Jesus Emmanuel God With Us! Stifel Success in Jesus Name Accounting Section

Walk me through the 3 financial statements

The 3 major financial statements are Income Statement, Balance Sheet, and Statement of Cash Flows

Income Statement

Tells us information about the companies revenues and expenses, with net Income being the final line on the statement

Balance Sheet

Shows the company’s Assets - meaning its resources such as Cash, Inventory, Property, Plant and Equipment (PPE)

It also shows a company;s liabilities such as Accounts Payable and debt

Lastly it shows shareholder’s equity.

Assets must equal liabiltiies + shareholder’s equity for a balance sheet to be balanced

Example of Major Line Items on Income Statement

Revenue

Cost of Goods Sold

Selling & General Administrative Expenses

Operating Income

Net Income

Major Line Items on the Balance Sheet

Cash

Accounts Receivable

Inventory

Plant, Property, and Equipment

Accounts Payable

Accured Expenses

Debt

Shareholder’s Equity

Cash Flow Statement

Net Income

Depreciation & Amortization

Changes in OPerating Assets & Liabiltiies

Capital expenditures

Cash Flow from Investing

Cash Flow from Financing

Dividends Issued

How do the 3 Financial Statements Link Together

Well Net Income from the Income Statement flows into Shareholder’s Equity on the Balance Sheet and into the top line of the Cash Flow Statement

Changes on the Balance Sheet appear as working capital changes on the Statement of Cash Flows

And Investing and Financing Activities directly effect Balance Sheet Items such as Debt and Shareholder’s Equity as well as PP&E

If you only had 1 statement to review the overall health of a company which statement would it be?

The Cash Flow Statement because it gives a true picture of the cash the company is actually generating, Separate from the non-cash expenses.

And since Cash Flow is the greatest indicator of the health of any business it’d be the most ideal statement to have

Let’s say I could only look at 2 statements to asses a company’s health which 2 would I use

I’d pick the Income statement and balance Sheet because you can create the Cash Flow statement form both of those, if you have the before and after Balance Sheet corresponding to the income statement period

Walk me through how Depreciation going up by $10 would effect the financial statements

For the Income Statement: Operating Income would decline by $10 and Net Income would decline by a slightly smaller value based on the tax rate, let’s say $5 based on a 50% tax rate

For the Cash Flow Statement: The Net Income at the top of the Cash Flow Statement goes down by $5 but since the $10 Depreciation is a non-cash expenses that gets added back overall Cash Flow from Operations goes up by $5.

Net Change in Cash also goes up by $5

For Balance Sheet: PP&E would go down by $10 because of the depreciation and Cash would go up by $5 from changes in the cash flow statement

**NOTE Cash in Balance Sheet would go up the difference between the change in depreciation and of the decline in Net Income in the Income Statement, this scenario just used 5 for convenience

**They suggest for this question answering it in the order of:

1. Income Statement

2. Cash Flow Statement

   1. Balance Sheet

If Depreciation is a non-cash expense, why does it affect the cash balance

While depreciation is a non-cash expense, it is tax deductible.

And taxes are a cash expense, so depreciation effects cash by reducing the amount of taxes you pay.

Where does Depreciation usually show up on the Income Statement?

(Depreciation is found on the balance sheet)

From my experience the effects of depreciation are usually shown in Operating Expenses or Cost of Goods Sold.

It has the same result regardless of where it shows up, it always reduces pre-tax income

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

For Income Statement: No changes

For Cash Flow Statement: Since inventory is an asset used in operations, it would decrease the company’s Cash Flow from operations by $10.

This would also be reflected at the bottom line with Net Change in Cash decreasing by $10

For Balance Sheet: Inventory is an asset just like Cash, so while inventory goes up $10 cash goes down $10, leaving the accounting equation balanced with

Assets = Liabilties + Shareholders Equity

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

Well the Income Statement gives a record of revenue and expenses

Inventory tends to be sitting in a warehouse and the expenses associated with it are only recorded when the product is manufactured or sold

A change in inventory won’t be recorded in Cost of Goods Sold or Operating Expense for that reason

Apple decides to buy $100 dollars worth of iPod factories using debt, how are the 3 financials statements effected beginning in Year 1?

For Income Statement: At the start of Year 1 there would not be any changes to Apple’s Income Statement yet

For Statement of Cash Flows: the $100 investment in iPod factories would mean a $100 reduction in Cash Flow from Investing

but also a $100 addition in Cash Flow from Financing leaving the Net Change in cash at 0.

For balance Sheet: There would now be an additional $100 in PP&E so asset would be up $100 but liabilities would also be up $100 due to the increase in debt, leaving the accounting equation balanced.

Now lets 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 a depreciation rate of 10% per year what happens. (Remember you began by buying $100 worth of iPod factories using debt)

For Income Statement: Interest expenses would be $10 dollars and then you would incur a loss in operating income of $10 from depreciation expense.

So altogether pre-tax income would decrease by $20

Assuming a tax rate of 40% net income would fall by $12

For Cash Flow Statements: The Top Line Net Income would decrease by $12 dollars. Since depreciation is a non-cash expenses, you’d add the $10 deprecation cost back and so Cash Flow from Operating would be down only $2.

So the Net Change in Cash would be down $2

For the Balance Sheet: Under assets cash would be down by $2 and PP&E would be down $10 due to deprecation. So over all assets would be down $12.

On the other side of the accounting equation. Since Net Income was down by $12, shareholder’s equity would be down by $12

Could you ever end up with negative shareholder’s equity?

Yes,

1. In Leveraged Buyouts with dividend recapitalizations, if the company has taken out a large portion of its equity in the form of cash, shareholders equity may become negative.

2. It can also happen if a company has been losing money consistently and has a declining Retained Earnings balance

What is working capital and how is it used?

Working Capital is the difference between Current Assets and Current Liabilites

(Current Assets - Current Liabiltiies)

If working capital is positive it means a company can pay off its short-term liabiltiies with its short term assets. It gives an idea of the health of the company

What is Operating Working Captial

Its

(Current Assets -excluding Cash & Cash Equivalents) - (Current Liabilities -excluding Debts)

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

Negative working capital means a company’s short term liabilities exceed their short term assets.

Depends on the type of company.

1. If its a company based on subscriptions or longer term contracts, then Negative Working Capital would be caused by high deferred revenue balances

2. If its large retail company or restaurant, often times they have a negative Working Captial because customers pay upfront - and they can use the cash generated to pay off their Accoutns Payable rathetr than keepign a large cash balance on hand. It could be a sign of business efficiency.

   1. A Negative working Capital could point to possble financial toruble and a future bankruptcy if a company is unable ot pay its high debt balance.

What happens when banks write down their assets and take huge quarterly loses. Specifcally: Walk me through what happens of the 3 statements when there’s a writedown of $100

For the Income Statement: The $100 write-down shows up in the pre-tax income line. With a 40% tax rate, net income declines by $60

For the Cash Flow Statement: On the top line, Net income is down by $60 dollars but the write down is a non-cash expense so we add it back, and therefore Cash Flow from Operations increases by $40

There is an increase of $40 in total Net Change in Cash

For the Balance Sheet: The Cash would increase by $40 in Assets but the depreciation of the given asset is down $100. So the total assets would be down $60.

On the other side of the accounting equation because Net Income is down $60, Shareholder’s Equity will is also be down $60. Keeping the accounting equation in balance.

Define write down

is an accounting adjustment that reduces the book value of an asset, when its fair market value has fallen below its previous book value

Write down for a liability is actually a gain, as you’re saying the comany no longer expects to pay back the full amount owed (this typically happens when you renegotiate debt)

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

*First confirm the type of bailout, if its a debt or equity bailout or a combination. The most common scenario is an equity investment form the government. Here’s what happens in that scenario:

For the Income Statement: There is no changes

For the statement of Cash Flows: The Cash Flow from Financing goes up by $100 to reflect the government’s bailout investment, so the Net Change in Cash is up $100

For the Balance Sheet: Cash would increase by $100 meaning assets are up $100 and on the other side of the accounting equation Shareholder’s Equity would go up $100 to make it balance

Walk me through a $100 write-down of debt, as in OWED debt, a liability, and its effect on a company’s 3 financial statements

For Income Statement: A write-down on a liability would be recorded as a gain on the Income Statement, and so assuming a 40% tax rate. Net Income would increase by $60

For Statement of Cash Flows: The top line of Net Income would increase by $60. The Cash Flow from Operations would be down $40, as we subtract the debt write down. So the Net Change in Cash is down $40.

For Balance Sheet: The Cash would be down by $40 and the total assets would be down by $40 and on the other side of the accounting equation the shareholders equity + liabilities would be down $40 (as debt is down by 100 but Net Income increase by 60).

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

Generally speaking companies that agree to provide services in the future often collect cash upfront to ensure stable revenue but due to GAAP (Generally Accepted Accounting Principles), you only record revenue when you actually perform the services for the customers.

Good examples are cell phones carriers like T-Mobile with annual contracts and some subscription software services

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

Cash collected form customers not recorded as revenue goes under Deferred Revenue on the Balance Sheet under Liabilities

What’s the difference between Accounts Receivable and Deferred Revenue?

Account Receivable is cash yet to be collected for service that have provided to customers

while Deferred Revenue is cash that has already been collected though services have not yet been provided to customers

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

Generally it takes 40-50 days to collect accounts receivable, although it tends to be longer for companies selling high-end items and it may be shorter for companies selling lower-cost goods.

What is the difference between cash-based accounting accural accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out

Accrual accounting recognizes revenue when collection is reasonable certain (for example after a customer has ordered the product) and it recognizes expenses when they are incurred rather than when they are paid out in cash (for example when salary expense for employees work in December would be inccured at the end of December even if they get paid in January)

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

Under Cash-Based accounting the company would only record revenue after the customer pays their credit card obligations maybe at the end of the month. After this it would show up as Revenue on Income Statement and Cash on the Balance Sheet

Under accrual accounting the company would record Revenue in Income Statement after the customer makes the purchase using their card and record Accounts Receivable in Balance Sheet

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

If the asset has a useful life over 1 year, it is capitalized (meaning it is put on the Balance Sheet rather than shown as an expense on the Income Statement).

The asset is then depreciated (if its a tangible asset) or amortized (if its an intangible asset) over a certain number of years.

Example of capitalized goods: Purchases like factories, equipment, and land all last longer than a year and therefore show up on the Balance Sheet.

Examples of expensed items: employee salaries and cost of manufacturing (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

Why do companies report both GAAP and non-GAAP (pro-forma earnings)?

Many companies today face “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, Deferred Revenue Write down in their Income Statements.

As a result some companies believe the Income Statements under GAAP don’t completely reflect how profitable most companies truly are to shareholders. Non-GAAP earnings are almost always higher because these expenses are not included.

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

There’s a variety of reasons that could explain that scenario. For instance:

1. The company was spending to much on Capital Expenditures - and these are not reflected at all in EBITDA, but it could still be cash-flow negative

2. The Company’s debt all matures on one date and it was unable to refinance due to a “credit crunch” (couldn’t raise the necessary funds) and so it runs out of cash trying to pay back the debt

3. It faces a signficant on-time charge from an event such as Litigation

NOTE and REMEMBER: EBITDA excludes investment in and deprecation of long-term assets, interest and on-time charges. These are all things can bankrupt a company.

Capital Exependitures

These are Investing Activities recorded in the Statement of Cash Flows,

a company uses to acquire, upgrade, or maintain long-term assets that will benefit the business for more than one accounting period.

Examples: Google spending $5 Million to build a new data center

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

Usually Goodwill becomes impaired 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 signifcantly less than they originally found in short the acquirer over paid

It can also happen when a company discontinuous part of its operations and must impair the associated goodwill

Under what circumstances would Goodwill increase?

Goodwill can increase if the company re-assess its value and finds that it is worth more, although this is incredible rare.

It usually happens in the following scenarios:

1. A company gets acquired and Goodwill changes as a result, since its an accounting “bridge” for the purchase price in an acquisition that balances any leftover amount between what was paid and the net fair value of those items

2. The company acquires another company and pays more for the company than what the company’s assets are actually worth