Interview Question with the Three Financial Statements

romulusmars's picture
Rank: Baboon | 121

It's a common question - what effect does a depreciation expense have on all three financial statements? I can solve that one, but what other accounts or expenses are commonly asked about?

For example, what effect does capex have on all three statements?
I know it decreases cash flow from investing, increases PP&E on balance sheet, but what about income statement?

financial statements interview questions

In investment banking interviews, it is common for an interviewer to ask how would XYZ change affect the three financial statements. The most common question is "what is the impact of a $10 increase in depreciation on the three financial statements?"

We answer this question below:

  • Income Statement - Increase in expense by $10 to represent the increase in depreciation. Pre-tax income is down by $10. After tax (assuming a 40% tax rate), net income will be down $6.l
  • Statement of Cash Flows - Net Income flows onto the statement of cash flows as down $6. Then depreciation is added back due to the fact that it is a non-cash expense. -$6 + $10 = cash up $4
  • Balance Sheet - Cash is up by $4 on the assets side but PPE is down by $10 as depreciation is making that less valuable. Assets are down by $6. On the SE and Liabilities side, net income flows into retained earnings, making it down $6.

How Does Depreciation Impact Balance Sheet Position?

Without taking into account the income statement and cash flow statement impacts that flow through to the balance sheet, depreciation lowers the balance of the property, plant, and equipment.

Answering Financial Statements Questions

There are numerous iterations of this question. We list some of the common ones below.

  • $10 Purchase of Inventory
  • $20 Sale of Inventory
  • $20 Sale of Inventory on Account
  • $10 Increase in Capex
  • $10 Write Down of $110 Asset

There can realistically be any number of these questions and the only way to prepare for these questions it to really understand the three statements and think through any number of manipulations. Understanding the links between the statements are critical - you can learn more about this in the video below.

We review one of these questions posed by the OP below:

The income statement is unaffected as the purchase of new capital assets does not affect the current operating period. On the statement of cash flows, cash is lowered by $10 as the company has to shell out $10 to purchase or improve their assets. On the balance sheet, cash is down by $10 which is then offset by PPE increasing by $10. Assets are therefore unchanged. There is no impact to the SOCF or BS.

Read More About Accounting Interview Questions

Preparing for Investment Banking Interviews?

The WSO investment banking interview course is designed by countless professionals with real world experience, tailored to people aspiring to break into the industry. This guide will help you learn how to answer these questions and many, many more.

Investment Banking Interview Course Here

Comments (58)

Best Response
Jan 3, 2008

Dude if you can't figure this out you really need to study your accounting. Go grab the vault guide or something. Interviewers can basically pick any line item and/or expense and tell you to go through the three statements so you should know this extremely well. D&A, Capex, LIFO/FIFO, A/R, A/P, Inv, COGS, you name it.

To answer the question, capex doesn't affect the income statement. Increase in capex decreases cash on cfs by X, which flows to the bs through a decrease in cash by X and an increase in PPE by X. All you have to do is think about it logically instead of going through all the accounting adjustments and it almost always makes sense.

Another tip is to start with IS, then CFS, then BS - once the BS has balanced, then you're done.

    • 3
Jan 3, 2008

agreed with Mr. White -- think intuitively about this stuff and it should make sense. The only thing to keep in mind with questions about D&A and stuff like that is to understand which items need to be tax-adjusted and which do not, in order to arrive at the proper IS/CF numbers (namely, D&A is a non-cash charge and the aggregate amount should be added back to net income if you're calculating your CF's using the indirect method). And yes, also remember that CAPEX doesn't show up on your P&L.

Jan 3, 2008

I just got this in a phone interview 20 min ago.

Think of buying a factory or something, makes more sense

BS - Cash decrease, PP&E increase, no effect on liabilities unless you borrowed money for purchase

IS - Dep goes up, NI goes down by Dep Exp (1-Tax), since Dep is tax shield/whatever

CF - NI goes down, Dep would be adj, so ending cash is less

Retained Earnings - NI down, end result is decrease

Not sure if the above is 100%, but it's close haha.

Jan 3, 2008

This is correct (mostly) if you assume you bought (at working capacity) the investment at the beginning of the accounting period, in which case you would depreciate it. The easiest way to answer this question is, again, to go from IS to CFS to BS; otherwise you'll have to go through the cash calc twice (i.e. once for capex and once again for the D&A), and it'll be a lot harder to keep track of if they require you to use numbers or some variable to make sure things balance. As you can see from your CF logic, it is correct that ending cash is less, but it's incorrectly stated to be due to depreciation (at least I think that's what you're getting at), since D&A is a non-cash expense and will increase cash due to the tax shield it provides - the reason cash is less is because of the capex. However, it is unlikely for beginning of period questions and/or dual part questions like that to be asked.

waltersobchek:

I just got this in a phone interview 20 min ago.
Think of buying a factory or something, makes more sense
BS - Cash decrease, PP&E increase, no effect on liabilities unless you borrowed money for purchase
IS - Dep goes up, NI goes down by Dep Exp (1-Tax), since Dep is tax shield/whatever
CF - NI goes down, Dep would be adj, so ending cash is less
Retained Earnings - NI down, end result is decrease
Not sure if the above is 100%, but it's close haha.

Jan 3, 2008

so cf is higher than if dep exp is understated

Jan 3, 2008

i forgot about that

Jan 3, 2008

Cash flow is the same no matter what the depreciation is. Since cash flow = Net Income + Dep.

Jan 3, 2008
boz928:

Cash flow is the same no matter what the depreciation is. Since cash flow = Net Income + Dep.

yes, but higher depreciation acts as a "tax shield" which lowers you taxable income...which leads to more cash...here are soem practice problems I found..READ THE LAST ONE:

Identify each of the following items as either a positive cash flow, negative cash flow, or no effect, and identify the dollar amount (if a cash flow). Assume a marginal tax rate of 40%:

Q:Increase in Accounts Receivable by $5,000
A:Negative cash flow of $5,000 (a use of funds)

Q:Increase in Inventory by $10,000
A:Negative cash flow of $10,000 (a use of funds)

Q:Increase cash revenues by $100,000
A:Positive cash flow
$100,000 - 0.40($100,000) = $60,000

Q:Increase cash expenses by $60,000
A:Negative cash flow
-$60,000 + 0.40($60,000) = -$36,000

Q:Increase Accounts Paybable by $10,000
A:Positive cash flow of $10,000 (funds that do not have to be paid until some time in the future)

Q:Increase depreciation expense for tax purposes by $30,000
A:Positive cash flow
$30,000 (0.40) = $12,000

    • 1
Jan 3, 2008

Not trying to be rude. But you shouldnt be correcting someone when they are right. Double check your answers.

What if the poor guy looked at your wrong response and then got confused.

Jan 3, 2008

Any accounting textbook should explain how the statements are related. As long as you're excel-literate, you should be able to play around a little and figure it out.

Jan 3, 2008

I/S and B/S:

Net Income on I/S flows into Retained Earnings on B/S

Debt on B/S impacts Interest Expense on I/S

I/S and C/S:

NI from I/S flows into the reconciliation for C/S

C/S and B/S:

Cash on B/S is the Beg. Cash Balance on the C/S

Change in Working Capital is reflected on the C/S, particularly under Operating C/S

Ending Cash Balance flows right into the Cash item on the Balance Sheet for the next period

I don't think I missed anything, but I am in a rush, but that is the general gist.

    • 1
Jan 3, 2008

Thanks! That should help a lot. Just to be sure, can someone please confirm that that would be the best way to answer this question in an interview?

Jan 3, 2008

your assets decrease on BS (your liabilities will too if the asset was debt-financed). you recognize a gain of 2.5M below continuing operations on your I/S. there is a cash inflow of 7.5M from operations on your CF statement (there will be a cash outflow from financing activities if the asset was financed through debt).

Jan 3, 2008
pacman007:

your assets decrease on BS (your liabilities will too if the asset was debt-financed). you recognize a gain of 2.5M below continuing operations on your I/S. there is a cash inflow of 7.5M from operations on your CF statement (there will be a cash outflow from financing activities if the asset was financed through debt).

You normally wouldn't consider a sale of a plant (unless you were in the real estate business) part of CFO. It would usually go under CFI, just as the purchase of the plant would go through CFI in the first place.

Otherwise, pacman's right.

Jan 3, 2008
pacman007:

your assets decrease on BS (your liabilities will too if the asset was debt-financed). you recognize a gain of 2.5M below continuing operations on your I/S. there is a cash inflow of 7.5M from operations on your CF statement (there will be a cash outflow from financing activities if the asset was financed through debt).

Assuming indirect method for the CF statement, you will need to add subtract the gain of $2.5M under operating activities because its reflected within the Net Inc but the cash inflow has already been accounted by the $7.5M in financing.

Jan 3, 2008

If you're selling a plant with book value of 5 @ 7.5, it means you're realizing a $2.5mm gain on sale, which means you'd incur a tax obligation of (7.5 - 5) * (tax rate). Assuming a nice, even marginal rate of 40%, you'd have to pay taxes of $1mm, which means net income +1.5

Cash from investing activities is +7.5; -1 for outflows for capital gains tax, for net increase in cash of +6.5

This flows through to the BS, cash up by +6.5, PP&E -5; which means on the other side, retained earnings +1.5

Everything balances

Jan 3, 2008

"it seems that in China or HK, there are other standards requiring that a portion of depreciation should be capitalized and counted in inventory, than reflected in COGS."

Huh?

Inventory isn't depreciated(as far as I know.)

Depreciation is a way to allocate costs with revenues. The COST of inventory (aka COGS) is the cost that is matched with the revenues from selling the inventory.

You typically depreciate assets for which it's hard to match those costs with revenues because the asset remains on the balance sheet for more than that period. Anyway, capitalizing depreciation makes no sense, because that's like reversing the depreciation.

Can anyone else comment?

Jan 3, 2008

Well to my knowledge depreciation shows up in both COGS and also in the income statement.

I am assuming he was looking for the answer around the ballpark of "Well D&A can be found in both COGS and IS due to machinery that is used to make the good is depreciated in COGS. But you also have depreciation with IT equip or a desk and furniture since it is not related to the manufacturing of a good"

I think maybe something along those lines. Anyone else care to chim in ?

"Do you like Huey Lewis and the News?"

Jan 3, 2008

COGS is in the Income Statement...

Revenue
COGS
...
Depreciation Exp.

If this is a question about how depreciation is reflected in the 3 statements, then it's: Balance sheet: accumulated depr. Income statement: depr. exp. Cash flows: add back (typically) depr exp to the net income.

I mean, i'm pretty confused with the question though, so...

Jan 3, 2008
Febreeze:

COGS is in the Income Statement...

Revenue
COGS
...
Depreciation Exp.

If this is a question about how depreciation is reflected in the 3 statements, then it's: Balance sheet: accumulated depr. Income statement: depr. exp. Cash flows: add back (typically) depr exp to the net income.

I mean, i'm pretty confused with the question though, so...

^^This

Jan 3, 2008

Most income statements don't show depreciation as a separate line item. Depending on the company and industry standards, it is usually included as part of COGS or SG&A. Can't speak to how China or HK do things, but that's at least how things are often done here in US.

It doesn't really make a difference in your answer, so I don't see why it matters. Either way depreciation is a non-cash "cost of selling goods".

Generally just get depreciation off the statement of cash flows in the operating section.

Jan 3, 2008

Not sure if it will let me post a link to another website here, but see this:
http://yahoo.brand.edgar-online.com/displayfilingi...

Microsoft's income statement from their 10K. No line for depreciation. And yet when you look in their statement of cash flows, you can see they had 3 billion in depreciation. They lumped it in with something else, most likely cost of revenue or general & administrative. Read entire 10K and footnotes to figure out exactly where..

Jan 3, 2008
MFFL:

Not sure if it will let me post a link to another website here, but see this:

Microsoft's income statement from their 10k. No line for depreciation. And yet when you look in their statement of cash flows, you can see they had 3 billion in depreciation. They lumped it in with something else, most likely cost of revenue or general & administrative. Read entire 10K and footnotes to figure out exactly where..

oh that's why they kept asking me why D&A in IS...

It seems like the test book CorpFin of Ross and CFA taught me sth. unreliable..

Much appreciated!

Jan 3, 2008

On the income statement for US GAAP D&A is buried into COGS and SG&A. If you want to see it broken out on individual line items you have to go to the Statement of Cash Flows.

Jan 3, 2008
mossy695:

On the income statement for US GAAP D&A is buried into COGS and SG&A. If you want to see it broken out on individual line items you have to go to the Statement of Cash Flows.

that makes sense. my question is, will all the depr. that year be captured in IS?

Jan 3, 2008

Ok, so, in practice they include the costs of depreciation in the cost of inventory. That actually makes for a more precise matching of the costs and revenues.

"My question is, if so, when a company cannot sell out all the inventories that carry "depreciation", what is the answer to this traditional "depreciation and 3 statements" question?"

So, to answer OP, if they don't sell all of the inventory, those costs are captured within inventories, but are still reflected in the fixed assets through by netting them against accumulated depreciation.

Is that fair to say?

Jan 3, 2008
Febreeze:

Ok, so, in practice they include the costs of depreciation in the cost of inventory. That actually makes for a more precise matching of the costs and revenues.

"My question is, if so, when a company cannot sell out all the inventories that carry "depreciation", what is the answer to this traditional "depreciation and 3 statements" question?"

So, to answer OP, if they don't sell all of the inventory, those costs are captured within inventories, but are still reflected in the fixed assets through by netting them against accumulated depreciation.

Is that fair to say?

humm.... I am confused now. Because if depr. is associated with COGS, I think you must sell out all the inventories that capture the depr. that year right? So if you cannot sell them out, a portion of depr. that year cannot show up in IS?

let's say a weird situation.

your PPE depreciated 10 and you didn't sell out anything that year. so how will the IS and BS change?

assuming no tax

1) net income -10 due to depr. and same with total asset and equity

or

2) nothing changes in IS. PPE -10, inventory +10 and nothing changes in total asset

Jan 3, 2008

I'll start this by saying I have no idea what the Chinese accounting standards are like.

Under US GAAP depreciation is expensed each period in order to match the expense with the time period in which benefits are recognized. From what I gather from prior postings it sounds like the Chinese rule is to capitalize depreciation for equipment used to produce inventory into the inventory account itself like US GAAP does with factory overhead. This is another way of matching benefits with expenses because the depreciation does not hit the income statement until the inventory is credited and COGS is debited at the time of sale, which occurs when revenue is recognized.

I have no idea the way in which the depreciation will be allocated to the units of inventory but I would guess that the depreciation to be capitalized for this period will only be allocated to inventory that was produced during the current period and not any finished goods that existed in inventory at the beginning of the period.

The overall impact of this method is that the depreciation does not hit the income statement until the inventory in which it was capitalized to is sold.

So back to the interview question, I would focus on the two extremes, no inventory is sold during the period, and all inventory is sold during the period.

If no inventory is sold the depreciation stays in inventory and has no income statement impact, therefore no cash flow statement impact, PPE is lower 10 and Inventory is higher 10, total assets unchanged and total liabilities + equity unchanged.

If all of the inventory is sold then its just like the usual question with depreciation hitting the income statement through COGS, the tax benefit and all the usual stuff.

If some inventory is sold it depends on the inventory method that is used, LIFO, FIFO ...

Jan 3, 2008
we_be_bad:

I'll start this by saying I have no idea what the Chinese accounting standards are like.

Under US GAAP depreciation is expensed each period in order to match the expense with the time period in which benefits are recognized. From what I gather from prior postings it sounds like the Chinese rule is to capitalize depreciation for equipment used to produce inventory into the inventory account itself like US GAAP does with factory overhead. This is another way of matching benefits with expenses because the depreciation does not hit the income statement until the inventory is credited and COGS is debited at the time of sale, which occurs when revenue is recognized.

I have no idea the way in which the depreciation will be allocated to the units of inventory but I would guess that the depreciation to be capitalized for this period will only be allocated to inventory that was produced during the current period and not any finished goods that existed in inventory at the beginning of the period.

The overall impact of this method is that the depreciation does not hit the income statement until the inventory in which it was capitalized to is sold.

So back to the interview question, I would focus on the two extremes, no inventory is sold during the period, and all inventory is sold during the period.

If no inventory is sold the depreciation stays in inventory and has no income statement impact, therefore no cash flow statement impact, PPE is lower 10 and Inventory is higher 10, total assets unchanged and total liabilities + equity unchanged.

If all of the inventory is sold then its just like the usual question with depreciation hitting the income statement through COGS, the tax benefit and all the usual stuff.

If some inventory is sold it depends on the inventory method that is used, LIFO, FIFO ...

thank you man, it makes senses now.

so in terms of
"let's say a weird situation.

your PPE depreciated 10 and you didn't sell out anything that year. so how will the IS and BS change?

assuming no tax

1) net income -10 due to depr. and same with total asset and equity

or

2) nothing changes in IS. PPE -10, inventory +10 and nothing changes in total asset"

the answer should be #2 right?

and we have to use scenario analysis to answer the traditional question in interviews, or just walk through the traditional answer?

Jan 3, 2008

http://www.ibankingfaq.com/interviewing-technical-...

That's how you answer it, if it's the traditional question.

Jan 3, 2008
Febreeze:

That's how you answer it, if it's the traditional question.

thanks man, I know the traditional answer as mentioned in the original post. What I am interested in is that if you cannot sell out all the inventory produced that period, how to answer the question? - which is different from the traditional answer I believe, as Mr. We_Be_Bad has elaborated

Jan 3, 2008

ppe -10
inventory +3
depreciation exp. +7
operating income -7
rev -4.2 (40% tax)
cash +2.8 (subtract 4.2, add 7)

so, basically, the value of the asset shows the current depreciation, but you still match costs with revenues. can anyone comment?

edit: i still don't think that would happen, because depreciation is different than asset impairment - it's meant to match the costs with the revenues. so, they probably just depreciate the part that's sold, and leave the rest with the asset itself, not the inventory.

Jan 3, 2008

If no inventory is sold during the year then yes "2) nothing changes in IS. PPE -10, inventory +10 and nothing changes in total asset" would be what happens.

Jan 3, 2008

Isn't a portion of depreciation for production equipment always allocated to work-in-process inventory as factory overhead thus capitalizing it? Same for other expenses like rent, a portion would be allocated to WIP then plugged for COGS in expense. I thought this was included in GAAP?

Jan 3, 2008

This thread is getting convoluted. Has anybody actually been able to confirm that in HK or China they attach depreciation to individual units of inventory? Or are we all just taking that premise from what the OP's friends said and trying to back in to the answer? Sounds like a classic case of the telephone game.

Based on what you said, I would assume that the question asked in the interview is simply checking to see if you know that Depreciation is often included in a generic expense category like "Cost of Sales" or "SG&A". I feel like I rarely see the textbook "Cost of Goods Sold" line item because it strictly refers to the cost of the inventory units that you sold. Most firms use something like "Cost of Revenues" or "Cost of Selling Goods" as a more umbrella expense item that can include not just the actual cost of the units they sold, but also the cost of selling those goods (e.g. depreciation).

Jan 3, 2008
MFFL:

This thread is getting convoluted. Has anybody actually been able to confirm that in HK or China they attach depreciation to individual units of inventory? Or are we all just taking that premise from what the OP's friends said and trying to back in to the answer? Sounds like a classic case of the telephone game.

Based on what you said, I would assume that the question asked in the interview is simply checking to see if you know that Depreciation is often included in a generic expense category like "Cost of Sales" or "SG&A". I feel like I rarely see the textbook "Cost of Goods Sold" line item because it strictly refers to the cost of the inventory units that you sold. Most firms use something like "Cost of Revenues" or "Cost of Selling Goods" as a more umbrella expense item that can include not just the actual cost of the units they sold, but also the cost of selling those goods (e.g. depreciation).

Yeah, I think the interviewers were getting at what your 2nd paragraph talks about. To the OP: if you think about a retailer, D&A is often allocated to both COGS and SG&A, just like rent expense. Neither are typically broken out as line items on the income statement. I think that's all they wanted you to know.

Jan 3, 2008

feb, lol @ your sig

    • 1
Jan 3, 2008

.

Jan 3, 2008

Depends on the nature of the source of income (ie, local currency, functional currency or presentation currency) which results in a use of either the current or temporal method of translation.

Sorry for brief info, on my phone, but that should be enough to Google from.

Jan 3, 2008
Oreos:

Depends on the nature of the source of income (ie, local currency, functional currency or presentation currency) which results in a use of either the current or temporal method of translation.

Sorry for brief info, on my phone, but that should be enough to Google from.

Thank you for bringing back CFA Level II nightmares.

My name is Nicky, but you can call me Dre.

Jan 3, 2008

If it's a US company having branches in Europe and Euros went up for example, their sales in Europe will be paid in Euros; as a result, the company will have to exchange the Euros to USD. The sales $ in Income statement will go up even though there isn't a fundamental increase in sales of the actual product/service. That would trickle down to an increased Net Income that increases the amount of Retained Earnings in the Statement of Retained Earnings. Cash from Statement of of Cash Flow will inevitably increase because Net Income is included, and then the cash will go into BS so Assets are increased (So are Shareholders Equity + Liabilities because Retained Earnings are in Shareholder's Equity)

Jan 3, 2008

Like the dive from Saxman. In an interview would just stick with the basics below:

1. Income statement (Revs adjusted) which flows through full model
2. EBIT line and below most companies have hedges in place for roughly 10% flux in FX or another metric (mention this to look smart). Then say "if no hedges then...
3. Up or down on Net Income because of change (depends on movement)
4. Flow to cash flow... but net effect on foreign income is done at the end of the statement right after CFF as you can see from a filing.
5. Then you just calculate the change in cash/retained earnings to see what happens to the balance sheet.

Wouldn't boil the ocean on this one. If you're really hard core you can draw it all out once, but basically they are looking to see that you understand changes in FX, how they link and the real trick is really that the adjustment is **generally** done after the CFF line (just pull up a large-cap 8-k)

Jan 3, 2008

So just to clarify, on the statement of cash flows - net income on top would not change, the change would be reflected solely at the bottom of the statement under exchange rate adjustments?

Jan 3, 2008

There are two ways to think about it.

1. Mr. Saxman where you run through net income (so yes NI will change) leads to changes to RE. His answer is fine. This is the most common accounting type answer.

2. You run your cashflows based in a single currency then at the very bottom you adjust with a FX adjustment so NI looks under or over stated. Here's an example from EMC, look just below net cash in financing there is an adjustment

http://www.sec.gov/Archives/edgar/data/790070/0000...

The reason the above comment was phrased slightly differently was to show you have real experience looking at statements. Its a bit more "interesting" the way it is phrased and if they push you for the "cookie" response use Mr. Saxman.

The trick to interviews is to show you're paying attention when you do work and can hint that you've seen it before. If you talk about it a bit more high level and imply you've read through thousands of these statements before they are more likely to hire you. Hope that helps.

Jan 3, 2008
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Jan 3, 2008
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