Two different answers for same/similar M&I 400 question regarding factories breaking down.
This involves a chain of questions that come before it so I apologize if it is a little confusing. Ultimately, the debt needs to be paid and the factories need to be written down.
I understand that these two questions are slightly different in terms of the time period that they start with. Does someone mind elaborating more about the difference between these two questions?
This first question comes from the Accounting Guide from the M&I 400. It is question#3 for the multi-step scenarios for the basic portion of accounting. At the end of Year 2, the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements ONLY from the start of Year 2 to the end of Year 2.
After 2 years, the value of the factories is now $80 if we go with the 10% Depreciation per year assumption. It is this $80 that we will write down on the 3 statements. Also, don’t forget about the Interest Expense – it still needs to be paid in Year 2.
Income Statement: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense, so Pre-Tax Income is down by $100. Net Income is down by $60 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but the Write-Down and Depreciation are both non-cash expenses, so we add them back and cash flow is up by $30 so far. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Financing falls by $100. Overall, cash at the bottom decreases by $70.
Balance Sheet: Cash is now down by $70, and PP&E has decreased by $90, so the Assets side is down by $160. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $60, Shareholders’ Equity is down by $60. Both sides are down by $160 and balance.
This portion is from the M&I 400 questions guide and is question 14. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.
After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements.
First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48.
On the Cash Flow Statement, Net Income is down by $48 but the write-down is a non- cash expense, so we add it back – and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68.
On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148, and both sides balance.
End of year 2 you have depreciation expense as well as interest expense, you wouldn’t have those at the beginning of the year. Which part are you not getting?
I apologize for not mentioning this earlier, but this is the question before. It talks about the beginning of year 2 and in this scenario, Apple needs to pay interest and D&A happens. They don't say that it is the end of year 1 but rather the start of year 2.
Question 2 on the M&I Basic Multi Step Accounting Guide: Now let’s go out one year, to the start of Year 2. Assume the Debt is high- yield, so no principal is paid off, and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now?
Assume that we have already factored in the changes from Part 1 and are only tracking what happens AFTER those have taken place.
After a year has passed, Apple must pay Interest Expense and must record the Depreciation. Income Statement: Operating Income decreases by $10 due to the 10% Depreciation charge each year, and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income falls by $12. Cash Flow Statement: Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
Balance Sheet: On the Assets side, Cash
is down by $2 and PP&E is down by $10 due to the Depreciation, so overall the Assets side is down by $12.
On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.
Remember that the Debt number itself does not change since we’ve assumed that nothing is paid back.
Which part don’t you get?
I am confused in the inconsistencies of time periods and the resulting answers among the questions.
One question talks about the start of year 2 where you pay off the interest from year 1 and account for the D&A. In the other question, it talks about the end of year 3. However, it does not account for paying off the interest from year 2 or the D&A from year 2. Then, in the other question, it talks about the end of year 2 but the D&A and interest from year 2 are in this question.
I'm just confused on when to account for the D&A and interest. Is that something I should specify when I am answering the question?
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