Conceptual Questions
What are the three main financial statements and why do we need all three of them
The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.
You need these statements because there is a big difference between a company’s Net Income and the cash it generates
Name 5 common line items on the Income Statement
your choice...
Name 3 common line items on CFS
...
What is the most important accounting equation here
Assets = Liabilities + Shareholders’ Equity
List an item that appears on all three statement and where is it located in each?
Net Income (bottom on I/S, top row on CFO, RE in B/S)
What’s the most important financial statement?
Cash Flow Statement
What are PP&E, R&D, COGS, and EBITDA?
Property, Plant & Equipment
Research & Development
Cost of Goods Sold
Earnings Before Interest, Tax, D&A
Where does issuing debt appear on the CFS?
Cash Flow from Financing (cash inflow)
What does retained earnings represent and how is it calculated
Cumulative net income minus dividends.
A company’s Depreciation increases by $10. What happens on the 3 financial statements?
Income Statement: Pre-Tax Income falls by $10, and Net Income falls by $8 assuming a 20% tax rate.
• Cash Flow Statement: Net Income is down by $8, but you add back the $10 in Depreciation since it’s non-cash, so cash flow is up by $2, and cash at the bottom is up by $2.
• Balance Sheet: Cash is up by $2, but PP&E is down by $10 due to the added Depreciation, so the Assets side is down by $8. The L&E side is also down by $8 because Net Income fell by $8, which reduced Retained Earnings, so both sides balance.
• Intuition: The company saves on taxes with a non-cash expense.
Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?
A/R it corresponds to future cash payments that customers are expected to make. An Asset is something that will result in additional cash in the future, or that can be sold for cash, so AR qualifies.
Deferred Revenue is a Liability because it will cost the company cash in the future. The company has already collected all the cash associated with this future revenue. So, in the future, when it finally delivers the product or service, it will have to spend something on the delivery and will also have to pay taxes on the revenue it records.
Should purchase of PP&E be listed on Income Statement? If so, where? If not, why not?
No, I/S records expenses related to the current period’s operations — not investments in future periods.
A PP&E purchase is a capital expenditure: it provides long-term benefit (more than one year). Under accrual accounting, instead of expensing the full purchase immediately, the company capitalizes the cost as an asset on the Balance Sheet and then depreciates it over time.
Why is CapEx (capital expenditure) subtracted in the CFS?
It represents a cash outflow for long-term investments
What is Goodwill and how does it change over time?
Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired company is worth far less and therefore writes down the Goodwill. That appears as an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement.
Salesforce.com sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens on the statements?
This scenario corresponds to Deferred Revenue. The payment for the entire year is $1,200.
• Income Statement: No changes.
• Cash Flow Statement: DR increasing by $1,200 will boost the company’s cash flow, so cash at the bottom is up by $1,200.
• Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance.
Name at least three adjustments you need to make when mapping from Income Statement to Cash Flow Statement
Non-cash expenses (D&A, stock-based compensation); changes in net working capital (AR, AP, inventory); Net capital spending/Capex (PP&E)
A company prepays insurance for $12,000 covering 12 months. At year-end, only 9 months have passed. How does this affect the Income Statement?
$9,000 insurance expense appears on the Income Statement; $3,000 remains as a prepaid asset on the Balance Sheet (not expensed yet).
A company reports the following during the year: Accounts Receivable decreases by $30, raised $40 of debt to purchase inventory, Accounts Payable is down by $20. What’s the total effect on Cash Flow from Operations (CFO)?
ΔAR = +$30 inflow
ΔInventory = –$40 outflow
ΔAP = –$20 outflow
Net CFO change = –$30
Only operating current assets and liabilities (AR, AP, inventory, etc.) affect working capital.
Raising or using cash directly is a financing decision, not a working capital change.
What happens to the Balance Sheet if the company issues new equity?
Cash ↑ (asset), Common Stock/Equity ↑ (shareholders’ equity)
What happens if a company buys $100 of PP&E using debt?
IS: no change
CFS: Investing ↓ $100, Financing +$100 → net zero cash
BS: PP&E ↑ $100, Debt ↑ $100
Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean? (Think about components of SE)
Yes, some examples:
1. negative Net Income for many years
2. issues a huge dividend to its owners (e.g., following a leveraged buyout)
Negative Equity is almost always a negative sign because it means the company has been unprofitable or has done something irresponsible with its dividends or share repurchases.
Negative Equity is also common for tech and biotech startups that record massive losses in their early years due to high spending and no revenue.
A company changes its depreciation method from straight-line to accelerated. What happens to the Income Statement in the early years?
Depreciation expense increases → EBIT and Net Income decrease → lower taxes in early years.
A company sells a piece of equipment for $200 with a book value of $150. How is the gain reflected in the CFS?
CFO: Subtract $50 (non-cash gain).
CFI: Add full $200 proceeds as inflow.
A company realizes that it has too much cash, so it wants to issue dividends or repurchase shares. How do they impact the Balance Sheet differently? Assume $100 in dividends vs. $100 in shares repurchases.
Cash is down by $100, so the Assets side is down by $100; on the L&E side, dividends will reduce Retained Earnings by $100, whereas a share repurchase will reduce Treasury Stock by $100. But in either case, Equity is down by $100, so the L&E side is down by $100 and both sides balance.
A company collects $60 cash for services to be delivered next year. Also, $40 of the prior prepaid revenue is now recognized. How does it affect the three statements?
IS: Revenue +$40 (recognition of previously deferred revenue)
CFS:
Cash from Operations: +$60 collected
No cash effect for revenue recognition of previously collected $40
BS:
Cash ↑ $60
Deferred Revenue ↑ $20 (new collection – recognized revenue)
Retained Earnings ↑ $40