BIWS 400 - Basic Accounting

Walk me through the 3 financial statements.
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Walk me through the 3 financial statements.
The three financial statements are the income statement, balance sheet, and statement of cash flows.

The income statement gives the company's revenue and expenses, and goes down to net income, the final line item 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 shareholder's equity. Assets must be equal to liabilities and shareholder's equity.

The cash flow statement begins with net income, adjust for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash.
Can you give me examples of major line items on each financial statement?
For the income statement, there is Revenue, COGS, SG&A, Operating Income (EBIT), Pre-tax income (EBT), and Net Income.

For the Balance Sheet, there is Cash, AR, Inventory, PP&E, AP, Accruals, Debt, and Shareholder's equity.

For the Statement of Cash Flows, there is NI, D&A, Stock-Based Compensation, changes in Operating Assets & Liabilities, CFO, CapEX, CFI, Sale/Purchase of Securities; Dividends Issued, and CFF
How do the 3 statements link together?
To tie the statements together, NI from the IS flows into Shareholder's Equity on the BS, and into the top line of the CFS.

Changes to BS items appear as working capital changes on the CFS, and investing and financing activities affect the BS items such as PP&E, Debt, and Shareholders' Equity. The Cash and Shareholders' Equity items on the BS act as "plugs," with Cash flowing in from the final line on the CFS.
If I were stranded on a desert island, only had one statement and I wanted to review the overall health of a company - which statement would I use and why?
You would use the CFS because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. That's the #1 thing you care about when analyzing the overall financial health of any business -- its cash flow.
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 IS and BS, because you can create the CFS from both of those (assuming, of course that you have "before" and "after" versions of the BS that correspond to the same period the IS is tracking).
Walk me through how Depreciation going up by $10 would affect the statements.
For the IS, Operating Income would decline by $10 and assuming a 40% tax rate, NI would fall by $6.

For the CFS, the NI line on the top would fall by $6, but the $10 Depreciation would be added back because it is a non-cash expense. Since there are no other changes to the CFS, the overall Net Change in Cash would rise by $4.

For the BS, PP&E would fall by $10 on the Asset side, but cash is up by $4. Therefore, the decrease in $6 on the Asset side would balance with the decrease in $6 on the debt and equity side because of the decrease in NI.
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. Since taxes ARE a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.
Where does Depreciation usually show up on the IS?
It could be in a separate line item, or it could be embedded in COGS or Operating Expenses -- every company does it differently. Regardless of where it is recorded, Depreciation will always reduce Pre-Tax income.
What happens when Accrued Compensation increases by $10?
*Confirm that the accrued compensation is now being recognized as an expense rather than just changing non-accrued to accrued compensation*

Operating Expenses on the IS will go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (*assuming a %40 tax rate).

On the CFS, NI is down $6, and Accrued Compensation will INCREASE Cash Flow by $10, so overall CFO is up by $4 and the Net Change in Cash results in a $4 increase.

On the BS, Cash is up by $4 as a result, so Assets are up by $4. On the Debt and Equity side, since Accrued Compensation is a liability, Liabilities will be up by $10, but Retained Earnings will be down by $6 due to the decrease in NI, so both sides will balance.
What happens when Inventory goes up by $10, assuming you pay for it with cash?
There will be no changes to the IS because no revenue has been recognized.

On the CFS, since Inventory is an asset, your CFO will decrease by $10. There are no other changes in CFI or CFF so the Net Change in Cash will fall by $10.

On the BS under assets, Inventory will rise $10 but Cash will fall by $10 end everything to remain in balance.
Why is the IS not affected by changes in Inventory?**common interview mistake -- incorrectly stating that Working Capital changes show up on the IS** In the case of Inventory, the expense is only recorded when the goods associated with it are sold, so if it's just sitting in a warehouse, it does not count as a COGS or Operating Expense until the company manufactures it into a product and sells it.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?At the start of "Year 1," before anything else has happened, there would be no changes on Apple's IS (yet). On the CFS, the additional investment in factories would show up under CFI as a net reduction in Cash Flow ( so Cash Flow is down buy $100 so far). And the additional $100 worth of debt raised would shoe up as an addition to Cash Flow, canceling out the investment activity. So the cash balance stays the same. On the BS, there is now an additional $100 worth of factories in the PP&E line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?After a year has passed, Apple must pay interest expense and must record the depreciation. Operating Income would decrease by $10 due to the $10 depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, NI would fall by $12. On the CFS, NI at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that CFO is down by $2. That's the only change on the CFS, so Ending Cash Balance will fall by $2. On the BS, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since NI was down by $12, Shareholders' Equity is also down by $12 and both sides balance. **Remember, the debt number under Liabilities does not change since we've assumed none of the debt is actually paid back**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 paid back now. Walk me through the 3 statements.After 2 years, the value of the factories is now $80 if we go with the 10% depreciation assumption. It is this $80 that we will write down in the 3 statements. First, on the IS, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, NI declines by $48. On the CFS, NI is down by $48 but the write-down is a non-cash expense, so we add it back -- and therefore CFO INCREASES by $32. There are no changes under CFI, but under CFF there is a $100 charge for the loan payback -- so CFI falls by $100. Overall, the Net Change in Cash falls by $68. On the BS, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since NI was down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilities & Shareholders' Equity are down by $148 and both sides balance.Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?Since no revenue is being recognized, there will be no change to the IS. For the CFS, inventory is up by $10, so CFO DECREASES by $10. There are no further changes, so the Ending Cash Balance will fall by $10. On the BS, Inventory is up by $10 ad Cash is down by $10. Therefore, Total Assets will remain the same and both sides will remain in balance.Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.For the IS, Revenue is up by $20 and COGS is up by $10, so Gross Profit and Operating Profit will increase by $10. At a 40% tax rate, NI is up by $6. For the CFS, NI on the top has increased by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPods), which is a net ADDITION to cash flow -- so CFO is up by $16 overall These are the only changes to the CFS, so Ending Cash Balance increases $16. On the BS, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the Debt and Equity side, NI was up by $6 so Shareholders' Equity is up by $6 and both sides balance.Could you ever have negative Shareholders' Equity? What does it mean?Yes, It is common to see this in 2 scenarios: 1. LBOs 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 numbers negative. 2. It can also happen if the company has been losing money consistently and therefore has a declining RE balance, which is a portion of Shareholder's Equity.What is Working Capital? How is it used?Working Capital = CA - CL If it is 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 (negative or positive) tells you whether or not the company is "sound." Bankers look at Operating Working Capital more commonly in models, and that is defined as (CA-Cash and Cash Equivalents) - (CL-Debt).What does negative 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 things it can 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 -- so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don't pay quickly and upfront and the company is carrying a high debt balance).Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write-down of $100.First, on the IS, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. On the CFS, NI is down by $60 but the write-down is a non-cash expense, so we add it back -- and therefore CFO increases by $40. Overall, the Net Change in Cash rises by $40. On the BS, Cash is now up by $40 and an asset is down by $100 (it's not clear which asset since the question never stated the specific asset to write-down). Overall, the Asset side is down by $60. On the other side, since NI was down by $60, Shareholder's Equity is also down by $60 -- and both sides balance.Walk me through a $100 "bailout" of a company and how it affects the 3 statements.**First, confirm what type of "bailout" this is Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: No changes to the IS. On the CFS, CFF goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. On the BS, Cash is up by $100; on the other side, Shareholders' Equity would go up by $100 to make it balance.Walk me through a $100 write-down of bad debt -- as in OWNED debt, a liability -- on a company's BS and how it affects the 3 statements.This is counter-intuitive. When a liability is written down you record it as a GAIN on the IS (with an asset write-down, it's a LOSS) -- so Pre-Tax income goes UP by $100 due to this write-down. Assuming a %40 tax rate, NI is up by $60. On the CFS, NI is up by $60, but we need to SUBTRACT that debt write-down -- so CFO is down by $40 and Net Change in Cash is down by $40. On the BS, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the NI was up by $60 -- so Liabilities & Shareholders' Equity is down by $40 and it balances.When would a company collect cash from a customer and NOT record it as revenue?Three examples could be: 1. Web-based subscription software 2. Cell phone carriers that sell annual contracts 3. Magazine publishers that sell subscriptions Companies that agree to service in the future often collect cash upfront to ensure stable revenue -- this makes investors happy as well since they can better predict a company's performance. Per the rules of GAAP, you only record revenue when you actually perform the services -- so the company would not record everything as revenue right away.If cash collected is not recorded as revenue, what happens to it?Usually, it goes in the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance "turns into" real revenue on the IS.What's the difference between accounts receivable and deferred revenue?Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue re[resents how much it is waiting to record as revenue.How long does it usually take for a company to collect its accounts receivable balance?Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high end items and it might be lower for smaller, lower transaction-value companies.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 a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?IN cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits funds in its bank account -- at which point it would show up as both Revenue on the IS and Cash on the BS. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the BS, it would go into AR at first. Then, once the cash is actually deposited in the company's bank account, it would "turn into" Cash.How do you decide when to capitalize rather than expense a purchase?If the asset has a useful life of 1 year, it is capitalized (put on the BS rather than shown as an expense on the IS). 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 BS. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the IS as normal expenses instead.Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their IS's. As a result, some argue that IS's under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because the expenses are excluded.A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?Several impossibilities include: 1. The company is spending too much on CapEx -- these are not reflected at all in EBITDA, but it could still be 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 completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company/ **Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest, and one-time charges -- and all of these could end up bankrupting the company.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 has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the IS. (see eBay/Skype). It can also happen when a company discontinues part of its operations and must impair the associated goodwill.Under what circumstances would Goodwill increase?Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is RARE. What usually happens is 1 of 2 scenarios: 1. The company gets acquired of bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price of an acquisition. 2. The company acquires another company and pays more than what its assets are worth -- this is then reflected in the Goodwill number.