Accounting and the 3 Financial Statements
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?
A company might want to purchase investments if it has excess cash and cannot think of other ways to use it. For example, the company can't reinvest the cash into hiring more employees, buying more equipment or factories, or acquiring other companies or assets, and it also doesn't want to distribute the cash to investors via dividends or repay its debt. The initial purchase of these investments will show up only on the Cash Flow Statement and will reduce the company's cash flow. Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company's Pre-Tax Income, Net Income, and its Cash balance.
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?
A company might write down an Asset if its value has declined substantially, and it's no longer accurate to reflect it at the original value on the Balance Sheet. For example, maybe the factory is damaged by a hurricane or new technology makes the factory obsolete. On the statements, you record this write-down as an expense on the Income Statement, but you add it back as a non-cash expense on the Cash Flow Statement. The result is that the company's cash balance increases due to the tax savings. On the Balance Sheet, Cash is up, this Asset's value is down, and Retained Earnings will balance the change on the Assets side because Net Income has decreased.
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.
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).
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.
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.?
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 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.
What's the most important financial statement?
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.
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.
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.
How do the 3 statements link together?
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.
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.
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. 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).
What if you could use only 2 statements to assess a company's prospects - which ones would you use, and why?
You would use the Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those (assuming there are "Beginning" and "Ending" Balance Sheets that correspond to the same period shown on the Income Statement). It would be MUCH harder to "construct" an Income Statement from the Balance Sheet and Cash Flow Statement (for example).
What are the 3 financial statements, and why do we need them?
The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement. The Income Statement shows the company's revenue, expenses, and taxes over a period and ends with Net Income, which represents the company's after-tax profits. The Balance Sheet shows the company's Assets - its resources - as well as how it paid for those resources - its Liabilities and Equity - at a specific point in time. Assets must equal Liabilities plus Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and then shows the company's cash from Investing or Financing activities; the last lines show the net change in cash and the company's ending cash balance. You need these statements because there is a big difference between a company's Net Income and the cash it generates - the Income Statement alone doesn't tell what its cash flow is. Remember the key valuation formula: Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate) The 3 financial statements let you estimate the "Cash Flow" part, which helps you value the company more accurately.
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.
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?
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.
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.
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.
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).
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.