Accounting Principles and Statements

Questions and Answers

What is included in the Income Statement?

Sales Revenue

Depreciation

Operating Income (EBITDA)

All of the above (correct)

Why is the Income Statement not affected by changes in Inventory?

The expense is only recorded when the goods associated with it are sold (COGS).

What are the primary components of the Statement of Cash Flows?

Net Income

Operating Activities

Investing Activities

All of the above (correct)

What does the Balance Sheet represent?

Assets = Liabilities + Shareholder Equity Signup and view all the answers

How do the three financial statements link together?

Net income from the Income Statement flows into Shareholders' Equity on the Balance Sheet and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement. Signup and view all the answers

If a company incurs $10 of depreciation, how does this affect the three financial statements?

Income Statement: EBIT declines by $10, net income declines by $6. Cash Flow Statement: Net income decreases by $6, depreciation increases by $10, resulting in a $4 increase in cash flow. Balance Sheet: Net PP&E decreases by $10, cash increases by $4, retained earnings decrease by $6. Signup and view all the answers

If depreciation is a non-cash expense, why does it affect the cash balance?

It is tax-deductible; depreciation reduces the amount of taxes you pay, affecting cash. Signup and view all the answers

Where does depreciation usually show up on the Income Statement?

All of the above Signup and view all the answers

How does a $100 cash purchase of equipment on Dec. 31 impact the three financial statements?

Year 1: No effect on Income Statement, Cash Flow Statement shows $100 use of cash in investing activities; Balance Sheet: cash decreases by $100, PP&E increases by $100. Signup and view all the answers

How does a $100 debt purchase of equipment on Dec. 31 impact the three financial statements?

Year 1: No effect on Income Statement, Cash Flow Statement shows $100 use of cash in investing activities, balance increase in financing activities; Balance Sheet: PP&E up $100, debt up $100. Signup and view all the answers

If cash collected is not recorded as revenue, what happens to it?

It usually goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Signup and view all the answers

Study Notes

Income Statement

Composed of five major sections: Sales Revenue, Cost of Goods Sold (COGS), Operating Expenses, Depreciation, Interest, and Taxes.
Begins with Sales Revenue and ends with Net Income.
Gross Profit is calculated as Sales Revenue minus COGS.

Impact of Inventory Changes on Income Statement

Inventory changes do not affect the Income Statement until goods are sold, linking expense recognition to actual sales.

Statement of Cash Flows

Reflects cash generation and usage, categorized into three activities: Operating, Investing, and Financing.
Operating Activities include Net Income adjustments for non-cash items and changes in working capital accounts.
Investing Activities cover capital expenditures and investments.
Financing Activities consist of cash movements related to debts, dividends, and equity sales.

Balance Sheet

Displays a company's financial position at a specific time, showcasing Assets, Liabilities, and Shareholder Equity.
Assets are divided into Current (cash, accounts receivable, inventory) and Long-term (property, plant, and equipment).
Equation: Assets = Liabilities + Shareholder Equity.

Linking the Three Financial Statements

Net income from the Income Statement contributes to Shareholder Equity on the Balance Sheet and the Cash Flow Statement.
Changes in Balance Sheet accounts influence cash flow due to working capital adjustments.
Transactions in investing and financing activities modify items on the Balance Sheet.

Impact of Depreciation on Financial Statements

A $10 pretax depreciation reduces EBIT by $10, resulting in a $6 decline in Net Income (assuming a 40% tax rate).
Cash Flow Statement shows Net Income decrease of $6 and adds back depreciation, resulting in a $4 increase in cash flow from operations.
On the Balance Sheet, Net Property, Plant & Equipment (PP&E) decreases by $10, while cash increases by $4, and retained earnings decrease by $6.

Depreciation's Role in Cash Flow

Depreciation lowers taxable income, reducing the tax burden and thereby indirectly influencing cash reserves.

Presentation of Depreciation on Income Statement

Can appear as a separate line item or included within COGS or Operating Expenses.

Cash Purchase of Equipment

Year 1: $100 capital expenditure has no immediate impact on net income, cash flow from operations, or the Income Statement.
Year 2: Straight-line depreciation leads to a $20 decrease in net income, an $8 increase in cash flow, and adjusted balances on the Balance Sheet.

Debt Purchase of Equipment

Year 1: No immediate changes to Income Statement; $100 increase in capex reflected in cash flow from investing activities, with no net impact on cash.
Year 2: Includes $20 depreciation and $10 interest expense, totaling an $18 decrease in net income, leading to a $2 increase in cash flow.

Treatment of Cash Collected Not Recorded as Revenue

This cash is recorded as Deferred Revenue on the Balance Sheet under Liabilities until it is earned as revenue on the Income Statement.

Cash-based vs. Accrual-based Accounting

Contrast between recognizing revenue and expenses when cash is exchanged (cash-based) versus when they are incurred or earned (accrual-based).

Description

Test your knowledge of key accounting principles including the income statement, cash flow statement, and balance sheet. This quiz covers the major components and concepts, as well as how inventory changes impact financial reporting.