Financial Accounting - Advanced

Question 1

How is GAAP accounting different from tax accounting?

Answer 1

1. GAAP is accrual-based but tax is cash-based.
2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

Question 2

What are deferred tax assets/liabilities and how do they arise?

Answer 2

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.

• Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet;
• Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.

*** They’re most common with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset

Question 3

Walk me through how you create a revenue model for a company.

Answer 3

There are 2 ways you could do this: a bottoms-up build and a tops-down build.

1. Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together.
2. Tops-Down: Start with “big-picture” metrics like overall market size, then estimate the company’s market share and how that will change in coming years, and multiply to get to their revenue.

Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible.

Question 4

Walk me through how you create an expense model for a company.

Answer 4

1. To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward.
2. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics.
3. Cost of Goods Sold should be tied directly to Revenue and each “unit” produced should incur an expense.
4. Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

Question 5

Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?

Answer 5

Use estimates.

• For the revenue if you don’t have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years.
• For the expenses, if you don’t have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

Question 6

Walk me through the major items in Shareholders’ Equity.

Answer 6

Common items include:

1. Common Stock – Simply the par value of however much stock the company has issued.
2. Retained Earnings – How much of the company’s Net Income it has “saved up” over time.
3. Additional Paid in Capital – This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering.
4. Treasury Stock – The dollar amount of shares that the company has bought back.
5. Accumulated Other Comprehensive Income – This is a “catch-all” that includes other items that don’t fit anywhere else, like the effect of foreign currency exchange rates changing.

Question 7

Walk me through what flows into Retained Earnings.

Answer 7

Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued

If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends.

Question 8

Walk me through what flows into Additional Paid-In Capital (APIC).

Answer 8

APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises

Take the balance from last year, add this year’s stock-based compensation number, and then add in the value of new stock created by employees exercising options this year.

Question 9

What is the Statement of Shareholders’ Equity and why do we use it?

Answer 9

This statement shows everything we went through above – the major items that comprise Shareholders’ Equity, and how we arrive at each of them using the numbers elsewhere in the statement. You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.

Question 10

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?

Answer 10

1. Restructuring Charges
2. Goodwill Impairment
3. Asset Write-Downs
4. Bad Debt Expenses
5. Legal Expenses
6. Disaster Expenses
7. Change in Accounting Procedures

Note that to be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges “below the line” then you do not add it back for the EBITDA / EBIT calculation.

Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges.

Question 11

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

Answer 11

Normally you make very simple assumptions and assume these are % of Revenue, % of OpEx, or % of COGS… Here are examples:

1. Accounts Receivable: % of Revenue
2. Deferred Revenue: % of Revenue
3. Accounts Payable: % of COGS
4. Accrued Expenses: % of OpEx or SG&A
   - Then you either carry the same percentages across in future years or assume slight changes depending on the company

Question 12

How should you project Depreciation and Capital Expenditures?

Answer 12

• The simple way:

— Project each one as a % of Revenue or previous PP&E balance

• The more complex way:

— Create a PP&E schedule that splits out different Assets by their useful lives, assumes Straight-Line Depreciation over each Asset’s useful life, and then assumes CapEx based on what the company has invested historically

Question 13

How do Net Operating Losses (NOLs) affect a company’s 3 statements?

Answer 13

The “quick and dirty” way to do this:

• Reduce the Taxable Income by the portion of the NOLs that you can use each year
• Apply the same tax rate
• Subtract that new Tax number from your old Pretax Income number (which should stay the same).

The way you should do this:

• Create Book Tax vs. Cash Tax schedule where you calculate the Taxable Income based on NOLs
• Look at what you would pay in taxes without the NOLs
• Book the difference as an increase to the Deferred Tax Liability on the Balance Sheet.

This method reflects the fact that you’re saving on cash flow – since the DTL, a liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.

Question 14

What’s the difference between Capital Leases and Operating Leases?

Answer 14

• Operating Leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement.
• Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

1. If there’s a transfer of ownership at the end of the term.
2. If there’s an option to purchase the asset at a bargain price at the end of the term.
3. If the term of the lease is greater than 75% of the useful life of the asset.
4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.

Question 15

Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement?

Answer 15

• This happens if D&A is embedded in other Income Statement line items.
• When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A.