Accounting: Single-Step Changes on the Financial Statements

Question 1

Walk me through the financial statements when a company’s Operating Expenses increase by $100.

Answer 1

• Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by $100, and Net Income is down by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75. There are no other changes, so Cash at the bottom is down by $75.
• Balance Sheet: Cash is down by $75, so the Assets side is down by $75, and CSE on the L&E side is down by $75 due to the reduced Net Income, so both sides balance.
• Intuition: Nothing; it’s a simple cash expense.

Question 2

A company’s Depreciation increases by $20. What happens to the financial statements?

Answer 2

• Income Statement: Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but you add back the $20 in Depreciation since it’s non-cash, so Cash at the bottom is up by $5.
• Balance Sheet: Cash is up by $5, but PP&E is down by $20 due to the Depreciation, so the Assets side is down by $15. The L&E side is also down by $15 because Net Income falls by $15, which reduces CSE, so both sides balance.
• Intuition: This non-cash expense does not “cost” the company anything, but it reduces the company’s taxes.

Question 3

A company runs into financial distress and needs Cash immediately. It sells a factory that’s listed at $100 on its Balance Sheet for $80. What happens to the statements?

Answer 3

• Income Statement: You record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but you add back the $20 Loss since it’s non-cash. You also show the full proceeds received, $80, in Cash Flow from Investing, so cash at the bottom is up by $85.
• Balance Sheet: Cash is up by $85, and PP&E is down by $100, so the Assets side is down by $15. The L&E side is also down by $15 because CSE falls by $15 due to the Net Income decrease, so both sides balance.
• Intuition: The company gets the $80 in Cash proceeds, but it also gets $5 in tax savings from the Loss, so its Cash goes up by $85 rather than $80.

Question 4

A company decides to CHANGE a key employee’s compensation by offering the employee stock options instead of a cash salary. The employee’s cash salary was $100, but she will receive $120 in stock options now. How do the statements change?

Answer 4

Operating Expenses go up by $20, but the company also records $120 in non-cash expenses that are not Cash-Tax Deductible:

• Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but you add back the $120 in SBC as a non-cash expense. However, this SBC is not truly Cash-Tax deductible, so there’s a Deferred Tax adjustment for ($30), since ($120) * 25% = ($30). The company did not reduce its Cash Taxes with this SBC. Cash at the bottom is up by $75.
• Balance Sheet: Cash is up by $75, and the Net DTA is up by $30 because of the Deferred Tax adjustment, so the Assets side is up by $105. On the L&E side, CSE is down by $15 because of the reduced Net Income, but it’s also up by $120 because of the SBC, so the L&E side is up by $105, and both sides balance.
• Intuition: The company increases its Cash balance by switching the employee to StockBased Compensation, but it doesn’t realize any Cash-Tax savings from doing that – so, Cash is up by $75 rather than $120, $90, or some other, larger number.

If you don’t feel comfortable with the tax part, you could skip the Deferred Tax adjustment and just say that Cash, rather than the Net DTA, increases by $30.

Question 5

Walk me through the financial statements when a customer orders a product for $100 but doesn’t pay for it in cash. Then, walk through the cash collection, combining it with the first step.

Answer 5

The first step corresponds to Accounts Receivable increasing by $100, and the second step represents AR decreasing by $100. Here’s what happens when it increases:

• Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100, and Net Income is up by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $75, but the increase in AR reduces cash flow by $100, so Cash at the bottom is down by $25.
• Balance Sheet: Cash is down by $25, but AR is up by $100, so the Assets side is up by $75. On the L&E side, CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and balance.
• Intuition: The company has to pay taxes on Revenue it hasn’t yet collected in cash, so its Cash balance falls by $25.

And when the AR is collected, combining it with the first step:

• Income Statement: The Net Income is still up by $75, and there are no other changes.
• Cash Flow Statement: Net Income is still up by $75, but now the AR increase reverses, so the Change in AR is $0. Therefore, Cash at the bottom is up by $75.
• Balance Sheet: Cash is now up by $75, and AR goes back to its original level, so the Assets side is up by $75. The L&E side is still up by $75 because of the CSE increase due to the increased Net Income in the first step, so both sides balance.
• Intuition: This is a simple cash collection of a $100 payment owed to the company. Cash goes from being down by $25 in the first step to being up by $75 to reflect this.

Question 6

A company prepays $20 in utilities one month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is recognized, combined with the first step.

Answer 6

This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the increase:

• Income Statement: No changes.
• Cash Flow Statement: The $20 increase in Prepaid Expenses reduces the company’s cash flow by $20, so Cash at the bottom is down by $20.
• Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains balanced.
• Intuition: This is a simple cash payment for expenses that have not yet been incurred.

And then when Prepaid Expenses decrease, combining it with the first step:

• Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but the increase in Prepaid Expenses now reverses, and there are no other changes, so Cash at the bottom is down by $15.
• Balance Sheet: Cash is down by $15, and Prepaid Expenses return to their original level, so the Assets side is down by $15. The L&E side is also down by $15 due to the reduced Net Income that flows into CSE, so both sides balance.
• Intuition: Cash decreases by $15 because this represents the payment and recognition of a simple $20 cash expense, which reduces taxes by $5.

Question 7

Walmart buys $400 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600, combining it with the first step.

Answer 7

The first step is a simple Inventory purchase. In the second step, the company has to record COGS and the Revenue associated with the product sales. Here’s the first step:

• Income Statement: No changes.
• Cash Flow Statement: The $400 Inventory increase reduces the company’s cash flow, so Cash at the bottom is down by $400.
• Balance Sheet: Cash is down by $400, but Inventory is up by $400, so the Assets side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains in balance.
• Intuition: This is a simple cash purchase for an expense that has not yet been incurred.

And then here’s the second step, combining it with the changes in the first one:

• Income Statement: Revenue is up by $600, but COGS is up by $400, so Pre-Tax Income is up by $200, and Net Income is up by $150 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $150, the Inventory increase now reverses because the Inventory has been sold, and there are no other changes, so Cash at the bottom is up by $150.
• Balance Sheet: Cash is up by $150, and Inventory returns to its original level, so the Assets side is up by $150. The L&E side is also up by $150 because Net Income increases by $150 and flows into CSE, so both sides balance.
• Intuition: Cumulatively, this process is a simple $200 increase in Pre-Tax Income, which boosts Net Income by $150 at a 25% tax rate.

Question 8

Amazon decides to pay several key vendors $200 on credit and says it will pay them in cash in one month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash? Combine the second step with the first one.

Answer 8

This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and then decreasing by $200 when they’re finally paid out in cash.

• Income Statement: Operating Expenses increase by $200, so Pre-Tax Income is down by $200, and Net Income is down by $150, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $150, but AP increasing by $200 results in higher cash flow since it means the expenses haven’t been paid in cash yet. So, Cash at the bottom is up by $50.
• Balance Sheet: Cash is up by $50, so the Assets side is up by $50. On the L&E side, AP is up by $200, but CSE is down by $150 due to the reduced Net Income, so the L&E side is up by $50, and both sides balance.
• Intuition: This expense is “non-cash” at this point because it reduces the company’s taxes but doesn’t cost anything in cash. Cash is up because of the reduced taxes.

And then here’s the second step, combined with the first step:

• Income Statement: Net Income is still down by $150. No other changes.
• Cash Flow Statement: Net Income is still down by $150, but now the AP increase reverses, so the Change in AP becomes $0. As a result, Cash at the bottom is down by $150.
• Balance Sheet: Cash is down by $150, so the Assets side is down by $150. On the other side, AP returns to its original level, and CSE is down by $150 because of the reduced Net Income, so both sides are down by $150 and balance.
• Intuition: From beginning to end, this is a simple $200 cash expense; Cash decreases by $150 rather than $200 due to the tax savings in the first step.

Question 9

Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens to the statements?

Answer 9

This scenario corresponds to Deferred Revenue increasing because the company collects the Cash, but cannot yet recognize it as Revenue. The payment for the entire year is $1,200.

• Income Statement: No changes.
• Cash Flow Statement: DR increasing by $1,200 boosts 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.
• Intuition: This is a simple $1,200 cash inflow, with no taxes, for services the company has not yet delivered.

Question 10

What happens after one month has passed, and the company has delivered one month of service for $100?

Assume that there are $20 in Operating Expenses associated with the delivery of the service for this one month. Combine this step with the previous one.

Answer 10

• Income Statement: Revenue is up by $100, but Operating Expenses are up by $20, so Pre-Tax Income is up by $80, and Net Income is up by $60 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $60, and part of the DR increase now reverses, so the increase in DR is now $1,100 rather than $1,200. Cash at the bottom is up by $1,160.
• Balance Sheet: Cash is up by $1,160, so the Assets side is up by $1,160. On the L&E side, Deferred Revenue is now up by $1,100 instead of $1,200, and CSE is up by $60 due to the increased Net Income, so both sides are up by $1,160 and balance.
• Intuition: Cash is up by less than it was in the previous step because the company must pay expenses and taxes when part of the cash inflow is now recognized as Revenue.

Question 11

A company issues $100 in common stock to new investors to fund its operations. How do the statements change?

Answer 11

• Income Statement: No changes.
• Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from Financing, and there are no other changes, so Cash at the bottom goes up by $100.
• Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common Shareholders’ Equity on the other side goes up by $100, so the L&E side is up by $100, and both sides balance.
• Intuition: This is a simple cash inflow that doesn’t impact the company’s taxes at all.

Question 12

This same company now realizes that it has too much Cash, so it wants to issue Dividends or repurchase common shares. How do they impact the three statements differently? Compare $100 in Dividends with a $100 Stock Repurchase.

Answer 12

These changes both make a similar impact; the main difference is that Dividends do not reduce the common shares outstanding, but a Stock Repurchase does.

• Income Statement: No changes.
• Cash Flow Statement: Both of these show up as negative $100 entries in Cash Flow from Financing, reducing the Cash at the bottom of the CFS by $100.
• Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E side, Dividends reduce Retained Earnings within CSE by $100, while a Stock Repurchase reduces Treasury Stock within CSE by $100. But in either case, CSE is down by $100, so the L&E side is down by $100, and both sides balance.
• Intuition: These are simple cash outflows that don’t affect the company’s taxes at all.

We can’t determine how the common shares outstanding change without information on the share price at which the Stock Repurchase takes place.

Question 13

A company that follows U.S. GAAP signs a 10-year, $1,000 Operating Lease on January 1 and pays a total of $100 in Rent throughout the year.

Assume a 6% Discount Rate, and walk me through the financial statements over this entire year in a single step.

Answer 13

Initially, the company records the Operating Lease Assets and Liabilities on its Balance Sheet ($1,000 on both sides), and then it records the Rental Expense on the Income Statement. The 6% Discount Rate means that the initial “Interest Expense” is 6% * $1,000 = $60, so the “Depreciation” equals $100 – $60 = $40. Since the lease payments are constant, the “Lease Principal Repayment” equals the “Depreciation” here:

• Income Statement: Operating Expenses are up by $100 due to the Rent, so Pre-Tax Income falls by $100, and Net Income falls by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, but Operating Lease Assets and Liabilities increase by $1,000, which offset each other. But then they both decrease by $40, which is also an offset. So, Cash is down by $75 at the bottom.
• Balance Sheet: On the Assets side, Cash is down by $75, and Operating Lease Assets are up by $960, so Total Assets are up by $885. On the L&E side, the Operating Lease Liabilities are up by $960, and CSE is down by $75, so this side is up by $885, and both sides balance.
• Intuition: Cash is down by $75 because this is a simple $100 cash expense with $25 in tax savings, and the Lease Asset and Lease Liability change by the same amounts.

Question 14

A company that follows IFRS now signs a 10-year, $1,000 Operating Lease with a cash Rental Expense of $100 per year.

Assume a 6% Discount Rate and walk me through the statements over the entire year.

Answer 14

Under IFRS, the company records Depreciation of $1,000 / 10 = $100 per year and an initial Interest Expense of $1,000 * 6% = $60.

The Lease Principal Repayment = Cash Rental Expense – Interest Expense = $100 – $60 = $40.

• Income Statement: Depreciation is up by $100, and the Interest Expense is up by $60, so Pre-Tax Income is down by $160, and Net Income falls by $120 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $120, but you add back the $100 of Depreciation and record the $1,000 additions to the Finance Lease Assets and Liabilities (which offset each other). Also, you record a negative $40 for the Lease Principal Repayment. Cash is down by $60 at the bottom.
• Balance Sheet: Cash is down by $60, and the Finance Lease Assets are up by $900 due to the initial $1,000 increase and the $100 of Depreciation, so Total Assets are up by $840. On the other side, the Finance Lease Liabilities are up by $960, and Common Shareholders’ Equity is down by $120, so both sides are up by $840 and balance.
• Intuition: Cash is down by $60 because there’s a total of $200 in new Lease Expenses, but $100 of them are non-cash, and $160 of them reduce the company’s taxes. So,

($200) + $100 + $160 * 25% = ($60).

Question 15

For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records $40 in Depreciation. Walk me through the financial statements.

Answer 15

You don’t need to walk through the Tax Schedule for this type of change because the numbers are simple:

• Income Statement: The $20 in increased Depreciation reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate, so the company saves $5 in taxes.
• Cash Flow Statement: Net Income is down by $15, and you add back the $20 in Depreciation as a non-cash expense. However, the company recorded $40 of Depreciation for Cash-Tax purposes, so it actually reduced its Cash Taxes by $10, not $5. You record this additional $5 as a positive in the Deferred Income Taxes line on the CFS. Cash at the bottom is up by $10.
• Balance Sheet: Cash is up by $10 on the Assets side, and Net PP&E is down by $20, so the Assets side is down by $10. On the L&E side, the Deferred Tax Liability is up by $5, and CSE is down by $15 due to the reduced Net Income, so the L&E side is also down by $10, and both sides balance.
• Intuition: Cash is up by $10 rather than $5 or $0 because the company’s actual Cash-Tax

savings equals $40 * 25% = $10.

Question 16

A company has a factory shown at $200 on its Balance Sheet, but a hurricane hits the factory and destroys part of it, so the company records a $100 PP&E Write-Down. Walk me through the statements.

Answer 16

Normally, PP&E Write-Downs are not Cash-Tax deductible, so the “correct” treatment is:

• Income Statement: The $100 PP&E Write-Down reduces Pre-Tax Income by $100, and Net Income falls by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, but you add back the $100 WriteDown as a non-cash expense. In reality, however, the company saved nothing in Cash Taxes, so you also record a negative $25 in Deferred Income Taxes, and Cash at the bottom is unchanged.
• Balance Sheet: Cash does not change, but the Deferred Tax Asset increases by $25, and Net PP&E decreases by $100, so the Assets side is down by $75. The L&E side is also down by $75 because CSE falls due to the reduced Net Income, so both sides balance.
• Intuition: Cash does not change because Write-Downs are typically not Cash-Tax deductible, so the DTA, rather than Cash, increases.