FINANCIAL STATEMENTS FOR LAWYERS

AGENDA
Accounting Basics
Balance Sheet
Income Statement
Cash Flow Statement

ACCOUNTING BASICS

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DOUBLE ENTRY ACCOUNTING

• Businesses have two sides

– Assets and their sources on one side
– Claims for these assets on the other side
• This methodology accounts for
– Assets
– Liabilities
– Owners’Equity

DOUBLE ENTRY ACCOUNTING

• Every transaction affects two or more accounts

• Some examples - a company might:
– Purchase products for later sales to customers
• Cash decreases and Inventory increases
– Borrow money
• Cash increases and Debt increases
– Purchase a building for cash and a mortgage note
• increases an asset (Building), decreases another
asset (Cash), and increases a liability (Mortgage
Note)

BASIS OF PRESENTATION

• Cash Basis
– Financial transactions are only recorded when cash
changes hands!
• Accrual Basis
– All financial transactions are recorded as they occur

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EXAMPLE: ACCRUAL VS. CASH

• ABC Aerospace announces the sale of a $500 million

airplane
– Under this agreement, ABC will receive payments of
$100 million each year for the next five years
– Under the accrual method, what would revenues
reflect at the end of this year?
– Under the cash method, how would this differ?

CASH BASIS ACCOUNTING

• Simple
• Only considers cash payments and receipts
– Not sales and purchases on credit
• For most businesses, cash basis will not provide a full
picture
• Allowed for tax purposes for:
– Any business with less than $1 million in sales
• (3 year average)
– Service business w/less than $10 million in sales

ACCRUAL BASIS ACCOUNTING

• Most companies use this method

• Seeks to capture all economic activity
• Firms book sales when:
– Goods are shipped
– Services rendered

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PROBLEMS WITH ACCRUAL BASIS

• Can be misleading!
– A company may not have actually received payments
from booked revenues
• Can be manipulated!
– e.g. telecom company swaps

US GAAP

• GAAP = Generally Accepted Accounting Principles

• Describe basic methods to measure
– Profits
– Assets/Liabilities
– Additional financial disclosures
• Requires accrual basis
• Assume GAAP is used unless otherwise stated

INTERNATIONAL ACCOUNTING STANDARDS

• Country-based accounting standards in Europe made it difficult

to compare results of companies registered in different
countries
• International Accounting Standards Board (IASB) was created
to provide a single set of standards
• As of 2005, publicly traded companies in EU required to
provide financial statements compliant with International
Financial Reporting Standards (IFRS)
• IFRS involves some reclassifications and in some cases,
valuation methodologies
• Hong Kong, Korea, Singapore, Australia, Canada, and Russia
support a single set of standards
• SEC has pledged its support of IFRS

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 ACCOUNTING ORGANIZATIONS

• SEC (Securities and Exchange Commission)

– Statutory authority for public accounting & reporting
• FASB (Financial Accounting Standards Board)
– Seven-member independent board
– Sets accounting standards (GAAP)
– Successor to AICPA committee
– Designated by SEC
• AICPA (American Institute of CPAs)
– CPA Professional Association
– Sets ethical standards and auditing standards

FINANCIAL STATEMENT PREPARATION

• Responsibility of management
• Contains management estimates
– May skew numbers between five and ten percent
– May create opportunities for manipulation

INFORMATION ACCOMPANYING FINANCIAL STATEMENTS

• MD&A (Management’s Discussion & Analysis)

– SEC requires companies to have this section
– Reviews the company’s financial condition and results of
operations
– Also gives management’s outlook on the coming year
• Management Report
– Defines management’s responsibilities for preparing
company’s financial statements
– Reinforces senior management’s responsibilities for the
company’s financial and internal control system
– Reinforces the shared role of management, directors, and
auditors in preparing financial statements

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INFORMATION ACCOMPANYING FINANCIAL STATEMENTS

• Auditor’s Report
– An independent CPA hired by management
– Assures that the company’s financial statements are
prepared in conformity to generally accepted principles
• Explanatory Notes
– A means of communicating additional information
regarding items included and excluded from the body
of statements

BALANCE SHEET

BALANCE SHEET ANALYSIS

• The “Doctor’s Report”

– Helps determine company’s financial condition
• Stands alone on a separate statement
• Links with both the income statement and the cash flow
statement
• Assets = Liabilities + Shareholder’s Equity

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BALANCE SHEET ANALYSIS

• Assets
• Resources expected to yield future benefits
– increase in cash inflows or decrease in cash outflows
• Classification of Asset Accounts on Balance Sheet
– Usually begins with cash, the most liquid asset
– Descends to least liquid - long-term/non-current assets
• Examples of assets
– Cash
– Receivables
– Inventory
– Property, plant, equipment
– Goodwill

BALANCE SHEET ANALYSIS

• Liabilities
– Obligations to provide good or service in the future in
exchange for benefits received in present or past
• Classification of Balance Sheet Liability Accounts
– Usually begins with current liabilities
– Lists by timing of payments due and priority in which
accounts will be paid
• Examples of liabilities
– Accounts payable
– Warranties
– Short-term debt
– Long-term debt

BALANCE SHEET ANALYSIS

• Owner’s Equity
• Classification of Net Worth (Owner’s Equity) Accounts
– Mathematical difference between the company’s total
assets and total liabilities (Assets = Liabilities +
Equity)
• However, this is NOT how equity is determined
• Funds invested in firm by owners
– Directly
– Indirectly

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 SOURCES OF OWNERS’ EQUITY

• Suppose we have a new company

• Transaction 1 of 4: Invest $10,000
• Balance Sheet
Assets Liabilities
Cash 10,000 Owners’ Equity Direct investment X creates
equity
Paid-In Capital 10,000 • Paid-in Capital, Common
Total 10,000 Total Liabilities & 10,000
Stock, Pref. Stock
Assets Owners’ Equity

SOURCES OF OWNERS’ EQUITY

• Transaction 2: Borrow $50,000

Assets Liabilities
Cash 60,000 Note Payable 50,000

Owners’ Equity
• Cash and Liabilities increase
Paid-In Capital 10,000 • No change in Equity

Total 60,000 Total Liabilities & 60,000

Assets Owners’ Equity

SOURCES OF OWNERS’ EQUITY

• Transaction 3: Buy $25,000

of inventory

Assets Liabilities

Cash 35,000 Note Payable 50,000

Inventory 25,000 Owners’ Equity • Convert Cash asset into

Inventory asset
Paid-In Capital 10,000
• No change in Liabilities or
Equity
Total 60,000 Total Liabilities & 60,000
Assets Owners’ Equity

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 SOURCES OF OWNERS’ EQUITY

• Transaction 4:
Sell inventory for $40,000
• $15,000 profit!
Assets Liabilities

Cash 75,000 Note Payable 50,000

Owners’ Equity
Profit “reinvested”
Paid-In Capital 10,000 creates Equity
Retained Earnings 15,000 • Retained Earnings

Total 75,000 Total Liabilities & 75,000

Assets Owners’ Equity

SAMPLE BALANCE SHEET

Assets Liabilities
Current Assets Current Liabilities
Cash $4,000 Accounts Payable $1,600
Accounts Receivable $5,000 Accrued Expenses Payable $2,400
Inventory $7,150 Income Tax Payable $160
Prepaid Expenses $960 Total Current Liabilities $4,160
Total Current Assets $17,110
Non-Current Liabilities
Non-Current Assets Notes Payable $10,000
Fixed Assets $22,610 Total Non-Current Liabilities $10,000
Accumulated Depreciation ($11,560)
Total Non-Current Assets $11,050 Shareholders Equity
Paid-in Capital $4,000
Total Assets $28,160 Retained Earnings $10,000
Total Shareholders Equity $14,000
Total Liabilities & Shareholder Equity $28,160

INCOME STATEMENT

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INCOME STATEMENT ANALYSIS

• The “Report Card”

– Helps determine if company is operating well
• Reflects financial standing over a period of time
– Between two Balance Sheets
• Analyzing Revenues (Sales)
– Reported sales should be a true reflection of market demand and
their potential to be converted to cash.
• Analyzing Expenses (Costs)
– The nature of the activity resulting in the expense and
expectations about the trends is explored here.
• Net Income (Profit)
– Shows the increase (decrease) in net profit of a company before
considering distributions to and contributions from shareholders.

INCOME STATEMENT ELEMENTS

• Sales (Revenues)
– Proceeds, cash or credit, received in exchange for
products or services
• Cost of Goods Sold (COGS)
– What is paid to produce product or service
– Only changes upon sale
• Otherwise amount remains on balance sheet in
inventory
• Selling, General & Administrative (SG&A)
– Most operating expenses, e.g. marketing, payroll,
advertising, telco, etc.

INCOME STATEMENT ELEMENTS

• Depreciation
– Non-cash expense based on reduction in value of fixed
assets
• Interest
– Interest payment on debt
• Taxes
– Payments to government based on pre-tax income
• Net Income
– Company profit or “bottom line”

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HOW TO RECOGNIZE REVENUE

• The SEC has observed that revenue generally is realized

or realizable and earned when all of the following criteria
are met:
– There is persuasive evidence that an arrangement
exists
– Delivery has occurred or services have been rendered
– The seller’s price to the buyer is fixed or determinable,
and
– Collectability is reasonably assured

CASE: INFORMIX

• Between 1994 and 1997, Informix “cooked books” to better

compete with Oracle
• Accounting scandal in the mid-1990s
– Eroded confidence in management, stalled growth
• During tech boom, Informix shares slipped from about $30 to
slightly more than $5 in 1997
• What happened?
– Management exaggerated Informix's revenues by:
• Booking revenues before sales were completed and
• Offering liberal return policies to boost near-term sales

SAMPLE INCOME STATEMENT

Sales $50,000
Cost of Goods Sold $30,000
Gross Profit $20,000
Selling General & Admin. $12,000
EBITDA* $8,000
Depreciation $2,400
EBIT** $5,600
Interest Expense $800
EBT*** $4,800
Tax $1,600
Net Income $3,200

* Earnings Before Interest, Taxes, Depreciation, and Amortization

** Earnings Before Interest and Taxes
*** Earnings Before Taxes

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CASH FLOW STATEMENT

CASH FLOW STATEMENT ANALYSIS

• The “Piggy Bank” for the company

• Determines if a company generates cash
– From its operations
– From its investing activities
– From its financing activities
• The cash flow statement takes
– Net Income from the current income statement
– Beginning and ending balance sheet items
– Reconciles the flows of cash for the period

SAMPLE CASH FLOW STATEMENT

Cash Flow From Operating Activities

Net Income $3,200
Accounts Receivable Increase ($1,600)
Inventory Increase ($1,950)
Prepaid Expense Increase ($290)
Depreciation $2,400
Accounts Payable Increase $160
Accrued Expense Increase $240
Income Tax Payable Increase $40
Cash Flow From Operating Activities $2,200
Cash Flow From Investing Activities
Purchases of Property, Plant & Equipment ($2,550)
Cash Flow From Financing Activities
Short-Term Debt Increase $400
Long-Term Debt Increase $600
Stock Issue $120
Dividends Paid ($800)
Cash Flow From Financing Activities $320
Change in Cash ($30)
Beginning Cash $4,030
Ending Cash $4,000

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WHY CASH FLOW?

• Cash flows have become widely regarded as the best

measure of a company’s performance
• Why?
– Earnings, by contrast, tend to be misleading and easily
manipulated
• Intangibles (i.e. depreciation)
• Accounting techniques (i.e. FIFO vs. LIFO)

SHORTFALLS OF CASH FLOW

• Businesses not allowed to report cash flow/share

– Stipulated by FASB
– Would be easy to compute
• FASB: Net Income is best performance measure
• Cash flow varies dramatically from year to year
– May mislead investors

HOW MUCH CASH SHOULD A BUSINESS HAVE?

• Depends on the type of business

• Every business requires sufficient cash reserves to cover
day-to-day changes in business
• Excess cash can mean lost opportunities
• Deficient cash can mean delinquent payments and lower
credit ratings
• Businesses face the constant balancing act of maintaining
the right cash

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 Balance Sheet
ASSETS LIABILITIES

FINANCIAL Current Assets

Cash $ 8,000
Current Liabilities
Accounts Payable $ 3,000
Accounts Receivable $ 10,000 Accrued Expenses Payable $ 5,000
STATEMENT LINKS Inventory $ 14,000 Income Tax Payable $ 1,000
Prepaid Expenses $ 2,000 Total Current Liabilities $ 9,000
Total Current Assets $ 34,000
Ending cash
balance Non Current Liabilities
Non Current Assets Notes Payable $ 19,000
links to cash Fixed Assets $ 45,000
account on Accumulated Depreciation $ (23,000) Total Non-Current Liabilities $ 19,000
Total Non-Current Assets $ 22,000
the balance Shareholders Equity
sheet Total Assets $ 56,000 Paid In Capital $ 8,000
Retained Earnings $ 20,000
Net income less Total Shareholders Equity $ 28,000
dividends links Total Liabilities & Shareholders Equity $ 56,000
to retained
earnings account
on the balance Cash Flow Statement
Income Statement sheet Cash Flow From Operating Activities
Net Income $ 6,400
Accounts Receivable Increase $ (3,200)
Sales $ 100,000 Inventory Increase $ (3,900)
Cost of Goods Sold $ 60,000 Prepaid Expense Increase $ (600)
Gross Profit $ 40,000 Depreciation $ 4,800
Accounts Payable Increase $ 360
Selling General & Admin. $ 24,000 Accrued Expense Increase $ 500
EBITDA* $ 16,000 Income Tax Payable Increase $ 100
Depreciation $ 4,800 Cash Flow From Operating Activities $ 4,400
EBIT** $ 11,200
Cash Flows From Investing Activities
Interest Expense $ 1,600 Purchases of Property, Plant & Equipment $ (5,000)
EBT*** $ 9,600
Cash Flows From Financing Activities
Tax $ 3,200 Short-Term Debt Increase $ 800
Long-Term Debt Increase $ 1,200
Net Income $ 6,400 Net income forms Stock Issue $ 300
Dividends Paid $ (1,600)
starting point of the Cash Flows From Financing Activities $ 700
cash flow statement
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** Earnings Before Interest and Taxes
Change in Cash
Beginning Cash
$
$
(100)
7,900
*** Earnings Before Taxes Ending Cash $ 8,000
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FINANCIAL STATEMENTS SUMMARY

BALANCE SHEET INCOME STATEMENT CASH FLOW STATEMENT

• Assets = Liabilities + • Income = Revenues - Expenses • Cash flows based on

Owner’s Equity • Income does not necessarily operating, investing,
• Assets listed at original cost equate with cash financing
• Liabilities and owner’s equity • Expenses may include • Cash flows reconcile
provide sources of financing non-cash items differences between accrual
and cash accounting
• Current assets can be • Revenues may include
liquidated within one year payments not yet received • Cash flows track changes
over a period of time
• Current liabilities must be • Income statements track
paid within one year changes over a period of time • Cash flows lead to the
amount
• Balance sheet numbers reflect • Net income less dividends of cash generated or lost
positions at one point in time equals retained earnings during a period
• Retained earnings represent
income left after dividends
paid

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