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 firms 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 Bs lease payment goes through
cash flows from operations as RENT while Firm As 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 As CFO will be overstated relative to Operating Lease Firm
Bs 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 firms income statement to changes between
the firms 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:
a. Regular operations generate enough cash to sustain the business.
b. Enough cash is generated to pay off existing debts as they mature.
c. Unexpected obligations can be met.
d. 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)
b)
c)
d)
e)

Retiring debt securities by issuing equity securities to the lender.

Converting preferred stock to common stock.
Acquiring assets through a capital lease
Obtaining long-term assets by issuing notes payable to the seller
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 dont 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?

a.
b.
c.
d.

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:
a.

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 years dividends, before any dividends are paid to common
shareholders.
b. 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 recd 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
issuers 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.