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Accounting Technical Interview Questions

Updated: Feb 8

One often overlooked area when preparing for investment banking interviews is accounting. Despite its seemingly back-office nature, accounting is the cornerstone of any financial analysis and, ultimately, of investment banking itself. A solid grasp of accounting principles is not just a recommendation but a requirement, especially if you aim to excel in company valuations. From understanding the intricacies of financial statements to gauging a company's performance through various metrics, accounting knowledge can set you apart in your interviews. In this article, we delve into the most common accounting questions you'll encounter in investment banking interviews.


 

Are you ready to stand out in your next investment banking interview?


 

What are the three main financial statements?

  • The three main financial statements are income statement, cash flow statement, and balance sheet. The income statement calculates the net income of the period by deducting accrual-based expenses from accrual-based revenues. The cash flow statement begins with net income (i.e. in case of the commonly used indirect method) and makes various additions and subtractions to calculate the cash generated during the accounting period. The balance sheet lists the size of the company’s assets and liabilities at the end of the accounting period.

How are the three financial statements linked?

  • The income statement captures all accrual-based revenues and costs to arrive at net income. Net income then increases (if positive) or decreases (if negative) the retained earnings position in the balance sheet. Net income, however, does not reflect actual cash flows because some revenues might be non-cash (e.g. if customers have not paid yet) and some expenses might also be non-cash (e.g. depreciation or PIK interest). Therefore, the cash flow statement starts with net income (at least if the cash flow statement is structured with the indirect method) and then adds back all non-cash expenses and subtract all non-cash income that was accounted for in the income statement. The cash flow statement then further considers all investing and financing cash flows to arrive at an overall change in cash between two accounting periods. This change in cash calculated in the cash flow statement is then reflected in the change in cash in the balance sheet between two accounting periods.

Linkage between the 3 financial statements
  • Note that these are just the main connections between the three financial statements, there are of course much more connections. For example, if capex increases (in the cash flow statement) then PP&E increases (in the balance sheet) and then depreciation increases in the following period (in the P&L). In general, any change in the balance sheet will bring about a change in the cash flow statement.

How is the income statement structured?

income statement
  • The income statement starts with revenues or sometimes called “net revenues” or “net sales”. “Net” can mean different things and revenue will be defined individually within the notes of the annual report. Usually, net just means that it is post cancellations and returns. However, for a company that operates an online marketplace or a brokerage, net revenues might mean revenues minus the cost of the product (which was just passed through). Refer to the notes of the financial report for more info on how revenues are defined.

  • Operating costs (such as COGS and SG&A) are then deducted from revenue to get to the operating result. Depreciation and amortization (“D&A”) are usually not shown separately in the income statement and are included in SG&A (or less commonly in COGS). Next, non-operating expenses and income (such as interest expense) is deducted to get to the profit before tax (“PBT”). Finally, the effective tax amount is deducted to get to net income.

How does the cash flow statement calculate the change in cash (via the indirect method)

cash flow statement

Assuming you could only see one of the three financial statements of a company to evaluate its condition, which one would you pick and why?

  • You would pick the cash flow statement because the balance sheet does not tell you anything about profitability and the income statement shows you profits but the company could still go bankrupt or be very unattractive due to high capex requirements. With the cash flow statement, you could see how much cash the company has been generating over the last periods to get an idea if this company generates or burns cash.

Assuming you could only see two of the three financial statements of a company to evaluate its condition, which two would you pick and why?

  • You would pick the balance sheet and the P&L because you can approximate the cash flow statement with the help of the balance sheet and the P&L assuming that you have two consecutive balance sheets.

Why do investment bankers refer so frequently to EBTIDA?

  • EBITDA is a “quick-and-dirty” proxy for the operating cash flow of a business because major non-cash charges (such as depreciation and amortization) are excluded. Since depreciation and amortization is heavily dependent on discretionary management decisions, any figure below EBITDA makes comparisons between companies harder because the performance figure is then influenced by discretionary accounting decisions. Finance professionals therefore like EBITDA because it is harder to manipulate and therefore serves as a good basis for comparison across companies. Also, D&A can fluctuate a lot between years if driven by non-recurring events and thus EBIT (if not properly adjusted for these non-recurring D&A events like goodwill impairments) can fluctuate heavily and make it unsuitable as a good basis for comparison between companies.

Is EBITDA a good approximation for how much cash a company has generated?

  • No, EBITDA is not a good approximation for cash flow as it does not include key cash flow items such as taxes, changes in net working capital and capex. EBIT is actually sometimes closer to the operating cash flow because depreciation is deducted which is oftentimes close to the capex figure.

Can a company with positive EBITDA go bankrupt?

  • Yes, a company goes bankrupt when it can no longer service its debt as well as any other outstanding obligations. While EBITDA is indicative of the underlying cash flow, it omits key cash flow items. For example, the company could have a lot of debt which means it has to pay high interest payments which can lead to bankruptcy. Other examples are high working capital or capital expenditures or a high one-time charge such as a litigation expense which is not included in EBITDA.

Can a company with positive net income go bankrupt?

  • Yes. A deterioration of cash flow items such as working capital can cause a company to go into bankruptcy. Imagine, for example, that the customers don’t pay, and the accounts receivables position just becomes bigger and bigger. In that case, the company has recorded the revenues it has earned in its income statement, but it will never receive the cash for it. Note that if the company knows that it will not receive the cash for a product or service which it delivered, for example, because the client went bankrupt, then it cannot record fake revenues for those transactions. If these transactions have accumulated as accounts receivable, then they must be written off immediately. Other examples are high capex spending which could lead the company to take on unsustainable debt levels. Finally, it’s also imaginable that the debt of the company matures during a financial crisis when neither banks nor capital markets are willing to refinance the debt.

How do you get from net income to the free cash flow as well as to the free cash flow to equity?

  • The easiest way to get to FCF and FCFE is to first calculate EBITDA and then calculate the two cash flow metrics from there on as shown below:

Free cash flow to equity calculation from net income via EBITDA

How are subsidiaries treated in the financial statement of the parent?

  • It depends on how much the parent owns (and more importantly effectively controls) of the subsidiary:

  • Financial Assets (<20% ownership/control): shown as financial assets on the left side of the balance sheet. Income and changes in value from these financial assets flow – according to the respective accounting standards – through the income statement and are shown as income from financial assets which is shown below operating income.

  • Investments in Associates (>20% - <50% ownership/control): Associates are not consolidated but instead accounted for via the at-equity method.

  • Joint Ventures (=50% ownership/control): Accounted for under the at-equity method.

  • Majority ownership (>50% ownership/control): Such subsidiaries are fully consolidated, that is, all assets and liabilities are accounted for in the consolidated books of the parent as if the parent company owns 100% (even if the parent company just owns 51%). The same principle applies to the income and cash flow statement. The share in the subsidiary which is not owned by the parent is accounted for as minority or non-controlling interest within the equity position of the parent and the income statement has a line at the bottom showing how much net income belongs to the non-controlling interest.

  • Note that under most accounting rules, it’s not the ownership percentage but the degree of control which determines how subsidiaries are accounted for. For example, in a JV where both parties hold 50%, but party A has contractual guaranteed control over the board, A might fully consolidate the JV instead of using the at-equity method.

How does the at-equity method work?

  • In the at-equity method, a position on the balance sheet is created called something like “at-equity accounted investments”. This investment account is based on the fair value of the acquired stake in the subsidiary (as well as the stake in acquired goodwill). The key idea of the at-equity method is to account for the stake in the business in a single position on the balance sheet of the parent which reflects the value of the stake in the equity position of that subsidiary. Therefore, a net loss in the income statement of the subsidiary as well as dividends reduce the value of the equity and thus also the value that the parent shows in its balance sheet for the subsidiary. A net profit of the subsidiary increases its equity position (if the earnings are not distributed as dividends) and therefore increases the value of the “at-equity accounted investments” the parent shows in its balance sheet. The share of profit and loss of companies which are accounted for under the at-equity method is shown in the income statement of the parent as “profit/loss from at-equity accounted investments”; as this is a non-cash position, the operating cash flow is then adjusted (i.e. a profit would be deducted and a loss would be added back).

Company A pays £500 to acquire a 20% stake in a subsidiary B at the end of the financial year. In the next financial year, the subsidiary makes £100 in net income and pays out a dividend of £10. What is company’s A at equity position in the subsidiary at the end of the financial year?

  • At the beginning of the financial year, A’s at-equity position is the £500 that it invested. That increases during the following financial year by A’s share in the net income 20%*£100=£20 and decreases by A’s share of the dividend 20%*£10=£2. Therefore, at the end of the following financial year, A’s at equity position in B is booked at £500+£20-£2=£518.

What is the treasury stock method (“TSM”)?

  • The TSM calculates the fully diluted number of shares outstanding by considering the impact of dilutive financial instruments such as in-the-money stock options. The TSM first calculates the proceeds to the company for issuing new shares at a certain strike price (note that only those options which are in-the-money, i.e. those where the strike price is lower than the current share price will be exercised). After that, the TSM looks at how many stocks (in the financial market) can be purchased with those proceeds. The gap between the number of shares the company needs to provide and the shares it was able to buy on the market from the proceeds are the new shares that the company needs to issue (i.e. the dilution).

A company has 10m shares outstanding at a share price of £100. The management of the company has 100k options that allow them to obtain shares for £120 and 200k option that allow them to obtain shares for £80. Using the treasury share method, what are the fully diluted number of shares?

  • Note that only the options with a strike price of £80 are in-the-money as the management will not exercise the options with a strike price of £120 (as that would mean paying the company £120 to get stocks worth £100).

  • First, calculate the proceeds for the company.

    • Proceeds = £80 * 200k = £16,000k

  • The company then uses those proceeds to rebuy shares on the market:

    • Repurchase shares = £16,000k / £100 = 160k

  • The company needs to provide 200k shares if the options are exercised, however, they can use the proceeds from the option exercise to purchase 160k options, so the company only needs to issue 40k new shares. The diluted number of shares, if the company originally had 10m shares outstanding then is 10.04m (=10m + 40k) shares.

In an interview, what’s the best way to answer questions such as “how does this item impact the 3 financial statements?”

  • First, start with the P&L impact, then use net income as the starting point in your cash flow statement to calculate the change in cash. Finally, link the P&L (i.e. net income going into retained earnings) and the cash flow statement (which is directly impacting the cash position) to the balance sheet and identify any other items in the balance sheet which are impacted.

A company makes a £1,000 cash purchase of PP&E (i.e. property, plant & equipment) on the last day of the accounting year 0. How will this impact the 3 financial statements in year 0 and 1? Assume straight line depreciation over 10 years and a 30% tax rate.

Year 0:

  • Income Statement: A purchase of PP&E is considered capex (i.e. capital expenditure) and impacts the income statement only through depreciation. Since we assume the PP&E is bought at the last day of the accounting year, we do not assume depreciation in year 0. The income statement is therefore unchanged.

  • Cash Flow Statement: No change to net income and no change to depreciation or working capital so cash flow from operations is unchanged. However, there is £1,000 capex which is recorded in the cash flow from investing activities. As this is a cash purchase, there is no change in the cash flow from financing activities.

  • Balance Sheet: Cash (asset) down £1,000 and PP&E (asset) up £1,000. The transaction therefore only touches the left side of the balance sheet.

Year 1:

  • Income Statement: £100 of depreciation, which results in a £70 reduction to net income given the tax effect.

  • Cash Flow Statement: Net income down £70 and depreciation up £100. No change to cash flow from investing or financing activities. The net effect is that cash is up by £30.

  • Balance Sheet: Cash (asset) up £30 and PP&E (asset) down £100 so left side of balance sheet down £70. Retained earnings (shareholders’ equity) is down by £70 (due to the net loss in the income statement) and thus the balance sheet is balanced.

Does a company’s cash position increase if there is unplanned depreciation (e.g. a fire burns down a factory)?

  • Yes, because net income reduces by an absolute amount which is less than the depreciated amount because of the tax deductibility of depreciation. However, the full depreciated amount is then added back in the cash flow statement (because it is non-cash), thus increasing the cash position.

  • For example, the factory that is destroyed during the fire has a value of £100 and the tax rate is 20%. Therefore, the profits before tax go down by £100 via depreciation and then the company pays £20 less in tax which means that net income goes down by 80 (=100-20). However, depreciation is just a non-cash accounting metric and therefore the full depreciation is added back to net income in the cash flow statement which is why cash goes up by 20 (=-80+100).

  • Note that the cash position only increases due to the tax deductibility of depreciation which (i) depends on the specific accounting rules and might not always hold true in practise and (ii) if the factory really burns down, the company will likely have to replace it and therefore spend a lot of capex to rebuild it.

Imagine you open a steak house in London. Accordingly, you buy meat at Tesco for £100 in the morning which is now part of your inventory. During the day, you sell all your steak for a total of £300. Explain what happens to the financial statements during the day (i.e. after your visit to Tesco and assume a tax rate of 20%).

  • First, you record revenues of £300. The inventory of £100 cycles out through COGS and therefore the earnings before tax are £200 (=300-100). You then pay taxes of £40 (=200*20%) and record a net income of £160.

  • In the cash flow statement, inventory decreases by £100 which is added to the net income of £160, therefore, cash is up by £260. And this makes sense intuitively as well because you received £300 from clients and had to pay £40 to the taxman.

  • On the balance sheet, on the asset side, cash increases by £260 and inventory goes down by £100, therefore we are up £160 on the asset side. On the right side of the balance sheet, retained earnings goes up by net profit (i.e. £160) and therefore the balance sheet nets out.

Follow-up Question: You then purchase another £100 in meat which increases your inventory. What happens to the P&L?

  • Nothing happens in the P&L because buying inventory is an asset exchange (cash against meat) which does not affect the P&L. It does however impact the cash flow statement as inventory goes up by £100 which is a use of cash.

Follow-up Question: Since your business is going successfully, you decide to expand and invest into a second steak house which costs £10,000. You finance it fully via an equity injection. What happens in the financial statements in the following period?

  • First, the equity position in the balance sheet increases by £10,000 due to your equity injection. Simultaneously, the cash position on the left-hand side of the B/S increases by the same amount so that the B/S balances again.

  • When you make the purchase, the cash position falls by £10,000 and PP&E (i.e. property, plant & equipment) increases by £10,000.

  • At the end of the accounting period, the entrepreneur records depreciation on the PP&E which reduces profits before tax, but since the depreciation is non-cash, it increases cash flow due to the tax shield.

Follow-up Question: What is different in the above example if you use debt instead of equity to finance the transaction?

  • If you use debt instead of equity, the debt position (instead of equity position) in the balance sheet increases.

  • In addition to the depreciation, profit before tax will also be reduced by interest expense on the debt. Further, the company will likely have to amortize the debt and thus make a cash payment towards redeeming the loan.

Follow-up Question: Imagine that after a few periods, the new steak house burns completely down and loses all its value. The new steak house previously had a market value of £12,000 and a book value of £8,000. What happens in the 3 financial statements?

  • First, note that the market value is irrelevant here. The burnt down shop is written down as exceptional depreciation in the P&L for its book value (i.e. £8,000). This then directly reduces profits before tax by the same amount and therefore reduces tax by £1,600 (=£8,000 * 20% tax rate). Therefore, net income is down £6,400 (=£8000 - £1,600). In the cash flow statement, the depreciation is added back (as no actual cash was burnt…) and therefore cash is up by £1,600 (=-£6,400 + £8,000).

Assume you are the CEO of a company that has £100m in revenue and an EBITDA margin of 10%. Would you prefer a 10% increase in volume (assuming all costs are variable), a 5% increase in price, or a 5% decrease in all operating costs?

  • First calculate EBITDA = £100m * 10% = £10m

  • Operating costs are therefore = Revenue – EBITDA = £90m

  • First scenario: if you increase the quantity by 10%, you would make £110m in revenues and since your operating costs are assumed to be completely variable, they would also go up by 10% to £99m. Your new EBITDA would be £11m which corresponds to an increase of £1m.

  • Second scenario: if you increase prices by 5%, then revenues go up to £105m but operating costs don’t change so the new EBITDA is £15m which corresponds to an increase of £5m.

  • Third scenario: If operating costs decrease by 5%, then revenue is still at £100, but operating costs decrease to £85.5m. Therefore, EBITDA is then £14.5m which corresponds to an increase of £4.5m.

  • In summary, the price increase results in the highest EBITDA uplift of £5m, followed by the decrease in operating costs, followed by the 10% volume increase.

What is the difference between expensing and capitalizing an asset?

  • A capitalized asset goes onto the balance sheet of the business and is then depreciated over time. An asset which is expensed does not go onto the balance sheet but is immediately expensed for as an operating cost in the income statement. Long-term assets (with a useful life of more than 1 year) are capitalized whereas short-term assets (with a useful life of less than 1 year) are expensed.

What is working capital and why does it matter?

  • Working capital refers to the short-term financing need resulting from the operating part (i.e. buying raw materials, holding them on stock, and selling them) of the business. The key question is whether the current operating assets are larger or smaller than the current operating liabilities. If the company, for example, has more current operating assets (i.e. inventories and accounts receivables) vs current operating liabilities (accounts payables), then – in order for the balance sheet to balance – the company needs to fill the liability gap somehow. It could for example put more equity into the business or – more commonly used – increase its debt by drawing on its revolver. While this is not catastrophic per se, it does mean that the company will be more leveraged and pay more interest expense as a result. If net working capital is positive and the company grows, expect that the corresponding financing needs of the company grow as well.

How is net working capital (“NWC”) calculated?

  • Net working capital is calculated as:

NWC = Current assets (less cash) – current liabilities (less debt)

  • A stricter definition of net working capital which is often used in practise is looking at just operating NWC which is calculated as follows:

Operating NWC = Accounts receivables + inventories - accounts payables.

  • It indicates the capital that is used or tied-up short-term as part of the operating nature of the business. Think about inventory for example this way: a manufacturing company needs to hold inventories to produce goods. However, holding inventories requires buying these with cash and therefore storing inventories in a warehouse holds up cash that cannot be used otherwise. Think about accounts receivables as a loan: For example, company A sells a product to company B and company A gives company B 90 days to pay the bill. Essentially, A is giving B a loan to finance the purchase as company B cannot or does not want to pay cash immediately. Lastly, accounts payables are deducted because like company B above, the company in question receives the loan and therefore saves cash.

  • Note that depending on the company, more items than just the 3 most common operating working capital items above are part of operating NWC. In principle, you want to take a close look at all operating items in the current assets and current liabilities section of the balance sheet. Other possible operating working capital items under current assets are prepayments and accrued income / revenue, and other receivables. Other possible operating working capital items under current liabilities are accrued expenses, tax payables, and other payables.

Is it possible for a company to have negative net working capital?

  • Yes, this is possible. Technically this means that current liabilities (i.e. accounts payables) are larger than current assets (i.e. accounts receivables and inventories). You can think about this as the suppliers financing not only the accounts receivables and inventory position but also giving a loan to the company on top of that.

  • In practise, negative working capital is generally only seen with companies that have significant market power against its suppliers and customers. Think for example about a big supermarket chain. The supermarket only holds limited inventories that it sells within a few days and once they are sold, the supermarket collects the cash immediately from the retail customers at the till. If the supermarket has market power vs its suppliers, it can decide to pay the suppliers for example 30 days after receiving the product. By that time, the supermarket has already sold the product and received cash for it.

What are retained earnings and what is their purpose?

  • The retained earnings position (within the equity position on the balance sheet) accumulates the net profits and losses of a company (after accounting for potential dividend payments which reduce the equity position). Retained earnings are therefore the portion of a business’s profits that are not distributed but saved for future use. Retained earnings could therefore be used to fund capex, M&A, or any type of expansion the company decides to pursue in the future. Note that retained earnings can also be used to fund dividends at a later stage (especially in case net income is negative in one year but the company wants to hold on to its dividend policy).

Can retained earnings become negative?

  • As losses reduce the retained earnings position, the position can even become negative. Note that the share price of a public company can never become negative as investors are always willing to purchase it for at least £0 as they don’t have any further downside from owning a stock in a limited liability company.

Is it possible that the entire equity capital position on the balance sheet becomes negative?

  • Yes, this is possible, and it does not necessarily mean that the company is bankrupt. Imagine for example that a company has an equity capital position of £100. Also assume that the company has goodwill on the balance of £200 from a large previous acquisition. The company then has concerns about the validity of the goodwill and decides to write it off. Ceteris paribus, the equity capital position becomes -£100 (ignoring taxes). The company might still be profitable and have a going concern even after the equity position turns negative and investors will be willing to spend a positive sum to become a shareholder in the company.

What are items within the shareholder equity position in the balance sheet?

  • Common items include:

    • Common stock: Nominal (i.e. par) value of the common stock the company has issued

    • Preferred stock: Nominal (i.e. par) value of the preferred stock the company has issued

    • Additional paid-in capital: Excess proceeds from issuing stocks over their nominal (i.e. par) value

    • Retained earnings: Shows the accumulated net income position minus dividends. It’s possible that the retained earnings position of a company is negative.

    • Accumulated other comprehensive income: Links to the 4th financial statement (next to income statement, balance sheet, and cash flow statement) which is the other comprehensive income statement. This item tracks all other changes that don’t fit anywhere else such as the effect of foreign currency conversion changes on profits.

What different pension schemes exist?

  • In general, there are 2 main pension schemes:

    • The defined contribution plan is a scheme where the employer consistently pays a defined amount into a pension plan for the employee. The employee hereby carries the investment risk, and the employer has no obligation (such as to pay a minimum pension) besides paying a fixed amount into the plan every month.

    • The defined benefit plan is a scheme in which a company guarantees a certain level of pension that must be paid once the employee hits the retirement age. Thus, the defined benefit plan creates future financial liabilities which can (and ideally should) be financed by building pension provisions in the current period. The present pension obligation can be calculated by discounting the expected future pension obligation (i.e. the stream of payments the company will have to make once the employee retires). Therefore, the pension provision is interest bearing in the sense that it increases every year by the discount rate. Note that it is the role of pension experts to use actuarial calculations to arrive at the current pension obligation as it depends on many variables such as life expectancy, retirement age, interest rate, salary development until retirement, etc.

What is meant by LIFO and FIFO?

  • LIFO stands for last-in first-out and assumes that the last unit to arrive in the inventory is sold first; FIFO stands for first-in first-out and assumes that the oldest unit (the one that arrived first) is sold first.

If you want to preserve cash as a business, would you prefer the LIFO or FIFO inventory accounting method in a time of rising prices?

  • You would use LIFO because that would give you a higher cost of goods sold (inventory circles out through cost of goods sold on the income statement) and would, thus, lower your pre-tax income and reduce the amount of taxes owed.

Assume that a company receives money from a client, why would the company not immediately book that money as revenue?

  • The company should only record it as revenue once the product or service has been delivered to the client and the risks and rewards of the product / service sit with the client. Thus, if the product has not yet been delivered (e.g. in the case of a prepayment), then the company should not record it as revenue yet. One exception to this rule is if the product or service takes multiple accounting periods to be built before it is delivered to the client. The company may then use the percentage of completion method to recognize revenues before the product or service is delivered to the client.

Follow-up question: If the company does not immediately recognize the money received from a client as revenue, what happens with the money?

  • On the balance sheet, cash goes up on the asset side and deferred revenue or received payments goes up on the liability side.

What is the percentage of completion method?

  • The percentage of completion method is used to recognize revenues and expenses of a long-term project which stretches over more than 1 accounting period. In that case, the company is able to realize revenues and costs even though the project is not completed and has therefore not been delivered to the client, yet. According to the percentage of completion method, revenues and costs are reported in terms of how much work (as a percentage of the total outstanding work) has been completed. The method therefore only works if the company can reliably estimate the rate of completion of the project and it must have confidence that it can see the project to the end and that the customer will pay. Note that the percentage of completion method offers potential for fraudulent behaviour because it is based on management’s assessment.

What is the difference between an accrual and a deferral?

  • A deferral occurs after a payment or receipt. An accrual occurs before a payment or receipt. There are accruals and deferrals for expenses and for revenues.

What are deferred revenues?

  • Deferred revenue refers to receipt of cash in one accounting period, that will be earned (in the income statement) in future accounting periods. For example, an insurance provider has a cash receipt in December for a 1-year insurance coverage starting in January. The insurance provider then reports this as part of its revenues in the next year. Other common examples are mobile phone contracts which are billed in advance or any sort of subscription software where the cash is collected in advance of the service being offered.

Why are deferred revenues a liability?

  • An asset is associated with future cash flow whereas a liability is associated with a future cash outflow. For example, cash – which is an asset – is associated with positive interest income. A machine is associated with producing a product which then generates positive cash flows. On the other side, a bank loan – which is a liability – will cause interest expense and amortization payments. In that way, deferred revenue is a liability because you have already received the cash and now, the only thing that’s left, is that you are liable to deliver the product or service.

What is the difference between deferred revenue and accounts receivable?

  • Accounts receivable represents revenue which has been earned but not yet received in cash. Deferred revenue represents future revenue which has not been earned in the current accounting period, but for which cash has already been collected.

What are deferred expenses?

  • A deferral of an expense refers to a cash payment that was made in one accounting period but will be reported as an expense in the income statement in a later accounting period. An example is the cash payment in December for next year’s insurance premium that will be reported as an expense in the income statement in the next year. Therefore, the deferred expense of one company is the deferred revenue of another.

What are accrued expenses?

  • An accrued expense refers to an expense that has been reported (i.e. accrued) in the income statement but for which no cash payment has been made yet. An example of an accrued expense is the heating provided that is used in December, but the payment will not be made until January.

Assume that the accounts receivable position declines by £100, what happens to cash?

  • If accounts receivable falls, then there is no impact on the income statement; in the cash flow statement, the accounts receivable item – which is a working capital asset – goes down by £100 which means a cash inflow of £100. Therefore, cash goes up by £100 which also makes sense intuitively because if accounts receivable goes down, this means that we received cash from a customer.

Assume that deferred revenue goes up by £100, how does your cash change?

  • Deferred revenue is “future” revenue that is not recognized as revenue in the current accounting period. Therefore, there is no change in the income statement. Deferred revenue is a liability and since it increases, it is an inflow of capital which is recorded in the operating cash flow statement (sometimes as part of working capital). The outcome is that overall cash goes up by £100.

Assume that deferred revenue now falls by £100, what happens to cash? Assume 20% tax rate.

  • Deferred revenue falls when the revenue is recognized in the income statement. No operating costs are assumed (although in practise there should be some…) so that EBT is up by £100, and net income is up by £80. Deferred revenue is a liability and since it goes down, this is an outflow of cash (of £100) which is recorded in the operating section of the cash flow statement (under working capital). Total cash is therefore down by £20.

  • In the previous question where deferred revenue goes up by £100, cash was up by £100. In this question where deferred revenue falls by £100, cash is down by £20. Therefore the combined effect over both periods is that cash is up by £80 which also makes sense intuitively because we got £100 in cash from the customer and paid £20 to the taxman.

Assume that prepaid expenses go up by £100, how does your cash change?

  • Prepaid expenses mean that you pay for expenses in cash before having incurred them in your income statement. Therefore, your income statement is not impacted. In your operating cash flow, the increase in prepaid expenses (which is a working capital asset) means that cash goes down by £100 which also makes sense because you paid out £100.

Assume that a company pays out a dividend of £100, how does that change your net income and your cash?

  • Dividends are not included in the income statement so there is no impact on net income. The dividend shows up in the cash flow from financing and since it is a use of cash, cash is down by £100.

What happens to the financial statements of a bank when the government gives the bank £50 of rescue capital (i.e. a bailout) during a financial crisis?

  • The most common scenario is that the government injects equity capital into the business although a bailout with debt capital could also be possible. First, there are no changes to the income statement. The cash flow (i.e. cash flow from financing) is up by £50 to reflect the government injection. On the balance sheet, the cash is up by £50, and the equity position is also up by £50 so that the balance sheet is balanced.

How does the equity position (i.e. specifically common stock and additional paid-in capital) change when the stock price moves up?

  • Changes in the stock price do not impact the shareholders’ equity position on the balance sheet. The shareholders’ equity position in changed by issuing stocks, but once the stocks have been issued, they don’t impact the shareholders’ equity position.

Assume that a company buys back £100 of its own stock, how does that impact the 3 financial statements?

  • First, there is no change in the income statement. Note that EPS (which is oftentimes shown below the income statement) changes because the number of outstanding shares is reduced. However, EPS is not an official GAAP or IFRS reporting figure and not part of the “official” income statement. In the cash flow statement, under financing, cash goes down by £100 due to the purchase of shares. In the balance sheet, cash goes down by £100 and shareholders’ equity also goes down by £100. More specifically, there is a new contra-equity position (i.e. a negative position) in the shareholders’ equity account called, for example, treasury stock which is now negative £100.

The founder of a business takes the company public through an IPO and raises £100. How does the cash of the business change?

  • The cash of the business does not change if the founder of the IPO does a secondary whereby he simply sells his shares to the public market (in that case, only the private cash position of the founder changes). However, if the company also does an equity increase (i.e. a primary) whereby it issues new shares as part of the IPO, then those proceeds would directly increase the cash position of the company. Just for clarification, investors in the IPO cannot differentiate between primary and secondary shares, they have the same rights, and it does not matter which ones you hold.

Assume the share price of the IPO’ed business drops by 50%, what is the cash impact?

  • Fluctuations in the share price do not impact the cash flow or shareholders’ equity position in the business.

A company pays out £100 of interest expense out of which half is paid in cash and half is paid-in-kind (“PIK”). How does that impact the 3 financial statements? Assume 20% tax rate.

  • In the P&L, the £100 of interest expense reduces net income by £80. In the cash flow statement, the £50 of PIK is added back because there is no associated cash outflow so that total cash is only down by £30. In the balance sheet, cash is down by £30, retained earnings is down by £80 and debt is up by £50 (because of the PIK).

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