Accounting

Practice

Answer out loud first, then check. Mark each card; the ones to review come back first next time.

1. Walk me through the three financial statements.

   The income statement shows revenue less expenses over a period, down to net income. The balance sheet shows assets, liabilities and equity at a point in time, and assets always equal liabilities plus equity. The cash flow statement starts from net income, adjusts for non-cash items and working capital to get cash from operations, then adds investing and financing flows to explain the change in cash.

   Likely follow-up: Which one would you look at first, and why?

2. How do the three statements link?

   Net income from the income statement is the first line of the cash flow statement and flows into retained earnings on the balance sheet.

   The cash flow statement adds back non-cash charges, reflects changes in balance sheet items (working capital, capital spending, debt, equity) and ends with the change in cash, which matches the cash line on the balance sheet.

   Likely follow-up: Where does depreciation appear in each statement?

3. Depreciation goes up by $10. Walk me through the three statements, with a 25% tax rate.

   Income statement: pre-tax income falls by $10, tax falls by $2.5, so net income falls by $7.5.

   Cash flow statement: net income is down $7.5, but depreciation is added back, +$10, so cash from operations rises by $2.5.

   Balance sheet: cash is up $2.5 and PP&E is down $10, so assets fall by $7.5; retained earnings fall by $7.5, so liabilities plus equity also fall by $7.5. It balances.

   Likely follow-up: Why does cash go up when profit goes down?

4. A company buys $100 of inventory with cash. What changes?

   Income statement: nothing, until the inventory is sold.

   Cash flow statement: the increase in inventory is a use of working capital, so cash from operations falls by $100.

   Balance sheet: cash down $100, inventory up $100. Total assets do not change.

   Likely follow-up: And when that inventory is sold for $150?

5. That inventory is sold for $150, at a 25% tax rate. Walk me through it.

   Income statement: revenue +$150, cost of goods sold +$100, pre-tax income +$50, tax +$12.5, net income +$37.5.

   Cash flow statement: net income +$37.5 and the fall in inventory releases $100, so cash from operations rises by $137.5.

   Balance sheet: cash +$137.5, inventory −$100, so assets rise by $37.5; retained earnings rise by $37.5.

   Likely follow-up: What if the sale were on credit?

6. If you could look at only one statement to judge a company's health, which would it be?

   The cash flow statement: it shows whether the business actually generates cash, which profit alone does not. It starts from net income, so you still see profitability, and it shows what the company spends to stay in business and how it is financed. For a bank or an insurer the balance sheet matters more.

   Likely follow-up: Why can profit and cash diverge for years?

7. Can a profitable company go bankrupt?

   Yes. Profit is not cash. A fast-growing company can tie up cash in receivables and inventory, or a company can have debt falling due that it cannot refinance. It runs out of cash while still reporting net income.

   Likely follow-up: Which lines would warn you first?

8. What is working capital, and why does an increase use cash?

   Operating working capital is current operating assets (receivables, inventory) less current operating liabilities (payables, accrued expenses, deferred revenue). When it grows, the company has put more cash into the gap between paying suppliers and collecting from customers, so cash flow falls.

   Likely follow-up: Name a business with negative working capital.

9. What is goodwill, and what happens to it after the deal?

   Goodwill is the purchase price less the fair value of the target's identifiable net assets, after writing those assets up to fair value and recognising intangibles such as customer lists. Under US GAAP it is not amortised; it is tested for impairment at least once a year and written down if the business is worth less than its carrying value.

   Likely follow-up: How does an impairment flow through the statements?

10. An asset carried at $100 is written down to $80. Walk me through it at 25% tax, assuming the charge is tax deductible.

    Income statement: a $20 impairment, pre-tax income −$20, tax −$5, net income −$15.

    Cash flow statement: net income −$15, add back the non-cash $20, so cash rises by $5.

    Balance sheet: cash +$5, the asset −$20, so assets fall by $15; retained earnings fall by $15.

    Likely follow-up: What changes if the impairment is not tax deductible, as is often the case for goodwill?

11. A software company bills a customer $120 upfront for a 12-month subscription. What happens in the first month?

    At billing and collection: cash +$120 and deferred revenue, a liability, +$120. Nothing on the income statement.

    In the first month the company earns one twelfth: revenue +$10 and deferred revenue −$10. Cash flow from operations shows the full $120 in the period it was collected, through the increase in deferred revenue.

    Likely follow-up: Why do investors in subscription businesses watch deferred revenue?

12. Stock-based compensation is $10. Walk me through the statements at 25% tax, assuming the expense is deductible.

    Income statement: expense +$10, pre-tax income −$10, net income −$7.5.

    Cash flow statement: net income −$7.5, add back the non-cash $10, cash +$2.5.

    Balance sheet: cash +$2.5. Equity: retained earnings −$7.5 and additional paid-in capital +$10, so equity +$2.5. It balances.

    Likely follow-up: Why do some analysts treat stock-based compensation as a cash cost in a valuation?