Accounting Questions

First, net income from the bottom of the income statement flows to the top of the cash flow statement into cash flows from operations. Together with CFI and CFF, the cash flows into the assets section of the balance sheet. Finally, net income from the income statement flows into retained earnings under the equity section of the balance sheet.

How does a $10 increase in Depreciation affect the 3 financial statements? Assume a 40% tax rate

Assuming a 40% tax rate, the net income at the bottom of the income statement would be -6. We add back 10 in the cash flow statement under CFO. The net change in cash at the bottom of CFS is 4. +4 goes into the assets section of the balance sheet, but PP&E goes down by 10 due to depreciation. -6 net income flows into retained earnings under the equity section of the balance sheet. The balance sheet is balanced.

The income statement is based on accrual accounting. This means that the revenue is recognized at the time when goods and services are delivered, and costs are recognized at the time when they occur. We care not about cash inflows and outflows but rather when economic transactions occur.
If revenue/expense corresponds to the same time period of the income statement, changes will impact the income statement.
If revenue/expense affects a company's taxes, changes will impact the income statement.

Explain what happens on the 3 statements when the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. (Assume a 40% tax rate)

Stock-based compensation is a non-cash expense, so on the income statement, EBT decreases by 100. With a 40% tax rate, net income is -60. -60 net income flows into the top of CFO, but we add back 100 because it is a non-cash expense, so the net change in cash is 40. 40 flows into the assets section of the balance sheet. We add back 100 under the equity section of the balance sheet, and -60 from net income goes into retained earnings. The balance sheet is balanced.

A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change. (Assume a 40% tax rate)

Revenue = 120 -100 = 20. Assuming 40% tax rate, net income is 12. +12 flows to the top of CFO. -20 gain on sales under CFO. +120 under CFI. Net change in cash = 112. +112 in assets, then -100 in assets. Retained earnings = 12.

Explain the changes on 3 statements if Accounts Receivable goes down by $50. (Assume a 40% tax rate)

Income statement unaffected. Because accounts receivable is a working capital line item, the change in net working capital is +50. The net change in cash is +50. +50 on assets in balance sheet. -50 from accounts receivable under assets as well. Balanced.

Explain the changes on 3 statements if we purchase $100 Inventory using Cash. (Assume a 40% tax rate)

The income statement is unaffected because no transaction of goods and services have occurred. -100 under CFO. -100 in cash +100 in inventory in assets. Balanced.

Explain the changes on 3 statements if Prepaid Expenses increase by $10. (Assume a 40% tax rate)

Income statement unaffected. -10 CFO. -10 in cash, +10 in prepaid expenses under assets. Balanced.

Explain the changes on 3 statements if Prepaid Expenses decreases by $10. (Assume a 40% tax rate)

IS: Prepaid Expenses decreasing will decrease Earnings Before Tax by $10 because the expense has been recognized. With a 40% tax rate, Net Income will decrease by $6.
CF: Net Income decreasing by $6 flows through to the top line of CFO, where we add back $10 because Prepaid Expenses is a Working Capital Asset line item and it decreased by $10. Thus, the net change in cash is +$4
BS: Since the net change in cash is +$4, Cash increases by $4; Prepaid Expenses decreases by $10 since it is given in the question. Net Income flows through to Retained Earnings, so the Retained Earnings balance falls by $6. Since both Assets and Liabilities and Equity decrease by $6, therefore the balance sheet stays balanced

Explain the changes on 3 statements if Deferred Revenue increases by $20. (Assume a 30% tax rate)

IS: Deferred Revenue increasing will not impact the income statement because the revenue that is correlated with has not been recognized yet from a timing perspective. Therefore, there is no change in Net Income
CF: In Cash Flow from Operations, we record a cash inflow of $20, because Deferred Revenue is a Working Capital Asset line item and it increased by $20. Thus, the net change in cash is +$20
BS: Since the net change in cash is +$20, Cash increases by $20; Deferred Revenue increases by $20 since it is given in the question. There is no change in Retained Earnings because there was no change to Net Income. Since both Assets and Liabilities and Equity increase by $20, therefore the balance sheet stays balanced

Explain the changes on 3 statements if Deferred Revenue decreases by $20. (Assume a 30% tax rate)

IS: Deferred Revenue decreasing will increase Earnings Before Tax by $20 because the revenue has been recognized. With a 30% tax rate, Net Income will increase by $14
CF: Net Income increasing by $14 flows through to the top line of CFO, where we subtract $20 because Deferred Revenue is a Working Capital Liability and it decreased by $20. Thus, the net change in cash is -$6
BS: Since the net change in cash is -$6, Cash decreases by $6; Deferred Revenue decreases by $20 since it is given in the question. Net Income flows through to Retained Earnings, so Retained Earnings increases by $14. Since both Assets and Liabilities and Equity decrease by $6, therefore the balance sheet stays balanced

Yes, even though common stock cannot be negative, retained earnings can be negative, since dividends draw from it and net income flows through to the retained earnings balance each year. If retained earnings is more negative than the value of common stock, it results in negative shareholders' equity.

No, market cap can never be negative
market cap = share price * number of shares outstanding. neither of these values can be negative

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