How Does an Increase in the Allowance for Doubtful Accounts Flow Through the Financial Statements? Depreciation and the Purchase of Equipment. The impact of deferred revenue on a company's financial statements. Flow Through Questions NOTES TO ACCOMPANY VIDEOS These notes are intended to supplement the videos on ASimpleModel.com. They are not to be used as stand alone study aids, and are not written as comprehensive overviews of the topic detailed. The purpose of these notes is to provide a tangible collection of the visuals used in the videos with comments highlighting the more important aspects covered. 2018, LLC. All rights reserved.
013 Flow Through Questions INTRODUCTION: I regularly ask friends that work for or manage hedge funds and private equity funds what it is they look for most in an analyst as it relates to the financial modeling skill set, and what I hear most frequently is the ability to thoroughly understand and articulate how cash is created and consumed by a business. Concisely: an ideal candidate understands how a particular transaction impacts all three financial statements and can articulate the affect on cash flow. The ability to build financial models is a great skill set but the ability to sustain this mental framework, and think through all of these changes without having to reference a financial model should be the ultimate objective. As this framework develops, you will find that you are anticipating outcomes in your financial analysis as you make changes to your model (and perhaps more importantly in dialogue and negotiations). It will give you pause when the outcome is not congruent with your expectation, and help you find either errors in your model, or irregularities in the data you are working with. Eventually you will learn to spot these relationships and patterns without doing the work in Excel. As I have stated several times, I believe the process of integrating the three primary financial statements and the associated supporting schedules is one of the best ways to begin cementing these relationships and developing this mental framework because the process provides visuals for otherwise abstract concepts. The video associated with these notes uses an empty template with no historical information as a template to demonstrate how the purchase of equipment and associated depreciation impact the three financial statements. The notes also include a variety of additional topics (outlined on the page that follows). All of this material will be tested on the associated quiz and exam. (Note: I have always found it helpful to have an image of the accounting equation available as a reference while working through these exercises.) 2
013 Flow Through Questions TABLE OF CONTENTS: Quick Review of Accounts Receivable 4 Allowance for Doubtful Accounts The Direct Write Off Method The Allowance Method 5 5 6 Deferred Revenue 9 Quick Review of Depreciation in a Financial Model 11 Depreciation (Video Example) 12 DEBITS & CREDITS: These notes will consistently reference journal entries associated with the items listed above. If these concepts are new to you, I encourage you to pause and work through the exercise with a copy of the expanded accounting equation as a visual aid. Click on the link that follows for an image of the accounting equation: https://www.asimplemodel.com/topic/7/asm-quick-references/the-accounting-equation-debitscredits/ 3
013 Flow Through Questions Allowance for Doubtful Accounts Quick Review of Accounts Receivable: When a company sells a good or service it will often extend credit terms. A company s accounts receivable balance represents credit sales minus payments received and any adjustments. The company might deliver an invoice stating net 15, net 30 or net 60 days, meaning that payment is expected within that time frame. The sale and payment are recorded as follows: Recording a credit sale (i.e. payment not made in cash): Dr. Accounts Receivable (AR Increases) Cr. Revenue (Revenue Increases) Payment made by customer (cash is received): Dr. Cash (Cash Increases) Cr. Accounts Receivable (AR Decreases) It follows that a company can have a lot of cash tied up in accounts receivable, which is why Day Sales Outstanding (DSO) is closely monitored in financial analysis. DSO = Accounts Receivable / Average Sales per Day An increasing DSO means the collectability of receivables is declining. In other words, the company is struggling to convert sales into cash. Payment Terms with Discount: To encourage customers to pay sooner, the company might offer a discount. For example, payment terms 2/10, net 30 means the full amount is due within 30 days, but if payment is received within 10 days the customer will receive a 2% discount. 4
013 Flow Through Questions Allowance for Doubtful Accounts Allowance for Doubtful Accounts (a contra current asset account associated with Accounts Receivable): Note: Put as simply as possible, a contra account reduces the value of the account it is associated with. Recall that an asset account is increased by a debit. It follows that a contra asset account will always have a credit balance or zero balance. The Allowance for Doubtful Accounts is a reduction to receivables representing uncertainty the receivable will be collected. Often the Accounts receivable balance is presented net of the Allowance for Doubtful Accounts. Accounts Receivable, Net = Accounts Receivable Allowance for Doubtful Accounts What we project in most models. Accounts Receivable Financial Reporting: the Direct Write Off Method If a company does not create an Allowance for Doubtful Accounts, then the company will create a journal entry to write off a receivable in the event that the receivable cannot be collected (i.e. that the customer does not pay). When this happens the company must report bad debt expense on the income statement (debit entry) and reduce accounts receivable by the same amount (credit entry). Journal Entry (when a customer fails to pay): Dr: Bad Debt Expense (Increase) Cr: Accounts Receivable (Decrease) Typically this will happen in a different accounting period, which creates two issues: (1) it is a problem under the matching principle because the failure to pay is recorded in a different period, and (2) it means assets (in this case AR) might be overstated. 5
013 Flow Through Questions Allowance for Doubtful Accounts Accounts Receivable Financial Reporting: the Allowance Method The Allowance Method of reporting Accounts Receivable is the preferred method. Under this approach the company estimates what percentage of current receivables will not be collectible, and creates an Allowance for Doubtful Accounts. For example, assume the company has sales of $100,000 each month and estimates that 1% of sales will not be collected. On the income statement you will see $1,000 of bad debt expense each month, and on the balance sheet the Allowance for Doubtful Accounts would grow by $1,000 each month. Journal Entry (recording regular anticipated bad debt expense in each accounting period): Dr: Bad Debt Expense (Increase) Cr: Allowance for Doubtful Accounts (Increase) Keep in mind that this is an estimate. It does not mean that a customer has actually failed to make a payment. When a specific account actually becomes uncollectible that receivable is written off against the allowance: Journal Entry (specific client fails to pay): Dr: Allowance for Doubtful Accounts (Decrease) Cr: Accounts Receivable (Decrease) Notice that under the Allowance Method, a write off will not decrease net receivables. Accounts Receivable and the Allowance for Doubtful Accounts were reduced by the same amount. Consequently AR, Net remains the same. It s important to note that under the Allowance Method, when a customer does not pay, the change is recorded entirely on the balance sheet. 6
013 Flow Through Questions Allowance for Doubtful Accounts How Does an Increase in the Allowance for Doubtful Accounts Flow Through the Financial Statements? Income Statement: On the income statement, pretax income will be reduced by the increase in bad debt expense for the period, and net income will be reduced by the product of the amount of the increase and (1 Tax Rate). Balance Sheet: The increase will reduce Accounts Receivable, Net and consequently result in a lower Day Sales Outstanding. Cash Flow Statement: Bad debt expense is a non-cash item. (Included in AR, Net) It follows that if the allowance for doubtful accounts is understated then net income is overstated and vice versa. Additional Thought Exercise #1: If the allowance for doubtful accounts has a credit balance of $10,000, and you have reason to believe that an additional $5,000 of accounts receivable will not be collected, then an adjustment is required. For the sake of clarification, in this instance you believe that the allowance for doubtful accounts, which has a present credit balance of $10,000, should have a credit balance of $15,000. Journal Entry (to adjust the allowance for doubtful accounts upwards from a credit balance of $10,000 to a credit balance of $15,000): Dr: Bad Debt Expense $5,000 Cr: Allowance for Doubtful Accounts $5,000 7
013 Flow Through Questions Allowance for Doubtful Accounts Additional Thought Exercise #2: Assume that a company invoices its customers with terms of net 30 days, and that the company is estimating that 1% of credit sales will not be collected. What would the company record on the balance sheet assuming credit sales of $1,000,000 for the month? Journal Entry: Dr: Bad Debt Expense ($1,000,000 * 1% = $10,000) Cr: Allowance for Doubtful Accounts ($1,000,000 * 1% = $10,000) The balance sheet would reflect an accounts receivable balance of $1,000,000 less $10,000 balance in the allowance of doubtful accounts for a net amount of $990,000. Summary Review Journal Entries for Accounts Receivable: Recording a credit sale (i.e. payment not made in cash): Dr. Accounts Receivable Cr. Revenue Payment made by customer (cash is received): Dr. Cash Cr. Accounts Receivable Bad Debt Expense: Dr. Bad Debt Expense Cr. Allowance for Doubtful Accounts Writing Off a Bad Debt: Dr. Allowance for Doubtful Accounts Cr. Accounts Receivable 8
013 Flow Through Questions Deferred Revenue Deferred Revenue In this post we will look at the impact of deferred revenue on a company's financial statements. As you work through this post keep in mind that deferred revenue, which is also referred to as unearned revenue, represents a liability to the company. A visual representation of how deferred revenue flows through the three financial statements can be found at the bottom of this section. Please refer to the image on the next page for the sequence that follows. Example: A company invoices a customer for a $100 research report that requires payment in Month 3, and will be delivered to the customer in Month 4. MONTH ONE: Customer receives the invoice. Company records the following journal entry: Dr: Accounts Receivable $100 Cr: Deferred Revenue $100 Note: In this example no cash is received in Month 1. In many deferred revenue examples some cash is received in the first period. In this case you would simply debit cash and credit the deferred revenue account in the first accounting period for the sum received. Balance Sheet: Accounts receivable (asset) increases by $100, and deferred revenue (liability) increases by $100. Cash Flow Statement: Since we have an equal increase in both an asset and a liability, the impact to cash is zero. MONTH TWO: Nothing happens. You can see that there are no cash adjustments on the CF statement. MONTH THREE: In month three the customer pays. You will notice, however, that the report has not been delivered. So while the company has received cash in this period it will not record revenue. Journal Entry: Dr: Cash $100 Cr: Accounts Receivable $100 Balance Sheet: The accounts receivable balance is reduced by the amount of cash received, in this case $100. Deferred revenue remains a liability because the company has not yet delivered the product. Cash Flow Statement: The cash flow statement will take the difference in accounts receivable from the balance sheet, in this case creating a cash inflow of $100. 9
013 Flow Through Questions Deferred Revenue MONTH FOUR: In month four the research report is delivered and revenue is recorded. Journal Entry: Dr: Deferred Revenue $100 Cr: Revenue $100 Income Statement: The revenue associated with the contract flows through the income statement and (assuming it was priced appropriately) positive Net Income (NI in the image below). Balance Sheet: Deferred revenue is reduced to zero. Stockholder's equity (retained earnings specifically) grows by this amount of net income. Cash Flow Statement: At the top of the cash flow statement, net income grows by the amount associated with the sale of this research report. Deferred revenue, which was reduced from $100 to $0 on the balance sheet reduces cash flow by $100. The impact to cash flow for the period is -$100 + NI. (Note: because we do not show the cost of producing the report in this example, it can be assumed that NI is equal to $100 and that the impact to cash is $0.) 10
013 Flow Through Questions Depreciation Quick Review of Depreciation in a Financial Model: Depreciation on the Income Statement: Before we begin with the depreciation example, I wanted to provide some commentary on depreciation and the manner in which it is projected on the income statement in a financial model. There are two common approaches to projecting depreciation in a financial model: Depreciation embedded in COGS: With this approach, depreciation is not identified as its own line item on the income statement. Since depreciation is part of COGS, and both can be projected as a % of revenue, depreciation remains embedded in COGS on the income statement and is not identified separately on the income statement (closer to GAAP or IFRS presentation). INCOME STATEMENT 20X1 20X2 20X3 20X4 20X5 20X6 20X7 Revenue 74,452 83,492 91,841 101,025 111,128 122,241 134,465 Growth (%) NA 12.1% 10.0% 10.0% 10.0% 10.0% 10.0% Cost of Goods Sold 64,440 72,524 79,634 87,597 96,357 105,992 116,592 % of Sales 86.6% 86.9% 86.7% 86.7% 86.7% 86.7% 86.7% Gross Profit 10,012 10,968 12,208 13,428 14,771 16,248 17,873 % of Sales 13.4% 13.1% 13.3% 13.3% 13.3% 13.3% 13.3% Operating Expenses (SG&A) 6,389 6,545 7,540 8,294 9,124 10,036 11,040 % of Sales 8.6% 7.8% 8.2% 8.2% 8.2% 8.2% 8.2% Operating Income (EBIT) 3,623 4,423 4,667 5,134 5,647 6,212 6,833 COGS listed net of depreciation on the income statement: In the Leveraged Buyout video series, most of the models have income statements that specifically list "COGS (Net of D&A). If you are forecasting historicals without contemplating a change to operations (just continuing on growth trajectory), the first approach generally works. Since LBO strategy frequently contemplates a change in capital structure and operating strategy, it is likely that capital expenditures will look different post transaction. SCENARIO 1 12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019 12/31/2020 12/31/2021 12/31/2022 12/31/2023 Net Sales 50,000 50,000 50,000 52,500 55,125 57,881 60,775 63,814 67,005 Growth (%) NM 0.0% 0.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% COGS (Net of D & A) 29,383 29,383 29,383 30,852 32,395 34,014 35,715 37,501 39,376 % of Sales 58.8% 58.8% 58.8% 58.8% 58.8% 58.8% 58.8% 58.8% 58.8% Gross Profit 20,617 20,617 20,617 21,648 22,730 23,867 25,060 26,313 27,629 % of Sales 41.2% 41.2% 41.2% 41.2% 41.2% 41.2% 41.2% 41.2% 41.2% SG&A (Net of D & A) 8,595 8,595 8,595 9,025 9,476 9,950 10,448 10,970 11,519 % of Sales 17.2% 17.2% 17.2% 17.2% 17.2% 17.2% 17.2% 17.2% 17.2% EBITDA 12,022 12,022 12,022 12,623 13,254 13,917 14,612 15,343 16,110 % of Sales 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% Depreciation 1,250 1,250 1,250 1,311 1,376 1,445 1,517 1,593 1,673 Amortization 170 170 170 170 170 EBIT 10,772 10,772 10,772 11,142 11,708 12,301 12,925 13,580 14,437 I thought it was important to make this distinction should there ever be any confusion surrounding depreciation on the income statement. 11
013 Flow Through Questions Depreciation Depreciation and the Purchase of Equipment In this post we will answer two questions: 1. How does the purchase of a piece of equipment for $1,000,000 affect the financial statements? 2. How does an increase in depreciation flow through the financial statements? For the purpose of this exercise, assume a useful life of 10 years, and that the purchase is made in cash. Note: Too often this question is phrased by asking what happens when depreciation expense increases or decreases. While depreciation schedules can change, I thought it would provide helpful context to include the source of depreciation in the question. First let s start with the purchase of equipment. The company makes the purchase with cash on the balance sheet. This means that everything takes place on the asset side of the balance sheet: 1. Increase in Assets: Equipment 2. Decrease in Assets: Cash JOURNAL ENTRY: Dr. Equipment $1,000,000 Cr. Cash $1,000,000 (Note: I have always found it helpful to have an image of the accounting equation available as a reference while working through these exercises.) FINANCIAL STATEMENT IMPACT: Excluding the related depreciation expense, which we will address in part two. Balance Sheet: Cash is reduced by the amount of the purchase, and PP&E is increased by the amount of the purchase. Cash Flow Statement: The purchase of equipment appears as a cash outflow under Cash Flow from Investing Activities. 12
013 Flow Through Questions Depreciation Financial Model: The input that will cause this change to be reflected in a three statement model will most likely be located on the PP&E Schedule under "Capital Expenditures." The PP&E Schedule will link to PP&E on the balance sheet causing the $1,000,000 increase. The PP&E schedule will also link to capital expenditures under cash flow from investing activities on the cash flow statement. Recall that cash on the balance sheet is the sum of the prior period s cash balance and the current period s cash flow, the latter coming from the cash flow statement. By reducing cash flow for the period by the amount of the purchase, the balance sheet remains balanced. (Note: For a quick refresher on how the supporting schedules link to the three primary financial statements please watch Overview of the Process.) NOW we own the asset. Second let s look at the impact of an increase in depreciation expense associated with this purchase. We have assumed a useful life of 10 years, which (conveniently) means that depreciation expense increases by $100,000 in each period. (Please see the video on the Income Statement if this does not make sense.) FINANCIAL STATEMENT IMPACT: Income Statement: Depreciation related to equipment used to manufacture a product will fall under Cost of Goods Sold (COGS). So the first thing you will note is that COGS increases by $100,000 (because it includes depreciation). This reduces taxable income by $100,000. If you assume a 20% tax rate, then the tax payment is reduced by $20,000 and net income is reduced by $80,000 (note: this is why depreciation expense is often referred to as a "tax shield"). Balance Sheet: PP&E is reduced by the amount of depreciation. Retained earnings is reduced by the change in net income (-$80,000). The change in cash will be described in the next step. Cash Flow Statement: We start at the top with a lower net income (reduced by $80,000). We then add back depreciation expense of $100,000 because it is a non cash item. This increases cash flow from operations by $20,000. Financial Model: In summary, the balance sheet remains balanced because Cash (Asset) is increased by $20,000; PP&E (Asset) is reduced by $100,000; Retained Earnings (Stockholder s Equity) is reduced by $80,000. 13