Financial Accounting Questions
Finance Tutorial
December 1, 2006
1. Define and explain the components of and relationship among the income statement, balance sheet, and cash flow statement.
2. Discuss ways that management can manipulate earnings by using discretion in presenting financial statements.
a. Income Smoothing: The technique of reducing earnings in good years, by deferring gains and recognizing losses. Earnings can also be inflated in bad years, by recognizing gains and deferring losses.
b. Big Bath manipulation technique: The piling up of losses in recognized bad years in hopes of magnifying gains in the following good years.
c. Classification of good and bad news: Bias of reporting good news about the line (part of continuing operations) and bad news below the line (extraordinary or discontinued operations).
d. Since there are no cash flow consequences to accounting changes (e.g., changes in depreciation methods, useful lives), they must be analyzed for earnings manipulation.
3. Identify the requirements for revenue recognition to occur.
1. Earnings activities are substantially completed.
2. Revenue can be measured with reasonable accuracy.
3. The major portion of the costs has been incurred, and the remaining costs can be reasonably estimated.
4. The eventual collection of the cash is reasonably assured.
5. Also remember that transactions giving rise to revenue should be arms-length.
4. How does a stock split affect the balance sheet?
It does not change the amount in any asset, liability or SHE account. It does increase the number of shares of common stock issued and outstanding while proportionately decreasing the par or stated value of that common stock.
5. There are 2 identical firms. Firm A borrowed money to build a new factory, while Firm B issued equity to build an identical factory. How will these 2 firms’ cash flow statements differ?
Firm A will have a lower Cash Flows from Operations than Firm B. Why? Firm A must pay interest on the debt, which comes out of CFO. Firm B has no required payments, but if Firm B paid out dividends this would decrease Cash Flows from Financing.
6. Distinguish between permanent and temporary tax differences. Which gives rise to a deferred tax asset or liability?
Permanent differences are differences in taxable and pretax incomes that are never reversed.
Some examples are tax-exempt interest revenue and the proceeds from life insurance on key employees, both of which are not taxable but are recognized as revenue on the financial statements.
Tax-exempt interest expense and premiums paid on life insurance of key employees are examples of expenses on the financial statements, but they are not deductions on the tax returns.
These differences are NEVER DEFERRED but are considered decreases or increases in the effective tax rate. If the only difference between taxable and pretax incomes were a permanent difference, then tax expense would be simply taxes payable.
Temporary differences are differences in taxable and pretax incomes that will reverse in future years. That is, current lower (higher) taxes payable will be a future higher (lower) taxes payable. These differences result in deferred tax assets or liabilities. Various examples are as follows:
LT liabilities: The LT tax liability that results by using a declining balance depreciation for the tax returns and SL depreciation for the financial statements.
Current liabilities: The deferred tax assets created when warranty expenses are accrued on the financial statements but are not deductible on the tax returns until the warranty claims are paid.
LT assets: The deferred tax asset created when post retirement benefits expense in pretax income exceeds that allowed for a deduction on tax returns.
SHE: The gains or losses from carrying marketable securities at market value are deferred tax adjustments.
7. This is an example of a concept concerning adjustments that an analyst may want to make to a firm’s cash flows before they are compared to cash flows from another firm.
Capital lease vs. operating lease: There are 2 identical firms. Firm A gets it assets through a capital lease while Firm B gets its assets through an operating lease. How will their SCF differ?
Their lease payments will be the same, but Firm B’s lease payment goes through cash flows from operations as RENT while Firm A’s lease payment is split between the interest portion that goes through CFO and the principal reduction portion of the lease obligation that goes through Cash Flows from Financing.
Capital Lease Firm A’s CFO will be overstated relative to Operating Lease Firm B’s CFO.
Remember though, total cash flows (CFO + CFF) will be the same for both firms.
8. Describe the cash conversion cycle.
9. How do you compute Free Cash Flow?
10. Explain the relevance of cash flows to analyzing business activities.
The statement of cash flows relates the firm’s income statement to changes between the firm’s beginning of period and end-of-period balance sheets. The objective of the statement of cash flows is to show where all the cash came from and then where it all went during the accounting period.
This provides information that earnings cannot. Cash flow is essential to the continued operation of a business. It is important because it tells decision-makers whether:
- Regular operations generate enough cash to sustain the business.
- Enough cash is generated to pay off existing debts as they mature.
- Unexpected obligations can be met.
- The firm can take advantage of new business opportunities that may arise.
11. Describe the elements of operating cash flows?
Net cash flow from operations focuses on the liquidity of the company, rather than on profitability.
Interest and dividend revenue and interest expense are considered operating activities, but dividends paid are considered financing activities.
All income taxes are considered operating activities, even if some arise from financing or investing.
12. Describe the elements of investing cash flows?
Investing cash flows essentially deal with long-term assets.
Capital expenditures for LT assets
Proceeds from sales of assets
Cash flows from investments in joint ventures and affiliates and long-term investment in securities.
13. Describe the elements of financing cash flows?
Cash flow from financing represents acquiring and dispensing ownership funds and borrowings.
Financing cash flows deal with LT debt and equity. Examples include cash flows from additional debt and equity financing.
Debt financing includes both short and long-term financing.
Dividends paid are a financing cash flow because dividends flow through the R/E statement.
14. Some investing and financing activities do not flow through the statement of cash flows because they do not require the use of cash. Give some examples of these non-cash transactions.
a) Retiring debt securities by issuing equity securities to the lender.
b) Converting preferred stock to common stock.
c) Acquiring assets through a capital lease
d) Obtaining long-term assets by issuing notes payable to the seller
e) The purchase of non-cash assets by issuing equity or debt securities.
f) Exchanging one non-cash asset for another non-cash asset
While these activities don’t flow through the SCFs, they should be disclosed in either the footnotes or on a separate schedule as investing or financing events that did not affect cash.
15. What assets on the balance sheet are marked-to-market at the end of every operating period? What would the journal entry look like (what financial statement accounts are affected)?
Passive investments in READILY MARKETABLE securities.
Trading securities – unrealized gains/losses (a.k.a. holding gains/losses) flow through the income statement into SHE.
Available-for-sale securities – unrealized gains/losses go directly to SHE through Other Comprehensive Income. MV changes do not affect net income until these assets are sold.
16. What basic types of transactions trigger adjusting journal entries?
- Expiration or consumption of assets
- Realization (earning) of unearned revenues
- Accrual of unrecorded expenses
- Accrual of unrecorded revenues
17. How does preferred stock differ from common stock?
Preferred stock generally has some priority over common stock. Two of these priorities are:
- Dividend priority – Preferred shareholders receive dividends on their shares before common shareholders do. If dividends are not paid in a given year, those dividends are normally forgone. However, some p/s contracts include a cumulative provision stipulating that any forgone dividends must first be paid to preferred shareholders, together with the current year’s dividends, before any dividends are paid to common shareholders.
- Liquidation priority – If a company fails, its assets are liquidated with the proceeds paid to the debtholders and shareholders, in that order. Shareholders, therefore, have a greater risk of loss than do debtholders. Among shareholders, the preferred shareholders receive payment in full before common shareholders. This liquidation preference makes preferred shares less risky than common shares. Any liquidation payment to preferred shares is normally at is par value, although it is sometimes specified in excess of par; called a liquidating value.
18. There are two broad categories of stockholders’ equity, 1) contributed capital and 2) earned capital. Describe the components of each of these categories.
a. Contributed capital – This section reports the proceeds rec’d by the issuing company from original stock issuances. It often includes common stock, preferred stock and additional paid-in-capital. Netted against these capital accounts is treasury stock, the amounts paid to repurchase shares of the issuer’s stock from its investors less the proceeds from the resale of such shares. Collectively, these accounts are generically referred to as contributed capital (or paid-in capital).
b. Earned capital – This section consists of (a) retained earnings, which represent the cumulative income and losses of the company less any dividends to shareholders, and (b) accumulated other comprehensive income (AOCI), which includes changes to equity that have not impacted income and are, therefore, not reflected in retained earnings. AOCI often includes items such as foreign currency translation adjustments, changes in market values of derivatives, unrecognized gains and losses on AFS securities, and minimum pension liability adjustments.
19. What are the 2 general types of pension plans?
a. Defined contribution plans
b. Defined benefit plans
See p. 9-11
20. What is goodwill? How does it come about & how is it treated under GAAP?
21. When would you repurchase bonds?
Ratios
Long-lived assets
When would you repurchase bonds? Want to get out of covenants. Reputational penalty.