Introduction

Accounting questions are one of the most common topics in investment banking interviews. Not only ill they quickly reveal if you grasp the basics required for the finance sector, but these questions also spread across various levels of difficulty, providing the interviewer with quite a broad range of options.

In essence, accounting questions span from basic concepts to advanced scenarios:

• ‍Basic Concepts: For example, understanding the difference between Accounts Receivable and Deferred Revenue.

• ‍Single-Step Scenarios: Such as explaining the impact on financial statements when Depreciation and Amortization (D&A) increases by £10.‍

• ‍Multi-Step Scenarios: For instance, discussing the financial impact of buying £100 of inventory fully financed by debt and then selling the produced items.‍

• Advanced Accounting: Including complex questions like the consequence of acquiring a 75% stake in another company for £100.

These questions aim to test not only your technical knowledge but also your analytical thinking and problem-solving skills.

Basic Accounting Principles

Accrual vs. Cash-Based Accounting

Accounting methods are essential for accurately recording and reporting a company’s financial performance. The two primary methods are accrual accounting and cash-based accounting.

• ‍Accrual Accounting: States that revenues and expenses are recorded when transactions occur, regardless of when cash is exchanged. This method provides a more accurate picture of a company’s financial position and performance by recognizing economic events regardless of cash flow.

• ‍Cash-Based Accounting: Records revenues and expenses only when cash is exchanged. This simpler method may not reflect the true financial health of a company, as it does not account for outstanding receivables or payables.

Key Takeaway: Accrual accounting provides a more accurate picture of a company’s financial health by recognizing economic events when they occur, rather than when cash is exchanged.

Revenue Recognition and Matching Principles

As a corollary, there are two principles are fundamental to accrual accounting:

• ‍Revenue Recognition Principle: This principle dictates that revenue should be recorded in the period when goods or services are delivered, not when cash is received. For example, if a company delivers a product in December but receives payment in January, the revenue is recognized in December.‍

• ‍Matching Principle: This principle requires that expenses be recorded in the same period as the revenues they help to generate. For instance, if a company incurs costs to produce goods sold in December, those costs should be recorded in December, even if the payment is made later.

Key Takeaway: Because most companies use accrual accounting, the revenue recognition principle and matching principle apply.

Key Financial Statements

Understanding the three main financial statements is critical for investment banking interviews. These statements provide a comprehensive view of a company's financial health and performance.

Income Statement

The income statement, also known as the profit and loss statement, shows a company’s revenues and expenses over a specific period, such as a month, quarter, or year. It begins with revenue and subtracts various costs and expenses to arrive at net income.

Key components:

• Revenue: The total value of goods or services sold.

• ‍Cost of Goods Sold (COGS): Direct costs associated with producing the goods or services sold.

• Gross Profit: Revenue minus COGS.

• ‍Selling, General & Administrative Expenses (SG&A): Indirect operational expenses.

• EBITDA: Earnings before interest, taxes, depreciation, and amortization.

• ‍Depreciation & Amortization (D&A): Non-cash expenses related to the loss of value of fixed and intangible assets.

• EBIT: Earnings before interest and taxes, calculated as EBITDA minus D&A.

• ‍Interest Expense: Cost associated with debt repayment.

• Pre-Tax Income (PBT): EBIT minus interest expense.

• ‍Taxes: Expense based on the corporate tax rate.

• Net Income: PBT minus taxes, representing the company’s profit.

Key Takeaway: The income statement shows the company’s revenue, expenses, gains, and losses over a period of time.

Balance Sheet

The balance sheet provides a snapshot of a company’s assets, liabilities, and shareholders' equity at a specific point in time. It follows the fundamental accounting equation: Assets = Liabilities + Shareholders’ Equity. Key components include:

• ‍Assets: Resources expected to generate future economic benefits, categorized as current (e.g., cash, accounts receivable, inventory) and non-current (e.g., property, plant, and equipment, intangible assets).

• ‍Liabilities: Obligations that will result in future cash outflows, categorized as current (e.g., accounts payable, short-term debt) and non-current (e.g., long-term debt, deferred tax liabilities).

• ‍Shareholders’ Equity: The residual interest in the assets after deducting liabilities, including common shares, additional paid-in capital, retained earnings, and treasury stock.

Key Takeaway: The balance sheet provides a snapshot of a company’s financial position at a specific point in time, showing what the company owns and owes.

Cash Flow Statement

The cash flow statement tracks the cash inflows and outflows over a specific period, divided into three sections:

• ‍Operating Activities: Cash generated from regular business operations. Adjustments are made for non-cash items such as depreciation and changes in working capital.

• ‍Investing Activities: Cash used for investment-related actions such as purchasing equipment or selling investments.

• ‍Financing Activities: Cash exchanges involving investors and lenders, including issuing or repurchasing stock and raising or repaying debt.

This statement is essential for understanding a company’s liquidity and overall cash management.

Key Takeaway: The cash flow statement shows the company’s change in cash over a period of time.

Direct vs. Indirect Method

There are two primary methods to prepare the cash flow statement: the direct method and the indirect method.

Both methods focus on the cash flows from operating activities but differ in presentation and calculation.

Direct Method

The direct method provides a detailed breakdown of cash receipts and cash payments from operating activities. It lists all major categories of gross cash receipts and payments, which makes it straightforward and easy to understand. This method provides more clarity on how cash is generated and used in operations.

Steps for Preparing Cash Flow Statement Using the Direct Method:

1. Cash Receipts from Customers: Sum the cash received from customers during the period.
2. Cash Payments to Suppliers and Employees: Sum the cash paid to suppliers and employees.
3. Cash Payments for Operating Expenses: Include cash paid for operating expenses not classified elsewhere.
4. Cash Payments for Interest and Taxes: Include cash paid for interest and taxes.

Indirect Method

The indirect method starts with net income and adjusts for changes in balance sheet accounts to convert the accrual basis of accounting to cash basis. It is more commonly used because it is simpler to prepare using information from the company’s financial statements.

Steps for Preparing Cash Flow Statement Using the Indirect Method:

1. Start with Net Income: Begin with the net income from the income statement.
2. Adjust for Non-Cash Expenses: Add back non-cash expenses such as depreciation and amortization.
3. Adjust for Changes in Working Capital: Adjust for changes in working capital accounts such as accounts receivable, accounts payable, and inventory.
4. Adjust for Non-Operating Gains and Losses: Adjust for gains and losses that are not related to operating activities.

Key Takeaway: The cash flow statement summarizes cash inflows and outflows over a period of time, highlighting the company's cash management and generation.

Key Accounting Ratios

Accounting ratios provide insights into various aspects of a company’s financial health. Key ratios include liquidity ratios, profitability metrics, and leverage ratios.

Liquidity Ratios:

• Current Ratio: Current Assets / Current Liabilities. It measures a company’s ability to pay short-term obligations.

• ‍Quick Ratio: (Current Assets - Inventory) / Current Liabilities. It assesses the company’s ability to meet short-term obligations without relying on inventory sales.

Profitability Ratios:

• Gross Margin: Gross Profit / Revenue. It indicates the percentage of revenue that exceeds the cost of goods sold.

• ‍EBITDA Margin: EBITDA / Revenue. It indicates the percentage of revenue that reamins after Opex.

• Net Margin: Net Income / Revenue. It shows the percentage of revenue that remains as profit after all expenses.

• ‍Return on Equity (ROE): Net Income / Shareholders’ Equity. It measures the return generated on shareholders' equity.

• Return on Assets (ROA): Net Income / Total Assets. It indicates how efficiently a company uses its assets to generate profit.

Leverage Ratios:

• Debt to Equity: Total Debt / Shareholders’ Equity. It shows the proportion of debt to shareholders' equity.

• ‍Interest Coverage Ratio: EBIT / Interest Expense. It measures a company’s ability to pay interest on its debt.

Frequently Asked Questions

Let's dive into some "classical" scenarios and concepts that are very common during investment banking interviews.

Scenarios

Understanding how different transactions impact financial statements is crucial. Here are some common scenarios:

Changes in Depreciation:

• Income Statement: An increase in depreciation expense reduces EBIT and net income.

• ‍Balance Sheet: Accumulated depreciation increases, reducing the book value of assets.

• Cash Flow Statement: Depreciation is added back in operating activities as it is a non-cash expense.

Changes in Accrued Expenses:

• Income Statement: Increased accrued expenses reduce net income.

• ‍Balance Sheet: Accrued expenses (liabilities) increase, affecting retained earnings.

• Cash Flow Statement: The increase in accrued expenses is added back in operating activities.

Changes in Accounts Receivable:

• Income Statement: Revenue increases, but no immediate impact on net income.

• ‍Balance Sheet: Accounts receivable (assets) increase.

• Cash Flow Statement: The increase in accounts receivable is deducted in operating activities.

Changes in Inventory:

• Income Statement: No immediate impact until the inventory is sold.

• ‍Balance Sheet: Inventory (assets) increases, reducing cash or increasing accounts payable.

• Cash Flow Statement: The increase in inventory is deducted in operating activities.

Key Takeaway: Changes in key financial metrics like depreciation, accrued expenses, accounts receivable, and inventory have cascading effects across the income statement, balance sheet, and cash flow statement.

Key Concepts

EBITDA and Operating Cash Flow

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a key metric for assessing a company's operational performance, and probably the most widely recognized and used metric. By removing the effects of financing and accounting decisions, it provides a clearer picture of operational profitability.

However, EBITDA does not account for capital expenditures, working capital changes, or other significant cash flows, limiting its usefulness as a standalone metric.

Deferred Revenue and Accounts Receivable

Deferred revenue represents cash received for goods or services not yet delivered, classified as a liability. Accounts receivable represents revenue earned but not yet received in cash, classified as an asset. Both affect cash flow and need careful management to ensure liquidity.

Accrued Expenses and Accounts Payable

Accrued expenses are incurred but not yet paid, affecting the income statement and balance sheet as liabilities. Accounts payable are amounts owed to suppliers, also classified as liabilities. Both need to be monitored to manage cash flow and financial obligations.

Goodwill and Intangible Assets

Goodwill is created during acquisitions, representing the premium paid over the fair value of the acquired company's net assets. It is not amortized but tested for impairment annually. Intangible assets, such as patents, have a finite useful life and are amortized over time. Understanding these assets' treatment is crucial for accurate financial analysis.

IFRS 16: Leases

IFRS 16 is a particularly tricky topic that frequently appears in investment banking interviews. The standard, which introduced significant changes to lease accounting, came into effect relatively recently in 2019. Interviewers often like to test candidates on this subject to see if they are up-to-date with current accounting standards and can understand their implications.

Key Changes Introduced by IFRS 16

The IFRS 16 standard, effective from January 1, 2019, introduced significant changes in lease accounting. The primary change brought about by IFRS 16 is in how lessees (companies leasing assets) account for leases in their financial statements. Key modifications include:

• ‍Elimination of Operating Lease Classification for Lessees: Previously, operating leases were treated as off-balance-sheet items. Under IFRS 16, most leases are now recognized on the balance sheet, requiring lessees to recognize a right-of-use asset and a corresponding lease liability.

• ‍Recognition of Lease Liability and Right-of-Use Asset: Lessees must now recognize a lease liability representing the obligation to make lease payments and a right-of-use asset representing the right to use the leased item.

• ‍Expense Recognition: Instead of recognizing a straight-line lease expense, lessees now recognize interest on the lease liability and depreciation on the right-of-use asset, resulting in a front-loaded expense profile over the lease term.

Key Takeaway: IFRS 16 aims to enhance financial reporting transparency and comparability between companies by requiring the recognition of lease obligations on the balance sheet.

Impact on Financial Ratios and Performance Measures

The implementation of IFRS 16 affects financial ratios and performance measures:

• ‍EBITDA: With lease expenses removed from operating expenses, EBITDA increases, providing a more accurate reflection of operational performance.‍

• ‍Balance Sheet Metrics: The inclusion of lease liabilities and right-of-use assets impacts metrics like return on assets (ROA) and debt-to-equity ratios.

Conclusion

Accounting principles are the stepping stone that you will help you navigate investment banking interviews. It´s the first place where you should start. By understanding the most relevant accounting concepts, the three financial statements, and common scenarios outlined in this post, you will be well-prepared to tackle accounting-related questions that come your way. Keep practising and stay curious.