90% get this question wrong
About this lesson
Share this with someone who has a technical interview this week. Prepay $20M of insurance for 2 years. Three statement impacts: today, end of year 1, and end of year 2. Most people get day 1 right but start to fall apart at the end of year 1. Today: Step 1 - Income statement: no impact. You haven’t used the insurance yet, so there is nothing to expense. Step 2 - Cash flow reconciliation: CFO reflects the $20M cash outflow as a change in working capital (prepaid assets increased). CFI: no impact. CFF: no impact. The $20M out flows through to the change in cash. Step 3 - Balance sheet: connect the change in cash to the cash account: cash is down $20M. Connect net income to retained earnings: no change, because net income didn’t move. Step 4 - Fill in the remaining pieces: prepaid insurance is up $20M. Both sides balance. End of Year 1: Step 1 - Income statement: $10M of the prepaid insurance has now been used. Insurance expense of $10M hits the income statement. At a 20% tax rate, net income is down $8M. Step 2 - Cash flow reconciliation: net income is down $8M. No cash moved this period, but the prepaid asset decreased by $10M (a source of cash in working capital). CFO is up $2M. That $2M is the tax shield. You got the $10M expense but only $8M hit net income. The $2M difference is the tax benefit flowing through operations. CFI: no impact. CFF: no impact. Step 3 - Balance sheet: connect the change in cash to the cash account: cash is up $2M from the tax shield. Connect net income to retained earnings: retained earnings are down $8M. Step 4 - Fill in the remaining pieces: prepaid insurance drops from $20M to $10M. Both sides balance. End of Year 2: Same exact mechanics as year 1. Another $10M of insurance expense. Net income down another $8M. CFO up another $2M from the tax shield. Prepaid insurance goes to zero. The asset is fully consumed. The important thing to remember here is the cash left the bank account on day 1. In years 1 and 2, you’re simply
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