Wall Street Prep

Investment Banking Interview Accounting Question: "Walk me through the accounting for the following transaction"

Note: We continue our series on investment banking interview questions with this investment banking interview accounting question example. For this question, you'll need basic accounting knowledge.

The Question:

If I issue $100mm of debt and use that to buy new machinery for $50mm, walk me through what happens in the financial statements when the company first buys the machinery and in year 1.  Assume 5% annual interest rate on debt, no principal pay down for the 1st year, straight-line depreciation, useful life of 5 years, and no residual value.

Sample Great Answer

If the company issues $100mm of debt, assets (cash) goes up by $100mm and liabilities (debt) goes up by $100mm.  Since the company is using some of the proceeds to buy machinery, there is actually a second transaction that will not affect the total amount of assets.  $50mm of cash will be used to buy $50mm of PPE; thus, we are using one asset to buy another one.  This is what happens when the company first buys the machinery.

Because we have issued $100mm of debt, which is a contractual obligation, and because we are not paying down any part of the principal, we must pay interest expense on the entire $100mm. So, in year 1 we must record corresponding interest expense which is the interest rate times the principal balance. Interest expense for the 1st year is $5mm ($100mm * 5%).  And, since we now have $50mm of new machinery, we must record depreciation expense (as required by matching principle) for use of the machinery.

Since the problem specifies straight-line depreciation, useful life of 5 years, and no residual value, depreciation expense is $10mm (50/5).  Both interest expense and depreciation expense provide tax shields of $5mm and $10mm, respectively, and will ultimately reduce the amount of taxable income.

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Archana Subash
Archana Subash

Awesome examples....request more mutual fund transactions accounting treatments

Adam Still
Adam Still

I know the question says straight line depreciation but I know the IRS doesn't allow you to use straight line when writing off depreciation expense, they make you use MACRS. A lot of the accounting IB questions talk about the tax benefit of depreciation, but always default to using the… Read more »

Haseeb Chowdhry
Haseeb Chowdhry

Hi Adam, The trick with different depreciation methods is to understand their underlying implications, particularly with regards to taxes. For instance, if you use an accelerated depreciation schedule for cash tax purposes, you will have a lower cash tax expense in earlier years. At the same time, if GAAP tax… Read more »

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