1.3 Accounting Decisions in Models

Why Accounting Choices Are Model Inputs

FMVA cases rarely ask you to pick the correct GAAP policy the way a CPA exam would. They ask you to trace a policy through all three statements. Depreciation method, revenue timing, lease treatment, and capitalize-versus-expense decisions change EBIT, taxes, PP&E, deferred taxes, net working capital, and cash — often in opposite directions. If you only move one statement, the model breaks.

The rest of this section is a map of the choices that show up on the open-book Excel case and the multiple-choice items around it.

Depreciation: Straight-Line Versus Accelerated

Straight-line (SL) spreads depreciable basis evenly: (Cost − Salvage) / Useful life. Accelerated methods (double-declining balance, declining balance, or tax MACRS in the United States) take more depreciation in early years and less later. Total depreciation over the life is the same if salvage and life are the same; timing is what changes.

Depreciation hits:

• Income statement: higher D&A lowers EBIT, lowers EBT, lowers tax expense, and lowers NI in the heavy years
• Balance sheet: accumulated depreciation is a contra-asset, so net PP&E is lower under accelerated methods in the early years
• Cash flow: D&A is non-cash and is added back in CFO. The cash effect is taxes, not the depreciation line itself
• Not NWC: depreciation is not AR, inventory, or AP. Do not park it in working capital. The related balance-sheet account is PP&E, and deferred tax if book and tax methods differ

Worked example: same asset, two book methods, tax equals book

Machine cost $100,000, salvage $0, life 4 years, EBITDA $80,000 each year, interest $0, tax rate 25%.

Straight-line D&A = $25,000 per year. Every year: EBIT $55,000; tax $13,750; NI $41,250; CFO = NI + D&A = $66,250.

Accelerated pattern for illustration (40% / 30% / 20% / 10% of cost):

Year-1 comparison: accelerated accounting lowers EBIT ($40,000 vs $55,000) and lowers taxes ($10,000 vs $13,750). Cash is higher by the tax savings of $3,750 ($70,000 vs $66,250). The extra $15,000 of depreciation never left the bank; only the extra $3,750 of tax did not leave the bank. Net PP&E at the end of Year 1 is $60,000 under accelerated versus $75,000 under SL.

Over four years both methods collect the same total tax if rates are constant and there is no salvage difference. The modeler's job is not to prefer a method. It is to keep PP&E, D&A, tax, NI, and cash consistent with the method the case specifies.

Book-tax difference and deferred tax

In practice, many companies use SL for book (the financial statements your model copies) and accelerated methods for tax. Then:

• Book EBIT and book tax expense follow SL
• Cash tax follows the tax return (accelerated)
• The difference is a deferred tax liability (DTL) that sits on the balance sheet

Year 1 if book is SL and tax is accelerated: book tax expense $13,750; cash tax $10,000; DTL increases $3,750. CFO = NI (after book tax) $41,250 + D&A $25,000 + increase in DTL $3,750 = $70,000, which matches cash tax of $10,000. If you model cash tax as book tax expense, you miss the DTL and understate cash in the early years. That is a classic FMVA flow-through miss.

Revenue Timing Choices

Revenue recognition is not only a principle (control transfer). It is a forecast assumption. Moving a $120,000 delivery across a year-end changes that year's revenue, COGS, inventory, AR or deferred revenue, EBIT, tax, NI, NWC, and CFO.

If the company bills in advance, cash can arrive before revenue: deferred revenue rises (a liability, often current), cash rises, NI does not. Indirect CFO then adds the increase in deferred revenue, correctly showing cash without earnings.

If the company bills after delivery, AR rises with revenue: NI is up, cash is not, and the increase in AR is subtracted in CFO.

Worked example: $120,000 job, 50% prepaid

Cost is $72,000, all inventory already on the books. Control transfers at year-end delivery.

• Revenue $120,000, COGS $72,000, gross profit $48,000
• If $60,000 was prepaid earlier: reverse $60,000 of deferred revenue; AR (or cash) for the remaining $60,000
• Inventory −$72,000
• Tax on $48,000 at 25% = $12,000, ignoring other items

NWC effect at delivery: AR +$60,000 if uncollected, inventory −$72,000, deferred revenue −$60,000. That mix is easy to get backward in Excel. Sketch the journal, then type the roll-forwards. Do not "true up" cash with a manual plug while leaving deferred revenue stuck on the opening balance sheet.

Operating Versus Finance Leases at a High Level

Under IFRS 16, almost all leases except short-term and low-value contracts go on the balance sheet: a right-of-use (ROU) asset and a lease liability. Expense is typically depreciation of the ROU asset inside EBIT plus interest on the liability below EBIT.

Under US GAAP (ASC 842) there are still two flavors for lessees:

• Finance lease: ROU asset and liability on the balance sheet; expense split between D&A (EBIT) and interest (below EBIT), similar to IFRS 16
• Operating lease: ROU asset and liability still on the balance sheet, but a single lease expense usually sits in operating expense (inside EBIT)

Both treatments put leverage on the balance sheet. They do not treat rent as an off-balance-sheet footnote the way old US operating leases did. For FMVA:

• Do not ignore the lease liability when you compute net debt
• Do not assume EBIT is comparable across a US operating-lease reporter and an IFRS reporter without adjustment
• Cash: the total cash rent is split between operating and financing sections depending on the standard and classification; the total cash out the door is still the rent paid

You are not being tested on the full ASC 842 classification tests. You are being tested on whether a capitalized lease increases assets and liabilities, whether expense hits EBIT as rent or as D&A, and whether interest exists below EBIT. Those three answers change margins, coverage ratios, and the debt schedule.

Capitalized Versus Expensed Spend (R&D and Software)

US GAAP expenses internal research and development as incurred, with limited software and some website-development exceptions. IFRS allows capitalization of development costs once technical feasibility and other criteria are met. Internally developed software that reaches the application-development stage may be capitalized under US GAAP.

When a case expenses $1,200,000 of software:

• EBIT falls $1,200,000 this year
• No asset is created
• Cash outflow is CFO
• Later years have no amortization from this spend

When the same case capitalizes $1,200,000:

• No immediate full EBIT hit
• An intangible (or PP&E) rises $1,200,000
• Cash outflow is CFI (investing), not CFO
• Later years: amortization lowers EBIT; the net asset declines; add amortization back in CFO

Worked example: capitalize and amortize over three years

Year 1 spend $1,200,000, straight-line amortization $400,000 per year, tax equals book at 25%, ignore other items.

Total cash over the life is the same $1,200,000 outflow. Profit timing, margin ratios, and the CFO versus CFI split all change. A peer that expenses will show lower Year-1 EBIT and lower Year-1 CFO than a peer that capitalizes, even if they spent the same cash. That is why quality-of-earnings questions ask where the spend sits, not whether cash left the bank.

Working-Capital Definitions in Models

Repeat the operating definition until it is automatic:

Operating NWC = AR + Inventory − AP

Extensions, when the case has them:

• Add other operating current assets (prepaids, other receivables)
• Subtract other operating current liabilities (accrued expenses, deferred revenue, and taxes payable if you treat them as operating)

Always exclude:

• Cash and cash equivalents (the CFS plug)
• Short-term investments if you treat them as excess cash
• Debt, the current portion of long-term debt, and lease liabilities (financing)
• Income-tax payable if you have a separate tax schedule and do not want it inside the NWC days formulas

ΔNWC = NWC_ending − NWC_beginning. A positive ΔNWC is subtracted in CFO (use of cash). Sign errors here are the most common reason an FMVA model is off by a round number.

Days formulas that feed NWC:

• AR days = AR / Revenue × 365
• Inventory days = Inventory / COGS × 365
• AP days = AP / COGS × 365 (or / purchases, if you have a purchases line)

Forecast the days, back into the balances, then let ΔNWC hit cash. Do not forecast NWC as a plug to make cash look right.

Two Traps That Fail Modeling Questions

Trap 1: Treating EBITDA as cash

EBITDA starts at operating profit and adds back D&A. It does not deduct cash taxes, cash interest, capex, or ΔNWC. A company can print $190,000 of EBITDA and still burn cash if it spends $70,000 of capex and $5,000 of NWC and pays $30,000 of interest and $30,000 of tax — as Apex did in the last section, where CFO was $125,000 and cash after capex was $55,000, not $190,000.

On the exam, if a stem says the company generated $190,000 of cash because EBITDA was $190,000, the statement is false unless capex, NWC, cash tax, and cash interest are all zero.

Trap 2: Treating net income as CFO

Net income is accrual profit. CFO = NI + non-cash items − ΔNWC (± other operating). A company can report $90,000 of NI and produce $125,000 of CFO (Apex added back D&A and only a small NWC use) or produce far less CFO if AR and inventory balloon.

Never copy NI into a cash-available-for-debt-paydown line. Link the cash flow statement. Never treat the D&A add-back as if it were cash in the door on top of EBITDA and on top of NI; pick the starting point and apply the adjustments that belong to that starting point.

The Exam Habit: One Booking, Three Statements

Before you click an answer or edit a case cell, ask:

1. Which income-statement lines move (revenue, COGS, D&A, opex, interest, tax, NI)?
2. Which balance-sheet stocks move (cash, AR, inventory, PP&E, deferred revenue, AP, debt, DTL, RE)?
3. Which cash-flow section gets the cash (CFO vs CFI vs CFF), and which adjustments are non-cash?

If those three answers are consistent with Assets = Liabilities + Equity, you are doing FMVA accounting. If you only moved EBIT, you are not done. Accounting is 10% of the estimated final-exam weight, but it is 100% of whether a three-statement case still balances after you change a policy.