Schenk – Accounting for Lawyers – Summer 2014
Fundamental Accounting Equation
Liabilities + Assets = Equity
Corporations: corporations are legal entities separate form their owners. Corporate laws divide the residual ownership into shares. A share entitles the owner to 1) participate in corporate governance by voting, 2) share proportionally in any earnings, in the form of dividends, and 3) share proportionally in residual corporate assets upon liquidation. Corporations incur double taxation – 1) on the corporation’s income 2) shareholders must pay tax on any amounts that the corp distributes as dividends. Ownership interest in a corporation is referred to as shareholders’ equity.
Shareholders: enjoy limited liability – corporation’s creditors cannot hold the shareholder’s personally liable.
Connection btwn balance sheet and income statement:
1. The net on the income statement – if it is a net income (credit balance), it would come over to the balance sheet as an increase in equity. Net loss is a reduction in equity.
2. In the balance sheet, you don’t close an account, the balance is just 0 (snapshot). On income statement accounts, they are always closed out at the end of the period (results of operation).
All expenses start off as debit because it reduces profit; all revenues start as credits
Assumptions provide a foundation for the accounting process
Economic Entity Assumption: business activities are separate from its owners
Monetary Unit Assumption: money is stable, which probably isn’t correct in times of inflation
Periodicity assumption states that economic life of a business can be divided into artificial time periods
Going concern assumption states that the enterprise will continue to operate long enough to carry out its existing objectives
If the going concern assumption is not used, then plant assets should be stated at their liquidation value, not at their cost.
Principles dictate how transactions and other economic events should be recorded and reported.
Historical Cost Principle: states that assets should be recorded at their original or historical cost
Objectivity/Verifiability principle: accountants prefer accounting treatments which can be supported by available and reliable evidence
As long as the basis for the estimate is disclosed, and others can corroborate the supporting data and methodology, accountants consider an estimate objective and verifiable
Revenue recognition principle dictates that revenue should be recognized in the accounting period in which it is earned
Accountants usually recognize revenues only when (1) an exchange transaction has occurred and (2) the accounting entity has complete or virtually completed the earnings process
Matching principle: “Let the expense follow the revenue”; it dictates that expenses be matched with revenues in the period where revenue was earned
Costs that will generate revenues in this accounting period ONLY, expensed immediately. They are reported as operating expenses in the income statement.
Costs that will generate revenues in future accounting periods are recognized as assets.
Consistency principle: accounting entities must give economic events the same accounting treatment from accounting period to period. If an entity changes their practice, it MUST be disclosed
Full disclosure principle: requires that material circumstances and events be disclosed (important enough to influence an informed reader’s judgment)
Fair Value principle recognizes the fact that financial accounting increasingly requires enterprises to use fair value or market value, rather than historical cost, to report certain assets and liabilities.
Calls into question the historic cost, objectivity, revenue recognition, consistency and full disclosure principles.
Modifying conventions are certain practical restraints on accounting principles
Materiality relates to an item’s impact on a firm’s overall financial condition and operations and indicates that items which are not material need not be recorded
Quantitative: $2 difference in a billion dollar company is immaterial
Qualitative: all things illegal are qualitatively material,
BASIC V. LEVINSON : The term material when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase/sell the securities registered
Conservatism: Be quick to recognize expenses, be slow to recognize revenue
Industry practices is the idea that peculiarities in some industries and businesses allow departure from basic accounting principles
Accountants use 4 different financial statements to describe an enterprise’s financial condition and the results of its operations:
1) Balance sheet: presents an enterprise’s assets, liabilities and residual equity at a particular moment
2) Income Statement: Shows how an enterprise has done and the resulting change in owners’ equity during that time period
3) Statement of Changes in Owner’s Equity: portrays the ups and downs in the ownership interest from all causes during that period
4) Statement of Cash Flows: analyzes the changes in the enterprise’s cash during the particular period
The Balance Sheet
**Presents the financial condition (enterprise’s assets, liabilities and residual equity at a particular moment)**
Ownership Interest (referred to as: Equity or Net Worth): difference between what a business owns (assets) and what it owes (liabilities)
Asset: means a future economic benefit that a particular enterprise owns or controls as the result of a past transaction or event; $$ shown on balance sheet as historical cost, not market value
Economic resources are recognized as assets when these req’ts are satisfied:
1) The entity controls it
2) Entity must reasonably expect the resource to provide a future profit
3) The entity must have obtained the resource in a transaction so that the entity can measure it
Examples: Personality: No – not acquired from a transaction; Computer purchased for office: yes, controls it, used to provide future profit, gained in a transaction; training for at will employee: no, she doesn’t control her secretary unless under contract
Historical cost: price at which the property was bought
Duties or Responsibilities are treated as liabilities when each is satisfied:
1. Debt or obligation must involve an existing duty or responsibility
2. Duty or responsibility must obligate the entity to provide a future benefit
3. The debt or obligation must have arisen from a transaction which has already occurred so that there is a reasonable measure for the obligation
Collections: unless a business has given a creditor a security interest in a particular asset or law grants such an interest, liabilities attach to the business’s assets generally rather than to the specific asset the creditor helped the entity acquire. If the entity does not pay its debts, creditors may force the business to liquidate. Creditor’s Rights Laws require the entity to satisfy its outside liabilities before paying any “inside claims”
Entity’s Assets – its liabilities = Equity
Because creditor laws require outside liabilities to be paid before inside claims, all liabilities reduce owner’s personal “stake”; if entity liquidated and all liabilities paid, the remainder is equity and goes to the owner
Equity increases when an owner invests assets into the business.
Equity decreases when the owner withdraws assets from the business accounts
Generally these types of accounts are increased with a debit: DEAL
Dividends (Draws) Expenses Assets Losses
Generally these types of accounts are increased with a credit: GIRLS
Gains Income Revenues Liabilities Stockholders' (Owner's) Equity
To increase, do what the normal balance is
The Classified Balance Sheet
Current Assets: include cash and other assets that the enterprise expects to convert into cash or use within one year. Current assets could include:
· Marketable securities: stocks and bonds
· Notes receivable: amounts due to the entity by promissory note
· Accounts receivable: uncollected amounts owed to the entity for goods or services sold on credit
· Inventories: goods held for sale/resale
· Prepaid Expenses: bills paid in full for the next year
Long-term Investments: include assets that an enterprise would not n
account for all goods that are on consignment that have not been sold; you cannot record until you have recorded the revenue.
There are lots of expenses that require judgment. We’re quick to report losses and expenses, but slow to report revenue.
KERZWILE Case: if there is a right to return you cannot record as revenue; speech recognition software for a doctor. Doctor would record what he did with the patient and what he recommended and then someone would transcribe it. Company couldn’t sell a lot of them. They said “why don’t you take our device and try it out” if you don’t like it just return it and if you keep it then we’ll bill you. They had salespeople that would sell/install. Problem: each time they put it in the doctors office for the trial, they would record it as revenue despite the fact that they had a right to return.
Schenk: when recording revenue, you have to record what you’re actually getting. For a short-term note that is collectible, you can account for that; for a long-term note, you need to make sure that the interest rate is fair – if the interest rate is too low, the face amount is not correct, you assume that part of the interest is accounted for in the note.
What do we need to think about as lawyers in terms of accounting
Think about what would you need in the documents if you had the worst outcome and what would you need if you had the best outcome?????
1. We may get an audit inquiry letter – if we will likely owe in a case, then rev must be recognized
2. Draft agreements – when we draft agreements, they invariably have accounting terms if it involves money; make sure we say “have your accountant check this too, just to be sure” – if in a loan agreement it says if you reach x amount, you default – then that rev must be recognized (must get waiver to the next balance sheet period); could also affect whether dividends could be paid out if a default occurs
3. Cases where a company has entered into a contract that has some contract restrictions (“if this happens, the loan is accelerated and you have to pay us today”). Many times, these contracts involve accounting terms.
a. Ex. Two people form a company – one at 60% and other at 40%. Agreement provides that if anyone wants to leave, there is a buy out clause:
i. Will be bought out based on equity based on GAAP. Several years later, the majority holder wants to leave and says I will give you the 60% of the equity. NOT A GOOD DEAL – THINGS ARE RECORDED AT HISTORIC COST AND DO NOT ACCOUNT FOR DEPRECIATION/APPRECIATION. All equipment and such has lost value and you would be buying them at their full value. WHEN NEGOTIOATING SAY YOU WANT TO BUY OUT AT FAIR VALUE.
ii. Income standard: No because accounting principles can be changed! Could buy a bunch of inventory at the end of a period, which would manipulate assets and bring the income down.
4. When involved with litigation with a client – Audit inquiry letters
***HOW TO ANALYZE IF A COMPANY HAS RECOGNIZED REVENUE CORRECTLY:
Things we look for:
o Conservative: recognized expenses when incurred, recognize revenue when earned
o Material: was it illegal, a lot of money?
o Consistent: even if consisten, must match with GAAP
o Matching: must match expense with revenue; INVENTORY REDUCTION must be recorded in same period as expense/revenue