Accounting interview questions: the three statements, explained simply
Almost every finance interview starts its technicals with accounting, because everything else (valuation, LBOs, merger models) is built on the three statements.
The income statement shows profit over a period. The balance sheet is a snapshot of what a company owns and owes on one date, and it always balances: assets = liabilities + equity. The cash flow statement starts with net income and explains how cash changed. If you can walk any change through all three statements, you're in good shape.
Core accounting questions
Basic
Walk me through the three financial statements.
A strong answer covers
- Income statement: revenue to net income over a period
- Balance sheet: assets = liabilities + equity at a point in time
- Cash flow statement: operating, investing, financing
- Brief mention of how they connect
Basic
How do the three financial statements link together?
A strong answer covers
- Net income flows to the top of the cash flow statement
- Net income (less dividends) flows into retained earnings
- Ending cash on the CFS becomes cash on the balance sheet
- Non-cash items and working capital changes connect IS and BS through the CFS
Basic
What's the difference between cash and accrual accounting?
A strong answer covers
- Cash: record when cash moves
- Accrual: record revenue when earned and expenses when incurred
- Public companies use accrual accounting
- Explains why net income and cash flow differ
Intermediate
Depreciation goes up by $10. Walk me through the three statements (40% tax rate).
A strong answer covers
- IS: pre-tax income −10, net income −6
- CFS: net income −6, add back +10, cash +4
- BS: cash +4, PP&E −10, assets −6
- Retained earnings −6, so the balance sheet balances
Intermediate
What is working capital and why does it matter?
A strong answer covers
- Current assets minus current liabilities (often excluding cash and debt)
- Increase in working capital uses cash; decrease frees cash
- Examples: inventory, receivables, payables
- Matters for cash flow and liquidity
Intermediate
If you could use only one financial statement to evaluate a company, which would you pick and why?
A strong answer covers
- Usually the cash flow statement
- Shows actual cash generated, harder to manipulate
- Captures capex and working capital
- Acknowledges the trade-off of losing balance sheet context
Intermediate
A company issues $100 of debt to buy $100 of equipment. Walk through the statements at the moment of the transaction.
A strong answer covers
- No income statement impact yet
- CFS: +100 financing, −100 investing, net cash 0
- BS: PP&E +100, debt +100
- Balance sheet balances
Intermediate
How does stock-based compensation affect the three statements?
A strong answer covers
- IS: expense lowers pre-tax and net income
- CFS: added back as a non-cash expense
- BS: cash unchanged, equity (APIC) up and retained earnings down
- Notes it's a real cost because it dilutes shareholders
Intermediate
Inventory is written down by $10 (25% tax). Walk through the statements.
A strong answer covers
- IS: pre-tax −10, net income −7.5
- CFS: net income −7.5, add back the non-cash write-down +10, cash +2.5
- BS: inventory −10, cash +2.5, assets −7.5
- Retained earnings −7.5, balances
Advanced
A company buys $100 of inventory with cash, then sells it for $150. Walk through the statements at each step (40% tax).
A strong answer covers
- Purchase: cash −100, inventory +100, no IS impact
- Sale: revenue +150, COGS +100, pre-tax +50, net income +30
- CFS on sale: net income +30, inventory decrease +100, cash +130
- Balance sheet balances at each step
Advanced
How is goodwill created, and what happens when it's impaired?
A strong answer covers
- Created in an acquisition when price exceeds fair value of net identifiable assets
- Sits on the balance sheet and isn't amortized under U.S. GAAP
- Impairment is a non-cash expense that lowers net income
- Added back on the CFS; goodwill and equity both fall
Advanced
Explain deferred revenue and how it affects cash flow.
A strong answer covers
- Cash collected before the service is delivered
- Recorded as a liability, recognized as revenue over time
- Increase in deferred revenue boosts operating cash flow
- Common in subscription businesses
Advanced
What's the difference between deferred tax assets and deferred tax liabilities?
A strong answer covers
- Come from differences between book and tax accounting
- DTL: pay more tax later, e.g. faster tax depreciation
- DTA: pay less tax later, e.g. net operating losses
- Both sit on the balance sheet
Advanced
How do leases show up on the financial statements under current U.S. rules?
A strong answer covers
- Most leases now go on the balance sheet
- Right-of-use asset and lease liability
- Operating leases: single lease expense on the IS
- Finance leases: depreciation plus interest expense
Quick quiz (10 questions)
Which statement is a snapshot at a single point in time?
- Income statement
- Balance sheet ✓
- Cash flow statement
- Statement of retained earnings
The balance sheet shows what a company owns and owes on one date. The other two cover a period.
Net income from the income statement flows into which two places?
- Revenue on the income statement and cash on the balance sheet
- Top of the cash flow statement and retained earnings ✓
- Accounts payable and the investing section of the cash flow statement
- Interest expense and the debt schedule on the balance sheet
Net income is the first line of cash from operations and flows into retained earnings in equity.
Capital expenditures show up in which section of the cash flow statement?
- Operating
- Investing ✓
- Financing
- They don't appear
Capex is spending on long-term assets, so it sits in cash from investing.
Assets = $500 and liabilities = $300. Shareholders' equity must be:
- $200 ✓
- $800
- $300
- $500
Assets = liabilities + equity, so equity is 500 − 300 = $200.
Ending cash on the cash flow statement becomes:
- Revenue on the income statement
- Retained earnings
- Capex
- Cash on the balance sheet ✓
The cash flow statement explains how the balance sheet's cash changed.
Depreciation rises $10 with a 40% tax rate. Net income changes by:
- −$10
- −$6 ✓
- −$4
- +$4
$10 lower pre-tax income, $4 less tax, so net income falls $6.
Depreciation rises $10 with a 40% tax rate. Ending cash changes by:
- +$4 ✓
- −$6
- +$10
- No change
Start with −$6 net income, add back the $10 non-cash expense: +$4.
Why does cash rise when depreciation rises?
- Depreciation is paid in cash, so the company holds back more of it
- It's a non-cash expense that reduces taxes paid ✓
- Equipment is sold, so the company collects cash from the sale
- Lenders lend more when depreciation rises, so debt brings in cash
No cash leaves for depreciation itself, but it shields income from tax.
A company buys $100 of equipment with cash. Right away, net income changes by:
- −$100
- −$40
- +$100
- $0 ✓
Buying equipment isn't an expense, so net income doesn't change ($0). The cost shows up later as depreciation.
Revenue rises $100 with no new costs and a 40% tax rate. Net income rises by:
- $60 ✓
- $100
- $40
- $0
$100 more pre-tax income minus $40 of tax = +$60.
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