Accounting - 400 IB

Walk me through the 3 financial statements

Income Statement: Shows revenue, expenses, and profit (Net Income).

Balance Sheet: Shows what the company owns (assets), owes (liabilities), and what’s left for owners (equity). Formula: Assets = Liabilities + Equity.

Cash Flow Statement: Starts with Net Income, adjusts for non-cash items, and shows cash from operations, investing, and financing, ending with the change in cash balance.

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

Income Statement: Revenue, COGS, Operating Income, Net Income

Balance Sheet: Cash, Inventory, PP&E, Debt, Equity

Cash Flow Statement: Net Income, Depreciation, Changes in Working Capital, CapEx, Financing Activities

How do the 3 statements link together?

Net income from Income Statement → ends up on Balance Sheet (Equity) and starts the Cash Flow Statement.

Changes in Balance Sheet items show up on the Cash Flow Statement.

Final cash from Cash Flow updates the Cash line on the Balance Sheet.

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

You’d use the Cash Flow Statement because it shows the real cash a company generates, ignoring non-cash items like depreciation. It’s the best way to judge a company’s true financial health and ability to fund operations, pay debt, and grow.

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

Income Statement and Balance Sheet — you can build the Cash Flow Statement from them if you have both.

Walk me through how Depreciation going up by $10 would affect the statements.

Income Statement (IS):Depreciation is non-cash, so it lowers Pre-Tax Income by $10. With a 40% tax rate, taxes drop by $4 and Net Income falls by $6.

Cash Flow Statement (CFS):Start with Net Income down $6, then add back $10 Depreciation since it’s non-cash.Net change in cash = +$4.

Balance Sheet (BS):

Assets: PP&E decreases by $10; Cash increases by $4 → total Assets down $6.

Equity: Retained Earnings fall by $6 due to lower Net Income.Balance Sheet stays balanced: Assets ↓$6 = Equity ↓$6.

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 Income Statement?

It might be its own line or part of COGS/Operating Expenses. Either way, it lowers pre-tax income.

What happens when Accrued Compensation goes up by $10?

Income Statement (IS):Accrued Compensation is an expense not yet paid, so Pre-Tax Income drops by $10. With a 40% tax rate, taxes fall by $4 and Net Income decreases by $6.

Cash Flow Statement (CFS): Start with Net Income down $6, then add back $10 for Accrued Compensation since it’s non-cash.Net change in cash = +$4.

Balance Sheet (BS):

Assets: Cash increases by $4.

Liabilities: Accrued Compensation increases by $10.

Equity: Retained Earnings falls by $6 from lower Net Income.Balance Sheet stays balanced: Assets ↑$4 = Liabilities ↑$10 and Equity ↓$6.

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

Income Statement (IS):

No impact — inventory purchase is not recorded on the Income Statement until the inventory is sold (then it hits COGS).

So, Pre-Tax Income and Net Income stay the same.

2. Cash Flow Statement (CFS):

Start with Net Income = No change.

In the Cash Flow from Operations section:

Inventory is an asset — when it increases, it reduces cash.

So, subtract $10.

Cash decreases by $10.

3. Balance Sheet (BS):

Assets:

Inventory increases by $10

Cash decreases by $10

→ No net change in Total Assets

Liabilities: No change

Equity: No change (Net Income unchanged)

Balance Sheet stays in balance

Why is the Income Statement not affected by changes in Inventory?

Inventory only becomes an expense when sold. If it just sits there, it's not recorded yet.

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

1. Income Statement (IS):

No impact yet.

No depreciation has occurred.

No interest expense is recorded yet (assume it hasn’t accrued yet).

So, Pre-Tax Income and Net Income stay the same.

2. Cash Flow Statement (CFS):

Start with Net Income = $0

Investing Activities:

CapEx (Capital Expenditures): −$100 (outflow for factory purchase)

Financing Activities:

Debt raised: +100

Net change in cash = $0

The $100 cash outflow for the factory is offset by $100 inflow from the new debt.

3. Balance Sheet (BS):

Assets:

PP&E (Property, Plant & Equipment): +100 (new factory added)

Cash: No change (net zero from cash flow)

Total Assets: +100

Liabilities:

Debt: +100

Total Liabilities: +100

Equity: No change (Net Income = 0)

Balance Sheet stays in 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?

Income Statement

Depreciation: −$10 → lowers Operating Income

Interest Expense: −$10 → further lowers Pre-Tax Income

Pre-Tax Income drops by $20

Taxes (40%): 40% of $20 = +$8 (tax savings)

Net Income = −$12

2. Cash Flow Statement

Start with:

Net Income = −$12

Add back depreciation (non-cash expense) = +10

Net cash = −$2

So, Cash Flow goes down by $2.

3. Balance Sheet

Cash = −$2 (from CFS)

PP&E = −$10 (from depreciation)

Equity = −$12 (from Net Income)

Balanced: Assets (−$12) = Liabilities (0) + Equity (−$12)

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.

Income Statement:

The $80 write-down is treated as a non-cash loss (impairment expense).

Pre-tax income drops by $80.

At a 40% tax rate, that’s a $32 tax shield.

Net income decreases by $48.

Cash Flow Statement:

Start with net income of –$48.

Add back the non-cash $80 write-down.

Cash flow from operations = +$32.

Then subtract $100 to repay the debt (cash outflow in financing activities).

Net cash change = –$68.

Balance Sheet:

Assets:

Cash is down $68.

PP&E is down $80 due to the write-down.

Total assets decrease by $148.

Liabilities and Equity:

Debt is down $100 (loan repaid).

Equity is down $48 (from lower net income).

Total Liabilities + Equity decrease by $148.

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?

Income Statement:

No change.Apple is just purchasing inventory — it hasn’t manufactured or sold anything yet, so there’s no revenue or expense to report.

Cash Flow Statement:

Cash Flow from Operations:Inventory increases by $10, which is a use of cash (it’s working capital going up).→ Cash decreases by $10.

Balance Sheet:

Assets:

Inventory (a current asset) increases by $10.

Cash decreases by $10.→ Total assets stay the same.

Liabilities and Equity:

No changes here since it was a cash transaction and there’s no income yet.

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. Happens in:

Leveraged buyouts where owners take out cash.

Companies with big losses.

It can show financial problems, but not always

What is Working Capital? How is it used?

Current Assets – Current Liabilities

Shows if a company can cover short-term bills.

Operating Working Capital = excludes cash and debt.

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

Negative working capital means a company’s current liabilities are higher than its current assets. This can be normal in industries like retail or subscriptions, where customers pay quickly and cash comes in before bills are due. But if a company can’t pay its obligations on time, it’s a sign of financial trouble.

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.

Income Statement:

A $100 writedown is recorded as a non-cash expense, which reduces Pre-Tax Income by $100.

Assuming a 40% tax rate, Net Income drops by $60.

Cash Flow Statement:

Start with Net Income down $60 (from above).

Since the writedown is non-cash, it’s added back in the Cash Flow from Operations section.

So:+ $100 non-cash writedown→ Net cash increases by $40.

Balance Sheet:

Assets:

The specific asset (e.g. goodwill, PP&E, etc.) is reduced by $100.

Cash increases by $40 (from the cash flow statement).→ Net change in assets = down $60.

Liabilities: No change.

Equity:

Retained Earnings down $60 (due to Net Income drop).→ Total equity down $60.

Balance Sheet stays balanced:Assets ↓ $60 = Equity ↓ $60.

Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

Income Statement:

No change.A bailout is not considered revenue or operating income — it’s a financing event, not an operational one.

Cash Flow Statement:

The $100 cash inflow is recorded under Cash Flow from Financing Activities, since it’s external capital coming in (like issuing stock or receiving funds).

So: Cash increases by $100.

Balance Sheet:

Assets:

Cash increases by $100.

Liabilities:

No change (unless it’s a bailout structured as debt, but here we assume equity).

Equity:

Common Stock / Additional Paid-In Capital increases by $100, reflecting the new investment.

Balanced: Assets ↑ $100 = Equity ↑ $100

Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.

Income Statement

The company records a $100 gain because it no longer owes that debt.

With a 40% tax rate, Net Income increases by $60.

Cash Flow Statement

Start with Net Income up $60.

Since the $100 gain is non-cash, subtract it under cash flow from operations.

Net cash decreases by $40.

Balance Sheet

Assets: Cash decreases by $40

Liabilities: Debt decreases by $100

Equity: Retained Earnings increases by $60 (due to higher Net Income)

The balance sheet balances: Assets down $40 = Liabilities down $100 + Equity up $60

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

If the service or product hasn’t been delivered yet, like with software subscriptions, annual phone contracts, or magazine subscriptions, you don’t record revenue right away. You wait until the service or product is delivered, following the revenue recognition principle.

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

It’s recorded as Deferred Revenue on the Balance Sheet (a liability). As the company delivers the service, that amount is recognized as real revenue on the Income Statement.

What's the difference between accounts receivable and deferred revenue?

Accounts Receivable: You’ve earned the revenue but haven’t been paid yet.

Deferred Revenue: You’ve been paid but haven’t earned the revenue yet.

How long does it usually take for a company to collect its accounts receivable balance?

It’s usually 30–60 days, though it can be longer for large purchases. The exact timing depends on the industry and the payment terms agreed with customers.

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

Cash Accounting: Record transactions when cash actually moves.

Accrual Accounting: Record when revenue is earned or expenses are incurred, even if cash hasn’t moved yet.

Big companies use accrual accounting because it gives a more accurate picture of performance.

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

Cash: Wait until cash is received.

Accrual: Count it as revenue immediately; show as A/R until paid

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

Capitalize costs if they provide value for over a year (like factories or equipment) — they go on the Balance Sheet.

Expense costs if they’re used up quickly (like salaries or COGS) — they go on the Income Statement.

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

GAAP earnings follow official accounting rules and include things like stock-based pay or other non-cash expenses.

Non-GAAP earnings take those out to show what the company’s core business really made in cash terms, so they usually look higher than GAAP earnings.

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

EBITDA can miss key red flags. A company might look strong on paper but still be risky if it’s spending too much on CapEx, has too much debt, faces large debt maturities, or takes huge one-time losses. EBITDA ignores all of these, so it doesn’t always show the company’s true financial health.

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

That’s called a Goodwill Impairment. It happens when a company overpays in an acquisition and later realizes the acquired business isn’t worth as much, so it records a loss to reduce the goodwill value on its balance sheet.

Under what circumstances would Goodwill increase?

After an acquisition when one company pays more than the other's assets are worth. It's the extra value recorded.

What's the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

LIFO means “last in, first out,” so the most recent inventory costs are used first when calculating expenses.

FIFO means “first in, first out,” so the oldest inventory costs are used first. When prices are rising, LIFO makes profits look smaller because it uses the newer, more expensive inventory for costs, while FIFO makes profits look higher because it uses the older, cheaper inventory.

Where can you find Depreciation and Amortization on the financial statements?

epreciation and Amortization appear on all three financial statements:

Income Statement: As Depreciation and Amortization expense (either as a separate line or within COGS or Operating Expenses).

Cash Flow Statement: Added back in Cash Flow from Operations because it is a non-cash expense.

Balance Sheet: Reduces PP&E (Depreciation) or Intangible Assets (Amortization) through accumulated depreciation or amortization.

How does $10 of Depreciation affect Free Cash Flow?

Depreciation lowers EBIT by $10. Assuming a 40% tax rate, EBIT after tax falls by $6.

However, Depreciation is a non-cash expense and is added back in the Free Cash Flow calculation.

So the net effect on Free Cash Flow is:

+ $4 (the tax shield from depreciation)

Let's say Microsoft sells a computer for $20 with a COGS of $10. Assume a 25% tax rate. Walk me through the 3 financial statements.

Income Statement:

Revenue increases by $20

COGS increases by $10

Pre-Tax Income increases by $10

Taxes (25%) = $2.50

Net Income increases by $7.50

Cash Flow Statement:

Start with Net Income up $7.50

Inventory decreases by $10 (reduction in working capital → add back)

Cash Flow from Operations increases by $17.50

Balance Sheet:

Cash increases by $17.50

Inventory decreases by $10

Net assets increase by $7.50

Retained Earnings increases by $7.50

Let's say you pay an employee $100, with 50% paid in cash and 50% paid in stock. Assume a 40% tax rate. Walk me through the 3 statements.

Income Statement:

Compensation Expense increases by $100

Pre-Tax Income decreases by $100

Taxes decrease by $40

Net Income decreases by $60

Cash Flow Statement:

Start with Net Income down $60

Add back $50 of stock-based compensation (non-cash)

Cash Flow from Operations decreases by $10

Balance Sheet:

Cash decreases by $10

Equity:

Retained Earnings down $60

Common Stock / APIC up $50

Net Equity decreases by $10

The Balance Sheet balances.

A company sells an asset for $100. Its book value is $60. Assume a 10% tax rate. Walk me through the 3 statements.

Income Statement:

Gain on sale = $40

Taxes (10%) = $4

Net Income increases by $36

Cash Flow Statement:

Start with Net Income up $36

Subtract $40 gain (non-cash)

Cash Flow from Operations down $4

Cash Flow from Investing up $100

Net cash increase = $96

Balance Sheet:

Cash increases by $96

PP&E decreases by $60

Retained Earnings increases by $36

The Balance Sheet balances.

A company has debt equal to 6× EBITDA. It sells an asset valued at 4× EBITDA and uses the proceeds to pay down debt. What happens to the Debt/EBITDA ratio?

Assume EBITDA = $100.

Debt = $600

Asset sold generates $50 of EBITDA and sells for $200 (4× EBITDA)

Debt decreases to $400

EBITDA decreases to $50

New Debt/EBITDA = $400 / $50 = 8×

The Debt/EBITDA ratio increases, even though debt was paid down, because EBITDA fell by more.

What are Deferred Taxes?

Deferred taxes arise from temporary differences between income reported for accounting purposes and income reported for tax purposes.

Deferred Tax Assets (DTAs): Represent future tax savings and appear under Assets.

Deferred Tax Liabilities (DTLs): Represent future tax payments and appear under Liabilities

What is the difference between Deferred Tax Assets and Deferred Tax Liabilities?

Deferred Tax Assets: Occur when a company pays more tax today than it reports in accounting income, resulting in future tax benefits.

Deferred Tax Liabilities: Occur when a company pays less tax today than it reports in accounting income, resulting in future tax payments.

Why does an increase in Inventory reduce Cash Flow from Operations?

An increase in Inventory represents a use of cash because the company has spent money to purchase inventory that has not yet been sold.

Inventory is part of Net Working Capital, so when it increases, Cash Flow from Operations decreases.

When answering 3-statement questions, what order should you always follow?

Always follow this order:

Income Statement

Cash Flow Statement

Balance Sheet

Let's say you purchase a $100 factory, debt is 50% and cash 50%. Interest on debt is 10%. The tax rate is 40%. Useful life on the factory is 5 years. How does this affect the three financial statements at the beginning of the year?

Income Statement:

No change

Cash Flow Statement:

CFO: ---

CFI: CAPEX (-$100) spending on factory

CFF: Debt $50

Net Cash is (-$50)

Balance Sheet:

Assets:

Cash: (-$50)

PP&E: $100 - gaining an asset (factory)

Liabilities:

Debt: $50

Assets up $50= Liabilities up $50

Let's say you purchase a $100 factory, debt is 50% and cash 50%. Interest on debt is 10%. The tax rate is 40%. Useful life on the factory is 5 years. You end up selling the factory for $100 to repay that debt. Walk me through the 3 statements.

Income Statement:

Depreciation (-$20) $100/5year useful life

Gain on Asset $20 $100-$80 book value

Interest ($5)

Tax (40%)

Net Income: (-$3)

Cash Flow Statement:

CFO:

Net Income: (3)

Depreciation: +20

Gain on Sale of Asset: (20)

Net CFO: (3)

CFI:

Sale of long-term asset (factory): +100

Net CFI: +100

CFF:

Debt repaid: (50)

Net CFF: (50)

Net Change in Cash: 47

Balance Sheet

Assets

Cash: +47

PP&E: -100

Net Assets=-$53

Liabilities

Debt: -50

Equity

Retained Earnings: -3

A company buys $250M of inventory using 100% debt. One year later, it sells the inventory for $500M. The debt has 5% interest and the tax rate is 40%. Walk through the IS, CFS, and BS for the year of the sale (assume no principal repayment).

INCOME STATEMENT

Sales: +500M

COGS: –250M

Gross Profit / EBIT: 250M

Interest Expense (5% × 250M): –12.5M

EBT: 237.5M

Taxes (40%):

Net Income: 142.5M

CASH FLOW STATEMENT

CFO:

Net Income: 142.5M

Inventory decrease (250M → 0): +250.0M

CFO = 392.5M

CFI:

No impact

CFF:

no change

Net Change in Cash: 392.5M

Balance Sheet:

Assets:

Cash: 392.5M

Inventory:(-250M)

Total Assets: 142.5M

Equity

R.E 142.5M

$100 factory is purchased. Financed with 50% debt, 50% cash. 3 statements at the start of the year.

Income Statement:

No change

Cash Flow Statement:

CFO: -

CFI - CAPEX:(-$100)

CFF - Debt: $50

Net Change in Cash: -$50

Balance Sheet:

Assets:

Cash - (-$50)

PP&E - $100

Net Assets: $50

Liabilities:

Debt - $50

$100 factory is purchased. Financed with 50% debt, 50% cash. 3 statements at the start of the year... Now it's the end of the year. The residual value of the is 40 dollars, useful life of 4 years. The interest on debt is 10%, 50% cash, 50% paid in kind. The tax rate is 40%.

Income Statement

Depreciation ($15) --> 100-40=60. 60/4= 15

EBIT - ($15)

Interest - ($5)

EBT - ($20)

------------

Tax (40%)

------------

Net income: ($12)

Cash Flow Statement:

CFO:

Net income: ($12)

Depreciation $15

P.I.K: $2.5 --> 5*50%=2.5

Net change in CFO: $5.50

CFI: -

CFF: -

Net change in cash: $5.50

Balance Sheet:

Assets:

Cash: $5.50

PP&E: ($15) --> Depreciation

Net Assets: (-$9.5)

Net Liabilities: $2.5 --> P.I.K

Equity: (-$12) --> Retained Earnings