IB LevFin Accounting Questions

6. 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.

9. What drives a company's Pension Plan Assets and Pension Benefit Obligations?

- A company's Pension Plan Assets change based on the return the company earns on those assets, how much the company contributes, how much it pays out to employees (Benefit Payments) and "Other Adjustments," which could include dozens of items - The liability component, or the Pension Benefit Obligations, changes based on the Service Cost, the Interest Cost, the Experience, Benefit Payments and "Other Adjustments" - The Employer Contributions and Benefit Payments are the most predictable, recurring items... so you tend to focus on them in forecasts

1. Do you always *need* to project the 3 financial statements for a company?

- No... you could easily project only the company's Free Cash Flow by forecasting its Income Statement and the top part of its Cash Flow Statement: Non-cash adjustments, Changes in Working Capital, and CapEx - Those FCF projections drive a company's implied value and determine its Cash and Debt balances over time... so you don't need a "full" projection of all 3 statements - Full projections help you to forecast certain items in more granular detail and observe the company's full capital structure over time

7. What happens on the statements after a year?

- Although you subtract Preferred Dividends from Net Income to calculate Net Income to Common, the Preferred Dividends are NOT tax-deductible - Income Statement: -- The company will record 10% * $100, or $10, in Interest Income on the real estate, so its Pre-Tax Income increases by $10... at a 40% tax rate, its Net Income goes up by $6... the $8 in Preferred Dividends are NOT tax-deductible, so they simply reduce Net Income by $8, and so "Net Income to Common" is down by $2 - Cash Flow Statement: -- Net Income to Common is down by $2... there are no other changes on the CFS in this period because there's no principal repayment of the Preferred Stock, and nothing changes with the long-term investments... so, cash at the bottom is down by $2 - Balance Sheet: -- Cash is down by $2, so the Assets side is down by $2... on the other side, Retained Earnings is down by $2, so the L&E side is also down by $2 and both sides balance - Intuition: The point of this question is that taxes play a huge role in making investment decisions. Since the investment income on the real estate is taxable, whereas Preferred Dividends are not, the company LOSES money! The after-tax yield of the real estate is only 10% * (1 - 40%), or 6%, which is less than the 8% Preferred coupon

11. Why is the Pension Expense on the Income Statement often added back on the CFS?

- Because the pension expense on the Income Statement is mostly a non-cash expense - On the Cash Flow Statement... most companies add back all, or a significant portion, of this Income Statement expense and then reflect their cash contributions into the pension plan

9. What's the key output from a 3-statement projection model?

- Besides the company's Cash, Debt, and Equity figures... the key output varies based on the analysis -- If you're analyzing a potential equity investment in a company, the key output is the IRR and MoM multiples under different scenarios -- In a credit analysis, the credit stats and ratios (Debt/EBITDA, EBITDA/Interest, etc.) in different cases are most important -- You might also focus on the company's financial metrics and ratios, such as ROA, ROE, and ROIC... especially if you're doing a "quick assessment" of the company

15. What's the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation?

- Both items are recorded when employees exercise options or warrants they previously received... these items arise because companies cannot deduct SBC for Cash-Tax purposes when it is initially granted... only when employees exercise the SBC - The difference is that Tax Benefits from SBC reflects what the company expected to deduct based on the value of the SBC at the time it was issued -- For example, $100 Original Value of SBC * 40% Tax Rate = $40 in Tax Benefits from SBC. It's a non-cash adjustment within Cash Flow from Operations on the CFS, and it flows into APIC on the Balance Sheet - Excess Tax Benefits reflects the additional amount the company can deduct as a result of these options and warrants increasing in value over time -- For example, if the value of the SBC has increased to $300, the Excess Tax Benefits would be ($300 - $100) * 40% Tax Rate = $80

2. What are the trade-offs of LIFO vs. FIFO?

- FIFO better reflects what the company actually paid for the Inventory it is now using in its finished products... while LIFO better reflects the current prices of that Inventory - Under IFRS, only FIFO is allowed... U.S. GAAP allows companies to use either method - Companies that want to optimize their Net Income and EPS often use FIFO because Inventory Costs tend to increase over time, and FIFO lets them record lower figures for COGS - But companies that care more about Cash Flow may prefer LIFO

10. How can you tell if a company is using credible assumptions to calculate its Pension Assets, Liabilities, and Pension Expense on the Income Statement?

- First, check that the company's "expected return" percentages are reasonable -- if the company is investing mostly in fixed income rather than equities, it should not be using a rate of return linked to the stock market's average annual return -- Most companies should use a percentage that's below the average market return to be more conservative - Then, check the discount rate and salary increase rate for the liability component - Finally, check the pension plan's targeted vs. actual allocation

8. How do you factor pensions into a valuation analysis?

- First, note that only defined benefit pension plans need to be treated differently... defined contribution plans have simple operating expenses that don't require special treatment - If the company has a defined benefit pension plan, and the plan is underfunded, then you should add the Unfunded Pension when moving from Equity Value to Enterprise Value - In an Unlevered DCF, it's best to exclude all components of the pension expense in the FCF projections except for the Service Cost... then, subtract the Unfunded Pension at the end when moving from Implied Enterprise Value to Implied Equity Value

24. 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

12. How is a 30% or 80% acquisition different from a 100% one on the financial statements?

- In a 30% acquisition... the buyer does not consolidate its financial statements with those of the seller, it does not create Goodwill or allocate the purchase price, and it records a single Asset on the BS for this minority stake: "Equity Investments" or "Associate Companies" - In an 80% acquisition, the buyer consolidates its financial statements 100% with those of the seller, it creates Goodwill, it allocates the purchase price, and it writes up assets -- It also records a "Noncontrolling Interest" line item on the L&E side of the Balance Sheet to represent the portion of the other company it does not own (20% here)

5. How do you project Working Capital items, such as Accounts Receivable, Inventory, and Accounts Payable?

- Normally, you assume that these are percentages of revenue, COGS, or operating expenses because most of them relate to a company's core business... then, you assume a specific percentage for each one based on historical trends or averages -- Accounts Receivable... % of Revenue. -- Prepaid Expense... % of Operating Expenses. -- Inventory... % of COGS. --Deferred Revenue... % of Revenue. -- Accounts Payable... % of COGS or Operating Expenses. -- Accrued Expenses... % of Operating Expenses - You could also project these metrics using "Days"... for example, Days Sales Outstanding = Accounts Receivable / Annual Revenue * 365 -- this figure represents how long it takes, on average, to collect Receivables from customers

5. 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.

- In this scenario, the "gap" between the purchase price and the other company's Shareholders' Equity is $500. $100 in Other Intangible Assets and $400 in Goodwill will be created... the Intangibles will amortize $20 per year over 5 years - Income Statement: -- Amortization increases by $20, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate - Cash Flow Statement: -- Net Income is down by $12, but you add back the $20 in Amortization as a non-cash expense, so cash at the bottom is up by $8 - Balance Sheet: -- Cash is up by $8, but Other Intangible Assets are down by $20, so the Assets side is down by $12. On the L&E side, Retained Earnings is down by $12 due to the reduced Net Income, so both sides are down by $12 - Intuition: The non-cash Amortization expense increases the company's cash balance by reducing its tax burden

8. Another year passes, and prices in this real estate market double. The company decides to sell its $100 in long-term investments for $200 at the end of Year 2. It then uses the proceeds to repay its Preferred Stock. What happens on the statements from the BEGINNING of Year 2, including the interest/investment income and Preferred Dividends, to the END of Year 2?

- Income Statement: -- Everything from the previous part still applies, so there's still $10 in Investment Income... but now the company also records a Gain of $100 on the sale of the real estate, so Pre-Tax Income is up by $110, and Net Income is up by $66 at a 40% tax rate... there's still $8 in Preferred Dividends, so Net Income to Common is up by $58 - Cash Flow Statement: -- Net Income to Common is up by $58, but the $100 Gain is non-cash, so you subtract it out and then show the Total Proceeds Received, $200, within Cash Flow from Investing... you also have to show the $100 repayment of the Preferred Stock, so cash at the bottom is up by $58 - Balance Sheet: -- Cash is up by $58, but the company's long-term investments have decreased by $100, so the Assets side is down by $42... the L&E side is also down by $42 because Retained Earnings increased by $58 due to the increased Net Income to Common, but Preferred Stock decreased by $100, so both sides balance - Intuition: This question demonstrates why this investment strategy might make sense: capital gains

15. 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

- 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 - 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

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

- Income Statement: -- Operating Expenses are up by $100, so Pre-Tax Income is down by $100 and Net Income is down by $60 at a 40% tax rate. - Cash Flow Statement: -- Net Income is down by $60. There are no other changes, so cash is down by $60 at the bottom - Balance Sheet: -- Cash is down by $60, so the Assets side is down by $60, and Retained Earnings on the L&E side is down by $60 due to the reduced Net Income, so both sides balance - Intuition: Nothing; it's a simple cash expense

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

- Income Statement: -- Pre-Tax Income falls by $10, and Net Income falls by $6 assuming a 40% tax rate - Cash Flow Statement: -- Net Income is down by $6, but you add back the $10 in Depreciation since it's non-cash, so cash flow is up by $4, and cash at the bottom is up by $4 - Balance Sheet: -- Cash is up by $4, but PP&E is down by $10 due to the added Depreciation, so the Assets side is down by $6. The L&E side is also down by $6 because Net Income fell by $6, which reduced Retained Earnings, so both sides balance - Intuition: The company saves on taxes with a non-cash expense

12. 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

5. 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?

- 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

10. What happens after a year passes if the company pays 5% interest on the debt and repays 10% of the principal? Also, explain the EPS impact.

- Income Statement: -- The company records 5% * $1,000, or $50, in interest expense, and so its Pre-Tax Income falls by $50... at a 40% tax rate, its Net Income is down by $30... the company now has 90 shares outstanding rather than 100, and has Net Income of $1,970 instead of $2,000, so its EPS increases to $21.89 ($1970/90 shares) - Cash Flow Statement: -- Net Income is down by $30, and the company also has to repay 10% of the principal, or $100, so cash is down by $130 at the bottom - Balance Sheet: -- Cash is down by $130, so the Assets side is down by $130... on the L&E side, Retained Earnings is down by $30 because of the reduced Net Income, and Debt is down by $100 because of the principal repayment, so the L&E side is down by $130 and both sides balance - Intuition: This question illustrates how companies can artificially inflate their EPS numbers by making nonsensical moves, such as borrowing at high costs to fund share

3. 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?

- Income Statement: -- You record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate - Cash Flow Statement: -- Net Income is down by $12, but you add back the $20 Loss since it's non-cash... you also show the full proceeds received, $80, in Cash Flow from Investing, so cash at the bottom is up by $88 - Balance Sheet: -- Cash is up by $88, but PP&E is down by $100, so the Assets side is down by $12... the L&E side is also down by $12 because Retained Earnings fell by $12 due to the Net Income decrease, so both sides balance - Intuition: 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

4. 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

1. 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

13. 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

6. 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

5. How would Net Income and Cash Flow from Operations change if a company switches from operating leases to capital leases?

- Initially, Net Income would be lower because Depreciation + Interest from capital leases tends to exceed Rent from operating leases... however, Cash Flow from Operations would increase because of the non-cash add-back for Depreciation - In the longer term, it's harder to predict the exact changes because it depends on the lease terms, how quickly the company repays the capital leases (or if it does at all), and how its rental expense under operating leases changes over time

3. What's the difference between capital leases and operating leases?

- It's similar to the difference between owning and renting an apartment - With capital leases (owning), the company records the leased items as Assets and the capital leases as Debt on its Balance Sheet -- The company also records Depreciation and Interest on its Income Statement and principal repayments of the capital leases on its CFS - With operating leases (renting), the company records nothing on its Balance Sheet and records the rent as a simple operating expense on its Income Statement - Operating leases are more common for the short-term leasing of equipment and property, while capital leases are more common for longer-term items since they give the lessee ownership rights

9. Your company wants to boost its EPS artificially, so it decides to issue debt and use the proceeds to buy back shares. Initially, the company has 100 shares outstanding at $100 per share, and a Net Income of $2,000. What happens IMMEDIATELY after your company raises $1,000 in long-term debt and uses it to repurchase $1,000 in stock?

- Its EPS before this move was $2,000 / 100, or $20.00... now, for the first part of this transaction: - Income Statement: No changes - Cash Flow Statement: -- The $1,000 Debt issuance boosts cash flow by $1,000, but the $1,000 stock repurchase reduces it by $1,000, so there's no net change in cash - Balance Sheet: -- There are no changes on the Asset side. On the L&E side, Debt is up by $1,000, but Treasury Stock within Equity is down by $1,000, so there's no net change, and the BS remains in balance

7. Two years later, the employees who received this SBC finally exercise their options, which are now worth $400 rather than $100. The company can now deduct this expense for Cash-Tax purposes. What happens on the financial statements?

- Nothing changes on the Income Statement - On the Cash Flow Statement, the company can now deduct $400 - $100 = $300... so it records this $300 * 40% = $120 as a positive entry under Deferred Taxes -- The company also records $100 * 40% = $40 in Tax Benefits from Stock-Based Compensation, so cash flow is up by $160 at this point -- But then, the company must subtract $300 * 40% = $120 in Excess Tax Benefits from Stock-Based Compensation and add it back in Cash Flow from Financing, re-classifying it there -- Those changes cancel each other out, so Cash is still up by $160 at the bottom - On the Balance Sheet, Cash is up by $160, and the DTA is down by $120... so the Assets side is up by $40 -- On the L&E side, APIC is up by $40 because of the Tax Benefits from SBC, so both sides are up by $40 and balance - Intuition: The company gets extra Cash by deducting the SBC ($400 * 40% = $160)

13. How do Net Operating Losses (NOLs) affect a company's financial statements?

- Nothing changes on the Income Statement when NOLs are accrued or used... you adjust for these items only on the Cash Flow Statement and Balance Sheet -- For example, if a company has Pre-Tax Income of negative $100, it still records its taxes using its Tax Rate * ($100)... so the company shows a Tax Benefit on the IS and it simply pays nothing in Cash Taxes --So, on the Cash Flow Statement, the company records a ($40) entry to reflect the fact that no tax benefit was received (assuming a 40% tax rate) -- The company's DTA increases by $40, and its off-Balance Sheet NOL balance increases by $100 - If the company earns positive Pre-Tax Income in the future, it can use its NOL balance to reduce its Taxable Income -- It still records Pre-Tax Income * Tax Rate for taxes on the IS, but it makes an adjusting entry on the CFS to reflect the lower Cash Taxes -- The off-Balance Sheet NOL balance declines by the NOLs used each year, and the Deferred Tax Asset changes by (NOLs Created - NOLs Used) * Tax Rate

11. A company records a Goodwill Impairment of $100. However, this Goodwill Impairment is NOT deductible for Cash-Tax purposes. Walk me through how the 3 statements change, assuming a 40% tax rate.

- On the Book Income Statement, Pre-Tax Income still falls by $100 due to the Impairment, so Net Income falls by $60 -- On the Tax Income Statement, Pre-Tax Income stays the same, so Net Income stays the same... as a result, Cash Taxes are $40 higher than Book Taxes - On the Cash Flow Statement, Net Income is down by $60, but we add back the $100 Impairment since it is non-cash... then, we also subtract $40 in the Deferred Taxes line item because Cash Taxes are higher than Book Taxes... cash at the bottom does not change - On the Balance Sheet, Cash stays the same, but Goodwill is down by $100 due to the Impairment, so the Assets side is down by $100 -- On the L&E side, the Deferred Tax Liability is down by $40, and Equity is down by $60 due to the reduced Net Income, so both sides are down by $100 and balance - Intuition: The company's Goodwill decreases, but it doesn't save anything on taxes as a result, so its Cash balance stays the same

8. A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in Year 1, $10 in Year 2, and $5 in Year 3. Walk me through what happens on the BOOK financial statements in Year 1, assuming a 40% tax rate

- On the Book Income Statement, you list the Book Depreciation number... so Pre-Tax Income falls by $10, and Net Income falls by $6 - On the Tax Income Statement, Depreciation is $15... so Net Income falls by $9 rather than $6 -- Taxes fall by $2 extra on the Tax Income Statement - On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and the $2 of Deferred Taxes to represent the fact that Cash Taxes were lower than Book Taxes in Year 1... at the bottom, Cash is up by $6 - On the Balance Sheet, Cash is up by $6, but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $4 -- On the other side, the Deferred Tax Liability increases by $2 due to the Book vs. Cash Tax difference... equity is down by $6 due to the lower Net Income, so both sides are down by $4 and balance - Intuition: The company gets a bit of extra Cash - $6 rather than the normal $4 - because it deducts a higher Depreciation for tax purposes in Year 1

10. Finally, let's move to Year 3. What happens?

- On the Book Income Statement, you use the Book Depreciation number... so Pre-Tax Income falls by $10, and Net Income falls by $6 -- On the Tax Income Statement, Depreciation is $5, so Net Income falls by $3 rather than $6... taxes fall by $2 less on the Tax version of the IS - On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and subtract the $2 to represent how Cash Taxes are higher than Book Taxes in Year 1... at the bottom, Cash is up by $2 - On the Balance Sheet, Cash is up by $2, but PP&E is down by $10 due to the Depreciation... so the Assets side is down by $8 -- On the L&E side, the Deferred Tax Liability decreases by $2 due to the Book vs. Cash Tax difference, and Equity is down by $6 due to the reduced Net Income... so both sides are down by $8 and balance - Intuition: The company now earns a bit less in extra Cash ($2 rather than $4) because it records a lower Depreciation deduction for tax purposes

6. A company records Stock-Based Compensation of $100, but this SBC is not deductible for Cash-Tax purposes. What happens on the financial statements, assuming a 40% tax rate?

- On the IS, the company's Pre-Tax Income falls by $100... so its Net Income falls by $60 - On the CFS, the company's Net Income is $60 lower, but it adds back the SBC as a $100 non-cash expense, so cash flow is up by $40 at first... however, the company did not truly reduce its Cash Taxes, so it must record a negative $40 adjusting entry under Deferred Taxes to represent that... its Cash at the bottom stays the same - On the Balance Sheet, Cash on the Assets side stays the same, but the company's DTA increases by $40 because of the negative Deferred Taxes on the CFS... so the Assets side is up by $40 -- On the L&E side, Retained Earnings is $40 higher because Net Income was down by $60, but SBC increased Common Stock & APIC by $100... both sides are up by $40 and balance - Intuition: The company paid nothing and saved nothing in taxes, but it expects to be able to reduce its taxes in the future

3. What would change if Company A owned only 10% of Company B?

- Technically, Company A should record its investment in Company B as a "security" rather than an Equity Investment in this scenario... so the accounting treatment for AFS or Trading Securities might apply - As a result, Company A might record the Dividends Received from Company B, but not its Net Income, on its Income Statement - However, these rules are vaguely defined, and many companies would continue to use Equity Investment accounting as long as they exert "significant influence" over Company B

2. Company A owns 30% of Company B. It has already recorded the Cash it paid to purchase Company B earns $20 in Net Income and issues $10 in Dividends. Walk me through the financial statements when this happens.

- On the Income Statement, Company A adds $20 * 30% = $6 in Net Income Attributable to Equity Investments at the bottom, so Net Income is up by $6 - On the Cash Flow Statement, Net Income is up by $6, but Company A must subtract Net Income Attributable to Equity Investments since it hasn't received these earnings in cash -- However, it does receive Company B's Dividends in Cash, so we make a positive adjusting entry for $10 * 30% = $3, and Cash at the bottom is up by $3 - On the Balance Sheet, Cash is up by $3 on the Assets side, and the Equity Investments line item is up by $6 because of the Net Income Attributable to Equity Investments... but then it decreases by $3 because of the Dividends, so the Assets side is up by $6 -- On the L&E side, Retained Earnings is up by $6 because of the increased Net Income, so both sides balance

1. Company A owns 70% of Company B. The financial statements have already been consolidated 100%, and Company A has created Goodwill and the Noncontrolling Interest. Company A issues Dividends of $200, and Company B generates Net Income of $100 and issues Dividends of $50. Walk me through the financial statements when this happens.

- On the Income Statement, Company A subtracts Net Income Attributable to Noncontrolling Interests of 30% * $100 = $30 at the bottom... so Net Income is down by $30 - On the Cash Flow Statement, Net Income is down by $30, but you add back Net Income Attributable to Noncontrolling Interests since it's non-cash -- Initially, Company A records 100% of both Company A and Company B's Dividends, so it shows a negative $250 on the CFS... but Company A also receives 70% of Company B's Dividends, so it records an add-back for 70% * $50 = $35 to reflect this -- So, Cash at the bottom of the CFS is down by $215 - On the Balance Sheet, Cash is down by $215, so the Assets side is down by $215... on the L&E side, Retained Earnings is down by $200 + $30 = $230 to reflect Company A's Dividends and the reduced Net Income -- The Noncontrolling Interest increases by $30 because of the Net Income Attributable to NCI, but then decreases by $15 because of Company B's Dividends, so the NCI is up by $15 -- The L&E side, therefore, is down by a total of $215, and both sides balance

9. Now let's move to Year 2. What happens?

- On the Income Statement, Pre-Tax Income is down by $10, so Net Income falls by $6 -- The Book and Tax versions of the IS are the same since Depreciation is the same on both - On the Cash Flow Statement, Net Income is down by $6, and you add back the $10 of Depreciation, but there are no changes to Deferred Taxes because Book Taxes = Cash Taxes this year... cash at the bottom increases by $4 - On the Balance Sheet, Cash is up by $4, but PP&E is down by $10, so the Assets side is down by $6... equity is down by $6 due to the reduced Net Income, so both sides are down by $6 and balance - Intuition... this is a standard "What happens when Depreciation increases by $10?" question - the company gets $4 extra Cash because of the tax savings

4. A company with an underfunded, defined benefit pension contributes $1,000 and records a Service Cost of $200 to reflect increases in employee compensation this year. Assume that pension plan contributions are NOT tax-deductible, and that the company pays a 40% tax rate. How do its financial statements change?

- On the Income Statement, the Service Cost of $200 reduces Pre-Tax Income by $200, so Net Income decreases by $120 at a 40% tax rate - On the CFS, Net Income is down by $120, but you add back this Service Cost of $200 since it's non-cash... you also subtract the company's pension contributions of $1,000, so Cash at the bottom is down by $920 - On the BS, Cash is down by $920, but the Pension Plan Assets are up by $1,000 because of the employer contributions, so the Assets side is up by $80 -- On the L&E side, the Pension Liability increases by $200 because of the Service Cost, and Retained Earnings decreases by $120 because of the reduced Net Income -- Both sides increase by $80, and the Balance Sheet balances - Intuition... the $1,000 company contribution costs them a lot of Cash, but they save a bit in taxes because of the Service Cost

5. Walk me through what happens when a company pays $20 in Interest on Debt, with $10 in Cash Interest and $10 in Paid-in-Kind (PIK) Interest. Assume a 40% tax rate

- On the Income Statement, the company records $20 in Total Interest, so Pre-Tax Income declines by $20, and Net Income falls by $12, assuming a 40% tax rate - On the Cash Flow Statement, Net Income is down by $12, but the company adds back the $10 in PIK Interest... so Cash Flow is down by $2, and Cash at the bottom is down by $2 - On the Balance Sheet, Cash is down by $2, so the Assets side is down by $2... on the L&E side, Debt increases by $10 because of the PIK Interest, and Equity falls by $12 due to the reduced Net Income... the L&E side is down by $2, and both sides balance - Intuition: The PIK Interest creates a small amount of tax savings, so Cash doesn't fall by quite as much as it would have with $20 in Cash Interest

12. A company has a Net Operating Loss (NOL) balance of $100. The company finally generates a Pre-Tax Income of positive $200 this year. Walk me through the financial statements, assuming a 40% tax rate.

- On the Income Statement, the company still records Pre-Tax Income of $200, Taxes of $80, and Net Income of $120 - On the Cash Flow Statement, Net Income at the top is up by $120... the company can apply $100 of NOLs to reduce its Taxable Income, so it only pays taxes on $100 of Pre-Tax Income rather than $200... as a result, its Cash Taxes are $40 rather than $80 -- You record this as a positive $40 adjusting entry under Deferred Taxes, so Cash at the bottom is up by a total of $120 + $40 = $160 - On the Balance Sheet, Cash on the Assets side is up by $160, but the Deferred Tax Asset is down by $40... so the Assets side is up by $120 -- The L&E side is also up by $120 because of the $120 increase in Net Income, which flows into Retained Earnings... both sides balance - Intuition: The company's Cash balance increases by more than expected because it uses losses from previous years to reduce its taxes this year

13. You're analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Available-for-Sale (AFS) Securities. The fair market value of these securities increases to $110. Walk me through what happens on the 3 statements.

- Since these are AFS securities, you do not report Unrealized Gains and Losses on the Income Statement... so there are no changes there - There are also no changes to the Cash Flow Statement - On the Balance Sheet, the Short-Term Investments line item increases by $10 on the Assets side... on the L&E side, Accumulated Other Comprehensive Income (AOCI) increases by $10 under Equity, so the Balance Sheet balances

3. 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 & expenses and excludes cash spending such as Capex

4. How can you make a proper comparison when one company uses all capital leases, and another uses all operating leases?

- The easiest method is to use EBITDAR rather than EBITDA to compare the companies... EBITDAR adds the rental expense on the Income Statement to EBITDA so that it completely excludes the effects of all leases - If you use EBITDAR... you also have to capitalize the rental expense for the company using operating leases, and add it to metrics like Enterprise Value and Total Debt for use in valuation multiples and credit stats - And you have to adjust figures like the interest coverage ratio as well... if you use EBITDAR instead of EBITDA, you must use (Interest + Rental Expense) instead of just Interest in the denominator

9. 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 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

10. How do quarterly projections differ from annual projections?

- The projection methodology is the same, but you have to use Year-over-Year (YoY) figures for the growth rates each quarter due to seasonality (e.g., sales might be the highest in Q4 and the lowest in Q1 each year) - You still make most CFS/BS line items percentages of Income Statement items, but you should base them on the Last Twelve Months' (LTM) figures instead -- For example, a company's AR balance at the end of Q2 should be linked to the company's revenue from Q3 of last year into Q2 of this year... the past 4 quarters -- It's misleading if you only link AR to revenue in Q2 of this year because the balance might also include much older receivables

14. 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

More Advanced Conceptual Questions

- These questions are more likely to come up than the ones on 3-statement projection models in the previous section, but they're still not that likely - You're more likely to get these questions if you've had substantial work experience in finance

6. How are Trading, Available-for-Sale (AFS), and Held-to-Maturity (HTM) Securities similar and different from each other?

- These security types are similar because they're all used for relatively small stakes in other companies' Debt and Equity - Also, Realized Gains and Losses and Dividends and Interest Income are treated the same way for all of these... everything appears on the Income Statement and affects the company's taxes - These securities differ based on their purpose, how they're recorded on the Balance Sheet, and how they treat Unrealized Gains and Losses

1. If a company switches from LIFO to FIFO, how will its Net Income and Cash Flow from Operations (CFO) change?

- This is a trick question because you also need to know how Inventory Costs have been changing - If Inventory Costs have been increasing... Net Income will be higher, and CFO will be lower under FIFO -- The company records lower COGS on its Income Statement but also records a greater Inventory Increase on the Cash Flow Statement, which reduces its CFO - If Inventory Costs have been decreasing... Net Income will be lower, and CFO will be higher under FIFO

10. 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

7. 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

11. 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

Advanced Accounting Scenarios on the Financial Statements

- This section contains the most likely interview questions in this guide - You could easily get questions about Equity Investments, Noncontrolling Interests, Deferred Taxes, and different security types

7. Why might you have to adjust the Book Value of Equity for a company with significant AFS Securities?

- Unrealized Gains on AFS Securities can "prop up" a company's Equity and give the impression that a company has more capital available to cover losses than it does -- It could come up for normal companies if you're looking at metrics like the Debt/Equity ratio in a credit analysis - If a company has significant Unrealized Gains or Losses, you might have to adjust its Equity if you believe the company is unlikely to realize these Gains or Losses

14. How do NOLs factor into financial projections and valuations?

- When moving from Equity Value to Enterprise Value, you subtract NOLs since they count as non-core-business Assets - In a 3-statement projection model, you can factor in NOLs by... make adjusting entries on the CFS to show what a company is paying in Cash Taxes over time - In a DCF analysis, it's easiest to ignore NOLs completely in the FCF projections and simply add them at the end when moving from Implied Enterprise Value to Implied Equity Value

14. Assume that these investments are classified as Trading Securities instead. Walk me through the financial statements after their value increases by $10.

- With Trading Securities, you do show Unrealized Gains and Losses on the Income Statement... so, on the Income Statement, Pre-Tax Income increases by $10, and Net Income increases by $6 at a 40% tax rate - On the Cash Flow Statement, Net Income is up by $6, but you subtract the $10 Unrealized Gain because it's non-cash, so Cash at the bottom is down by $4 - On the Balance Sheet, Cash is down by $4, and Short-Term Investments is up by $10, so the Assets side is up by $6... on the L&E side, Equity is up by $6 due to the increased Net Income. Both sides balance

4. 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?

- You can think of this one as operating expenses going up by $20, but the company also having - Income Statement: -- Operating expenses increase by $20, 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 you add back the $120 in SBC as a non-cash expense, so cash at the bottom is up by $108 - Balance Sheet: -- Cash is up by $108, so the Assets side is up by $108. On the L&E side, Retained Earnings is down by $12 because of the reduced Net Income, but Common Stock & APIC is up by $120 because of the SBC, so the L&E side is up by $108 and both sides balance - Intuition: 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)

3. How do you project a company's revenue?

- You could use a simple percentage growth rate assumption, base it on Units Sold * Average Unit Price, or base it on Market Share * Total Market Size - The best method depends on the company's market and how much time and information you have - For example, if the company discloses Units Sold and Average Unit Prices in its filings, you can use them to forecast its revenue - But if the company sells hundreds of products at different prices, but operates in a market with a known size and 3-4 major players, you might use Market Share * Total Market Size

4. How do you project a company's expenses and margins?

- You could use simple percentages for all the expenses and link them to revenue... for example, COGS might be 50% of revenue and SG&A might be 20% of revenue - Or, you could project expenses on a per-employee, per-location, per-unit, or per-factory basis... for example, you might assume that each widget costs $10 and that costs are increasing by 4% per year

8. Why do you link in the Interest Income and Interest Expense on the Income Statement as the LAST part of the process when projecting the financial statements?

- You need the company's Cash and Debt balances to calculate the Interest Income and Interest Expense... so you need the rest of the financial statements first - You might also use supporting schedules, such as a Debt Schedule, and you create those after finishing most of the model - Finally, depending on the model setup, the Interest link may create a circular reference -- Circular references make models more difficult to modify, so you should save this step until the end

23. 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 - 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

6. How can you make sure your Working Capital assumptions are reasonable?

- You should look at the total Change in Working Capital and compare it to the company's Revenue and Change in Revenue -- The Change in Working Capital represents whether a company generates additional Cash or needs extra Cash to fund its growth... so, it should trend with the Change in Revenue -- If the Change in WC as a % of the Change in Revenue has been 5-10% historically, it should stay in that same range going forward - You can also compare the Change in WC to the company's Total Revenue if Change in WC / Change in Revenue does not produce clean, consistent figures

2. What's the main point of projecting a company's financial statements?

- You want to capture the company's cash flow and how that cash flow affects the company's Cash, Debt, and Equity over time -Besides that, the purpose of the projections depends on the model... -- If you're valuing a company, the projections might be very simple and stop with FCF -- If you're evaluating the company's ability to raise and pay off Debt, you might focus on metrics such as Debt/EBITDA and EBITDA/Interest -- If you're looking at a potential equity investment in the company, you might focus on metrics such as the IRR and MoM multiple

Three-Statement Projections

- You're more likely to receive these questions in the context of case studies or modeling tests that you have to present and explain in interviews

21. 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 -- 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.

20. 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 (i.e. hurricane damage), and it's no longer accurate to reflect it at the original value on the Balance Sheet -- 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

14. 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 (time value of $) - 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

15. 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 -- Deferred Revenue is a Liability because it will cost the company cash in the future -- 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.

8. 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 represent funding sources for the company - 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).

6. 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.

11. 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 A/R -- 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

12. 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

5. 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 -- If they are using the Direct Method for creating the CFS, Cash Received or Cash Paid -- 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., their CFS start with Net Income and makes adjustments to determine the cash flow).

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

-- 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 -- A/P 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, A/P will reduce the company's cash, making them a Liability. --A/P and Accrued Expenses work in exactly the same way, but A/P 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).

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

-- The 3 major financial statements are... IS, CFS, BS -- 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)

17. 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

18. 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, 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 -- 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

19. 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

2. 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.

7. 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 book taxes (i.e. IS taxes) (Interest on debt is tax-deductible, so it shows up, but repayment of debt principal is not, so it does not show up)

10. 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 A/R at first. Then, once the cash is deposited in the company's bank account, it would move into Cash, and A/R would decrease

22. 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

13. 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, R&D, 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

9. 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 (i.e. D&A); OR - 2) It has NOT appeared on the Income Statement and it DOES affect the company's cash balance (i.e. Capex or Dividends)

4. 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)

Conceptual Accounting Questions

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2. 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

Interview Questions

Interview questions on these more advanced accounting and 3-statement modeling topics are unlikely unless you've had significant experience in investment banking or private equity

7. How should you project Depreciation and Capital Expenditures?

You could use several approaches... - Simplest... make each one a % of revenue - Alternative... make Depreciation a % of revenue, but link CapEx to an absolute dollar increase or percentage change - Complex... Create a PP&E schedule -- Estimate a CapEx increase each year based on management's plans, and then depreciate the existing PP&E using each asset's useful life... depreciating the new CapEx spending right after it takes place... sum up the total CapEx and total Depreciation each year