Would love to get some insight on these accounting questions. My friend and I disagree on how to answer these.
Walk through the financial statements when you purchase an asset w/ 50% debt and 50% equity.
Walk through a transfer from equity to debt?
How would an additional $100 in interest payments on machinery affect the financial statements?
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How would an additional $100 in interest payments on machinery affect the financial statements?
IS: interest expense up 10, assume 40% tax rate, so net income would go down 6.
CF: Net income down 6, so CF from Operations goes down by 6.
BS: Cash would go down 6, retained earnings down 6?
These are all the same question: Do you understand how the financial statements flow together? If you understand the flow of the financials, these kind of questions should be fairly straight forward. That being said, I acknowledge that it is easy to get confused or give an incomplete answer to questions like this in an interview. Here is what I believe to be the most complete and concise way to answer these kind of questions:
When the equipment (or any asset) is added: If cash was used, there would be no change to total assets on the BS. If debt is used to finance the acquisition total assets would increase by the amount of the purchase.
At the end of the period: The income statement would show increased depreciation and interest expense (if debt was used), which would decrease earnings and taxes (from the tax shield). This decrease in earnings would have a negative effect on stockholders equity. In addition, accumulated depreciation would increase, decreasing total assets. The statement of cash flows would show a cash flow for capital expenditures (if the asset is equipment), reported under cash flows from investing activities. If a tax asset/liability was created (due to different depreciation for GAAP and tax purposes), there would also be a decrease/increase in cash flows from operating activities.
In all of my interviews I never ran into any banker who was savy enough about accounting to ask about deferred tax assets and liabilities, but its a nice way to impress them if you do understand this aspect of accounting (if not, don't attempt).
-If you used a combination of debt and equity to fund your purchase, you simply need to acknowledge that the amount of debt and associated interest expense will be less than if all debt was used.
-This question is somewhat broad. I can perceive many ways in which a company could alter its capital structure in this way. (clarify and I will check back, or send me a pm)
-I assume that you mean interest on the debt used to purchase the machinery. This is just a simplified version of the above question. Increased interest would show up on the IS and would have an associated tax shield. Taxes and NI would be decreased. NI would flow to the BS and retained earnings would be less. Interest expense flows to the SCF through the NI line under operating activities. So, CF from operating activities would be less by the interest expense less its associated tax shield.
Hope this helps!
mschutzy, thanks for the response! Very helpful.
Knowing how the financial statements flow is definitely a weakness of mine, so how exactly should I improve? Accounting books discuss various line items, but don't seem to explain how an increase or decrease in one area flows throughout the rest of the documents. Is there a computer program where you can add or subtract an area to see what it affects?
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