Accounting Q&A: Basic Concepts

How are Prepaid Expenses (PE) and Accounts Payable (AP) different?

1. Prepaid Expenses have already been paid out in cash, but haven't yet shown up on the Income Statement, where as Accounts Payable haven't been paid out in cash but have shown up on the IS. 2. Prepaid Expenses is for product/services that have not yet been delivered to the company, whereas Accounts Payable is for products.services that have already been delivered.

Tax-deductible

Able to be deducted from taxable income when calculating income tax due

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

Although Depreciation is a non-cash expense, it is tax-deductible. Therefore, an increase in Depreciation will reduce the amount of taxes you pay, which boosts your cash balance. The opposite happens if Depreciation decreases.

Let's say I have a new, unknown item that belongs on the Balance Sheet. How can I tell whether it should be an Asset or a Liability?

An Asset will result in additional cash or potential cash in the future - think about how Investments or Accounts Receivable will result in direct cash increase, and how Goodwill or PP&E may result in an indirect cash increase in the future. Liabilities will result in less cash or potential cash in the future - think about how Debt or Accounts Payable will result in a direct cash decrease, and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue. Ask what direction cash will move in as a result of this new item and that ells you whether it's an Asset or Liability.

Credit crunch

An economic condition in which investment capital is difficult to obtain. Banks and investors become wary of lending funds to corporations, which drives up the price of debt products for borrowers.

Let's say that you have a non-cash expense (Depreciation or Amortization for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?

Because you want to reflect that you've saved on taxes with the non-cash expense. Let's say you have a non-cash expense of $10 and a tax rate of 40%. Your Net Income decreases by $6 as a result...but then you add back the entire non-cash expense of $10 on the CFS so that your cash goes up by $4. That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you'd be saying. "This non-cash expense has no impact on our taxes or cash balance."

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash. All large companies use accrual accounting because it more accurately reflects the timing of revenue and expenses; small businesses may use cash-based accounting to simplify their financial statements (you no longer need a Cash Flow Statement is everything is cash based).

Where do Changes in Working Capital (more commonly called "Changes in Operating Assets and Liabilities") appear?

Changes in Working Capital appear on the Cash Flow Statement in Cash Flow from Operations and tells you how these operationally-related Balance Sheet items change over time.

How long does it usually take for a company to collect its Accounts Receivable balance?

Generally the Accounts Receivable Days are in the 30-60 day range, though it can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.

Can you give examples of major line items on each of the financial statements?

IS: Revenue; COGS; Selling, general, and adminsitrative (SG&A) expenses; Operating Income (EBIT); Pre-Tax Income: Net Income BS: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity CFS: Cash Flow from Operations (Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities); Cash Flow from Investing (Capital Expenditures, Sale of PP&E, Sale/Purchase of Investments); Cash Flow from Financing (Dividends Issued, Debt Raised/Paid Off, Shares Issued/Repurchased)

How do you decide when to capitalize rather than expense a purchase?

If the purchase corresponds to an Asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years. Purchases like factories, equipment, and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only "last" for the current period and therefore show up on the Income Statement as normal expenses instead. Note that even if you're paying for something like a multi-year lease for a building, you would not capitalize it unless you own the building and pay for the entire building in advance.

You see an "Investments in Equity Interests" (aka Associate Companies) line item on the Assets side of a firm's Balance Sheet. What does this mean?

If you own over 20% but less than 50% of another company, this refers to the portion that you DO own. Example: Another company is worth $100. You own 25% of it. Therefore, there will be an "Investments in Equity Interests" line item of $25 on your Balance Sheet to represent the 25% that you own.

You see a "Noncontrolling Interest" (aka Minority Interest) line item on the Liabilities side of a company's Balance Sheet. What does this mean?

If you own over 50% but less than 100% of another company, this refers to the position you do not own. Example: Another company is worth $100. You own 70% of it. Therefore, there will be a Noncontrolling Interest of $30 on your Balance Sheet to represent the 30% you do not own.

You're reviewing a company's Balance Sheet and you see an "Income Taxes Payable" line item on the Liabilities side. What is this?

Income Taxes Payable refers to normal income taxes that accrue and are often paid out in cash, similar to Accrued Expenses...but for taxes instead. Example: A company pays corporate income taxes in cash once every 3 months. But they also have monthly Income Statements where they record income taxes, even if they haven't been paid out in cash yet. Those taxes increase the Income Taxes Payable account until they are paid out in cash, at which point Income Taxes Payable decreases.

Where does Depreciation usually appear on the Income Statement?

It could be in a separate line item, or it could be embedded in COGS or Operating Expenses, each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

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

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services or products are delivered, the Deferred Revenue balance turns into real revenue on the Income Statement and the Deferred Revenue balance decreases.

Why do companies report GAAP or IFRS earnings, AND non-GAAP/non-IFRS (or "Pro Forma") earnings?

Many companies have non-cash charges such as Amortization of Intangibles, Stock-based Compensation, and Write-Downs on their Income Statements, all of which negatively impact their Net Income. Companies therefore report alternative "Pro Forma" metrics that exclude these expenses and paint a more favorable picture of their earnings, under the argument that these metrics better represent "true cash earnings".

What's the difference between Accounts Payable and Accrued Expenses?

Mechanically, they're the same: they're Liabilities on the Balance Sheet used when you've recorded an Income Statement expense for a product/service you have received, but have not yet paid for in cash. they both affect the statements in the same way as well. The difference is that Accounts Payable is mostly for one-time expenses with invoices, such as paying for a law firm, whereas Accrued Expenses is for recurring expenses without invoices, such as employee wages, rent, and utilities.

How do the 3 statements link together

Net Income from the Income Statement becomes the top line of the Cash Flow Statement. Then, you add back any non-cash charges such as Depreciation & Amortization to this Net Income number. Next, changes to operational Balance Sheet items appear and either reduce or increase cash flow depending on whether they are Assets or Liabilities and whether they go up or down (if Assets go up more than Liabilities go up by, then cash flow goes down). That gets you to Cash Flow from Operations. Now you take into account investing and financing activities and changes to items like PP&E and Debt on the Balance Sheet; those will increase or decrease cash flow, and at the bottom you get the net change in cash. On the Balance Sheet for the end of this period, Cash at the top equals the beginning Cash number (from the start of this period), plus the net change in cash from the Cash Flow Statement. On the other side, Net Income flows into Shareholders' Equity to make the Balance Sheet balance. At the end, Assets must always equal Liabilities plus Equity.

"Short-Term Investments" is a Current Asset - should you count it in Working Capital?

No. If you wanted to be technical you could say it should be included in "Working Capital" as defined, but left out of "Operating Working Capital". The truth is that no one lists Short-Term Investments in this section because Purchases and Sales of Investments are considered investing activities, not operational activities. "Working Capital" is an imprecise idea and we prefer to say "Operating Assets and Liabilities" because that's a more accurate way to describe the concept of operationally-related Balance Sheet items - which may sometimes be Long-Term Assets or Long-Term Liabilities (i.e. Deferred Revenue).

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

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 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, but they wait weeks or months to pay suppliers - this is a sign of business efficiency and means that they always have healthy cash flow. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (example when the company owes a lot of money to suppliers and cannot pay with cash on-hand).

What is Operating Working Capital?

Operating Working Capital is used more commonly in finance, and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt) The point of Operating Working Capital is to exclude items that relate to a company's financing and investment activities - Cash, Investments, and Debt - from the calculation

Wait a minute...Deferred Revenue reflects cash that we've already collected upfront for a product/service we haven't delivered yet. Why is it a Liability? that's great for us!

Remember the definitions of Assets and Liabilities: an Asset results in more future cash, and a Liability results in less future cash. Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question, but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue. It's counterintuitive, but that is why Deferred Revenue is a liability: it implies additional future expenses.

Walk me through the 3 financial statements

The Income Statement shows the company's revenue and expenses over a period of time, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory, and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity - at a specific point in time. Assets must equal Liabilities plus Shareholders' Equity. the Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and changes in operating assets and liabilities (working capital), and then shows how the company has spent cash or received cash from Investing or Financing activities; at the end, you see the company's net change in cash.

Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don't interest payments also show up there? They're a financing activity!

The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement. Since they are a true cash expense and already appear on the IS, showing them on the CFS would be double-counting them and would be incorrect. Debt repayments are a true cash expense but they do not appear on the IS, so we need to adjust for them on the CFS. IF something is a true cash expense and it has already appeared on the IS, it will never appear on the CFS unless we are re-classifying it - because you have already factored in its cash impact.

Why is the Income Statement not affected by Inventory purchases?

The expense of purchasing Inventory is only recorded on the Income Statement when the goods associated with it have been manufactured and sold - so if its just sitting in a warehouse, it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.

What's the difference between Accounts Receivable and Deferred Revenue?

There are 2 main differences: 1. Accounts Receivable has not yet been collected in cash from customers, whereas Deferred Revenue has been. 2. Accounts Receivable is for a product/service the company has already delivered but hasn't been paid for yet, whereas Deferred Revenue is for a product/service the company has not yet delivered. Accounts Receivable is an Asset because it implies additional future cash whereas Deferred Revenue is a Liability because it implies the opposite.

A company has had a positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

There are several possibilities: 1. The company is spending too much on Capital Expenditures - these are not reflected in EBITDA but represent true cash expenses, so CapEx alone could not make the company cash flow negative. 2.The company has high Interest Expense and is no longer able to afford its Debt. 3. The company's Debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash when paying back the Debt 4. It has significant one-time charges (from litigation, for example) that have been excluded from EBITDA and those are high enough to bankrupt the company.

How can you tell whether or not an expense should appear on the Income Statement

Two conditions MUST be true for an expense to appear on the IS: 1. It must correspond to something in the current period 2. It must be tax-deductible Employee compensation and marketing spending, for example, satisfy both conditions. Depreciation and Interest Expense also meet both conditions - Depreciation only represents the "lose in value" of PP&E (or to be more technically precise, the allocation of the investment in PP&E) in the current period you're in.

When would a company collect cash from a customer and not record it as revenue?

Typically this happens when the customer pays upfront, in cash, for months or years of a product/service, but the company hasn't delivered it yet. Cases where you see this: 1. Web-based subscription software 2. Cell phone carriers that sell annual contracts 3. Magazine publishers that sell subscriptions You only record revenue when you actually deliver the products/services - so the company does not record cash collected as revenue right away.

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based v. accrual accounting?

Under cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - 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, it 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 actually deposited in the company's bank account, it would move into the Cash line item and Accounts Receivable would go down.

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Usually this happens when a company buys another one and the acquirer reassesses what it really got out of the deal - customer relationships, brand name, and intellectual property - and finds that those "Assets" are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and it can result in extremely negative Net Income on the Income Statement. It can also happen when a company discontinues part of its operations and must impair the associated Goodwill.

What is Working Capital? How is it used?

Working Capital = Current Assets - Current Liabilities If it's positive, it means a company can pay off its short-term Liabilities with its short-term Assets. It is often presented as a financial metric and its magnitude and sign (positive or negative) tells whether or not the company is "sound".

Could you ever have negative Shareholders' Equity? What does it mean?

Yes. It is common in 2 scenarios: 1. Leveraged Buyouts with dividend recapitalizations - it 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. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders' Equity. It doesn't "mean" anything in particular, but it might demonstrate that the company is struggling (in the 2nd scenario).

Let's say I could only look at 2 statements to assess a company's prospects -- which 2 would I use and why?

You would pick the Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those (assuming that you have the "Beginning" and "Ending" Balance Sheets that correspond to the same period the Income Statement is tracking).

If I were stranded on a desert island and only had one financial statement and I wanted to review the overall health of a company, which statement would I use and why?

You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating - the Income Statement is misleading because it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures. That's the #1 thing you care about when analyzing the financial health of any business - its true cash flow.