Accounting Questions: have a look
A few accounting questions:
How would a £100 increase in depreciation charges affect the financial statements, particularly the balance sheet?
How would an additional £100 in capex affect the financial statements? How does it affect EPS?
How would an additional £100 in interest payments on machinery affect the financial statements?
Suppose I had a £100 surprise windfall in a given year. How does that affect the financial statements? What does this do to my enterprise value?
Do we amoritize goodwill? If not, then what do we do with it?
Does an IB analyst have to know that?
let me take a shot.
depreciation affects the income statement (would reduce pre-tax expense by 100), cash flow statement (you add back the entirety of the 100), and the PP&E account on your balance sheet. so an addition in depreciation would result in a reduction in EBIT by 100, an increase in CF by 100 (net of the 100 post-tax decrease that flows through the income statement), and a 100 reduction in your assets in the PP&E account.
an additional 100 in capex will increase the PP&E line on your balance sheet by 100. your cash flow statement will have the negative 100 spend on it. your income statement will be affected, but you don't know how much unless you know how many years to depreciate it. e.g. if you depreciate it over 5 years, there would be 20 of depreciation for the next 5 years and your EPS would be reduced by the post-tax amount of the 20, spread over your shares outstanding.
an additional 100 in interest reduces pre-tax income by 100, flows through to the cash flow statement in net income, and reduces your balance sheet net cash at the end of the year (e.g., less cash or more debt)
100mm windfall is the exact opposite of the 100 extra in interest expense. does not do anything to enterprise value - your market cap will go up by 100 but your net debt will go down by 100, net zero affect on ent value.
goodwill is not amortized. it simply sits there unless either you are bought out or something bad happens to your firm's reputation, etc. and you take an impairment on that goodwill.
Depreciation would reduce PP&E and operating income by 100. If you assume a 40% tax rate, it would have a tax shield of $40 because you effectively pay $40 less tax due to the dep. So Dep would reduce Net Income by $60. On the cash flow statement, Net Income is $60 lower, but you would add $100 of non-cash Dep to get to Operating Cash Flow, so there is a $40 increase in OCF. The Cash account on the BS ultimately increases by $40.
In sum, Assets decreases by $60 (since PP&E dec by 100 and Cash inc by $40), and Equity decreases by $60 (since Net Income decreases by $60).
I dawg wins. The most common mistake that people forget is taxes.
EXGSB
by the way - goodwill is not amortized for book purposes, but it is typically amortizable for tax purposes (straight line over 15 years I believe). This is why transactions with goodwill result in DTLs and DTAs.
in an acquisition you allocate a percent of excess purchase price to intangible assets and depreciate those over their useful life. or you may write up the book value of existing PP&E (this is what provides the tax benefit to the buyer to buying assets instead of stock).
goodwill, however, is never amortized for tax purposes -- not even pre 2001, when book amortization was allowed.
Sorry, GS is right on this. Under Section 338 of the tax code, the asset write up creates tax deductible goodwill, typically amortized over 15 years.
Goodwill created under Section 368 is not amortized for book purposes, pursuant to SFAS 142, but rather subject to incurrance-based impairment. However, impairment is not judged by management, as stated previously. It is the sole domain of the company's auditors.
Heh, wish someone would have posted this earlier.. Was asked all of these questions in my GS interview.
Least they didn't ask you what 2 back 20 forward was.
Regarding the Capex question:
Where can CapEx be found on the IS?
In the depreciation?
Bracket, I believe they are getting at where the annual cost accounts impacted by Capex are. So, depreciation is the right concept, but they are also likely assuming that depreciation does not appear on the IS (or may not include all capex related depreciation - that's why you look for it on the CF even when it appears on the IS).
The answer is that it is allocated to various cost categories, mostly G&A but can appear in almost any operating cost line depending upon the nature of the capex.
For example, you buy a $500 desk for your CEO. That's $500 in capex. Assume 5 years useful life, and mid-period purchase. That's $50 in depreciation expense you recongize in the current period. Where does it hit on the income statement? Probably G&A in this case.
Capex is a cash element, so on the cahsflow statement only.
Depreciation is the "equivalent" on the IS though and can be used as a proxy in some circumstances.
you could also take the change in PP&E balance from year current vs year current +1, assuming you have a contra account for acc dep.
For goodwill, we don't amortize, we do periodic impairment test and write it down if the market value is lower than the current book value.
By the way, this is clearly financial accounting questions. So depreciation is not going to affect tax payment in any way. Tax accounting is totally different from financial accounting.
So there is no tax effect?
For the change in depreciation expense, if it's only because your change in estimate of salvage value or change of depreciation method in financial reporting, then no, no tax effect.
For other things, like change in interest expense, it might have tax effect, you can estimate it using the company's marginal tax rate, but you can't tell exactly how much it would be.
GAAP depreciation may not affect cash tax payment calculated for the tax books, but it most definitely affects GAAP taxes. This question is a GAAP question, and the decrease in GAAP taxes affects provision for income taxes, net income, deferred taxes, cash on balance sheet, shareholders' equity etc etc.
While I wouldn't ding an M&A candidate who missed the tax effect, I would definitely have to kill a candidate who claimed that GAAP depreciation has no effect on taxes.
It does not affect your tax in any way. Your provision for income taxes is not even from your income statement.
Goodwill is never Amortized under GAAP, It is amortized under tax purchases for and Asset purcahse (You just by part of a company) over 15 years.
If you do a stock purchase of a company then it is not depreciated. There is a rare occurrance when both parties agree to take a section 338 election then you can depreciate it over 15 years but it causes the seller to pay tax on the gain. Usually only happens if the seller is private.
I actually got this question on an associate level interview. "When is goodwill amortized?" Never for GAAP, for tax just for an asset purchase or a section 338 election.
Just a couple of nuance tweaks to that answer. An asset sale need not be for only part of the company. It can be, and often is, done for an entire company. The reason to do one versus the other is a question of basis in stock vs assets for tax purposes, legal liability issues, and administrative ease. A a generalization, tax considerations usually make sellers prefer to sell stock and buyers prefer to buy assets.
A 338(h)(10) election requires a dual election, and a surviving entity on the seller side to absorb the tax liability, and so this is why Fjbfj says a private company (a subsidiary sale more correctly). However, an election under 338(g) can be a sole election by the buyer, and does not require a subsidiary sale. However, the conditions to make a (g) election worthwhile are fairly rare.
A one time £100 increase in depreciation will result in: (a) a decrease in EBIT by £100 (if you are assuming this company is taxed, then the tax shield (assuming 40%) would be £40, which would result in Net Income being reduced by £60) (b) on the balance sheet for assets you will find that PP&E will be reduced by £100 (PP&E is always reported as a net amount) notice that this leaves an inequality in our A=L+E equation (c) on the Cash Flow Statement we will add back depreciation to Net Income (because it is a non cash charge to Net Income - remember depreciation is a cost allocation method and is meant to smooth expenses in some sort of rational manner). Once we work our way down the CFS we will have a new balance of cash at the end of the year. This balance will become our “cash†line item on the Balance Sheet. Notice this “cash†line item will be exactly equal to the amount of the inequality we recognized in part b.
The effects of an additional £100 increase in CapEx will appear on the CF and BS directly and on the I/S indirectly: (a) on the CFS you will see CapEx reflected as an increase in investing activities (which is a decrease in cash). The end result is that cash at end of year will be reduced by the amount of CapEx. (b) since, once again, this will make an inequality on the BS, we need to account for this. On the BS you will find that an increase in CapEx is an increase in capital assets. (c)There is no effect on the income statement in a direct way. However, the Income Statement is affected through depreciation. Because the asset must be expensed some how, it will be depreciated over its useful life. I assume you can work out how depreciation will affect the statements from question 1 above.
Answer to EPS question: EPS will decrease since NI will be decreased by the depreciation component associated with the new Capital asset acquired through the Capital Expenditures.
**godsavethequeen, I am not sure my number 3 is entirely correct.
Windfall of £100 will result in the following: (a) I will assume the windfall is a £100 increase in NI, as a result R/E will increase by £100 and cash will increase by £100. (b) Since Enterprise Value = market cap + debt + minority interest + preferred shares - total cash and cash equivalents, it is easy to see that EV will be reduced by the increase in cash, all else held constant (this means assuming there is no increase in the value of the stock as a result of the windfall and that the company decides to hold on to the cash rather than paying out a dividend or share repurch). EV will fall by £100.
Goodwill is no longer amortized in the United States per GAAP. It is maintained in its original form (at historical cost). Each year management is required by the SEC to review goodwill for impairment (impairment is the lost of value for some reason). If management finds that it is impaired, goodwill is written down (reduced) by a measured value to reflect that impairment.
I hope this helped you out in a more orderly fashion. It’s important to know your links in the financial statements. It will help you understand the inside workings of models you will build later on.
Awesome, awesome answer.. Thanks a lot, Jaygatsby. Much appreciated.
thx for the explanations ghengis and jaygats... excellent post godsavethe queen
Glad I could help.
For the question GhengisKhan was addressing:
Depreciation is most definitely found on the I/S. When Capital Expenditures are made, they are recorded on the B/S as assets and offset with a decrease in cash or an increase in Liabilities (keeping our equation balanced). They are "written down" over time through a depreciation method. So assuming your $500 desk, 10 yr straight line method, $50 of depreciation will be recognized in year 1. This reduces your net income. It is a tax shield in effect because it reduces the total taxable Operating Profits (EBIT).
It is through the conduit of depreciation that capex is expensed in a consistent, rational manner. The only other way capex is expensed would be through true write downs which factor in impairment of the asset.
That should clear up the capex confusion.
Jaygatsby
That was my thought process in my earlier post. Thanks for the clarification.
GhengisKhan is right that GAAP taxes will be affected by dep and interest shields. This is correct as the I/S is based on GAAP taxing methods.
Sonyyy I think you are confusing true government taxable income with GAAP taxable income. The two are separate and distinct. There is a provision built into accrual accounting that allows for this. It is called deferred tax asset or deferred tax liability. A deferred tax liability arises from a mismatch in timing due to revenue recognition between the financial statement net income and the NI calculated for government tax purposes. If, because of revenue recognition reasons according to GAAP, less income is taxed in year one (resulting in more future taxes) the company will record a deferred tax liability which reflects this obligation to pay future taxes.
To break it down in one sentence: Accrual (GAAP) vs government tax (IRS) income is different and is provided for in deferred tax asset/liability.
Therefore, for GAAP purposes, there is a tax shield on depreciation and interest (because these are expenses which reduce the amount of taxable NI, like any expense).
Ok, you are right. I should've put it in this way. Change in depreciation does not affect the tax you pay to IRS, it affects your tax on your income statement and your deferred tax liabilities.
Per your post, +++++++++++++++++++++++++++++++++++++++++++++ A one time £100 increase in depreciation will result in: (a) a decrease in EBIT by £100 (if you are assuming this company is taxed, then the tax shield (assuming 40%) would be £40, which would result in Net Income being reduced by £60) +++++++++++++++++++++++++++++++++++++++++++++
I know that interest on debt is a tax deductible expense, and hence the concept of a debt tax shield that increases the enterprise value when you add in the future tax savings added from the debt tax shield.
That given, can someone explain how asset depreciation (which is deducted from the NI on I/S) results in a tax shield?
How are tax shields on depreciation calculated, and how does it differ from tax shields from interest on debt (bonds, loans, other liabilites etc)?
What is the rationale behind tax shields on depreciation. Debt tax shields were instituted to encourage the bond market and to stimulate the credit markets; what's the rationale behind tax shields on depreciation expense on tangible assets?
Great post by the way!
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