A customer pays $100 upfront for a year of service. What happens on the three statements on day one, and after the year?
On day one there is no revenue yet. Cash and deferred revenue both rise $100, and operating cash flow is $100. Over the year, $100 of revenue is recognized, net income is $75 at 25% tax, deferred revenue falls $100 and cash falls $25.
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Example answer
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On day one, the income statement shows nothing new, because the company hasn't earned the revenue yet. On the cash flow statement, cash is up by $100. On the balance sheet, cash is up $100 on the assets side and there's a liability for the same amount, so it balances.
After the year, the service has been delivered, so the $100 comes through as revenue. Net income goes up, less tax. On the balance sheet, the liability goes away and retained earnings are up, so it balances again.
What holds it back
The day-one logic is right, but the liability is never named and the second half has no numbers. It misses that cash falls after the year, which is what the interviewer is testing.
I'll assume a 25% tax rate. On day one, the income statement shows nothing new. The company has the cash, but it hasn't delivered anything, so it hasn't earned the revenue yet. On the cash flow statement, net income is flat. Deferred revenue is up by $100, and a rise in a liability is a source of cash, so cash flow from operations and cash are both up by $100. On the balance sheet, cash is up $100 on the assets side and deferred revenue is up $100 on the liabilities side, so it balances. After the year, the service has been delivered, so the $100 comes through as revenue. Pre-tax income is up $100, tax is $25 and net income is up $75. On the cash flow statement for the year, I start with $75 of net income. Deferred revenue falls by $100, which I subtract, so cash flow from operations is down $25. On the balance sheet, cash is down $25. On the other side, deferred revenue is down $100 and retained earnings are up $75, a net fall of $25, so it balances again.
I'll assume a 25% tax rate and that tax is paid as the revenue is recognized. On day one, the income statement shows nothing new. The company has the cash, but it hasn't delivered anything, so it hasn't earned the revenue yet. On the cash flow statement, net income is flat. Deferred revenue is up by $100, and a rise in a liability is a source of cash, so cash flow from operations and cash are both up by $100. On the balance sheet, cash is up $100 on the assets side and deferred revenue is up $100 on the liabilities side, so it balances. It's a liability because the company owes the customer a year of service, or the money back. After the year, the service has been delivered, so the $100 comes through as revenue. I'll leave out the cost of delivering it to keep this clean. Pre-tax income is up $100, tax is $25 and net income is up $75. On the cash flow statement for the year, I start with $75 of net income. Deferred revenue falls by $100, which I subtract, so cash flow from operations is down $25. No cash came in from the customer this year, so the only movement is the tax payment. On the balance sheet, cash is down $25. On the other side, deferred revenue is down $100 and retained earnings are up $75, a net fall of $25, so it balances again. Put the two periods together and cash is up $75, retained earnings are up $75 and the liability is gone. The cash arrived on day one and the profit arrived over the year. That's why a growing business that's paid in advance can report more cash flow than earnings. One caveat is that if the cash is taxed when it's received, the $25 goes out earlier and a deferred tax asset covers the gap.
The numbers, step by step
Day one, then the end of the year, at a 25% tax rate, with tax paid when the revenue is recognized and no delivery costs.
- Day one: cash flow from operations$0 net income + $100 deferred revenue
- $100
- After the year: tax$100 × 25%
- $25
- After the year: net income$100 − $25
- $75
- After the year: cash flow from operations$75 − $100 deferred revenue
- -$25
- After the year: liabilities plus equity−$100 deferred revenue + $75
- -$25
- Cash across both periods$100 − $25
- $75
What the interviewer listens for
- Do you hold the revenue back on day one and say why?
- Do you name deferred revenue and put it on the liabilities side?
- Do you see that cash goes down after the year, not up?
- Do both balance sheets balance, with numbers?
- Can you say why cash and profit arrive at different times?
Common mistakes
- Booking $100 of revenue on day one because the cash came in.Revenue is recognized as the service is delivered, not when it's paid for.
- Calling the $100 an asset or leaving the other side of the entry out.The cash is the asset, and the obligation to deliver is the liability.
- Saying cash goes up again after the year.The customer already paid, so the only cash movement is $25 of tax going out.
- Adding the $100 fall in deferred revenue in cash flow from operations when it should be subtracted, because a falling liability uses cash.
More finance technicals
- A company writes down an asset by $100. Walk me through the three statements.
- A company makes a $100 sale on credit. What happens on the three statements?
- A company records $10 of stock-based compensation. Walk me through the three statements.
- What is PIK interest, and how does $10 of it flow through the three statements?
- If you could look at only one financial statement to judge a company, which would you choose and why?
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