Accounting

What should you do if a company's Cash Flow Statement starts with something OTHER than Net Income, such as Operating Income or Cash Received?

Convert to starting w/ NI For modeling and valuation purposes, you should convert this Cash Flow Statement into one that starts with Net Income and makes the standard adjustments. Large companies should provide a reconciliation that shows you how to move from Net Income or Operating Income to Cash Flow from Operations and that lists the changes in Working Capital and other non-cash adjustments. If the company does NOT provide that reconciliation, you might have to stick with the CFS in the original format.

In the second year, the acquisition goes horribly wrong, and your company realizes the acquired company is worth only about half of what it paid. So, it decides to write down half the Goodwill created in the deal - how do the 3 statements change, and what is the balance after the write-down?

$400 in Goodwill was created in this deal, so $200 will be left afterward. • Income Statement: You record a $200 Goodwill write-down, which reduces Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $120, but you add back the $200 Goodwill write-down since it's non-cash, so cash at the bottom is up by $80. • Balance Sheet: Cash is up by $80, but Goodwill is down by $200, so the Assets side is down by $120. On the L&E side, Retained Earnings is down by $120 due to the reduced Net Income. There are no other changes, so both sides are down by $120 and balance. • Intuition: The Goodwill write-down is a non-cash expense that reduces the company's tax burden, which boosts its cash balance. Advanced Note: Write-downs of Goodwill created from acquisitions are often NOT deductible for cash-tax purposes, so a DTA/DTL might be involved in real life. Do NOT bring up this point voluntarily in an interview.

Single Step Changes on the Fin Stmts

1. Changes to True Cash Items on the Income Statement - Straightforward since Net Income, Cash, and Retained Earnings change. 2. Changes to Non-Cash or Re-Classified Items on the Income Statement - Net Income, Cash, and Retained Earnings change, but something on the Balance Sheet also changes. 3. Changes to Operational Items on the Balance Sheet - These are trickier because the effects are different when an item decreases vs. when it increases, so you have to understand what the change means. 4. Changes to Non-Operational Balance Sheet Items or Cash Flow Statement Items - These are simple since there's no immediate Income Statement impact; something on the CFS will change, Cash will change, and something on the Balance Sheet will change.

One year passes. The company pays 10% interest on its debt, and it depreciates $10 on the factory each year. It also repays $20 of the loan each year. What happens on the statements in this first year?

10% interest corresponds to $10 in interest since we use the beginning debt balance to calculate interest. So: • Income Statement: You record $10 in interest and $10 in Depreciation, so Pre-Tax Income falls by $20, and Net Income falls by $12 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but the $10 in Depreciation is non-cash, so you add it back. The $20 loan repayment counts as a cash outflow, so cash at the bottom of the CFS is down by $22. • Balance Sheet: Cash is down by $22, and PP&E is down by $10, so the Assets side is down by $32. On the L&E side, the Debt is down by $20 and Retained Earnings is down by $12 due to the reduced Net Income, so the L&E side is also down by $32 and both sides balance. • Intuition: Cash declines mostly because of the principal repayment; the interest expense is offset a bit by the tax savings from the Depreciation.

A company mentions that it collects cash payments from customers for a monthly subscription service a year in advance. Why would a company do this, and what is the cash flow impact?

A company would collect cash payments for a monthly service long in advance if it has the market power do so. It's always better to get cash earlier rather than later because of the time value of money, so if the market and customers support this plan, any company would do it. Often, companies will provide an incentive, such as discounted pricing, a free bonus, or free services to incentivize customers to pay upfront. This practice always boosts a company's cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue will be a positive entry that boosts a company's cash flow. When this cash is finally recognized as revenue, Deferred Revenue declines, which appears as a negative entry on the CFS.

Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?

Accounts Receivable is an Asset because it corresponds to future cash payments that customers are expected to make. An Asset is something that will result in additional cash in the future, or that can be sold for cash, so AR qualifies. Deferred Revenue is a Liability because it will cost the company cash in the future. The company has already collected all the cash associated with this future revenue. So, in the future, when it finally delivers the product or service, it will have to spend something on the delivery and will also have to pay taxes on the revenue it records. While AR and DR may seem similar, they are the opposites of each other: AR has not yet been collected in cash but has been delivered, whereas DR has been collected in cash, but has not yet been delivered.

How can you tell whether an item should be classified as an Asset, Liability, or Equity on the Balance Sheet?

An Asset will generate future cash flow for the company or can be sold for cash. Think about how AR means the company should receive more cash in the future. A Liability will cost the company cash in the future and cannot be sold because it represents payments the company owes. Think about Debt or Accounts Payable and how they represent owed payments. Equity line items are similar to Liabilities because they represent funding sources for the company - but they will NOT result in future cash costs. They relate to funds the company has saved up on its own or funds that it has raised from outside investors with no cash cost (i.e., equity).

What if you could use only 2 statements to assess a company's prospects - which ones would you use, and why?

BS & IS - Lets you generate CF

What's the most important financial statement?

CF The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating. The Income Statement is misleading because it includes non-cash revenue and expenses and excludes cash spending such as Capital Expenditures.

The CFO of your firm recently unveiled plans to purchase short and long-term investments. Why would she want to do this, and how would this activity affect the statements?

Co has excess cash and no better uses for it CF - Purchase will reduce CF IS - Interest income will boost pre-tax income & Cash balance

A company has $1,000 in revenue, $200 in COGS, and $700 in operating expenses, and no other expenses. Walk through what happens on the 3 statements if half of the company's Income Taxes shift from current to deferred.

First, you have to calculate the company's total tax bill: $1,000 in revenue minus $200 in COGS minus $700 in operating expenses equals $100 in Pre-Tax Income and $40 in taxes at a 40% tax rate. • Income Statement: Nothing changes because you record BOTH current AND deferred taxes as part of the company's Income Taxes here. So, there's still $40 of Income Taxes. • Cash Flow Statement: Net Income stays the same, but now you have to add back $20 in the Deferred Income Tax line item because these taxes will be paid in some future period. Cash increases by $20 as a result. • Balance Sheet: Cash is up by $20, and so the Assets side is up by $20. On the L&E side, the Deferred Tax Liability will increase by $20 because of this deferral, so both sides increase by $20 and the Balance Sheet balances. • Intuition: This is a simple deferral of a cash expense into a future period, so the company's cash increases in the short term.

How do Goodwill and Other Intangible Assets change over time?

Goodwill remains constant unless it is "impaired," i.e., the acquirer decides that the acquired company is worth far less and therefore writes down the Goodwill. That appears as an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement. Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash Flow Statement. The balance decreases until it has amortized completely.

How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?

IFRS vs GAAP Income Statements and Balance Sheets tend to be similar across different regions, but companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income, or if they are using the Direct Method for creating the CFS, Cash Received or Cash Paid. There are also minor naming differences; for example, the Income Statement might be called the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the Balance Sheet might be called the "Statement of Financial Position." Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct Method for creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start with Net Income and make adjustments to determine the cash flow).

Your company just acquired another one for $1,000 in cash. The other company's Shareholders' Equity was $500, and you identified $100 in Other Intangible Assets with a useful life of 5 years. What happens on the 3 statements from just AFTER the acquisition closes to the end of the first year following the acquisition? Only factor in Goodwill and Other Intangible Assets.

IS - Am ^ $20, which reduces Pre-Tax Income by $20 & NI by $12 (40% Tax Rate) CF - NI v $12, Add back $20 for Am (non-cash Expense), Cash up $8 BS - Cash ^ $8, but Other Intangible Assets are down by $20 -> Assets v $12, RE v $12 b/c of NI Intuition: The non-cash Amortization expense increases the company's cash balance by reducing its tax burden.

Walk me through the 3 financial statements when a company's operating expenses increase by $100.

IS - Open ^ 100 -> Pretax v 100 -> NI v 60 (taxes) CF - NI v 60 -> CFO v 60 -> Ending Cash v 60 BS - Cash v 60 -> RE v 60

A company decides to CHANGE a key employee's compensation. It will offer the employee stock options instead of a real salary. The employee's salary was formerly $100, but she will receive $120 in stock options now. How do the statements change?

IS - Opex ^ 20 -> Pretax v 20 -> NI v 12 CF - NI v 12 -> SBC added back ^ 120 -> Ending cash ^ 108 BS - Cash ^ 108, RE v 12, CS & APIC ^ 120 The company saves a lot of cash by not paying the employee in cash anymore, and it also realizes tax savings. Just remember that its share count will also increase.

A company's Depreciation increases by $10. What happens on the 3 financial statements?

IS - Pretax v 10 -> NI v 6 (taxes) CF - NI v 6 -> CFO ^ 10 (dep) -> Ending Cash ^ 4 BS - Cash ^ 4 -> PP&E v 10 -> TA v 6 -> RE v 6 The company saves on taxes with a non-cash expense.

A company runs into financial distress and needs cash immediately. It sells a factory that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements?

IS - Pretax v 20 -> NI v 12 CF - NI v 12 -> CFO ^ 20 (add back loss) -> CFI ^ 80 proceeds from sale -> Ending Cash ^ 88 BS - Cash ^ 88, PP&E v 100, RE v 12 The company gets the $80 in cash proceeds, but it also gets $8 in tax savings from the Loss, so its cash goes up by $88 rather than $8.

What are the 3 financial statements, and why do we need them?

IS - Rev, Expenses, & Taxes. Gives us NI BS - A = L + E CF - Change in cash over time, CFO + CFI + CFF

How do the 3 statements link together?

IS -> NI CF -> NI -> Cash BS - Cash & RE To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement. Then, adjust this Net Income number for any non-cash items such as Depreciation & Amortization. Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or decrease the company's cash flow depending on how they've changed. This gets you to Cash Flow from Operations. Next, take into account investing and financing activities, which may increase or decrease cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom. Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to Retained Earnings within the Equity category on the Balance Sheet. Then, link each non-cash adjustment to the appropriate Asset or Liability; SUBTRACT links on the Assets side and ADD links on the L&E side. And then link each CFI and CFF item to the matching item on the Balance Sheet, using the same rule as above. Check that Assets equals Liabilities plus Equity at the end; if this is not true, you did something wrong and need to re-check your work.

A company begins offering 12-month installment plans to customers so that they can pay for $500 or $1,000 courses over a year instead of all upfront. How will its cash flow change?

In the short term - during THIS year - the company's cash flow will decrease because some customers no longer pay upfront in cash. So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on. This situation corresponds to Accounts Receivable: The Asset on the Balance Sheet that represents owed future payments from customers. The long-term impact depends on how much sales grow as a result of this change. If sales grow substantially and the company's Revenue and Net Income increase, that might be enough to offset the reduced cash flow and make the company better off.

A company decides to prepay its monthly rent - an entire year upfront - because it can save 10% by doing so. Will this prepayment boost the company's cash flow?

In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one payment per month. On the Income Statement in Month 1, the company will still record only the Monthly Rent for that month. But on the Cash Flow Statement, it will list a negative 12 * Monthly Rent under "Change in Prepaid Expenses" to represent the cash outflow for the prepayment. A 10% discount represents just over 1 month of rent, so the company's immediate cash flow will decrease substantially. In the long term, this discount will improve the company's cash flow because the timing difference will go away after a year.

Another year passes. Again, the company pays 10% interest on its debt based on the balance at the start of the year, and it depreciates $10 on the factory, with $20 loan principal repayment. At the very END of the year, a dragon attacks the factory, and it falls apart. The company has to write down the factory's entire value and repay the remaining loan balance. Walk me through what happens on the statements from the BEGINNING of Year 2 to the END.

Remember that the company only has $80 in debt remaining at the start of Year 2, so the interest expense will be 10% * $80, or $8, rather than $10. The initial PP&E is $90, but $10 of that gets depreciated, and the remaining $80 is written down. Although there's $20 of debt repayment, it's better to think of this as $80 during the entire year because there's $20 in "normal" repayment and then $60 at the end of the year. • Income Statement: You record $10 in Depreciation, $8 in interest expense, and $80 for the PP&E write-down, so Pre-Tax Income falls by $98, and Net Income falls by $59 (technically $58.8, but we're rounding). • Cash Flow Statement: Net Income is down by $59, but the Depreciation and the Write-Down are both non-cash, so you add back a total of $90. Cash is up by $31 so far. Then you factor in the loan repayments - a total of $80 - and cash is therefore down by $49. • Balance Sheet: Cash is down by $49, and PP&E is down by $90, so the Assets side is down by $139. On the L&E side, Debt is down by $80 and Retained Earnings is down by $59 due to the reduced Net Income, so the L&E side is down by $139 and both sides balance. • Intuition: Again, cash is down significantly mostly because of the loan repayment; everything else makes a minor impact.

Your CFO wants to start paying employees mostly in stock-based compensation, under the logic that it will reduce the company's taxes, but not "cost it" anything in cash. Is he correct? And how does Stock-Based Compensation impact the statements?

The CFO is partially correct. Yes, stock-based compensation is a non-cash expense that reduces a company's taxes but gets added back on the CFS, similar to Depreciation. However, unlike Depreciation or Amortization, Stock-Based Compensation incurs a real cost to the company and its investors because it creates additional shares. In other words, if the existing investors own 99% of the company's shares, those investors might own only 97% or 98% after SBC is issued. Thus, Stock-Based Compensation makes the company less valuable to the existing investors, even though, on paper, it seems to be just like any other non-cash expense.

How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?

The difference is very similar to the one above for AR and DR. Prepaid Expenses have already been paid out in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they do finally appear on the Income Statement, they'll reduce the company's future taxes, making them an Asset. Accounts Payable have not yet been paid out in cash but have been incurred as expenses, so they have appeared on the Income Statement. When the company finally pays them in cash, Accounts Payable will reduce the company's cash, making them a Liability. Accounts Payable and Accrued Expenses work in exactly the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), whereas Accrued Expenses is more for monthly, recurring items without invoices (e.g., utilities).

Wal-Mart buys $500 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600.

The first part is a simple Inventory purchase, and the second part is more of a "multi-step scenario" where the company has to record COGS and the revenue associated with the product sales. Here's the first part: • Income Statement: No changes. • Cash Flow Statement: The $500 Inventory increase reduces the company's cash flow, so cash at the bottom is down by $500. • Balance Sheet: Cash is down by $500, but Inventory is up by $500, so the Assets side doesn't change. The L&E side also doesn't change, so the Balance Sheet remains in balance. • Intuition: This is a simple cash purchase for an expense that has not yet been incurred. And then here's the next part (factoring in ONLY this step): • Income Statement: Revenue is up by $600, but COGS is up by $500, so Pre-Tax Income is up by $100 and Net Income is up by $60 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the decrease in Inventory increases cash flow by $500, so cash at the bottom is up by $560. • Balance Sheet: Cash is up by $560, but Inventory is down by $500, so the Assets side is up by $60. The L&E side is also up by $60 because Net Income was up by $60, and so Retained Earnings was up by $60; therefore, both sides balance. • Intuition: Look at the CUMULATIVE change - if you trace through both steps 1 and 2, cash is up by $60 from start to finish. And that increase corresponds to the company's after-tax profit from a $100 pre-tax profit on the sale of these goods.

A junior accountant in your department asks about the different ways to fund the company's operations and how they impact the financial statements. What do you tell him?

The two main methods of funding a company's operations are debt and equity. Debt is cheaper for most companies (see the previous lessons and guides on WACC and the Discount Rate), so most companies prefer to use debt... up to a reasonable level. Both equity and debt issuances show up on only the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company's cash balance. The only "after-effect" of equity is that the company's share count increases. This happens because any investor who buys the company's equity now owns a percentage of the company. With debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually pay back the full balance.

This same company now realizes that it has too much cash, so it wants to issue dividends or repurchase shares. How do they impact the 3 statements differently? Assume $100 in dividends vs. $100 in shares repurchases.

These changes both make a very similar impact; the main difference is that dividends do not reduce the shares outstanding, but a share repurchase does. • Income Statement: No changes. • Cash Flow Statement: Both of these will show up as negative $100 entries in Cash Flow from Financing, reducing the cash at the bottom of the CFS by $100. • Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E side, dividends will reduce Retained Earnings by $100, whereas a share repurchase will reduce Treasury Stock by $100. But in either case, Equity is down by $100, so the L&E side is down by $100 and both sides balance. • Intuition: These are simple uses of cash that don't affect the company's taxes at all.

Your company sells equipment for $85. The equipment was listed at $100 on your company's Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement. Why is this Loss considered a non-cash expense?

This Loss is a non-cash expense because you haven't actually "lost" anything in cash in the current period. When you sell equipment for $85, you get $85 in cash from the buyer. It's not as if you've "lost" $15 in cash because you sold the equipment at a poor price. The "Loss" refers to how you previously spent more than $85 to buy this equipment in some prior period. So, if you look at what you spent on the equipment many years ago and compare it to what you sold it for today, it seems like a "loss." But that doesn't matter because non-cash adjustments are based on what happens in the CURRENT PERIOD.

A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process the orders. The company also pays 5% interest on its debt and repays 10% of the principal. What happens on the statements over the course of THIS one year?

This question is the standard "Sell inventory for a certain amount of revenue" one, but there are a few twists. For one, we also have to factor in $100 of additional Operating Expenses. Also, we have to include the $10 interest expense on the debt ($200 * 5%) and the $20 principal repayment ($200 * 10%). • Income Statement: Revenue is up by $400, but COGS is up by $200, and Operating Expenses are up by $100 because of the extra employees. There is also $10 of additional Interest Expense because of the 5% interest rate on $200 of debt, so Pre-Tax Income is up by $90. Net Income is up by $54 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $54, and the company's COGS decreasing by $200 frees up an additional $200 of cash flow. So far, cash flow is up by $254. The company also has to repay 10% * $200, or $20, of the debt principal, and so cash at the bottom is up by $234. • Balance Sheet: Cash is up by $234, but Inventory is down by $200, so the Assets side is up by $34. On the L&E side, Debt is down by $20, and Retained Earnings is up by $54 because of the increased Net Income, so the L&E side is up by $34 and both sides balance. • Intuition: The company has bought goods, turned them into finished products, and profited from the sale. The company's cash goes up by less than expected because of the debt principal repayment and interest.

Amazon.com decides to pay several key vendors on credit and make them wait for the cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash?

This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and then decreasing by $200 when they're finally paid out in cash. • Income Statement: Operating Expenses increases by $200, so Pre-Tax Income is down by $200 and Net Income is down by $120, assuming a 40% tax rate. • Cash Flow Statement: Net Income is down by $120, but AP increasing by $200 results in higher cash flow since it means the expenses haven't been paid in cash yet. So, cash at the bottom is up by $80. • Balance Sheet: Cash is up by $80, so the Assets side is up by $80. On the L&E side, AP is up by $200, but Retained Earnings is down by $120 due to the reduced Net Income, so the L&E side is up by $80 and both sides balance. • Intuition: This expense is acting like a "non-cash charge" at this point because it reduces the company's taxes but doesn't cost them anything in cash. Cash is up because of the lower taxes. And then here's the next step (factoring in ONLY this step): • Income Statement: No changes. • Cash Flow Statement: Accounts Payable decreasing by $200 reduces the company's cash flow by $200, so cash at the bottom is down by $200. • Balance Sheet: Cash is down by $200, so the Assets side is down by $200, and AP is down by $200, so the L&E side is also down by $200 and both sides balance. • Intuition: This is a simple cash payment for an owed expense.

Walk me through what happens on the statements when a customer orders a product for $100 but doesn't pay for it in cash, and then what happens when the cash is finally collected.

This scenario corresponds to Accounts Receivable increasing by $100 and then decreasing by $100. First, here's what happens when it increases: • Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100 and Net Income is up by $60 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the increase in AR reduces cash flow by $100, so cash at the bottom is down by $40. • Balance Sheet: Cash is down by $40, but AR is up by $100, so the Assets side is up by $60. On the L&E side, Retained Earnings is up by $60 due to the increased Net Income, so both sides are up by $60 and balance. • Intuition: The company has to pay taxes on revenue it hasn't yet received in cash, so its cash balance falls. And when the AR is collected (factoring in ONLY this step): • Income Statement: No changes. • Cash Flow Statement: AR decreases, which is a change of positive $100 since it means the company has collected the cash now. Cash at the bottom is up by $100. • Balance Sheet: Cash is up by $100, but AR is down by $100, so the Assets side doesn't change. The L&E side also doesn't change, so both sides remain in balance. • Intuition: This is a simple cash collection of a payment owed to the company

Salesforce.com sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens on the statements?

This scenario corresponds to Deferred Revenue - collecting cash, but not being able to recognize it as revenue yet. The payment for the entire year is $1,200. • Income Statement: No changes. • Cash Flow Statement: DR increasing by $1,200 will boost the company's cash flow, so cash at the bottom is up by $1,200. • Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance. • Intuition: This is a simple cash inflow for services the company has not yet delivered.

A company prepays its rent ($20 per month) a month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is incurred.

This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the increase: • Income Statement: No changes. • Cash Flow Statement: The $20 Increase in Prepaid Expense reduces the company's cash flow by $20, so cash at the bottom is down by $20. • Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets side doesn't change. The L&E side also doesn't change, so the Balance Sheet remains balanced. • Intuition: This is a simple cash payment for expenses that have not yet been incurred. And then when Prepaid Expenses decrease (factoring in ONLY this step): • Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $12 assuming a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but the reduction in Prepaid Expenses boosts cash flow by $20, so cash at the bottom is up by $8. • Balance Sheet: Cash is up by $8, and Prepaid Expenses are down by $20, so the Assets side is down by $12. The L&E side is also down by $12 because Retained Earnings has dropped by $12 due to the reduced Net Income, so both sides balance. • Intuition: Cash goes up because this $20 expense is "non-cash" at this point - the company has paid for it in cash in a prior period - so it saves the company on taxes.

How do you know when a revenue or expense line item should appear on the Income Statement?

Two conditions MUST be true for an item to appear on the Income Statement: 1. It must correspond to ONLY the period shown on the Income Statement. This is why monthly rent shows up, but paying for a factory that will last for 10 years does not. 2. It must affect the company's taxes. Interest on debt is tax-deductible, so it shows up, but repayment of debt principal is not, so it does not show up. Whether or not something is received or paid in cash has nothing to do with this classification - companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from non-cash expenses (e.g., depreciation) all the time. Advanced Note: Technically, in point #2 we should say, "It must affect the company's BOOK taxes" (i.e., only the tax number that appears on the Income Statement). Many items that are not deductible for cash-tax purposes still appear on the IS and affect book taxes.

A company uses cash-based accounting (i.e., it only records revenue when it is received in cash and only records expenses when they are paid in cash) rather than accrual accounting. A customer buys a TV from the company "on account" (i.e., without paying upfront in Cash) and receives the TV right away. How would the company record this transaction differently from a company that uses accrual accounting?

Under cash-based accounting, the revenue would not show up until the company collects the cash from the customer - at which point it would add to Revenue on the Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet. Under accrual accounting, the sale would show up as Revenue right away, but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is deposited in the company's bank account, it would move into Cash, and Accounts Receivable would decrease.

Your company owns an old factory that's currently listed at $1,000 on its Balance Sheet. Why would it choose to "write down" this factory's value, and what is the impact on the financial statements?

Value has declined substantially, no longer accurate to reflect original value on the BS IS - Write down is an expense CF - Add write down back as a non-cash expense, results in ^ Cash due to tax savings BS - cash is up, assets value is down and RE balances it out

Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean?

Yes, easily. Think about a company that starts losing massive amounts of money, resulting in a negative Net Income. After many years, negative Net Income could easily turn the company's Equity negative. This might also happen if the company issues a huge dividend to its owners (e.g., following a leveraged buyout) that turns Equity negative. The "meaning" varies based on what has happened, but negative Equity is almost always a negative sign because it means the company has been unprofitable or has done something irresponsible with its dividends or share repurchases. Negative Equity is also common for tech and biotech startups that record massive losses in their early years due to high spending and no revenue.

Your friend is analyzing a company and says that you always have to look at the Cash Flow Statement to find the full amount of Depreciation. Is he right? And if so, what are the implications?

Yes, your friend is correct. This happens because companies often embed Depreciation within other line items, such as COGS and Operating Expenses, on the Income Statement. That's because portions of Depreciation might correspond to different functions in the company. For example, employees in sales & marketing, research & development, and customer support might all be using computers, so Depreciation of computers would show up in each of those categories. This fact has several implications: First off, you CANNOT assume that the Depreciation listed on the Income Statement is the full amount. A company might list a portion of it as an explicit line item but embed other portions elsewhere. Second, adding back the full amount on the CFS shows that Depreciation simply reduces the company's taxes without "costing" it anything in cash. This is why Depreciation boosts the company's cash balance as well: the tax savings.

How can you tell whether or not an item should appear on the Cash Flow Statement?

You list an item on the Cash Flow Statement if: 1) It has already appeared on the Income Statement and affected Net Income, but it's non-cash, and you need to adjust for it to determine the company's real cash flow; OR 2) It has NOT appeared on the Income Statement and it DOES affect the company's cash balance. Access the Rest of the IB Interview Guide 68 of 99 http://breakingintowallstreet.com In category #1 are items such as Depreciation and Amortization; Category #2 includes most of the items in Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends. Changes in Working Capital could fall into either category depending on the change (e.g., an increase in AR is in category #1, but a decrease in AR is in category #2).

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why the company did this - what would you tell him?

You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances. In an acquisition, you write down the seller's Shareholders' Equity and then combine its Assets and Liabilities with those of the acquirer. If you've paid exactly what the seller's Shareholders' Equity is worth - e.g., you paid $1,000 in cash and the seller has $1,000 in Equity, then there are no problems. The combined cash balance will decrease by $1,000, and so will the combined Equity. However, in real life, this almost never happens. Companies almost always pay premiums for companies they acquire, which means that the Balance Sheet will go out of balance. For example, if the seller here had $400 in Equity instead, the BS would go out of balance immediately because we wipe out $400 in Equity but spend $1,000 in cash. To fix that problem, you start by allocating value to the seller's "identifiable intangible assets" such as patents, trademarks, intellectual property, and customer relationships. In this case, we allocated $200 to these items. If there's still a gap remaining after that, you allocate the rest to Goodwill, which explains the $400 in Goodwill here.

Wal-Mart orders $200 of Inventory but pays for it using debt. What happens on the statements immediately after this transaction?

• Income Statement: No changes. • Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but the debt issuance boosts cash flow by $200, so there's no net change in cash. • Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E side is also up by $200 because Debt is up by $200, so both sides balance. • Intuition: This is a simple cash payment for an expense not yet incurred, combined with a debt issuance that offsets the cash outflow.

A company issues $100 in stock to new investors to fund its operations. How do the statements change?

• Income Statement: No changes. • Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from Financing, and there are no other changes, so cash at the bottom goes up by $100. • Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common Stock & APIC on the other side goes up by $100, so the L&E side is up by $100 and the BS balances. • Intuition: This is a simple cash inflow that doesn't impact the company's taxes at all.

A company issues $100 in Preferred Stock to buy $100 in long-term investments in real estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase?

• Income Statement: No changes. • Cash Flow Statement: The purchase of the long-term investments counts as an Investing activity and reduces cash flow by $100, but the Preferred Stock issuance boosts cash flow by $100, so there's no net change in cash. • Balance Sheet: Long-Term Investments is up by $100, so the Assets side is up by $100, and Preferred Stock on the other side is up by $100, so the L&E side is up by $100 and both sides balance. • Intuition: This is a simple cash purchase of investments funded by a Preferred Stock issuance, and neither event affects the company's taxes.

A company buys a factory for $100 using $100 of debt. What happens INITIALLY on the statements?

• Income Statement: No changes. • Cash Flow Statement: There's no net change in cash because the $100 factory purchase counts as CapEx, which reduces cash flow, and the $100 debt issuance is a cash inflow. • Balance Sheet: PP&E is up by $100, so the Assets side is up by $100, and Debt is up by $100, so the L&E side is up by $100, and the Balance Sheet stays balanced. • Intuition: This is a simple debt issuance and PP&E purchase, neither of which affects the company's taxes.

Now what happens after one month has passed, and the company has delivered one month of service? Assume there are no associated COGS or Operating Expenses, and walk through what happens ONLY in this month.

• Income Statement: Revenue is up by $100, so Pre-Tax Income is up by $100 and Net Income is up by $60, assuming a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the decrease in Deferred Revenue reduces cash flow by $100, so cash at the bottom is down by $40. • Balance Sheet: Cash is down by $40, so the Assets side is down by $40. On the L&E side, DR is down by $100, but Retained Earnings is up by $60 because of the increased Net Income, so the L&E side is down by $40 and the Balance Sheet balances. • Intuition: Cash goes down because the company now has to pay taxes on non-cash revenue: it collected the cash in some prior period, and now it has to pay taxes on it.