IBIG 04-01 Accounting & the Three Financial Statements

What two criteria must an item meet to appear on the Income Statement?

1. It must correspond 100% to the period shown (based on the delivery of products/services)

2. It must affect the business income available to common shareholders (Net Income to Common)

Why don’t CapEx, debt issuances, or stock issuances appear on the Income Statement?

They don’t correspond 100% to the current period

• they provide benefit (or funding) over many years

What does Gross Margin tell you?

How much additional profit the company earns from each additional sale before fixed expenses like employees and rent

What’s the difference between COGS and Operating Expenses?

• COGS = expenses linked directly to individual units sold (materials, shipping, labor for services)

• OpEx = costs not linked to individual products (marketing, rent, salaries, support, R&D)

What does Operating Income tell you vs. Net Income?

• operating income - earnings before “side activities”, interest, and taxes

• Net income - the bottom line, after ALL expenses and taxes

When is Net Income the same as Cash Flow?

In a simple business where you collect cash immediately on sales and pay cash immediately on expenses (no timing differences)

What is accoutns receivable and why is it an asset?

Revenue recorded for a product/service delivered by not yet paid in cash

• it’s an asset because it provides a future benefit (cash to be collected)

What happens to cash flow when AR increases?

It decreases cash flow relative to net income

• you recorded revenue (and pay tax on it) but haven’t collected the cash

What are accounts payable/accrued expenses?

Expenses for products/services received but not yet paid in cash

• AP = specific invoiced items

• Accrued Expenses = recurring items without invoices (utilities, rent, wages, insurance)

Does an increase in Accounts Payable always correspond to an Income Statement expense?

No. Buying inventory on credit increases inventory and AP with no IS change.

What is a prepaid expense and why is it an asset?

Cash paid upfront for a service not yet received (like annual insurance paid at the start of the year). It’s an asset because it delivers a future benefit (the service/future expense reduction)

What is deferred revenue and why is it a liability?

Cash collected upfront for products/services not yet delivered. It’s a liability because it’s an obligation to deliver in the future

What is inventory and what line item is it linked to?

Raw materials/supplies bought before sale; you can’t expense them until delivery

• linked to COGS - COGS rises only when finished goods are delivered

Why do we need the three financial statements (vs just tracking cash and equity)?

Because timing differences (caused by accounts such as AR, AP, Prepaids, Deferred Revenue, and Inventory) mean cash flow over a year can differ greatly from net income - the statements track all of it)

On the cash flow statement, what do positive vs negative adjustments mean?

• Positive = cash generated exceeds Net Income

• Negative = the company generated less cash than net income suggests

Why is CapEx recorded only on the Cash Flow Statement inititally?

The spending doesn’t correspond q00% to the current period - the asset lasts >1yr - so it’s allocated to the IS over time via depreciation

How do you calculate annual Depreciation (straight line)?

Capex Amount / Useful life

Why is deprecation a “non-cash expense”?

The cash was already spent on the CapEx in an earlier period; the depreciation expense itself involves no new cash outflow, so it’s added back on the CFS

Net effect on Cash in a year of pure depreciation?

Cash increases by the tax savings (depreciation * tax rate), because depreciation lowers taxable income

Why must you look at the Cash Flow statement to find total depreciation?

Companies often embed D&A within COGS or SG&A on the IS, so only the CFS shows the all-inclusive number.

How does issuing debt flow through the statements?

Cash inflow in Cash Flow from Financing, which increases the debt line on the BS. Nothing on the IS b/c it lasts more than one period

Where does Debt principal repayment show up?

Only on the cash flow statement in CFF - not the IS

What is the downside of issuing debt?

Interest expense, which hits the IS, reduces Net Income and Cash; and the principal must eventually be repaid

How does issuing equity flow through the statements?

Simple cash inflow on the CFS (CFF); nothing on the IS, but it dilutes existing owners (EPS down)

Does raising equity “cost” the company anything?

Yes - not a direct cash cost like interest, but it sells part of the company, diluting existing investors

• less in future distributions and sale proceeds

How do dividends flow through the statements?

Cash outflow in CFF; reduces cash and equity (retained earnings). Not on the IS - they’re distributed out of income, not deducted from income available to common

How do stock repurchases differ from dividends?

Mechanically similar (cash outflow, reduce cash and equity), but repurchases also reduce the share count via treasury stock; dividends do the opposite

What is preferred stock and where does it sit?

A hybrid “in the middle” of debt and equity, but closer to debt

• it has a fixed coupon (preferred dividends) recorded on the income statement

More expensive than debt, cheaper than equity

How are preferred dividends treated for taxes and on the statements?

NOT tax-deductible (unlike interest). They appear on the IS, are deducted from Net Income to get to Net Income to Common, and reduce Common Shareholders' equity

Why do few companies use Preferred stock?

It’s more expensive than debt and not tax-deductible. Companies use it mainly when lenders won’t by more debt and equity issuance isn’t feasible.

When any lease is first signed, what happens to the balance sheet?

The lease Asset (Right-of-Use Asset) and Lease Liability both increase by the same amount, which equals the present value of future lease payments. No cash impact

What makes a lease a finance lease (vs. an operating lease)?

An ownership-transfer option, a bargain purchase option, or meeting other criteria - giving the company the risks/benefits of ownership. Operating leases have none of these.

For a finance lease, how do you split the expense?

• Interest expense = Discount rate * Lease Liability (declines over time)

• Lease Depreciation = Initial lease asset / lease term

IS expense initially exceeds the cash paid for the lease

On the CFS, how is a Finance Lease handled?

Add back lease depreciation (like normal D&A); record a cash outflow for “Lease Principal Repayment”, which equals your cash lease expense - interest expense (rises as interest falls)

How are Operating Leases treated under IFRS?

Same as Finance Leases: split into Interest and depreciation, add back depreciation, subtract lease principal repayment

How are operating leases treated under US GAAP?

A single constant rental expense on the IS (no interest/depreciation split). The lease asset and liability decrease by the same amount each year (for constant payments)

How is the purchase of Financial investments recorded?

Cash outflow in CFI. Interest/dividend income appears directly on the IS

How is the sale of Financial Investments recorded?

Cash inflow in CFI. An IS impact occurs only if there’s a gain or loss

Why do large companies keep two sets of financial statements?

One for “Book” purposes (periodic filings) and one for “tax” purposes (the government) - they differ due to accelerated tax depreciation, non-deductible expenses, and tax credits

What do deferred taxes represent?

The difference between book taxes (on the IS) and cash taxes (paid to the government). W

When do deferred taxes on the CFS go negative vs. Positive?

• Negative when cash taxes exceed book taxes (pay more in cash than the IS shows)

• Positive when book taxes exceed cash taxes

When does the deferred tax liability (DTL) increase vs. decrease?

Increases when book taxes > Cash Taxes (will pay more later); decreases when cash taxes > book taxes (paying down the obligation).

What is a deferred tax asset (DTA)?

A line item representing potential future cash-tax savings (e.g. from NOLs or non-cash-tax-deductible expenses)

What is a Net Operating Loss (NOL)?

An accumulated balance of past negative Pre-Tax income that can offset future taxable income to reduce future cash taxes

Are NOLs the same as Deferred Tax Assets?

No. The DTA reflects only the tax-savings potential. A $100 NOL at a 25% rate - a $25 DTA. The full NOL is an off-balance -sheet item.

How do you handle DTAs and DTLs on the CFS, which has only one deferred taxes line?

Net them into a single “Net DTA” (DTA-DTL) or “Net DTL” line for easier linking

What happens if a company sells an asset for exactly its book value?

No IS impact. Cash rises by the proceeds, and the Asset (e.g., Net PP&E) falls by the same amount on the CFS/BS

When does selling an Asset crease a gain or loss?

• Sold above book value = gain

• Sold below book value = loss

The gain/loss appears on the IS because it is a current-period event

How is a gain on an asset sale handled on the CFS?

Reverse it (subtract the gain) in CFO, then show the FULL sale proceeds in CFI

Why do you reverse the Gain/Loss on the CFS?

It’s non-operational - you reclassify it out of CFO into CFI because it has to do with the firm’s investing activities. Also, you don’t literally lose/gain that cash in the current period; the cash effect is the actual proceeds.

What’s the formula for the change in cash from selling PP&E?

Change in cash = book value of PP&E sold + Gain (1-TaxRate) - loss * (1-TaxRate)

How is a write-down/impairment treated vs. depreciation?

Similar - non-cash expense, reduces Pre-Tax/Net Income, added back on the CFS, reduces the corresponding asset.

• Key Difference: Write-downs/impairments are usually NOT Cash-tax deductible

If a non-cash expense isn’t cash-tax deductible, what increases instead of cash?

The Net Deferred Tax Asset (DTA) - the company realizes the tax benefit only later (e.g., when it sells the written-down asset)

How is SBC treated on the statements?

IS expense that reduces Pre-Tax/Net Income; non-cash, so added back on the CFS; links into CSE

Is SBC Cash-tax deductible when granted?

No - only later

• when employees exercise options/ receive shares

But, timing is unpredictable, so models often omit that step

What makes SBC different from “true” non-cash expenses like depreciation?

It creates additional shares (dilution), so it reduces value to existing investors. In valuation its often treated as a real cash expense.

What are the basic acquisition accounting adjustments?

Combine both comapnies’ statements; reduce acquirer cash (or raise debt/issue stock) for the purchase; write off the target’s CSE

Why do Goodwill and Other Intangibles get created in a deal?

When the purchase price exceeds the Target’s CSE (~99% of deals), the combined BS goes out of balance, so you need to plug the gap with Other Intangibles (identifiable: patents, brands, customer relationships, etc.) and goodwill (the unidentifiable remainder of the premium)

How do goodwill and other intangibles change over time?

• Other Intangibles amortize (most of them)

• Goodwill does NOT amortize - it’s tested annually and impaired if its value drops

Are amortization of intangibles and goodwill impairment cash-tax deductible?

No - cash doesn’t increase from them; the DTA/DTL changes instead

What are the main differences between U.S. GAAP and IFRS?

1. Some item names differ (Revenue = Turnover)

2. IFRS CFS often starts with Operating/Pre-Tax Income or uses the Direct Method

3. IFRS places Dividends/Interest/Taxes in more varied CFS sections

4. IFRS splits Operating Lease expense into Interest + Depreciation, while U.S. GAAP uses a single rental expense

What should you do with an IFRA Cash Flow Statement that doesn’t start with Net Income?

Convert it - find the reconciliation between “Cash Generated from Operations” and Net Income/Operating Income, then rebuild the CFS to start with Net Income and make standard adjustments

What does the income statement show, and what are its two appearance criteria?

Revenue, expenses, and taxes over a period, ending in Net Income (to Common). Items must (1) correspond only to the period shown and (2) affect income available to common shareholders

Is the cash vs non-cash distinction relevant to whether an item appears on the IS?

No - plenty of non-cash items (D&A, SBC, even non-cash Revenue) appear on the IS because they meet the two criteria.

What does the Balance Sheet show, and what equation must hold?

A company’s Assets (resources) and Liabilities & Equity (how they were funded) on a specific date.

• A = L + E

Define an Asset vs. a Libaility/Equity Item

• Asset = something providing a future benefit (cash, growth, IP value, tax savings)

• Liability/Equity = a future obligation or funding source (cash payment, product deliver, interest+repayment)

What are the five components of Common Shareholders’ Equity?

1. Common stock (par value * shares)

2. Additional Paid-In Capital ( APIC = (market-par) * shares issued, cumulative)

3. Retained Earnings (cumulative Net Income to Common - Dividends)

4. Treasury Stock (cost of repurchased shares)

5. Accumulated Other Comprehensive Income (AOCI - FX effects, certain hedges, unrealized gains/losses)

Do APIC and Treasury Stock change when the share price changes?

No - both are recorded at the share price at the time of issuance/repurchase and don’t move with the market price afterward

Why does the cash flow statement exist (2 reasons)?

1. The IS may include non-cash revenue/expenses/taxes needing adjustment

2. There are cash inflows/outflows that never hit the IS (Capex, Dividends, etc)

What are the three sections of the Cash Flow Statement and their rough proxies?

1. CFO (Net Income + non-cash adjustments + operational BS changes; ~ current assets/liabilities)

2. CFI (investments, acquisitions, PP&E; ~ long term assets)

3. CFF (Debt, dividends, share issuance/repurchases; long-term liabilities & equity)

If Book Taxes and Cash Taxes are both negative, how do you compute Cash Taxes?

Cash Taxes = Book Taxes + DEferred Taxes (CFS)

• Ex: Book Taxes ($100) + Deferred Taxes (+$40) = ($60) Cash Taxes

What is the 3-step process to project the financial statements?

1. Simplify and consolidate the statements

2. Project line items (Revenue, COGS, OpEx, CapEx, AR, etc.)

3. Link the statements so the BS balances each year

When simplifying, how many line items should you aim for on each side of the Balance Sheet?

5-10 at most, combine the short-term/long-term versions, use a single Net DTA/DTL, and show one CSE line

In what order do you project the statements?

1. Start with Income Statement (leave interest blank)

2. Operational BS items

3. CFS with Net Income

4. adjust for non-cash items

5. Project CFI and CFF

6. sum the CFS

7. Link to the BS

8. Finally fill in Interest Income/Expense last

When linking the BS to the CFS, what’s the sign rule?

• On the assets side, subtract CFS links

• On the liabilities and equities side, add CFS links

How does the Net PP&E link to the CFS?

Previous Net PP&E - D&A - CapEx - Proceeds from PP&E disposals (CapEx is negative, so subtracting it adds it back)

Each change should appear how many times across the statements?

Once and only once - if a BS item increases, that increase should show up in exactly one spot on the CFS

What is the simple defintion of Free Cash Flow?

FCF = CFO - CapEx

Why is FCF defined as CFO - CapEx?

Everything in CFO is required to run the business, and almost everything in CFI/CFF is optional - except CapEx, which is required (buildings, equipment, computers)

What does FCF let you assess?

A company’s ability to generate cash from its business, including the cost of servicing its Debt and long-term funding

What does positive and growing FCF indicate (and what should you check)?

Generally healthy - the company doesn’t need outside funding. But check it’s driven by sales/market-share/margin growth, not creative cost-cutting, reduced CapEx, or Working Capital games

What does negative FCF mean?

The business isn’t self-sustaining and relies on outside financing.

• Ok in the short-term (startups)

• Red flag if persistnet - ask why and whether losses shrink as the business grows

What’s the traditional vs. the better definition of Working Capital?

• Traditional: Current Assets - Current Liabilities

• Better: Current Operational Assets - Current Operational Liabilities (excludes Cash, Investments, Debt) - matches to the CFS

Is positive or negativ Working Capital good or bad?

Neither inherently - depends on why

• High Deferred Revenue driving negative WC is good (cash collected up front)

• High Accounts Payable driving it is less positive (owes suppliers)

How is the Change in Working Capital defined on the CFS?

Change in WC = Old Working Capital - New Working Capital

• counterintuitive, but matches CFS presentation

If Working Capital increases, what happens to cash?

The company USES cash (negative on CFS. If WC decreases, it FREE UP cash (positive)

• Example: Inventory rising $200-$300 means $100 of cash spent

How do you typically project the Change in Working Capital?

As a percentage of the Change in Revenue (or Revenue) - often in the 0%-10% range - following any obvious historical patterns

Why do retailers vs subscription-software companies have opposite Change in WC signs?

• Retailers: usually negative (must buy Inventory before selling)

• Subscription software: usually positive (collect cash upfront → rising Deferred Revenue boosts cash flow

What is EBIT and how does it relate to the IS?

Earnings Before Interest and Taxes = Operating Income, adjusted for non-recurring/one-time charges

• It’s a proxy for FCF and shows core recurring profitability before capital structure and taxes

What is EBITDA and how do you calculate it?

Earnings Before Interest, Taxes, Depreciation & Amortization = EBIT + D&A (taken from the CFS, since D&A may be embedded in IS line items

• It’s a proxy for CFO

What is the Leverage Ratio and what does it tell you?

Total Debt/EBITDA

• how much Debt a company has relative to its ability to pay. Higher = riskier

What is the interest coverage ratio?

EBIT/Interest Expense

• how easily a company covers its interest after making expenditures necessary to keep the company running

Give the formulas for ROE, ROA, and ROIC

• ROE = Net Income to Common / Average (Common) Shareholders’ Equity

• ROA = Net Income to Common / Average Total Assets

• ROIC = NOPAT / Average Invested Capital

Give the formulas for DSO, DIO, and DPO

• DSO: (Average AR / Revenue) * days in period

• DIO = (Average Inventory / COGS) * days in period

• DPO = (Average AP / COGS) * days in period

What is the Cash Conversion Cycle (CCC)?

CCC = DIO + DSO - DPO

• how long it takes to convert Inventory and receivables into case. Lower is better

In what order should you walk through a 3-statement change question?

1. Income Statement

2. Cash Flow Statement (including deferred taxes)

3. Balance sheet - and explain why it balances

What are the 6 categories of 3-statement change questions?

1. Cash items on the IS

2. Operation items on the BS (working capital)

3. Non-cash items on the IS

4. Leases on the BS

5. Non-operational BS/CFS items

6. Multi-step scenarios

Category 1 - a cash IS item (e.g., Revenue +$100). What changes?

1. Pre-tax income

2. Net Income

3. Cash

4. CSE

5. BS Balances via Cash and CSE changing

Category 2 - for Working Capital items, what two questions do you ask?

1. Has the company delivered the product/service?

2. Has someone delivered something to the comapny it used this period

• If yes, IS changes

• If no, only BS and CFS change

For AR, Prepaid Expenses, Inventory, AP/Accrued, and Deferred Revenue - which directions hits the IS?

• AR increase

• Prepaid decrease

• Inventory decrease

• AP/Accrued increase

• Deferred revenue decrease

The opposite directions hit only the BS and CFS