS. EVERY LINE ITEM ON THE INCOME STATEMENT HAS THE SAME VALUE FOR BOTH YEARS, BUT THE NUMBERS ON THE LINES IN THE CASH FLOW STATEMENT ARE DIFFERENT FOR THE TWO YEARS. SPECULATE ON A FEW THINGS THAT MAY HAVE HAPPENED TO CAUSE THIS OUTCOME

- Changes on balance sheet: capital expenditures (changes in assets), changes in working capital, differences in actual taxes paid. - Changes in accounting standards - Possible Fraud tacking place

IMAGINE YOU RUN A FISH & CHIPS RESTAURANT. DESCRIBE THE ACCOUNTING ENTRIES FOR THE SALE OF A HAMBURGER? (DEBITS AND CREDITS)

- Debit: Account receivable or cash - Credit: Fish & Chips inventory - Debit:COGS - Credit:Sales

IF I ADD $10 OF PP&E TO A COMPANY, WALK ME THROUGH THE CHANGES TO THE STATEMENTS. NOW ADD THE DEPRECIATION.

- Fixed assets will go up by $10, debt increase $10 or cash decrease by $10 if paid by cash - If you depreciate it, let us say, by 10 years, then each year, depreciation (expense) increases $1( assuming at 10%), accumulated depreciation also increases $1. Accumulated depreciation is the counter item of fixed assets and the net asset at year end will be $9. Extra expense of $1 will deduct earnings and decrease equity by $1 (assume no tax)

WHAT ARE GROSS MARGIN? NET MARGIN? OPERATING MARGIN?

- Gross margin is gross profit / revenue (Gross profit = revenue -COGS) - Operating margin is operating income / revenue. Operating income is a proxy for earnings before interest and taxes (EBIT). - Net margin is net income / revenue

WHAT ARE THE THREE MAIN FINANCIAL STATEMENTS?

- Income Statement - Revenues -Cost of Goods Sold -Expenses = Net Income - Balance Sheet - Assets = Liabilities + Shareholder's Equity(must be valances) -Statement of Cash Flows - Beginning Cash + CF from Operations + CF from Investing + CF from Financing = Ending Cash

WHAT IS MINORITY INTEREST?

- Minority interest is the claim which one company has over anther e.g.a parent company has claim to its subsidiary's earnings, based upon a certain percentage (cannot be the more than 49%) -The accounting treatment for the parent company is the following: Net earnings should exclude earnings from subsidiaries.

WHAT DO YOU DO IF YOU UNDERSTATED DEPRECIATION BY $100 AND DISCOVERED THE ERROR IN A PERIOD AFTER THE STATEMENTS ARE ISSUED? (ASSUMING 30% TAX RATE).

- Net Income decreases by $70. There is a $100 decrease by taking out the extra $100 in depreciation, but there is a corresponding depreciation tax shield of $30 that partially offsets the decrease. - Shareholder's Equity decreases by $70 due to the decrease in Net Income. Net PPE decreases by $100 due to the increase in depreciation. The Accounting Equation (A = Liability + Shareholders' Equity) is balanced by creating a Deferred Tax Asset of $30. - Cash flow remains the same as this is a non-cash transaction.Net Income is reduced by $70, $100 in depreciation is added back, and $30 in changes to deferred tax is subtracted, resulting in no change.

WHAT ARE THREE WAYS RETAINED EARNINGS MIGHT GO DOWN?

- Retained earnings is the portion of net income which is retained by the corporation instead of distributed via dividends - Paying out dividend, net loss in current year or written down can incur retained earnings coming down

IF A COMPANY PAYS BACK ITS DEBT AHEAD OF SCHEDULE, WHAT IS THE IMPACT ON THE INCOME STATEMENT?

- Since there will be less schedule debt payment then there will be less interest expenses and as a result, the net income will increase which will also increase the tax charge

WHAT IS THE DIFFERENCE BETWEEN A BALANCE SHEET, INCOME STATEMENT, AND THE CASH FLOW STATEMENT?

- The balance sheet list all of the economic resources available to a company for a specific period of time. An income statement shows a firm's operating income and associating expenses for specific period of time. - The statement of cash flows shows more accurate picture of how much cash the business actually has on hand which is not necessarily the amount of net income on the income statement. The cashflow statement tracks the inflows and outflows of cash specific or a specific period of time and adjust for non-cash expenses and revenue which can sometimes distort the actual level of profitability from a cash perspective.

WHAT IS AN INCOME STATEMENT? WHAT ARE THE MAJOR LINE ITEMS ON IT?

- The income statement will list a company's income all the way down to its expenses and provides guidance on profitability of a business for a specified period of time. - Revenues: Source of income that arises from the sale of goods and/or services and is recorded when it is earned. - Expenses: COGS are direct cost incurred in the manufacturing the goods while SGA are all other cost in the selling process e.g. marketing and administration. - Net Income: Revenue minus expenses

HOW ARE THE THREE MAIN FINANCIAL STATEMENTS CONNECTED?

- The net income line item on the income statement will get added to retained earnings on the balance sheet. The same net Income from the income statement is also the starting point of the cash flow statement. - The new cash position on the balance sheet for the new accounting period should equal to the net cash position at the position of the cash flow statement. - Debt on the balance sheet is used to calculate interest expense on the income statement.

WHAT IS THE LINK BETWEEN THE BALANCE SHEET AND THE CASH FLOW STATEMENT?

- The new net cash position on the cashflow statement is the new cash balance on the balance sheet's assets section - Cash from operations on the Cash Flow Statement is affected by the Balance Sheet's numbers when calculating the net changes in working capital (approximately current assets minus current liabilities). •PPE is another Balance Sheet item that affects the Cash Flow Statement because depreciation is based on the amount of PPE a company has which also gets reflected on the income statement.

NAME THREE ITEMS INCLUDED UNDER OTHER COMPREHENSIVE INCOME?

- Unrealized Gains and losses for sale of securities - Gains and losses on derivatives - Gains and losses resulting from converting foreign currency subsidiaries to the parent currency - Unrealized gains and losses from a foreign currency hedge of a net investment in a foreign operation

IF A COMPANY CHANGES FROM FIFOTO LIFO, HOW WOULD THAT IMPACT ITS FINANCIAL STATEMENTS?

- When answering this question you have to consider the effects of inflation if nothing else has been stated to effect the price. Assuming that price of raw materials will increase over time due to inflation then the price of new inventory will cost more then old inventory (vice versa) - The effects of inventory costing on financial statements depend on whether costs are increasing or decreasing. - Assuming costs are increasing, FIFO to LIFO will increase COGSand thereby decrease Net Income. It will also reduce taxes due to higher inventory cost and of course inventory levels would fall. Cash flow increases. If costs are decreasing, and the opposite is true.

WHAT ARE THE MAJOR LINE ITEMS ON THE CASH FLOW STATEMENT?

1. Cash Flow from Operations: Includes the inflow and outflow of general business operation e.g. interest expense, suppliers, salaries, and taxes. 2.Cash Flow from Investments: sales or purchase of equipment and land(long term assets) 3.Cash Flow from Financing: debt and dividend payments.

WHAT IS THE DIFFERENCE BETWEEN THE INCOME STATEMENT AND CASH FLOW STATEMENT?

A company's revenue and related expenses are recorded on the Income Statement but it can be miss leading since it included non-cash revenue and expenses. The Statement of Cash Flows records specifically the flow of cash in and out of the business and it is being spent. The Cash Flow Statement also shows the issuance or repurchase of debt or equity and any capital expenditures or other investments that has taken place. You can also see the adjustment of non cash expenses on the cashflow statement to get a more accurate view of the actual cash the business has in the bank

WHAT IS THE DIFFERENCE BETWEEN ACCOUNTS RECEIVABLE AND DEFERRED REVENUE?

Accounts receivable is considered revenue as it has been earned and recognized because the product has been delivered, but the customer has not yet paid in cash yet. Deferred revenue is cash received for products which have yet to be delivered to the customers, so according to GAAP accounting the revenue can not be recognized yet until the associated cost has been incurred.

WHAT ARE DEFERRED TAX ASSETS AND LIABILITIES? HOW DO THEY ARISE? HOW DO YOU TREAT THEM?

Deferred Tax Assets (DTAs) will arise by paying taxes to the government which should have been paid, this usually happens as a result of accrual accounting. Lets take an example: if you receive a12 month prepayment forNetflix in month 1 but the services not yet been performed and have already paid the government taxes for the cash received, it would create a deferred tax asset because the revenue has not been booked on the income statement but have already paid taxes on it.This will reduce the amount that needs to be paid later on, note this is a temporary disturbance between over paying and will revert back to normal in the following time period.Deferred Tax Liabilities (DTLs) usually arise from paying less taxes in the current time period because we have switch to accelerated depreciation from strait line depreciation.

WHAT IS DEFERRED REVENUE AND WHY IS IT A LIABILITY?

Deferred revenue is cash that has been collected in advance for something that hasn't yet been delivered. Let's say, if you pay for a monthly Netflix subscription a year in advance, you haven't yet received your 12 months of service in one month, therefore the Netflix has not yet recognized the revenue since the service hasn't been delivered. At the beginning of the year they will show the full amount of the subscription in deferred revenue, and that amount will decrease by 1/12 of the amount each month as issues are delivered.Given that all of the cash is received up front so the liability falls on the company to now deliver the service in a timely manner. While the company has already reflected the influx on the cash flow statement. Since no additional cash is received each month, the reduction in the liability every month offsets the equivalent amount of revenue recognized so it has no effect on the company's cash flows.

IF YOU COULD USE ONLY ONE FINANCIAL STATEMENT TO EVALUATE THE COMPANY, WHICH WOULD YOU CHOOSE?

I would use the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating and what is actually in the bank. Due to the effects of non-cash expenses the Income statement can be misleading when reporting the actual cash position or profitability of the businesses well as the overall health of the business in terms of being able to fund and pay all liabilities without drawing from creditors.

WALK ME THROUGH THE IMPACT OF AN ASSET WRITE-DOWN ON THE FINANCIAL STATEMENTS.

If net book value is greater than maximum estimate of future cash flows or sale value, then the asset is/will have to be considered as impaired. Calculating impairment loss is equal to net book value minus fair value (market value of asset), this can be an issue if no data is available on the assets fair market value. Loss is taken on income statement, reducing income, which in turn reduces shareholder equity through reduced retained earnings.

WHAT'S THE DIFFERENCE BETWEEN OPERATING AND CAPITAL LEASES?

Leases are forms of financing that appear off the balance sheet. For operating leases -those in which the risks and rewards of ownership are not transferred to the lessee -this is acceptable. For capital leases, those in which the risks and rewards of ownership are transferred to the lessee, this requires the lease to be reflected on the balance sheet given that it is essentially a form of debt. A lease is a capital lease if it satisfies the following; •transfers ownership at end of lease term •contains a bargain purchase option •extends for at least 75% of the asset's life •pays out more than 90% of the fair market value of the asset over its term. Because the obligation associated with an operating lease is not on the balance sheet, an analyst may want to capitalize the lease -in other words, recast the financial statements to reflect the obligations of operating leases and the associated assets.

WHAT IS RETURN ON EQUITY (ROE)?

ROE is used to compare companies in the same industry because a higher ROE with low capital investment is not necessarily a better investment than a lower ROE company with high capital investment requirement. High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS)

WHAT IS THE LINK BETWEEN THE BALANCE SHEET AND THE INCOME STATEMENT?

Retained earnings on the BS is net income from the Income Statement less any dividend payments. Interest payments on the income statement is calculated by looking at the debt on the Balance Sheet, and PPE will be used to calculate any depreciation expense.

WHAT IS THE CASH FLOW STATEMENT?

The Cash Flow Statement is one of the three financial reports that all public and private companies are required by the regulated authority to produce on a quarterly basis. The CF Statement simply tries to show all the company's sources and uses of cash for a period of time. Since companies tend to use double entry accrual accounting, which means a company's net income may not and tends not to portray how much cash is actually flowing in or out due to non-cash expenses (depreciation), investing activities, financing activities, changes in working capital, etc. Because of this, even profitable companies may have trouble managing their cash flows, and non-profitable companies may be able to survive without raising outside capital.

WHAT IS THE DIFFERENCE BETWEEN ACCOUNTS PAYABLE AND ACCRUED EXPENSES?

The main difference is usually accounts payable is typically a onetime expense as a result of e.g.purchase of inventory and while accrued expenses are recurring expenses over time e.g. employee salary, which increases every day until at the end of the month when it is paid out as an expenses and we start all over again until the end of the next month.

WHAT IS WORKING CAPITAL?

Working capital is the capital necessary for the day-to-day up keep of operating the business. It is defined as current asset less current liabilities.The important point to remember in doing problems is that the cash flows associated with working capital are the changes in working capital. When working capital requirements go up(cost more to run the business), there is a negative cash flow (you need to use more cash for general up keep of the business); when working capital requirements go down there is a positive cash flow (funds freed up for other ventures)