Accounting and the 3 Financial Statements Flashcards

1
Q

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

A

I/S, B/S and CF/S.

  • I/S: Shows the company’s revenue, expenses and taxes over a period and ends with net income, representing after-tax profits.
  • B/S: shows assets (resources) and how it paid for them (liabilities + equity) at a specific point in time. A = L + E.
  • CF/S: Begins with Net Income, adjusts for non-cash items and changes in working capital, then shows company’s CFI & CFF; the final lines show net change in cash and ending cash balance.

Need these b/c there’s a difference between NI & cash flow.

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2
Q

How do the 3 statements link together?

A
  1. NI from I/S = top line of CF/S.
    2, Adjust for non-cash items (D&A ) and operating working capital (A/R, A/P, inventory, accrued expenses) to get CFO.
  2. Account for investing and financing activities, sum with CFO to get net change in cash.
  3. Cash at end of CF/S links to cash on B/S. Add NI to R/E.
  4. Link CF/S adjustments to appropriate A&L on B/S (i.e., increase in A/P).
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3
Q

What’s the most important F/S?

A

CF/S - tells you how much cash company generates. I/S includes non-cash items like D&A and excludes cash spending such as capex.

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4
Q

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

A

I/S + B/S. Combined, you can recreate the CF/S. Reverse would be much harder.

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5
Q

How might the F/S of a company in the U.K. or Germany differ from a U.S.-based one?

A

I/S and B/S will be similar, but companies using IFRS often begin the CF/S with something other than NI. May also have naming differences (i.e., P&L).

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6
Q

What should you do if a company’s CF/S starts with something other than NI, suhc as EBIT or cash received?

A

-Modeling: convert into one beginning with NI.

See if there is a reconciliation.

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7
Q

How do you know when a revenue or expense line item should appear on the I/S?

A

Two conditions to appear on I/S:

  1. Corresponds only to period shown on I/S;
  2. Must affect company’s taxes.
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8
Q

How can you tell whether an item should be classified as an Asset, Liability or Equity on the B/S

A

Assets generate future cash flow or can be sold for cash.

Liabilities cost the company cash in the future and can’t be sold b/c represents PMTs the co. owes.

Equity represents funding sources for the company - they don’t result in future cash flows.

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9
Q

How can you tell whether or not an item should appear on the CF/S?

A

List if:

  1. Already appeared on I/S and affected NI, but it’s non-cash (D&A); or
  2. Didn’t appear on I/S and affects cash (capex).
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10
Q

A company uses cash accounting rather than accrual accounting. If a customer buys a TV on account and receives it immediately, how would the company record that transaction differently than under accrual?

A
  • Cash: revenue wouldn’t show up until cash were received. Then, add to revenue, etc. on I/S and B/S cash.
  • Accrual: record revenue and A/R. Once cash deposited, decrease A/R and increase cash.
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11
Q

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.

A

This year, company’s cash flow will decrease b/c some customers won’t be paying upfront: $1K now becomes $83/month (A/R instead of cash).

Long-term, depends on resulting sales growth. If high, then increases to EBIT and NI may offset and make the company better off.

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12
Q

How would depreciation going up by $10 affect the 3 F/S?

A

I/S - assuming 40% tax rate, EBIT would fall $10 and NI $6.

CF/S - NI down $6, but $10 gets added back, so CFO is up $4. Net change in cash up $4.

B/S - net PP&A is down $10 and cash is up $4.

In sum, assets and equity are both down $6.

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13
Q

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

A

It is tax-deductible, so depreciation reduces tax expense, a cash item.

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14
Q

Where does depreciation usually show up on the I/S?

A

Depends: could be a separate line item or embedded in COGS or SG&A. Doesn’t change the result.

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15
Q

What happens if accrued compensation goes up by $10?

A

Assuming it’s being recognized as an expense:

I/S - salaries expense increases $10, so EBIT falls $10. At 40% tax rate, NI falls $6.

CF/S - NI is down $6, but change to accrued comp. increases by $10, so CFO is up $4. No other changes, so change in cash is $4.

B/S - Cash is up $4, liabilities are up $10 and equity is down $6.

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16
Q

What happens when inventory goes up by $10, assuming you pay for it with cash?

A

I/S - no changes.

CF/S - change in inventory is $10, so CFO is down $10. Change in cash = ($10).

B/S - Assets net out zero.

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17
Q

Why is the I/S unaffected by changes in inventory?

A

COGS expense is only recorded upon sale.

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18
Q

Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of Year 1, before anything else happens?

A

I/S - no changes.

CF/S - capex = ($100). CF from debt proceeds = 100. Net change in cash = $0.

B/S - increase PP&E by $100, debt (liability) by $100.

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19
Q

(Apple new factory example) At the start of Year 2, assuming the debt is high-yield so no debt is repaid, the coupon is 10% and the factories depreciate at 10%/yr, what happens?

A

I/S - Interest expense = $10, depreciation = $10. EBIT = ($20), NI = ($12).

CF/S - NI is down $12, add back $10 of D&A so CFO = ($2).

B/S - Cash is down $2, PP&E is down $10 so assets down $12. Balanced by equity being down $12.

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20
Q

(Apple new factory example) At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be repaid. What happens?

A

I/S - Factories have depreciated down to $80, so take an $80 expense (hits EBIT). At 40%, NI falls $48.

CF/S - NI = ($48) but write-off is non-cash, so +$80 = $32. CFF = ($100) from loan repayment. Change in cash = ($68).

B/S - Assets are down $68 from cash and $80 from write-off, totaling ($148). Liabilities are down $100 from debt and $48 from equity, so balanced.

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21
Q

Assume Apple orders $10 of iPod inventory, using cash. They order it, but don’t make/sell anything - what happens?

A

I/S - nothing.

CF/S - Change in inventory = ($10) = net change.

B/S - cash = ($10), inventory = $10, so offset.

22
Q

Assume Apple sells iPods (bought for $10 in cash) for $20. What happens?

A

I/S - sales = $20, COGS = ($10), EBIT = $10, NI = $6

CF/S - NI = $6, change in inventory = ($10), change in cash = $16.

B/S - Cash is up $16 and inventory is down $10, so total up $6. Equity is up $6 from NI.

23
Q

Could you ever end up with negative S/E? What does it mean?

A

Yes, in two common scenarios:

  1. LBOs with dividend recaps - owner has taken out a large chunk of its equity, which can make it negative;
  2. Company has been losing money - perpetually decreasing R/E could eventually turn S/E negative.
24
Q

What’s working capital? How is it used?

A

WC = Current Assets - Current Liabilities.

If positive, company can pay off short-term liabilities with short-term assets. Presented as a financial metric - sign indicates whether company is sound.

Bankers use operating working capital = non-cash WC.

25
Q

What does negative working capital mean? Is it a bad sign?

A

It depends:

  1. Companies with subscriptions / longer-term contracts will have high deferred revenue;
  2. Retail and restaurants often get upfront payments from customers - use cash to pay off A/P instead of accum. cash. Sign of business efficiency.
  3. Could point to financial trouble / insolvency - customers don’t pay quickly/upfront and company has high debt load.
26
Q

What happens if a bank has a $100 write-down?

A

I/S - expense reduces EBIT by $100, NI = ($60).

CF/S - ($60) NI + $100 non-cash = $40 change in cash.

B/S - cash up $40, asset written-down is down $100, so down $60. Offset by ($60 NI = change to R/E.

27
Q

Walk me through a $100 bailout of a company.

A

Assuming this is an equity injection:

I/S - nothing.

CF/S - CFF increases $100 = net change in cash.

B/S - cash is up $100, offset by $100 to S/E.

28
Q

Walk me through a $100 write-down of debt.

A

I/S - record a $100 gain, EBIT = $100, NI = $60.

CF/S - NI = $60 = CFO. CFF = ($100), so net change in cash = ($40).

B/S = Assets = ($40), liabilities = ($100), S/E = $60 so balanced at ($40.

29
Q

When would a company collect cash from a customer and not record it as revenue? In these situations, what do you record?

A

Record a deferred revenue liability:

  1. Web-based subscription software
  2. Cell phone carries with annual contracts
  3. Magazine subscriptions
30
Q

What’s the difference between A/R and D/R?

A

A/R - monies customer owe you.

D/R - services you owe customers.

31
Q

How long does it usually take for a company to collect its A/R balance?

A

Depends on the business and industry, but 40-50 days is common.

32
Q

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

A

Cash - recognizes revenue/expenses when cash is received or paid.

Accrual - recognizes revenue when collection is reasonably certain. More common because of prevalence of credit cards, etc.

33
Q

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

A

Capitalize - if asset’s useful life > 1y, put on B/S and depreciation.

Expense - if asset’s useful life < 1y, expense that year.

34
Q

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

A

Possibilities include:

  1. Excessive capex - cash burn not reflected in EBITDA.
  2. High interest expenses - can’t afford its debt.
  3. Credit crunch - debt matures and it can’t refi.
  4. Non-recurring items - large litigation or other expenses break the bank
35
Q

Normally Goodwill remains constant on the B/S - why would it be impaired and what would that mean?

A

ACQUISITIONS - If a company has been acquired, the buyer re-asses its intangibles and finds they are worth less than contemplated, then impairment. Common in acq. where the buyer overpaid.

DISCONTINUED OPERATIONS - must impair assoc. goodwill.

36
Q

Under what circumstances will Goodwill increase?

A

Two scenarios:

  1. Company gets bought - Goodwill changes when company gets bought, since plug.
  2. Company acq. another company - premium over net identifiable assets.
37
Q

How is GAAP accounting different from tax accounting?

A
  1. GAAP is accrual-based but tax is cash-based;
  2. GAAP uses straight-line depreciation; tax is different (i.e., accelerated);
  3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax is only concerned with revenue/expenses in the current period and what income tax you owe.
38
Q

What are DTAs / DTLs and how do they arise?

A

They arise because of TEMPORARY DIFFERENCES between what a company can deduct for CASH TAX PURPOSES vs. what what they can deduct for BOOK TAX PURPOSES.

  • DTLs: arise when tax expense on I/S hasn’t been paid in cash
  • DTAs: arise when you’ve paid cash taxes but not expensed on I/S.

Common with asset write-ups and write-downs in M&A deals. Will create DTL and DTA, respectively.

39
Q

Walk me through how you create a revenue model for a company.

A

Two methods:

  1. Bottoms-Up - start w/ individual products/customers, est. avg. sale value or customer value and then the growth rate in sales and sale values to tie together.
  2. Tops-Down - Start w/ big picture metrics (i.e., market size) then estimate company’s market share and how that will change in coming years, multiply to get revenue.

BOTTOMS UP IS MORE COMMON.

40
Q

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

A

Start with each different dept. of a copmany, # of employees in each, avg. salary/bonus/benefits and then make assumptions going forward.

Assume headcount is tied to revenue, then assume growth rates for salary, etc.

COGS should be tied directly to revenue and each unit produced should incur an expense.

Other stuff (i.e., rent, capex, etc.) should either (i) be linked to company’s internal plans or (ii) be linked to revenue.

41
Q

If we’re trying to create revenue / expense models but don’t have enough info, what do we do?

A

Use estimates:

  1. REVENUES - assume a simple growth rate
  2. EXPENSES - assume SG&A, etc. are % of sales.
42
Q

Walk me through the major items in S/E.

A
  • Common Stock
  • R/E
  • APIC
  • Treasury Stock
  • AOCI: catch-all
43
Q

Walk me through what flows into R/E.

A

R/E = BB + NI - Dividends.

44
Q

Walk me through what flows into APIC.

A

APIC = BB + Stock-Based Compensation + Value of Stock Created by Option Exercises.

45
Q

What’s the Statement of S/E and why do we use it?

A

Shows the major items comprising S/E and how we calculate using numbers elsewhere. Not always used, but helpful in cases of strange stock-based comp. and option grants.

46
Q

What are examples of non-recurring charges we need to add back to EBIT / EBITDA?

A
  • Restructuring Charges
  • Goodwill Impairment
  • Asset Write-Downs
  • Bad Debt Expense
  • Legal Expenses
  • Disaster Expenses
  • Change in Accounting Procedures
47
Q

How do you project B/S items like A/R and Accrued Expenses in a 3-statement model?

A

Make simplistic assumptions:

  • A/R = % of sales
  • D/R = % of sales
  • A/P = % of COGS
  • Accrued Expenses = % of OpEx / % of SG&A
48
Q

How should you project Depreciation and Capex?

A

Simple way - project each as % of sales or prior PP&E

Complex way - create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation and then assumes capex based on historical investments.

49
Q

How do NOLs affect a company’s 3 statements?

A

Option 1 - reduce taxable income by portion of NOL that you can apply each year, apply the same tax rate and subtract that new tax number from old pretax income.

Option 2 - Create a book vs cash tax schedule where you calculate Taxable Income based on NOLs, then look at what you’d pay in taxes w/o NOLs. Book difference as an increase to DTL.

50
Q

What’s the difference between capital leases and operating leases?

A

Operating leases - used for short-term leasing of equipment and property, no ownership. OPERATING EXPENSES (now debt-like).

Capital leases - used for longer-term items and transfer ownership rights; depreciate and incur interest payments (debt).

Cap lease conditions:

  1. Transfer of ownership at end of term;
  2. Option to purchase asset at bargain price at end;
  3. Lease term >75% of useful life; or
  4. PV(lease payments) > 90% of asset’s FMV.
51
Q

Why would D&A on I/S be different from CF/S?

A

Some or part of D&A may be in COGS, SG&A or separate item.