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Wall Street Prep
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Wall Street PrepDo companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, companies generally prefer straight-line depreciation. That's
because a company will record lower depreciation in the early years of the asset's life than if
they had used accelerated depreciation. As a result, companies using straight-line
depreciation will show higher net income than under accelerated depreciation.
Do companies depreciate land?
No, land is considered to have an indefinite life and is not depreciated.
Can companies amortise goodwill?
Under GAAP, public companies are not allowed to amortise goodwill. Instead, it must be
tested annually for impairment.
The longer answer is that under GAAP, public companies are not allowed to amortize
goodwill and must instead test it annually for impairment. However, private companies may
elect to amortize goodwill. In addition, for tax reporting purposes, goodwill may be amortized
over 15 years under some circumstances.
What is the impact of share issuance on EPS?
The major impact to EPS is that the actual share count increases, thereby decreasing EPS.
However, there is sometimes an impact on net income. That's because assuming share
issuances generate cash for the company, there will be higher interest income, which
increases net income and EPS slightly. Because returns on excess cash for most companies
are low, this impact is usually very minor and doesn't offset the negative impact to EPS from
a higher share count.
What is the impact of share repurchases on EPS?
The major impact to EPS is that the actual share count is reduced, thereby increasing EPS.
However, there is sometimes an impact on net income. That's because assuming share
repurchases are funded with the company's excess cash, any interest income that would
have otherwise been generated on that cash is no longer available, thereby reducing net
income - and EPS - slightly. Because returns on excess cash for most companies are low,
this impact is usually very minor and doesn't offset the positive impact to EPS from a lower
share count.
,How do you calculate earnings per share?
Earnings per share (EPS) is calculated as net income divided by the company's weighted
average shares outstanding during the period.
There are two ways to measure EPS - Basic and Diluted. Basic
EPS is net income divided by the actual shares, while Diluted EPS is net income divided by
actual shares and shares from potentially dilutive securities such as options, restricted stock,
and convertible bonds or stock.
A company acquired a machine for $5 million in 2003 and has since generated $3 million in
accumulated depreciation. In addition, the PP&E now has a fair value of $20 million.
Assuming GAAP, what is the value of that PP&E on the company's balance sheet?
The short answer is $2 million. Except for certain liquid financial assets which can be written
up to reflect fair market value, companies must carry the value of assets at their historical
cost.
Do you amortize intangible assets?
Intangible like customer lists, copyrights and patents - assets that have a finite life - are
amortized, while others like trademarks (and goodwill) are considered to have indefinite lives
and are not amortized.
How do capital leases affect the three financial statements?
Leases treated as capital leases (as opposed to operating leases) create an asset and
associated liability for the thing that is being leased. For example, if a company leases a
building for 30 years, the building is recognized as an asset on the lessee's balance sheet
with a corresponding debt-like liability. The income statement impact is the depreciation
expense associated with the building, as well as interest expense associated with the
financing.
How do operating leases affect the three financial statements?
Under US GAAP, companies can choose to account for leases as operating or capital
leases.
Operating leases primarily only impact the income statement. When leases are accounted
for as operating leases, lease (rent) payments are treated as operating expenses like wages
and utilities: Regardless of whether you sign a 1-year lease or a 30-year lease, every time
you pay the rent, cash is credited and an operating expense is debited.
, The only significant balance sheet impacts have to do with timing differences between
payments (prepaid and accrued rent) and the matching of rent payments to when the tenant
benefits from that rent (leading to balance sheet accruals for smoothing of rent escalations
and upfront rent incentives like a free month). Starting in 2019, operating leases will no
longer be allowed under US GAAP.
How can a profitable firm go bankrupt?
To be profitable, a company must generate revenues that exceed expenses. However, if the
company is ineffective at collecting cash from customers and allows its receivables to
balloon, or if it is unable to get favorable terms from suppliers and must pay cash for all
inventories and supplies, what can occur is that despite a profitable income statement, the
company suffers from liquidity problems due to the timing mismatch of cash inflows and
outflows.
While reliably profitable companies who simply have these working capital issues can
usually secure financing to deal with it, theoretically, if financing becomes unavailable for
some reason (the 2008 credit crisis is an example where even profitable companies couldn't
secure financing), even a profitable company could be forced to declare bankruptcy.
Is it bad if a company has negative retained earnings?
Not necessarily. Retained earnings will be negative if the company has generated more
accounting losses than profits. This is often the case for early-stage companies that are
investing heavily to support future growth. The other component of retained earnings is
common or preferred dividends, which could contribute to a lower or even negative retained
earnings.
What's more important: the income statement or the cash flow statement?
hey are both important and any serious analysis requires using both. However, I would think
that the cash flow is slightly more important because it reconciles net income, the
accrual-based bottom line on the income statement to what's happening to cash, while also
showing you the critical movement of cash during the period. Without the cash flow
statement, I can only see what's happening from an accrual profitability standpoint. The cash
flow statement on the other hand can alert me to any liquidity issues, as well as any other
major investments or financial activities that do not hit the income statement.
The one situation in which I would prefer the income statement is if I also have the beginning
and end-of-year balance sheet. That's because I could reconcile the cash flow statement
simply by looking at the balance sheet year over changes along with the income statement.
Why are increases in accounts receivable a cash reduction on the cash flow statement?
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