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What the interviewer is testing
Whether you can separate the cash payment from the expense recognition, move working capital correctly through the cash flow statement and keep the balance sheet balanced.
Answer framework
- At payment: no income statement effect.
- Cash flow statement: the increase in prepaid expenses reduces cash from operations by $12M.
- Balance sheet: cash down $12M, prepaid expenses up $12M; assets unchanged in total.
- Over the year: $12M rent expense, so pre-tax income falls $12M and net income falls $9M at a 25% tax rate.
- Cash flow: net income down $9M, plus the $12M decrease in prepaid, so cash from operations is up $3M; balance sheet: cash up $3M, prepaid down $12M, retained earnings down $9M.
Sample answer
I would split it into the payment and the expense. When the company pays $12M upfront, nothing hits the income statement, because the rent has not been used yet. On the cash flow statement, prepaid expenses increase by $12M, which is a use of cash in operating activities, so cash falls by $12M. On the balance sheet, cash is down $12M and prepaid expenses are up $12M, so total assets do not change and it balances.
Over the year the rent is used up. The income statement shows $12M of rent expense, so pre-tax income falls by $12M and, at a 25% tax rate, net income falls by $9M. On the cash flow statement, net income is down $9M, but the prepaid asset decreases by $12M, which is added back as a source of cash, so operating cash flow is up $3M. That $3M is the tax saving.
On the balance sheet, cash is up $3M and prepaid expenses are down $12M, so assets are down $9M; retained earnings fall by $9M, so equity is down $9M and it balances. Looking at the full year combined, cash is down $9M and retained earnings are down $9M.
Likely follow-ups
Common mistakes
- Putting the $12M rent expense on the income statement at the time of payment.
- Forgetting the tax effect when the expense is recognized.
- Recording the payment in investing activities instead of operating.
- Showing cash falling by $12M again when the expense is recognized.
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Related questions
Based on question #5 in the full question bank.