Accounting questions
Read firstHow the statements connect. Valuation without accounting is memorization.
Organized by concept rather than as a numbered list, because that is how they get asked. The follow-up matters more than the question, so each one has both.
The linkage questions
Walk me through the three statements.
The income statement shows revenue and expenses over a period and ends in net income. The balance sheet shows what the company owns and owes at one instant, and assets equal liabilities plus equity. The cash flow statement reconciles net income to the actual change in cash, in three sections: operating, investing, financing.
They are one system. Net income is the first line of the cash flow statement. Ending cash from the cash flow statement is the cash line on the balance sheet. Net income less dividends goes into retained earnings.
Then they ask
If you could only use one, which would you pick?
The cash flow statement. Hardest to manipulate, and net income appears at the top so you get part of the income statement for free. The real cost is losing the balance sheet, because you would not know the debt load.
Depreciation increases by $10. Walk me through the statements. Assume a 25% tax rate.
Income statement: depreciation is an expense, so pretax income falls $10 and net income falls $7.50.
Cash flow statement: start at negative $7.50 of net income, add back the full $10 because no cash left. Operating cash flow rises $2.50, and with nothing in investing or financing, cash rises $2.50.
Balance sheet: cash up $2.50, PP&E down $10, so assets fall $7.50. Retained earnings fall $7.50 with net income. Both sides fall $7.50. Balanced.
Then they ask
Why did cash go up when the company recorded a loss?
Because the only real event was a $2.50 tax deduction. The asset was paid for in an earlier year, and depreciation is the accounting catching up with cash that already left.
A company buys $100 of equipment funded entirely by new debt. Walk me through it.
Day one: nothing on the income statement, because buying an asset is not an expense. Investing shows $100 out, financing shows $100 in, so cash is unchanged. PP&E up $100, debt up $100.
Year one, straight line over ten years at 5% interest: $10 of depreciation and $5 of interest cut pretax income $15 and net income $11.25. Add back the $10 and operating cash flow falls $1.25. PP&E falls to $90, cash falls $1.25, retained earnings fall $11.25.
Then they ask
What about repaying the principal?
It is a financing outflow and never touches the income statement. That is why a company can be profitable and still fail to meet a maturity.
The non-cash charge questions
Inventory is written down by $30. What happens?
Net income falls $22.50 after tax. The full $30 is added back as a non-cash charge, so operating cash flow rises $7.50, which is the tax saving.
Balance sheet: inventory down $30, cash up $7.50, so assets fall $22.50. Retained earnings fall $22.50. Balanced.
Then they ask
Should the inventory decline also show up in working capital?
No, and that is the trap. Counting the add-back and the working capital source would produce $37.50 and create cash out of nothing. The inventory fell because it was written off, not because it was sold.
Goodwill is impaired by $30. How is that different?
Goodwill impairment is generally not tax deductible, so there is no shield. Net income falls the full $30.
The full $30 is added back, so operating cash flow does not move at all and neither does the cash balance. Goodwill falls $30, retained earnings fall $30.
Then they ask
Why is goodwill not amortized?
Because standard setters decided its life is indefinite, so it is tested for impairment instead. The practical effect is that the cost arrives all at once when an acquisition disappoints, rather than a little each year.
Why is stock-based compensation added back?
Because no cash left the company, and the cash flow statement reconciles net income to cash. On that question the add-back is correct.
It is contested because the shareholder still paid, in dilution. A company paying $100M in cash and one paying $100M in stock have the same economics for employees and different reported cash flow.
Then they ask
So how do you handle it in a valuation?
Either treat it as a real cost and do not add it back, or add it back and grow the share count. Doing both, which is the default in a lot of published models, understates the cost.
The accrual questions
How can a profitable company go bankrupt?
Profit is an accrual measure and payroll is a cash event. A company can recognize revenue on 60-day terms, pay its suppliers in 30, and grow fast enough that the gap consumes more cash than it has.
Growth makes it worse rather than better, because every new sale funds itself late and buys its inputs today.
Then they ask
What would you look at to see it coming?
Operating cash flow against net income over several years, and receivables and inventory against revenue. If earnings keep rising while cash does not, one of them is describing something that is not happening.
A customer pays $1.2M up front for three years of service. What happens?
Cash rises $1.2M immediately. Revenue is recognized as the service is delivered, so $400,000 in year one.
The remaining $800,000 sits as deferred revenue, a liability, because the company owes services rather than money.
Then they ask
What does that do to the cash flow statement?
The increase in deferred revenue is a working capital source, so operating cash flow is well above net income in year one. A subscription business that is growing looks like a cash machine, and the same mechanism runs in reverse when growth stops.
Drill it with different numbers
The tool below is the same one from the linkage lesson. Set the tax rate to something other than 25% and redo each case, because that is what the follow-up does.
Test yourself
01Do the depreciation question at a 40% tax rate instead of 25%.
Net income falls $6.00, the full $10 is added back, so operating cash flow rises $4.00. PP&E falls $10, cash rises $4.00, assets fall $6.00, retained earnings fall $6.00. Still balanced. Being able to redo it at a different rate is the point of the exercise, because that is what the follow-up does.
02Now do it with the tax rate at zero.
Net income falls the full $10, the full $10 is added back, and cash does not move at all. PP&E falls $10, assets fall $10, retained earnings fall $10. The whole cash effect of depreciation is the tax shield, and setting the rate to zero removes it entirely.
Every figure in this lesson that names a company comes from Target Corporation's Form 10-K for Fiscal 2025, the year ended 2026-01-31, filed 2026-03-11. Educational material, not investment advice.