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Accounting for Lawyers
University of California, Berkeley School of Law
DeLeo, Alfred F.

Accounting for Lawyers
DeLeo
Fall 2010
 
Generally
·         Accounting is the process of analyzing and justifying one’s actions to another.
·         The focus of modern accounting is on speaking to the financial markets
·         Participants in the markets use finance’s evaluation methods in pricing securities. Finance’s models need data to apply their formulae to. Businesses’ financial statements are the principal source of this data.
 
4 major financial statements:
·         (1) Balance Sheet (statement of financial position): a snap shot of the company’s financial situation at a particular time.
o    Assets = liabilities + equity
o    This is the fundamental equation for the balance sheet
o    Balance sheet must be prepared for the end of the company’s fiscal year (whi)ch doesn’t necessarily correspond to the calendar year
o    It reflects the cumulative effect of all the transactions of the company up to that moment of time…through the close of the day that you calculate the balance sheet.
o    The balance sheet that you close with at the end of the fiscal year becomes the same balance sheet you open with at the beginning of the next fiscal year.
o    Everything in the company’s history – every asset it’s acquired / every transaction is reflected in the balance sheet.
·         (2) Income Statement: covers a period of time, usually a fiscal year / or a quarter. It doesn’t need to be annual. It can be quarterly.
o    Starts with revenue. And has a lot of expenses.
o    The net income reflects net income or net loss. It represents a net increase or decrease to the equity owned by
·         (3) Statement of Cash Flows: tells the reader how the company got from its cash position at the beginning of the year to the cash position at the end of the year.
o    This type of statement is precise. If two different accountants were given numbers and prepared a statement of cash flows, they would come up with the same results. There is only one way to look at each entry.
o    It’s divided into three categories: Operating activities, investing activities, financing activities
o    The cash flow statement will reconcile to sequential balance sheets
·         (4) Statement of Changes in Retained Earnings: Tells reader how the company’s equity position in its stock got from point A to B
·         All these statements work together. There are links between them.
 
 
 
Debits and Credits
·         Debit to assetàincreases asset
·         Credit to assetàdecrease asset
·         Credit to equity accountàincreases it
·         Debit to equity accountàdecreases it
 
ASSETS = LIABILITIES + EQUITY
 
Assets are resources; Right-hand side shows claims to these resources (by creditors and by business’ equity owners)
 
Assets
·         Generally:
o    When you book an asset you will book it as an asset if it’s expected to have economic utility to you for more than the current year.
o    Asset book values are not fair market values. Book value is historical cost with some (not many) adjustments, e.g. depreciation
·         Cash
o    Company founder needs $100K to start has company. He gets a capital contribution of $100K (cash asset).
§  In exchange, he gives that person common stock (equity). To Increase an asset, you enter it as a debit.
o    You rented out your equipment to a client, which goes for $1,000 per day. The customer puts down $10K as a deposit, but you don't know how long they'll use it.
§  If they bring it back 5 minutes after walking out the door, you'll get $0. If they bring it back after 1 day you get $1,000. 2 days – $2K. But in the mean time, you don't know how much money you'll make. To be on the conservative side, you enter it as a liability under the title “unearned revenue”.
·         Equipment
o    Bought equipment for $180K. Don't ask whether the purchaser got a good / bad deal, so long as the buyer and seller don't know each other.
§  A note is given to the seller for $110K, and $70K is paid up front in cash.
§  Thus we want to reduce cash by $70K AND create a liability for $110K
·         Office Supplies
o    We spend $1,630 on office supplies. We expect it to be useful to us for the production of revenue for the current year.
o    With office supplies, some of it (maybe all) won’t be useful for the next year b/c it will be exhaustedà in which case we book it as an expense.
·         Pre-Paid Rent
o    A check to the landlord was written for $9000 for three months' rent. We reduce the cash asset.
o    We now have pre-paid rent of three months, which is an asset.
o    To increase an asset, it's a left-handed entry. $9k migrated from an asset cash account to an asset rent account.
o    You don't need to make an entry to both sides of the asset equation.
·         Non-Assets:
o    As a general rule, you can say that expenditures of less than a certain amount of money will be expensed currently and won’t be considered an asset.
o    Expenditures for items that will not be useful beyond the current period should be booked as expenses
·         Assets vs. Expenses: Why do we care?
o    An expense reduces your revenue, which is unattractive to shareholders (as seen in quarterly statements filed with SEC).
o    So there is a preference to defer expenses by calling them assetsàBUT potential for overstating revenue.
·         Accounts receivables
o    Debit this account when we’re legally entitled to be paid this money, but it hasn’t been paid yet.
o    Note:
§  Different rules apply if you’re not sure the debtor will be able to pay.
o    When we actually receive the money owed on this account, we reduce the account with a credit.
§  The other side of this is you ADD A DEBIT TO CASH by that same amount.
 
LIABILITIES
·         Note Payable (short-term creditors hold instruments)
o    You borrowed $110K to pay for the equipment (and you paid $70K in cash)
·         Bonds:
o    Long-term creditors are owed bonds
·         Unearned Revenue
o    You rented out your equipment to a client, which goes for $1,000 per day. The customer puts down $10K cash as a deposit, but you don't know how long they'll use it.
§  If they bring it back 5 minutes after walking out the door, you'll get $0. If they bring it back after 1 day you get $1,000. 2 days – $2K. But in the mean time, you don't know how much money you'll make. To be on the conservative side, you enter it as a liability under the title “unearned revenue”.
·         Accounts payable ($ owed to short-term trade creditors)
o    These are all costs incurred that are owing, but which you have not yet paid.
·         Dividends
o    Dividends are not payable to shareholders as a matter of right. They can keep it if it’s a reasonable need for working capital.
o    It’s only payable if a board of directors passes a motion in a meeting to pay a dividend.
§  Once the resolution to pay dividends is passed, it then becomes an OBLIGATION of the company.
§  Once the dividend has been validly declared, it becomes a LIABILITY.
o    Dividends generally need to be paid out of earnings. Companies usually get an opinion from their lawyer saying they have enough earnings to cover the dividend payment.
 
EQUITY
·         Common Stock
o    Company founder needed $100K to start has company. He received a capital contribution of $100K (cash asset).
o    In exchange, he gives that person common stock (equity).
·         Retained Earnings
o    The cumulative earnings that have been retained by the company. Retained and NOT distributed.
o    Dividend will effectively reduce the retained earnings account.
o    The retained earnings account is an equity account that will go right below common stock.
o    So if you want an account that’s going to reduce an account that’s on the right side of the balance sheet, the reduction of that account wil

o    Net revenue has two components:
§  (1) revenue from equipment rental (our service that we offer to customers); and
§  (2) expenses Salaries = a debit
 
Seven Adjustments made at the end of the period:
·         (1) Rental Expense:
o    On day 1, we spent $9000 to rent the space for three months worth of pre-paid rent. When we did that, we didn’t get a rental expense b/c we had not yet occupied the space.
§  Now, it’s the end of the month, and we’ve occupied the space. We have a 1-month rental expense.
·         (2) Interest Expense
o    We need to recognize the interest expense associated with the use of the money we borrowed for equipment (note payable of $110K)…we’ve accrued interest. We don’t enter it until it accrues. $825 in interest has accrued
§  Interest payable and interest expense – 825
·         (3) Depreciation:
o    Rental equipment which we bought for $180K, we have concluded that it has an economic useful life to us of ten years, and there’s NO salvage value. So, we will accrue $180K of expenses attributable to the acquisition of equipment over ten years of useful life.
§  The process whereby you allocate the expense attributable to the acquisition of an asset to its economic useful life (in the case of tangible, non-natural resource assets) is called DEPRECIATION
§  With intangible assets, e.g. patent, trade name, is called AMORTIZATION
§  NOTE: We use amortization to mean two different things. You need to know the context.
ú   One: the depreciation analogue for intangible assets.
ú   Two: the reduction of principal on debt
§  You might be asked what the amortization schedule is, i.e. how is the loan balance going to be reduced from its initial amount of $1 million to $0
§  With a natural resource, you DEPLETE it, e.g. gold mine
§  The asset is a tangible asset, other than a natural resource – $180000 divided by ten, divided by 12 – this is $1500
o    CONTRA ACCOUNT: this is a right-sided entry, even though it's a left-handed account. It is a contra-asset account.
§  A contra account is an account whose balance is WRONG relative to its position on the balance sheet.
§  So, when you put the balance of a contra-account onto the balance sheet, if you reflect it the way you reflect every other account, you'll be out of balance.
§  Contra accounts are reflected on the balance sheet ultimately as negative numbers. So, if you were to do a balance sheet reflecting equipment and accumulated depreciation equipment, it would show:
ú   Equipment: 180,000
ú   Less: asset depreciation $1,500
ú   Net: $178,500
§  We do it separately is that it's important that it reflect the original value.
·         (4) Inventory:
o    Recall office supplies purchased for $1,630. At the end of the period, we’ll do an inventory of these supplies.
o    We need to come up with a supplies expense number b/c one of the expenses that is appropriately attributable to the production of revenue are the supplies that we use to produce revenue. Office supplies value at the end of the month is $1,100.
o    So, we want the office supplies account to have$1100 balance.
o    This means we have to reduce that account by $530