Accounting Questions & Answers – Basic

What are the 3 major financial statements?

The Income Statement, Balance Sheet, and Cash Flow Statement.

What does the Income Statement show?

• Shows revenue and expenses

• Covers a period of time (not a snapshot)

• Breaks down to net income (profit)

he income statement shows a company’s revenue and expenses over a period of time and determines its profitability by calculating net income

What does the Balance Sheet display?

The balance sheet displays a company’s financial position at a specific point in time by listing its assets, liabilities, and equity. It shows what the company owns versus what it owes, and helps assess its financial stability and leverage

• The balance sheet is essentially a snapshot
  Lists assets, liabilities, and equity

• Displays what the company owns vs. owes

• Follows: Assets = Liabilities + Equity

• Helps assess leverage and financial stability

Shows the company’s financial position at a point in time

What is the purpose of the Cash Flow Statement?

The purpose of the cash flow statement is to show how a company generates and uses real cash over a period. It explains the difference between net income and actual cash flow, and helps assess the company’s liquidity, financial health, and quality of earnings.
Shows real cash generation

• Explains difference between net income and cash

• Tracks where cash comes from and where it goes

• Helps assess liquidity and financial health

• Evaluates the quality of earnings

How do the 3 financial statements link together?

• Income Statement → ends in net income

• Net income → flows to:

  • Cash Flow Statement (starting point)

  • Balance Sheet (retained earnings)

• Cash Flow Statement:

  • adjusts net income

  • gives net change in cash

• Balance Sheet:

  • cash updated

  • retained earnings updated

Which financial statement would you use to assess a company's overall health?

The Cash Flow Statement.

If you could only look at 2 statements, which would you choose?

• I would choose the cash flow statement and balance sheet

• Cash flow statement shows how net income converts into actual cash

• Helps assess quality of earnings (not just accounting profit)

• Balance sheet shows the company’s resources and obligations

• Lets you evaluate leverage, liquidity, and financial risk

• Together, they show:

  • how cash is generated

  • how it’s being used

  • how the company is financed

How does a $10 increase in Depreciation affect the financial statements?

• Depreciation increases by $10 → EBIT decreases by $10

• Lower EBIT → taxes decrease → net income decreases (by less than $10)

• On cash flow statement → add back $10 depreciation (non-cash)

• Net effect → cash increases slightly due to tax savings

• Balance sheet → PP&E decreases, cash increases, retained earnings decrease

Why does Depreciation affect cash balance if it's a non-cash expense?

• Depreciation reduces taxable income

• Lower taxable income → lower taxes

• Lower taxes → higher cash (tax shield)

Depreciation affects cash because it reduces EBIT, which lowers taxable income. Lower taxable income leads to lower taxes paid, which increases cash. So even though depreciation is a non-cash expense, it creates a cash benefit through the tax shield.

Where does Depreciation usually appear on the Income Statement?

“Depreciation usually appears within operating expenses on the income statement. It’s often included in the cost of goods sold if it relates to production assets, or in SG&A if it relates to non-production assets
Depreciation is part of operating expenses

* Can be included in:

* COGS (production-related assets)

* SG&A (non-production assets)

* Depends on how the asset is used

* Reduces EBIT (operating income)

What happens when Accrued Compensation increases by $10?

Operating Expenses increase by $10, Net Income decreases by $6, and Cash Flow from Operations increases by $4.

What is the effect of Inventory increasing by $10?

No changes to the Income Statement; Cash Flow from Operations decreases by $10, but Assets remain balanced.

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

Expenses are recorded only when the goods are sold.

What happens when Apple buys $100 worth of new factories with debt?

No changes to the Income Statement; Cash Flow decreases by $100 for the investment, but increases by $100 for the debt.

After one year, what happens to Apple's financials with the new factories?

Operating Income decreases by $10 for depreciation, Net Income falls by $12, Cash Flow from Operations decreases by $2, and Assets decrease by $12.

What is the impact of interest expense on Apple's financials after one year?

Interest expense decreases Pre-Tax Income by $10, affecting Net Income and Cash Flow.

How does depreciation affect the Balance Sheet?

PP&E decreases by the depreciation amount, affecting total Assets.

What is the relationship between Assets and Liabilities on the Balance Sheet?

Assets must equal Liabilities plus Shareholders' Equity.

What are the major line items on the Income Statement?

Revenue, Cost of Goods Sold, SG&A, Operating Income, Pretax Income, Net Income.

What are the major line items on the Balance Sheet?

Cash, Accounts Receivable, Inventory, PP&E, Accounts Payable, Accrued Expenses, Debt, Shareholders' Equity.

What are the major line items on the Cash Flow Statement?

Net Income, Depreciation & Amortization, Cash Flow from Operations, Capital Expenditures, Cash Flow from Investing, Cash Flow from Financing.

What is the significance of Net Income on the Cash Flow Statement?

It is the starting point for calculating cash flow from operations.

What happens to the Balance Sheet when Net Income decreases?

Shareholders' Equity decreases by the same amount as the decrease in Net Income.

How do changes in working capital appear on the Cash Flow Statement?

They appear as adjustments to cash flow from operations.

What is the effect of a non-cash expense like Depreciation on cash flow?

It increases cash flow from operations by reducing taxable income.

How does the Cash Flow Statement reflect investing activities?

It shows cash outflows for purchases of long-term assets and inflows from sales.

What is the role of Shareholders' Equity on the Balance Sheet?

It represents the owners' claim after liabilities are settled.

What happens to the Cash Flow Statement if a company issues dividends?

Cash Flow from Financing decreases.

What is the impact of capital expenditures on the Cash Flow Statement?

They are recorded as cash outflows under investing activities.

How does a change in Accounts Receivable affect cash flow?

An increase in Accounts Receivable decreases cash flow from operations.

What happens to Cash Flow from Investing when additional investment in factories is made?

It shows up as a net reduction in Cash Flow.

How does raising additional debt affect Cash Flow?

It shows up as an addition to Cash Flow, canceling out the investment activity.

What happens to PP&E on the Balance Sheet after an additional $100 worth of factories is added?

PP&E increases by $100.

What is the impact on Assets when $100 worth of factories is added?

Assets increase by $100.

What happens to debt on the Balance Sheet when $100 of debt is raised?

Debt increases by $100.

What is the effect of 10% depreciation on Operating Income after one year?

Operating Income decreases by $10.

How does interest expense affect Pre-Tax Income after one year with $10 interest expense?

Pre-Tax Income decreases by $20.

What is the impact of a 40% tax rate on Net Income with a decrease of $12?

Net Income falls by $12.

What happens to Cash Flow from Operations when Net Income is down by $12 and depreciation is added back?

Cash Flow from Operations is down by $2.

What is the overall change in Cash after one year?

Overall Cash is down by $2.

What happens to Cash and PP&E on the Balance Sheet after accounting for depreciation?

Cash is down by $2 and PP&E is down by $10.

What is the effect on Shareholders' Equity when Net Income is down by $12?

Shareholders' Equity is down by $12.

What happens to the value of factories after two years of 10% depreciation?

The value of the factories is now $80.

What is the impact on Net Income from an $80 write-down of factories?

Net Income declines by $48.

How does the write-down of factories affect Cash Flow from Operations?

Cash Flow from Operations increases by $32.

What is the effect on Cash Flow from Financing when a loan of $100 is paid back?

Cash Flow from Financing decreases by $100.

What is the overall Net Change in Cash after the write-down and loan payback?

Net Change in Cash falls by $68.

What happens to Assets on the Balance Sheet after the write-down of factories?

Assets decrease by $148.

What happens to Inventory when $10 of additional iPad inventory is ordered?

Inventory increases by $10.

What is the effect on Cash Flow from Operations when inventory is ordered?

Cash Flow from Operations decreases by $10.

What happens to Cash and Inventory on the Balance Sheet after ordering inventory?

Inventory is up by $10 and Cash is down by $10.

What happens to Revenue and COGS when iPads are sold for $20 at a cost of $10?

Revenue is up by $20 and COGS is up by $10.

What is the impact on Net Income after selling iPads for a revenue of $20?

Net Income is up by $6.

What happens to Cash Flow from Operations when inventory decreases after selling iPads?

Cash Flow from Operations is up by $16.

What does negative Shareholders' Equity indicate?

It can indicate financial trouble or a leveraged buyout.

What is Working Capital?

Working Capital = Current Assets - Current Liabilities.

What does positive Working Capital signify?

It means a company can pay off its short-term liabilities with its short-term assets.

What does negative Working Capital mean?

It can indicate efficiency or financial trouble, depending on the context.

What happens to Net Income when there is a $100 write-down with a 40% tax rate?

Net Income declines by $60.

What is the effect on Cash Flow from Operations after a $100 write-down?

Cash Flow from Operations increases by $40.

How does a $100 bailout affect the Cash Flow Statement?

Cash Flow from Financing goes up by $100.

What happens to Shareholders' Equity after a $100 bailout?

Shareholders' Equity goes up by $100.

What is the impact of a $100 write-down of debt on the financial statements?

It affects the Balance Sheet and may decrease liabilities.

What happens to the Income Statement when a government invests in a company?

No changes are made to the Income Statement.

How does a government investment affect the Cash Flow Statement?

Cash Flow from Financing goes up by $100.

What is the impact of a government investment on the Balance Sheet?

Cash and Assets increase by $100, and Shareholders' Equity increases by $100.

What is the effect of a $100 write-down of debt on the Income Statement?

Pre-Tax Income goes up by $100.

How does a $100 write-down of debt affect Net Income?

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

What happens to Cash Flow from Operations after a debt write-down?

It decreases by $40.

What is the overall impact on the Balance Sheet after a debt write-down?

Cash decreases by $40, Debt decreases by $100, and Shareholders' Equity increases by $60.

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

Examples include web-based subscription software, cell phone contracts, and magazine subscriptions.

What happens to cash collected that is not recorded as revenue?

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.

What is the difference between accounts receivable and deferred revenue?

Accounts receivable is revenue not yet collected; deferred revenue is cash collected but not yet recorded as revenue.

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

Typically in the 30-60 day range.

What is the difference between cash-based and accrual accounting?

Cash-based recognizes revenue and expenses when cash is received or paid; accrual recognizes revenue when collection is certain and expenses when incurred.

What happens when a customer pays for a TV with a credit card under cash-based accounting?

Revenue is recorded when the payment is authorized and deposited.

How is revenue recorded under accrual accounting when a customer pays with a credit card?

Revenue is recorded immediately, and it initially appears in Accounts Receivable.

When should a purchase be capitalized rather than expensed?

If the asset has a useful life of over 1 year.

Why do companies report both GAAP and non-GAAP earnings?

Non-GAAP earnings exclude non-cash charges, reflecting higher profitability.

How can a company have positive EBITDA and still go bankrupt?

High capital expenditures, interest expenses, or significant one-time charges can lead to bankruptcy.

What is Goodwill Impairment?

It occurs when a company reassesses its intangible assets and finds them worth less than previously thought.

Under what circumstances would Goodwill increase?

Goodwill can increase if a company is acquired or pays more than the value of another company's assets.

What is the difference between LIFO and FIFO?

LIFO uses the most recent inventory costs for COGS; FIFO uses the oldest inventory costs.

How does LIFO affect COGS and ending inventory when inventory prices are rising?

LIFO results in higher COGS and lower ending inventory values.

What is the impact of FIFO on COGS and ending inventory when inventory prices are falling?

FIFO results in lower COGS and higher ending inventory values.