Basic Accounting Interview Questions for Finance

The Income Statement shows a company's financial performance over a period and includes the following key components:

1. Revenue: The total income generated from the company’s core business activities. This is the starting point, representing the top line of the Income Statement.
2. Cost of Goods Sold (COGS): The direct costs of producing the goods or services sold. Subtracting COGS from Revenue gives Gross Profit.
3. SG&A (Selling, General & Administrative Expenses): Operating expenses that are not directly tied to production, such as marketing, salaries, and office expenses. Subtracting these from Gross Profit gives Operating Income (EBIT).
4. Operating Income: The profit from core business operations before interest and taxes.
5. Pretax Income: This is the Operating Income adjusted for any other income or expenses (such as interest income or expense). It’s the income before taxes are deducted.
6. Net Income: The final bottom line, after subtracting income taxes. This represents the company’s overall profitability for the period.

Each component affects the company’s profitability, either by contributing to income (Revenue) or reducing it through costs (COGS, SG&A, interest, and taxes).

Depreciation can either appear as a separate line item on the Income Statement or be included within Cost of Goods Sold (COGS) or Operating Expenses, depending on the company’s reporting practices. Regardless of its placement, depreciation always reduces Pre-Tax Income.

If depreciation increases by $500, it would affect the Income Statement as follows:

1. Increase in Depreciation: Depreciation is a non-cash expense, so an increase of $500 would increase operating expenses (SG&A or COGS, depending on the nature of the asset).
2. Reduction in Operating Income: Since depreciation is an expense, it would reduce Operating Income (EBIT) by $500.
3. Impact on Pretax Income: The increase in depreciation would also reduce Pretax Income by $500.
4. Net Income: Assuming a tax rate, the reduction in Pretax Income would lead to a lower Net Income. The tax savings from the depreciation would slightly offset this, so the Net Income would decrease by $500 * (1 - tax rate).

In summary, the increase in depreciation reduces both Operating Income and Net Income, but it also provides a tax shield, reducing the tax burden.

If inventory increases, it does not affect the Income Statement until it is sold, at which point it will be included in Cost of Goods Sold (COGS).

Working Capital is a measure of a company's short-term financial health and its ability to cover short-term liabilities with short-term assets. A positive Working Capital means the company can cover its short-term obligations, indicating good liquidity. 

Operating Working Capital excludes cash and debt to focus on operational efficiency. It is more commonly used in financial analysis as it reflects a company’s operational efficiency without the impact of financing activities

Causes of Negative Working Capital:

• Deferred Revenue: Companies with subscription models (e.g., Netflix) may have negative Working Capital because they receive payments upfront for services not yet delivered, creating high Deferred Revenue balances.
• Fast Cash Cycle: Companies with quick inventory turnover, such as Amazon, often have negative Working Capital because they receive payment upfront from customers, allowing them to pay off Accounts Payable without holding large cash reserves.
• Financial Distress: Negative Working Capital can also signal liquidity problems if a company struggles with slow receivables and has high debt.

Implications:

• Positive: Negative Working Capital can indicate efficient cash flow management, as the company generates cash upfront to fund operations.
• Negative: If caused by poor receivables management or excessive debt, it can signal financial instability, potentially leading to cash flow issues or bankruptcy.

Deferred revenue is money received for services or products not yet provided. It doesn’t impact the Income Statement right away, but is recorded as revenue when the service is delivered or the product is provided.

Examples include:

• Airlines: Selling tickets for future flights, recognizing revenue as flights are completed.
• Software as a Service (SaaS): Companies like Microsoft receive payment upfront for annual subscriptions, recognizing revenue over time.
• Gym memberships: Cash received upfront for a yearly membership, recognized monthly as services are provided.

• Balance Sheet: Initially, deferred revenue is recorded as a liability. As the service is performed, it is reclassified to revenue, reducing the liability.
• Cash Flow Statement: The cash received upfront is recorded as an increase in cash under operating activities. However, the actual revenue recognition does not directly affect cash flow, as it has already been received.

Cash-based accounting records transactions only when cash is actually received or paid. Accrual accounting, on the other hand, records transactions when they occur, regardless of when cash changes hands.

Example:

• Cash-based accounting: A freelance graphic designer who completes a project in December but gets paid in January recognizes the revenue in January when the payment is received.
• Accrual accounting: A fitness franchise sells annual memberships in December but delivers services (e.g., gym access) monthly throughout the year. The franchise recognizes revenue monthly as services are provided, not when the customer pays upfront in December.

Accrual accounting provides a more accurate view of financial performance by matching revenue with the time it was earned, rather than when cash flows in or out.

Cash-based accounting is typically used by small businesses, freelancers, or individuals with simpler operations who primarily deal with immediate cash transactions. It is easier to manage and works well when cash flow is straightforward, as income and expenses are recorded when cash is received or paid.

Accrual accounting is used by larger businesses, corporations, or companies with more complex operations, especially those that have credit transactions or offer services over time. It provides a more accurate picture of a company’s financial health by matching revenues to the period in which they are earned, regardless of when the cash is received, and is required for publicly traded companies.