Wall Street Prep Accounting Questions And Answers

What are the 3 financial statements, and why do we need them? - ANS The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement. The Income Statement shows the company's revenue, expenses, and taxes over a period and ends with Net Income, which represents the company's after-tax profits. The Balance Sheet shows the company's Assets - its resources - as well as how it paid for those resources - its Liabilities and Equity - at a specific point in time. Assets must equal Liabilities plus Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and then shows the company's cash from Investing or Financing activities; the last lines show the net change in cash and the company's ending cash balance. You need these statements because there is a big difference between a company's Net Income and the cash it generates - the Income Statement alone doesn't tell what its cash flow is. Remember the key valuation formula: Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate) The 3 financial statements let you estimate the "Cash Flow" part, which helps you value the company more accurately. How do the 3 statements link together? - ANS 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 What's the most important financial statement? - ANS The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating. The Income Statement is misleading because it includes non-cash revenue and expenses and excludes cash spending such as Capital Expenditures. What if you could use only 2 statements to assess a company's prospects - which ones would you use, and why? - ANS You would use the Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those (assuming there are "Beginning" and "Ending" Balance Sheets that correspond to the same period shown on the Income Statement) It would be MUCH harder to "construct" an Income Statement from the Balance Sheet and Cash Flow Statement (for example). 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.? - ANS Income Statements and Balance Sheets tend to be similar across different regions, but companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income, or if they are using the Direct Method for creating the CFS, Cash Received or Cash Paid. There are also minor naming differences; for example, the Income Statement might be called the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the Balance Sheet might be called the "Statement of Financial Position." Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct Method for creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start with Net Income and make adjustments to determine the cash flow). 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? - ANS For modeling and valuation purposes, you should convert this Cash Flow Statement into one that starts with Net Income and makes the standard adjustments. Large companies should provide a reconciliation that shows you how to move from Net Income or Operating Income to Cash Flow from Operations and that lists the changes in Working Capital and other non-cash adjustments. If the company does NOT provide that reconciliation, you might have to stick with the CFS in the original format. How do you know when a revenue or expense line item should appear on the Income Statement? - ANS Two conditions MUST be true for an item to appear on the Income Statement: It must correspond to ONLY the period shown on the Income Statement. This is why monthly rent shows up, but paying for a factory that will last for 10 years does not. 2. It must affect the company's taxes. Interest on debt is tax-deductible, so it shows up, but repayment of debt principal is not, so it does not show up. Whether or not something is received or paid in cash has nothing to do with this classification - companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from non-cash expenses (e.g., depreciation) all the time. Advanced Note: Technically, in point #2 we should say, "It must affect the company's BOOK taxes" (i.e., only the tax number that appears on the Income Statement). Many items that are not deductible for cash-tax purposes still appear on the IS and affect book taxes. How can you tell whether an item should be classified as an Asset, Liability, or Equity on the Balance Sheet? - ANS An Asset will generate future cash flow for the company or can be sold for cash. Think about how AR means the company should receive more cash in the future. A Liability will cost the company cash in the future and cannot be sold because it represents payments the company owes. Think about Debt or Accounts Payable and how they represent owed payments. Equity line items are similar to Liabilities because they represent funding sources for the company - but they will NOT result in future cash costs. They relate to funds the company has saved up on its own or funds that it has raised from outside investors with no cash cost (i.e., equity). How can you tell whether or not an item should appear on the Cash Flow Statement? - ANS You list an item on the Cash Flow Statement if: 1) It has already appeared on the Income Statement and affected Net Income, but it's non- cash, and you need to adjust for it to determine the company's real cash flow; OR 2) It has NOT appeared on the Income Statement and it DOES affect the company's cash balance In category #1 are items such as Depreciation and Amortization; Category #2 includes most of the items in Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends. Changes in Working Capital could fall into either category depending on the change (e.g., an increase in AR is in category #1, but a decrease in AR is in category #2). 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 using a credit card. How would the company record this transaction differently from a company that uses accrual accounting? - ANS Under cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would add to Revenue on the Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet. Under accrual accounting, the sale would show up as Revenue right away, but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would move into Cash, and Accounts Receivable would decrease. 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? - ANS In the short term - during THIS year - the company's cash flow will decrease because some customers no longer pay upfront in cash. So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on. This situation corresponds to Accounts Receivable: The Asset on the Balance Sheet that represents owed future payments from customers. The long-term impact depends on how much sales grow as a result of this change. If sales grow substantially and the company's Revenue and Net Income increase, that might be enough to offset the reduced cash flow and make the company better off. 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? - ANS 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. 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? - ANS Yes, your friend is correct. This happens because companies often embed Depreciation within other line items, such as COGS and Operating Expenses, on the Income Statement. That's because portions of Depreciation might correspond to different functions in the company. For example, employees in sales & marketing, research & development, and customer support might all be using computers, so Depreciation of computers would show up in each of those categories. This fact has several implications: First off, you CANNOT assume that the Depreciation listed on the In