Accounting Basic

Walk me through the 3 financial statements.

Income Statement (Revenue/Expenses → Net Income), Balance Sheet (Assets = Liabilities + Shareholders' Equity), and Cash Flow Statement (starts with Net Income, adjusts for non-cash items & working capital, then shows investing/financing activity → net change in cash).

Give examples of major line items on each financial statement.

IS: Revenue, COGS, SG&A, Operating Income, Pretax Income, Net Income. BS: Cash, AR, Inventory, PP&E, AP, Accrued Expenses, Debt, Shareholders' Equity. CFS: Net Income, D&A, Stock-Based Comp, Changes in Operating Assets & Liabilities, CFO, CapEx, CFI, Sale/Purchase of Securities, Dividends, CFF.

How do the 3 statements link together?

Net Income flows into Shareholders' Equity (BS) and the top of the CFS. BS changes appear as working capital changes on the CFS

Stranded on a desert island, only 1 statement to assess company health — which and why?

Cash Flow Statement — it shows true cash generation independent of non-cash expenses, which is the #1 thing to assess financial health.

Only 2 statements to assess a company — which 2 and why?

Income Statement and Balance Sheet — you can derive the Cash Flow Statement from "before/after" Balance Sheets plus the Income Statement.

How would Depreciation going up by $10 affect the 3 statements? (40% tax rate)

IS: Operating Income -$10, Net Income -$6. CFS: Net Income -$6, add back $10 Depreciation, CFO +$4, Net Change in Cash +$4. BS: PP&E -$10, Cash +$4, Assets -$6

If Depreciation is non-cash, why does it affect cash balance?

It's tax-deductible, and taxes are a cash expense — so Depreciation reduces the amount of cash taxes paid.

Where does Depreciation usually show up on the Income Statement?

Either a separate line item or embedded in COGS/Operating Expenses — varies by company, but it always reduces Pre-Tax Income.

What happens when Accrued Compensation goes up by $10? (40% tax rate)

IS: Opex +$10, Pre-Tax Income -$10, Net Income -$6. CFS: Net Income -$6, Accrued Comp +$10 (liability increase), CFO +$4, Net Change in Cash +$4. BS: Cash +$4, Liabilities (Accrued Comp) +$10, Retained Earnings -$6 — balances.

What happens when Inventory goes up by $10, paid in cash?

No IS change. CFS: Inventory (asset) increase reduces CFO by $10, Net Change in Cash -$10. BS: Inventory +$10, Cash -$10 — Assets unchanged, balances.

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

Expense is only recorded when goods are sold (COGS) — inventory sitting in a warehouse isn't an expense yet.

Apple buys $100 of new factories with debt — effect on 3 statements at start of Year 1?

No IS change yet. CFS: CFI -$100 (investment), CFF +$100 (debt raised) — net cash unchanged. BS: PP&E +$100, Debt +$100 — both sides balance.

Start of Year 2: high-yield debt (no principal paid), 10% interest rate, 10% factory depreciation — what happens?

IS: Operating Income -$10 (depreciation), Interest Expense -$10, Pre-Tax Income -$20, Net Income -$12 (40% tax). CFS: Net Income -$12, add back $10 D&A, CFO -$2, Cash -$2. BS: Cash -$2, PP&E -$10, Assets -$12

Start of Year 3: factories written down to $0 (value was $80), loan paid back — walk through 3 statements.

IS: $80 write-down → Pre-Tax Income -$80, Net Income -$48 (40% tax). CFS: Net Income -$48, add back $80 write-down, CFO +$32

Apple orders $10 of additional inventory using cash, nothing manufactured/sold yet — effect on 3 statements?

No IS change. CFS: Inventory +$10 reduces CFO by $10, Cash -$10. BS: Inventory +$10, Cash -$10 — Assets unchanged, balances.

They sell the iPads for $20 revenue at $10 cost — effect on 3 statements? (40% tax rate)

IS: Revenue +$20, COGS +$10, Gross/Operating Profit +$10, Net Income +$6. CFS: Net Income +$6, Inventory decrease (-$10) adds $10 to cash flow, CFO +$16, Cash +$16. BS: Cash +$16, Inventory -$10, Assets +$6

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

Yes — common after (1) LBOs with dividend recapitalizations (large equity taken out as cash), or (2) sustained net losses shrinking Retained Earnings. Can signal financial distress but isn't automatic right after an LBO.

What is Working Capital? How is it used?

Working Capital = Current Assets - Current Liabilities. Positive WC means short-term liabilities can be covered by short-term assets. Bankers prefer Operating Working Capital = (Current Assets - Cash) - (Current Liabilities - Debt), excluding financing-related items.

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

Not necessarily. Can reflect (1) high Deferred Revenue from subscriptions/contracts, (2) retail/restaurant efficiency (customers pay upfront — e.g., Amazon, Walmart, McDonald's), or (3) genuine financial trouble/possible bankruptcy if customers pay slowly and debt is high.

Banks write down assets for $100 loss — walk through the 3 statements. (40% tax rate)

IS: Pre-Tax Income -$100, Net Income -$60. CFS: Net Income -$60, add back $100 non-cash write-down, CFO +$40, Cash +$40. BS: Cash +$40, Asset -$100, Assets -$60

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

No IS change. CFS: CFF +$100, Net Change in Cash +$100. BS: Cash +$100, Assets +$100

Walk through a $100 write-down of debt (a liability) and how it affects the 3 statements. (40% tax rate)

IS: Liability write-down is a GAIN → Pre-Tax Income +$100, Net Income +$60. CFS: Net Income +$60, subtract $100 non-cash gain, CFO -$40, Cash -$40. BS: Cash -$40, Debt -$100, Shareholders' Equity +$60 — balances (Liabilities & Equity -$40).

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

Examples: web-based subscription software, cell phone annual contracts, magazine subscriptions — cash collected upfront for future services isn't revenue until the service is performed.

If cash collected isn't recorded as revenue, what happens to it?

It goes into Deferred Revenue (a liability) on the Balance Sheet

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

AR = revenue recorded but cash not yet collected. Deferred Revenue = cash collected but revenue not yet recorded/earned.

How long does it usually take to collect accounts receivable?

Generally 30-60 days, though higher for high-end/large transactions and lower for smaller, lower-value sales.

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

Cash-based: revenue/expenses recognized when cash actually changes hands. Accrual: revenue recognized when collection is reasonably certain (order placed) and expenses recognized when incurred. Most large companies use accrual

Customer pays for a TV with a credit card — cash-based vs. accrual accounting?

Cash-based: revenue recorded only once the card is charged, authorized, and funds deposited (shows as Revenue and Cash). Accrual: revenue recorded immediately, but goes to Accounts Receivable first, converting to Cash once deposited.

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

If the asset has a useful life over 1 year, capitalize it on the Balance Sheet and depreciate (tangible) or amortize (intangible) it over time. Short-term costs like salaries and COGS are expensed immediately on the Income Statement.

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

Many companies have non-cash charges (Amortization of Intangibles, Stock-Based Comp, Deferred Revenue write-downs) that some argue distort true profitability under GAAP. Non-GAAP earnings exclude these and are almost always higher.

A company has had positive EBITDA for 10 years but went bankrupt — how?

Possible causes: (1) excessive CapEx not reflected in EBITDA, (2) high interest expense it can't afford, (3) debt maturing all at once with no refinancing available (credit crunch), (4) large one-time charges (e.g., litigation). EBITDA excludes CapEx, interest, and one-time charges.

Why would Goodwill be impaired, and what does Goodwill Impairment mean?

Happens when an acquirer re-assesses intangible assets (customers, brand, IP) post-acquisition and finds them worth less than originally thought — often when the buyer overpaid (e.g., eBay/Skype). Results in a large net loss. Can also occur when discontinuing operations tied to that goodwill.

Under what circumstances would Goodwill increase?

Rarely from a value re-assessment. Usually from (1) the company itself being acquired (Goodwill is the accounting "plug" for purchase price), or (2) the company acquiring another company and paying more than the fair value of its assets.

What's the difference between LIFO and FIFO?

LIFO ("Last-In, First-Out") uses the most recent inventory costs for COGS