Accounting

What is a NINJA loan?

"No income, no job, no assets" - subprime loan, as it is typically made with little or no paperwork, generally to borrowers with less than average credit score These types of loans were a sign of the impending subprime meltdown and deterioration of lending standards by banks and mortgage originators These and other loans were packaged and sold as CDOs to investors. They were supposedly well diversified across different geographies, loan sizes, and income levels. The only way they would default is if there was a major collapse in the mortgage market due to oversupply and widespread economic slowdown

How would a $10 million increase in depreciation in year four affect the DCF valuation of a company?

- Depreciation increases by $10, causing EBIT to decline by $10. The after-tax effect is a decline of $10(1 - 40%) = $6 -Depreciation of $10 must be added back to calculate FCF, which leads to a net increase of $4 in FCF -Valuation will increase by the present value of $4, or $4 / (1 + WACC)4

Is an increase in accounts payable a source or use of cash?

A/P is a source of cash bc companies can purchase items w/o immediately paying cash.

What is the allowance method?

Bases bad debt expense on an estimate of uncollectible accounts Dr: Bad debt expense (estimate) Cr. Allowance for doubtful accounts

What is the LIFO reserve?

Contra asset account for the excess of FIFO over LIFO inventory

Say you knew a company's net income. What else would you need to figure out its cash flows?

D&A, other non-cash expenses (e.g. stock based compensation, impairment), changes in working capital accounts, capex, sale of PPE, debt issuance, debt repayments, equity issuance, stock repurchases, dividends

What is a held-to-maturity security?

Debt securities for which a company has a positive intent to hold until maturity. It is carried on the balance sheet at amortized cost. There are no unrealized gains

What is LIFO liquidation?

Dramatic decrease in inventory on hand causes a dip into LIFO layers and an increase in net income

Why is the income statement not affected by changes in inventory?

Expense is only recorded when goods associated with the inventory are sold to COGS

What is a loss carryback?

Firm may carry Net Operating Loss back two years to offset any income earned in those years and thereby receive funds for the taxes paid

What is a loss carry forward?

Firm may carry net operating loss forward 20 years to offset any income earned in those years and therefore receive funds for the taxes paid

How do you decide when to capitalize vs expense a purchase?

If the assets has a useful life over one year, it is capitalized on the balance sheet rather than expensed on the income statement. It is then depreciated (tangibles) or amortized (intangibles) over a certain number of years PP&E vs R&D

A pen costs $10 dollars to buy. It has a life of ten years. How would you put it on the balance sheet?

On the left side, $10 as an asset. Assuming a straight-line depreciation for book and no salvage value at the end of its useful life, it would be worth $9 at the end of the first year, $8 the second year, and so on. Net income will be lowered every year by the tax-affected depreciation, so shareholders' equity will be reduced by 60 cents, assuming a 40 percent tax rate.

What is inventory?

Tangible property that is held for sale in the normal course of business or used to produce goods/services for sale

If you could have only two of the three main financial statements, which would it be?

The balance sheet and income statement because as long as I have the balance sheet from the beginning and end of the period as well as the end of period income statement, I would be able to generate a statement of cash flows.

You sold an asset where you received $500 million in cash. How does this affect your three financial statements?

The key to this question is inquiring about the book value of the asset when sold. Ask the interviewer for this. For instance, if it is $400 million, then a $100 gain on sale of asset is recorded. Assuming a 40 percent tax rate, net income increases by $60 million. On the CFS, remember that assets are recorded at book value when sold. Therefore, you have a $400 million "sale of asset" under cash from investing activities. Your net cash flow is $460 million. On the BS, cash increases by $460 million and PP&E decreases by $400 million. The $60 million increase on the left side of the BS is offset by the $60 million increase in shareholder's equity on the right side

What is the link between the balance sheet and income statement?

The main link between the two is profits from the IS are added to the BS as retained earnings. Next, the interest expense on the IS is charged on the debt that is recorded on the BS. D&A is a capitalized expense from the IS that will reduce the PP&E on the asset side of the BS.

What is a trading security?

Trade for profit potential with unrealized gains and losses reported in net income. It is carried on the balance sheet at fair value. Used for debt or equity

What is the direct method?

Write down accounts receivable when actual customer default occurs Dr. Bad debt expense (write-off) Cr. Accounts receivable

Give examples of ways companies can inflate earnings.

(1) Switching from LIFO to FIFO. In a rising cost environment, switching from LIFO to FIFO will show higher earnings, lower costs and higher taxes. *Or LIFO liquidation (2) Switching from fair value to cash flow hedges. Changes in fair value hedges are in earnings, changes in cash flow hedges are in other comprehensive income. Having negative fair value hedges and then shifting them to cash flow hedges will increase earnings. (3) Changing depreciation methods (e.g. useful life) (4) Having a more aggressive revenue recognition policy. Accounts receivable will increase rapidly because they're extending easier credit. (5) Capitalizing interest or R&D that shouldn't be capitalized, so you decrease expenses on the income statement (6) Manipulating pre-tax or after-tax gains. (7) Compensate employees with options rather than cash (8) Asset sales or recognize one-time items on income statement (9) Writing down inventory

Give examples of when a company could collect cash from a customer and not record revenue.

(1) Web-based subscription software (2) Cell phone carriers with annual contracts (3) Magazine publishers that sell subscriptions *Companies that agree to services in the future often collect cash upfront to ensure stable revenue. This makes investors happy as well since they can predict the company's performance *Only record revenue when you can actually perform the services

How would lower gross margin affect the three financial statements?

*A decrease in gross margin causes gross profits to decline Income Statement: likely pay lower taxes; if nothing else changed, lower net income Statement of Cash Flows: less cash likely coming in; if nothing else changed, lower cash Balance Sheet: less cash and lower RE to balance effect

What is a credit default swap?

-Insurance on company's debt. A way to insure that an investor won't be hurt in event of default -Sold over the counter in a completely unregulated market -Can be used for hedging and speculating CDS Seller: promises to pay buyer certain amount if company defaults; receives annual payments in exchange for insurance; sellers include banks, hedge funds, insurance companies CDS Buyer: promises to pay seller annual payments; receives a large payout if the underlying company defaults; swap becomes more valuable if the underlying company becomes distressed

If depreciation is a non-cash expense, then why does it affect the cash balance?

-It is non-cash but it is tax-deductible and taxes are a cash expense -Depreciation affects cash by reducing the amount of taxes paid

What is an available-for-sale security?

-Neither HTM nor trading -Carried at market value -Unrealized gains/losses are presented net of tax in "Other Comprehensive Income"

What is the link between the balance sheet and the income statement?

-Net income generated in the income statement are added to shareholders' equity on the balance sheet as retained earnings -Debt on the balance sheet is used to calculate interest expense on the income statement -PPE will be used to calculated depreciation

What is a capital lease?

-Non-callable -And either: (1) ownership of the asset is transferred to lesee at end of lease (2) "bargain purchase" option exists (3) lease term is greater than or equal to 75% of the useful life of the asset (4) at inception of the lease, the present value of minimum payments of the lease is greater than or equal to 90% of the estimated fair market value *Requires asset and liability to be recorded *Treated as debt Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

What is the link between the balance sheet and statement of cash flows?

-SCF starts with beginning cash balance, which comes from the previous period's balance sheet -Cash from operations is derived using the changes in NWC from the balance sheet -Depreciation comes from PPE which affects OCF -Any change in PPE due to purchase or sale will affect ICF -Net increase in cash goes back onto next year's balance sheet

Why would goodwill be impaired and what does goodwill impairment mean?

-Usually happens when a company has been acquired and the acquirer re-assesses its intangible assets (e.g. brand, IP) and finds that they are not worth what they originally thought -Buyer overpaid for the seller, which results in a large net loss (e.g. eBay / Skype)

Is an increase in accounts receivable a source or use of cash?

A/R is a use of cash because for every dollar that should be coming in the door from those that owe money for goods/services, that cash has been delayed by a collection time period

What is the difference between cash based and accrual based accounting?

Cash-Based Accounting: -Recognize revenue and expenses when cash is actually received or paid out -This delays revenue recognition -There is a poor matching of true costs of generating revenue to the periods in which they are generated Accrual-Based Accounting: -Account for all transactions that economically occurred during a period -Revenue principle: entity has delivered goods/services, evidence of arrangement for payment, price is fixed and collection of cash is reasonably assured -Matching principle: revenue is matched with expense in the period in which they are incurred *Most large firms use accrual accounting because paying with credit cards and lines of credit is so prevalent these days

What are the differences between extraordinary and special charges?

Extraordinary - unusual and infrequent; below the line after-tax (e.g. hurricane) Special - unusual or infrequent; appears with income from continued operations pre-tax (e.g. employee layoffs, plant closing)

What is the FIFO method?

First in, first out. Inventory costs are those which were incurred later in the period and are more current relative to the end of the period. Results in a more accurate balance sheet and less accurate income statement

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

First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders' Equity would go up by $100 to make it balance.

If you had to choose between the LIFO or FIFO method, which would you choose?

If had a choice beween the two - in some ways it doesn't matter b/c it's just a trade-off between which financial statement is misrepresented (and investors are savy), but LIFO seems less manipulative to earnings (and minimized taxes) so I'd go with it

What effect does an asset write-down of $100 million have on the three financial statements?

Income Statement: Net income declines by $100(1 - 40%) = $60 Statement of Cash Flows: -Net income declines by $60 -Add back non-cash impairment of $100 -Net cash increase of $40 Balance Sheet: -Cash increases by $40 -Asset declines by $100 -RE decreases by $60

How would lower capex affect the three financial statements?

Income Statement: during the current year, there is no effect; however, depreciation expense is lower in subsequent years, which will increase net income and increase cash and RE in the future Statement of Cash Flows: decrease in investing cash flow, which means more cash Balance Sheet: more cash but lower PPE; total assets remains the same

How does a $10 million purchase of inventory from your supplier on credit flow through the three financial statements?

Income Statement: no effect until the inventory is sold Statement of Cash Flows: -Increase in inventory causes operating cash flow to decline by $10 -Increase in accounts payable causes operating cash flow to increase by $10 -No net effect on cash flow Balance Sheet: -Inventory increases by $10 -Accounts payable increases by $10

What are the effects of using LIFO vs FIFO assuming rising prices?

LIFO: results in a more current income statement based on fair value but a stale balance sheet with understated inventory assets (i.e. lower income taxes but lower assets) -IS: leads to higher COGS, thus lower pre-tax income -CF: leads to higher COGS, thus lower taxes paid, thus higher cash flows -BS: leads to lower inventory balance FIFO: results in a more current balance sheet based on fair value but a stale income statement with understated cost of goods sold (i.e. higher income taxes but higher assets) -IS: leads to lower COGS, thus higher pre-tax income -CF: leads to lower COGS, thus higher taxes paid, thus lower cash flows -BS: leads to higher inventory balance

What is the LIFO method?

Last in, first out. Inventory costs are those which were incurred earlier in the period and are stale relative to the end of the period. Results in a more accurate income statement and less accurate balance sheet

What is a net operating loss?

Period in which a company's allowable tax deductions are greater than its taxable income, resulting in negative taxable income *Generally occurs when a company incurs more expenses than revenue in a period *Can be used to recover past tax payments or reduce future tax payments

What is the definition of fair value?

Price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants

Walk me through the most important terms of a Purchase Agreement in an M&A deal

Purchase Price: Stated as a per-share amount for public companies. Form of Consideration: Cash, Stock, Debt... Transaction Structure: Stock, Asset, or 338(h)(10) Treatment of Options: Assumed by the buyer? Cashed out? Ignored? Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management? Reps & Warranties: What must the buyer and seller claim is true about their respective businesses? No-Shop / Go-Shop: Can the seller "shop" this offer around and try to get a better deal, or must it stay exclusive to this buyer?

What is the accounting for notes receivable?

Record at NPV of future cash flows Premium: c > r (FV < PV) Interest Revenue = r x (FV + Premium - Total Amortized) Discount: c < r (FV > PV) Interest Revenue = r x (FV - Discount - Total Amortized)

Under what circumstances would goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios: The company gets acquired or bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price in an acquisition. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number.

List the line items in the cash flow statement.

The CFS is broken up into three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In cash flow from operating, the key items are net income, depreciation and amortization, equity in earnings, non-cash stock compensation, deferred taxes, changes in working capital and changes in other assets and liabilities. In cash flow from investing, the key items are capital expenditures and asset sales. In cash flow from financing, the key items are debt raised and paid down, equity raised, share repurchases and dividends.

If you could have only one of the three main financial statements, which would it be?

The IS is definitely inappropriate to pick. Income statements are full of non-cash items, which work fine for theoretical purposes, like matching revenue to expenses in appropriate time periods, but if none of it could be liquidated then company is worth nothing. Most pick SCF, because cash is king in determining a company's health. SCF because it gives you a true picture of how much cash the company is actually generating, independent of all the non-cash expense a company might have. One interviewer selected BS because you can back out the main components of the cash flow statement (capex via PP&E and depreciation, net income via retained earnings, etc.). The BS is also helpful in distressed situations to determine the company's liquidation value.

If depreciation is non-cash, explain how a $10 pre-tax increase in depreciation causes cash to increase by $4.

The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.

What is the balance sheet?

The balance sheet presents the financial position of a company at a given point in time (1) Assets - economic resources of the company used to operate its business - Usually obtains these resources by incurring debt (promise to pay), obtaining new investors (not guaranteed, more risky), or through operating earnings (2) Liabilities - claims that creditors have on the company's resources -More senior than equity holdings and less risky, as it is paid back before distributions to equityholders are made (3) Equity - claims that investors have on the company's resources after debt is paid off

Carryover Basis (stock sale)

The buyer's basis in the acquired stock is stepped up to the purchase price (FV). The buyer assumes a carryover basis in the acquired assets. In deals structured as taxable asset purchases, the buyer records acquired assets at their stepped-up FVs on both its book and tax balance sheets. In stock acquisitions, however, the buyer receives a carryover tax basis and a stepped-up book basis in the acquired assets. Incremental post-transaction depreciation and amortization attributable to asset write-ups for book purposes—but not for tax purposes—in a stock acquisition result in lower taxable income for book purposes than for tax purposes. This incremental tax shield means the acquirer's book tax expense will be lower in future periods than the cash taxes actually due the IRS. A deferred tax liability (DTL) is recorded on the GAAP balance sheet to reflect the acquirer's higher cash tax liability (relative to GAAP tax expense).

A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it's only worth $50 million. What happens?

The buyer's share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half. Depending on how the deal was structured, the seller would effectively only be receiving half of what it had originally negotiated. This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact valuation.

If I increase AR by $10mm, what effect does that have on cash? Explain what AR is in layman terms.

There is no immediate effect on cash. AR is account receivable, which means the company received an IOU from customers. They should pay for the product or service at a later point in time. There will be an increase in cash of $10 million when the company collects on the account receivable.

Why do companies report both GAAP and non-GAAP earnings?

These days, many companies have non-cash charges such as amortization of intangibles, stock-based compensation, deferred revenue write-downs on their income statement. Some argue that the income statement under GAAP no longer reflects how profitable a company is. Non-GAAP earnings are almost always higher because these expenses are excluded, which looks better to investors

What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes. Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven't expensed them on the Income Statement yet. The most common way they occur is with asset write-ups and write-downs in M&A deals - an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset (see the Merger Model section for more on this).

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you're undercounting D&A.

Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should incur an expense. Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company's internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

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

Usually it goes to unearned revenue (balance sheet liability). Over time as services are performed, unearned revenue is debited and revenue is credited and it appears on the income statement

What is the difference between the income statement and statement of cash flows? How are the two financial statements linked?

-Income statement is a record of revenue and expenses while statement of cash flows records the actual cash that has either come into or left the company during that time period -SCF has OCF, ICF and FCF -Interestingly, a company can be profitable as shown on the income statement but still go bankrupt if it does not have the cash to meet its interest payments -Both statements are linked by net income

If you purchase a building for $100 million in cash on December 31, how would it flow through the three financial statements this year and next year?

*Assume fiscal year ends December 31, which means no depreciation during first year *Assume straight line over 5 years; 40% tax rate Year 1 Income Statement: capex thus no expense; no depreciation first year; no effect Statement of Cash Flows: -$100 decrease in investing cash flows due to capex -Net decrease in cash of $100 Balance Sheet: -Increase PPE by $100 -Decrease cash by $100 -No net change in assets Year 2 Income Statement: $20 depreciation causes net income to decline by $20(1 - 40%) = $12 Statement of Cash Flows: -Net income declines by $12 -Depreciation increases by $20 -Net increase in cash of $8 Balance Sheet: -Cash increases by $8 -PPE declines by $20 -RE declines by $12 from net income

What is goodwill?

-An intangible asset that can be found on a company's balance sheet. -Goodwill can often arise when one company is purchased by another company. In an acquisition, the amount paid for the company over book value usually accounts for the target firm's intangible assets. -Goodwill is seen as an intangible asset on the balance sheet because it is not a physical asset like buildings or equipment -Goodwill typically reflects the value of intangible assets such as a strong brand name, good customer relations, good employee relations and any patents or proprietary technology.

How are the three financial statements connected?

-Beginning cash balance on statement of cash flows comes from balance sheet; net income in operating cash flows comes from income statement -Adjustments made to net income on statement of cash flows using balance sheet accounts -Ending balance of cash appears on balance sheet and statement of cash flows -Net income increases shareholders equity through retained earnings Other connections: interest expense, depreciation, change in working capital

Under what circumstances would goodwill increase?

-If a company re-assesses its value and finds that it is worth more but that is rare -What usually happens is: (1) company gets acquired or bought out and goodwill changes as a result, since it is an account plug for the acquisition price (2) company acquires another company and pays more than what its assets are worth, which is then reflected in goodwill

How does goodwill affect the income statement?

-If an event occurs that diminishes the value of this intangible asset, the assets must be written down in a process called goodwill impairment -Goodwill is then subtracted as a non-cash expense and therefore reduces net income

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

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don't pay quickly and upfront and the company is carrying a high debt balance).

Suppose you purchase $100 million of equipment on December 31, 2001 with a debt issuance. Walk me through the impact of this event on the three financial statements during 2001 and 2002.

2001 Income Statement: no effect because there is no depreciation and no interest expense Statement of Cash Flows: -Investing cash flows declines by $100 as capex -Financing cash flows increases by $100 as debt issurance -Zero net effect on cash Balance Sheet: -Increase in PPE by $100 -Increase in Debt by $100 2002 Income Statement: *Assume useful life of 5 years, 40% tax rate, 10% interest rate and no amortization (zero coupon) -$20 depreciation expense and $10 interest expense -$30(1 - 40%) = $18 decrease in net income Statement of Cash Flows: -Net income down by $18 and depreciation up by $20 -Net increase in cash of $2 Balance Sheet: -Increase in cash by $2 -Decrease in PPE by $20 -Decrease in RE by $18 *Could also consider interest payable increasing and debt decreasing

What is a mortgage-backed security?

A security that pays its holder a periodic payment based on the cash flows from the underlying mortgages that fund the security -MBS allow investing community to lend money to homeowners with banks acting as middleman -Many MBS were rated AAA because they were considered highly diversified, and it was though that the housing market would not collapse across the board

Which structure (stock purchase vs asset purchase) does the seller prefer and why? What about the buyer?

A stock deal generally favors the seller because of the tax advantage. An asset deal for a C corporation causes the seller to be double-taxed; once at the corporate level when the assets are sold, and again at the individual level when proceeds are distributed to the shareholders/owners. In contrast, a stock deal avoids the second tax because proceeds transfer directly to the seller. In non-C corporations like LLCs and partnerships, a stock purchase can help the seller pay transaction taxes at a lower capital gains rate (there is a capital gains and ordinary income tax difference at the individual level, but not at a corporate level). Furthermore, since a stock purchase transfers the entire entity, it allows the seller to completely extract itself from the business. A buyer prefers an asset deal for similar reasons. First, it can pick and choose which assets and liabilities to assume. This also decreases the amount of due diligence needed. Second, the buyer can write up the value of the assets purchased—known as a "step-up" in basis to fair market value over the historical carrying cost, which can create an additional depreciation write-off, becoming a tax benefit. Please note there are other, lesser-known legal advantages and disadvantages to both transaction structures.

What is a stock purchase and what is an asset purchase?

A stock purchase refers to the purchase of an entire company so that all the outstanding stock is transferred to the buyer. Effectively, the buyer takes the seller's place as the owner of the business and will assume all assets and liabilities. In an asset deal, the seller retains ownership of the stock while the buyer uses a new or different entity to assume ownership over specified assets.

What is financing cash flows?

Accounts for external activities such as issuing cash dividends, issuing or repaying debt, or issuing or repurchasing stock

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises If you're calculating it, take the balance from last year, add this year's stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.

What is securitization?

An issuer bundles together a group of assets and creates a new financial instrument by combining those assets and reselling them in different tiers

What is meant by recovery value?

Amount an investor receives in bankruptcy liquidation from his investment in a particular financial instrument. Recovery rate is the associated percentage

What are the components of the statement of cash flows?

Beginning cash +Operating cash flow: cash generated from the normal operations of a company +Investing cash flow: change in cash outside the scope of normal business (e.g. purchase of PPE and other investments not reflected in income statement); cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment. +Financing cash flow: cash from changes in liabilities and shareholders' equity including any dividends that were paid out to investors in cash (e.g. issuance of debt or equity, share repurchases) =Ending Cash

Walk me through the major items in Shareholders' Equity.

Common Stock - Simply the par value of however much stock the company has issued. Retained Earnings - How much of the company's Net Income it has "saved up" over time. Additional Paid in Capital - This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering. Treasury Stock - The dollar amount of shares that the company has bought back. Accumulated Other Comprehensive Income - This is a "catch-all" that includes other items that don't fit anywhere else, like the effect of foreign currency exchange rates changing.

Suppose you issue $80 worth of debt for $100 in cash. Walk me through the effect of this transaction on the three financial statements.

Dr. Cash 100 Cr. Debt 80 Cr. Gain 20 Income Statement: $20(1 - 40%) = $12 increase in net income Statement of Cash Flows: -$12 increase in net income -Subtract $20 non-cash gain -Add $100 of financing cash flow from debt issuance -Net increase in cash of $92 Balance Sheet: -Cash increases by $92 -Debt increases by $80 -RE increases by $12

Suppose you repurchase debt of $100 for $80 in cash. What is the effect of this transaction on the three financial statements?

Dr. Debt $100 Cr. Cash $80 Cr. Gain $20 Income Statement: $20(1 - 40%) = $12 increase in net income Statement of Cash Flows: -$12 increase in net income -Subtract $20 non-cash gain -Subtract $80 of financing cash flow from repurchase of debt -Net decrease in cash of $88 Balance Sheet: -Cash decreases by $88 -Debt decreases by $100 -RE increases by $12

If you use accelerated depreciation on your tax books but straight line on your GAAP books, how does this flow through the 3 statements?

Early years: - Income statement: straight-line depreciation, then tax affected - Cash flow statement: Add back difference between book and tax depreciation (post-tax) - Balance sheet: Cash increases, DTL increases Later years: -Income statement: straight-line depreciation, then tax affected -Cash flow statement: Add back difference between book and tax depreciation (post-tax) (most-likely will be cash outflow) -Balance sheet cash decreases, DTL decreases as you pay more in tax than you report on your books The most common source of deferred tax liabilities is depreciation, the process by which companies allocate the cost of assets. Say that your company spends $6,000 on a machine that will last three years and that it pays a 30 percent tax on profits. Under regular financial accounting, you depreciate the machine by $2,000 per year for the next three years. Each year, your company's financial statements (but not necessarily its tax returns) show a reduction in net income of $2,000 and a $600 reduction in taxes. Now say tax accounting allows your company to front load the depreciation so the company depreciates $3,000 in the first year, $2,000 in the second and $1,000 in the third. In the first year, the company claims $3,000 in depreciation expense on its tax return, reducing its taxes by $900. It creates a $300 deferred tax liability on its balance sheet to represent the difference between what it "should" have paid based on its financial statements and what it actually paid. In the third year, the situation reverses itself. The company pays $300 more in taxes than what the financial statements show it "should." The company handles the difference by eliminating the liability from the balance sheet. It can be helpful to think of a deferred tax liability as the amount by which a company has "underpaid" its taxes in the past, an amount that will have to be made up in the future. But it's important to understand that the company didn't actually underpay. The company completely fulfilled its tax obligations; it just recognized those obligations in its financial accounting on a different timetable than when it paid them in its tax accounting.

You own a hotdog business. (1) Assume that you buy a hot dog on credit for $1 and sell that hot dog to a person on credit for $3. (2) You receive cash from the party that bought the hot dog and you pay off your creditor. Explain the impact on the three financial statements of both events.

Event 1: Dr. Inventory $1 Cr. Accounts Payable $1 Dr. Accounts Receivable $3 Cr. Revenue $3 Income Statement: increase net income by $2(1 - 40%) = $1.20 Statement of Cash Flows: -Increase net income by $1.20 -Increase in inventory causes decline of operating cash by $1 -Increase in accounts receivable causes decline of operating cash by $3 -Increase in accounts payable causes increase of operating cash by $1 -Net decrease in cash of $1.80 Balance Sheet: -Decrease in cash $1.80 -Increase inventory $1.00 -Increase accounts receivable $3.00 -Increase accounts payable $1.00 -Increase RE by $1.20 Event 2 Dr. Cash $3 Cr. Accounts Receivable $3 Dr. Accounts Payable $1 Cr. Cash $1 Income Statement: no effect due to accrual accounting Statement of Cash Flows: -Decrease in accounts receivable causes increase in operating cash of $3 -Decrease in accounts payable causes decrease in operating cash of $1 -Net increase in cash of $2 Balance Sheet: -Increase in cash of $2 -Decrease accounts receivable $3 -Decrease accounts payable of $1

How is GAAP accounting different from tax accounting?

GAAP is accrual-based but tax is cash-based. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation). GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

Suppose you purchase $100 million of equipment (5 year useful life) on December 31, 2001 with a debt issuance. On January 1, 2003, the equipment breaks down and is worthless. Walk me through the impact of this event on the three financial statements.

If the equipment breaks down and is worthless, the company must write it down to $0. On January 1, 2003, the equipment is on the books at $80 million and the company must pay back the entire loan. Income Statement: -$80 write down causes net income to decline by $80(1 - 40%) = $48 Statement of Cash Flows: -Net income is down $48 -Add back the non-cash write-down of $80 -Cash from financing decreases by $100 when you pay back the loan; net cash declines by $68 Balance Sheet: -Assets: Cash decreases by $68, PPE decreases by $80 = $148 decline -Debt: Declines by $100 -RE: Declines by $48

You misstated depreciation in your model. It should be $10 million higher. How does this affect the three financial statements?

Income Statement: $10 depreciation expense, 40% tax rate -Reduction in net income of $10(1 - 40%) = $6 Statement of Cash Flows: reduction in net income flows to cash flow from operations -Net income reduced by $6 -Depreciation increases by $10 -Net increase in cash from operations of $4 -Ending cash increase by $4 Balance Sheet: ending cash flows onto the balance sheet -Cash increases by $4 -PPE loses $10 in value -Net decrease in assets of $6, which matches the net drop in shareholders' equity due to reduction of retained earnings from $6 drop in net income

We're creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the factory purchase, and what would our new Enterprise Value be?

In this scenario, you would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow. The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) - the "4" just represents year 4 here. Then you would subtract this amount from the Enterprise Value.

Suppose you purchase a new fixed asset at $100 with 50% cash and 50% debt on December 31. Take me through how it affects all the financial statements.

Income Statement: -No depreciation or interest during the first year Statement of Cash Flows: -Investing cash flow decreases by $100 due to capex -Financing cash flow increases by $50 due to debt issuance -Net decrease in cash of $50 Balance Sheet: -Decrease in cash by $50 -Increase in PPE by $100 -Increase in Debt by $50

Suppose you sell a pair of jeans for $20 that cost you $10. Walk me through the effect of this transaction on the three financial statements.

Income Statement: -Revenue increases by $20 while COGS increases by $10 -Net income increases by $10(1 - 40%) = $6 Statement of Cash Flows: -Net income increases by $6 -Decrease in inventory of $10 leads to a cash increase of $10 -Net increase in cash of $16 Balance Sheet: -Cash increases by $16 -Inventory declines by $10 -RE increases by $6

Suppose you buy $100 million of inventory. You sell the inventory at 50% gross margin. Using a 50% tax rate, walk me through the changes in the three financial statements.

Income Statement: -Revenue increases by $200 and COGS increases by $100 -Net income increases by $100(1 - 50%) = $50 Statement of Cash Flows: -Increase in net income of $50 -Decrease in inventory causes operating cash flow to increase by $100 -Net increase in cash flow of $150 Balance Sheet: -Increase in cash of $150 -Decrease in inventory of $100 -Increase in RE of $50

What is a collateralized debt obligation?

It is a broad asset class in which a number of interest paying assets are packaged together (securitized) and sold in the form of bonds that pay coupon payments based on the assets' future cash flows. Investor pays market value for the CDO and then has the rights to the interest payments over time.

Tangible property that is held for sale in the normal course of business or used to produce goods/services for sale

Mark-to-market is the process by which securities are recorded on financial statements using current market prices, as opposed to purchase prices or accounting values As the credit crisis unraveled, many banks/investors were forced to write-down assets to current market values (1) Many banks used these assets as collateral to borrow against in order to make other investments. As asset values declined, they were able to borrow less (2) As assets are marked down, investors are likely to sell their assets so that they do not keep losing value. Selling naturally depresses market values further (3) In late 2008, this caused a panic and people moved their personal investments into cash and were willing to sell at any cost

Could you get DTLs or DTAs in an asset purchase?

No, because in an asset purchase the book basis of assets always matches the tax basis. They get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.

If a company issues a PIK security, what impact will it have on the three statements?

PIK stands for "paid in kind," another important non-cash item that refers to interest or dividends paid by issuing more of the security instead of cash. This can mean compounding profits for the lenders and flexibility for the borrower. For instance, a mezzanine bond of $100 million and 10 percent PIK interest will be added to the BS as $100 million as debt on the right side, and cash on the left side. On the CFS, cash flow from financing will list an increase of $100 million as debt raised. When the PIK is triggered and all else is equal, interest on the IS will be increased by $10 million, which will reduce net income by $6 million (assuming a 40 percent tax rate). This carries over onto the CFS where net income decreases by $6 million and the $10 million of PIK interest is added back (since it is non-cash), resulting in a net cash flow of $4 million. On the BS, cash increases by $4 million, debt increases by $10 million (the PIK interest accretes on the balance sheet as debt) and shareholders equity decreases by $6 million.

What is investing cash flows?

Reports aggregate change in cash resulting from gains/losses from investments in the financial markets and operating subsidiaries as well as changes resulting from capital expenditure investment

Walk me through the major line items of the income statement.

Revenue -COGS =Gross Profit -SG&A -D&A =Operating Income (EBIT) -Interest Expense =Income before Taxes - Taxes =Net Income

What is Sarbanes-Oxley and what are the implications?

Sarbanes-Oxley was a bill passed by Congress in 2002 in response to a number of accounting scandals. To reduce the likelihood of accounting scandals, the law established new or enhanced standards for publicly held companies. Those in favor of this law believe it will restore investor confidence by increasing corporate accounting controls. Those opposed to this law believe it will hinder organizations that do not have a surplus of funds to spend on adhering to the new accounting policies.

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.

This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down - so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60 - so Liabilities & Shareholders' Equity is down by $40 and it balances. If this seems strange to you, you're not alone - see this Forbes article for more on why writing down debt actually benefits companies accounting-wise:

If a company has seasonal working capital, is that a deal killer?

Working capital ("WC") is current assets less current liabilities. Seasonal working capital applies to firms whose business is tied to certain time periods. When current assets are higher than current liabilities, this means more cash is being tied up instead of being borrowed. For instance, UGG mostly manufactures snow boots. In the winter, demand is higher, so the firm must build up inventories to meet this demand at this time, increasing current assets. Since more cash is tied up, this can increase the liquidity risk. If UGGs suddenly go out of fashion, then the company is stuck holding the inventory. Also, if people frequently pay with credit for the company's products, the amount is listed as accounts receivable ("AR"), which represents future profits but is noncash. Therefore, if the company cannot collect this owed cash in time to pay its creditors, it runs of the risk of bankruptcy. This is an issue to note and watch, but it is not a deal killer if you have an adequate revolver and can predict the seasonal WC requirements with some clarity. In general, any recurring event is fine as long as it continues to perform as planned. The one-time massive surprise event is what can kill an investment.

Could you ever end up with negative shareholders' equity? What would this imply?

Yes, it is possible. (1) Dividend Recap. Shareholders' equity turns negative immediately after dividend recapitalization in an LBO situation. Means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative (2) Continuous losses. It can also happen if the company has been losing money consistently and therefore has declining retained earnings, which is a portion of shareholders' equity *Does not "mean" anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling