Accounting for Lawyers[1]

Accounting for Lawyers Week #1 August 24, 2006 Notes on Syllabus: We are welcome to come to either his undergrad office hours or his law school office Make sure that you don’t miss the next two weeks DEBIT: LEFT CREDIT: RIGHT Balance Sheet: ASSETS = LIABILITIES + SHAREHOLDER’S EQUITY SHAREHOLDER’S EQUITY: CONTRIBUTED CAPITAL + RETAINED EARNINGS Net income is determined first so that you can plug it into the statement of retained earnings. Ending retained earnings are then calculated so that you can plug it into the balance sheet equation above) Chapter 1: Introduction   Accounting is all about telling a story: the story about a company It is told through 4 documents: o Statement of Cash Flows o Balance Sheet  Demonstrates that assets ALWAYS equal the sum of its liabilities and  What is owner’s equity? o Really is it normally shareholder’s equity  Contributed capital + retained earnings o Statement of Retained Earnings  Beginning retained earnings + net income – Dividends = Ending retained earnings o Income statement  Measures revenues and expenses  If revenues exceed expenses you have net income Who wants to know? o Shareholders (actual and potential) o Creditors (actual and potential o No one is going to lend you any money o Clients 1       o Suppliers o The government: the IRS, the SEC (at the state level too) What do they need from the story? It must be reliable; free from error and bias It must be relevant: what is the story NOW It must be comparable to the stories other companies in that industry are telling It must be consistent with the story you told in prior years Problem 1 (pg. 3): 1. What has the company earned? a. 600K from initial investment b. 40K from interest 2. What has the company spent? a. 50K for training b. 150K for equipment 3. What’s the value of the business? There are a number of ways to answer this: a. We have equipment that is worth 180K now: does this count? b. We have trained employees that are worth 50K: does this count? c. We have cash in the amount 440K: does this count? Because there are multiple answers to this ―value‖ question there needs to be a standardized way of determining what ―value‖ means. FASB AICPA: Membership organization like the ABA for accountants SEC: Securities and Exchange Commission PCADB SARBOX: Sarbanes Oxley Act  This was adopted in response to all of the corporate scandals  The USC now directs that GAAP can be determined by the SEC, however, FASB has been changed so that it is funded by the public company fees o What does it cost a company?  Company with market float of 3.5 billion: $18,000 in SOX fees  Company with market float of 350 million: $3,000 in SOX fees IASB: international so we don’t need to know IOSCO: international so we don’t need to know GAAP: Generally Accepted Accounting Principles 2        These are the rules of accounting Banks, investors, etc. are going to insist that Rules are made by FASB (―Fazbee‖) FASB: Financial Accounting Standard Board: They come from business and academia The general rule is that FASB makes the accounting rules BUT the SEC can supersede the GAAP rules with regard to public companies if they want to. The SEC does indeed supersede the GAAP rules with Reg S-X You don’t get nervous is FASB gives you a call but you do get real nervous if SEC gives you a call. o Who is ―you?‖  In addition to the company itself, the lawyers, the CEOs, the CFOs, the auditors, the accountants, the underwriters and others can be in both civil and criminal trouble. Objectives and Foundational Principles  Objectives: o You want to provide useful information o Make sure that the information is relevant, reliable, comparable, consistent  General Assumptions: o Separate entity assumption: what you are accounting for is a separate, distinct entity o Going concern assumption: you are always assuming that the company will continue in business o Time period assumption: we can account for this business within a specified time period  Matching principle: o We match all of the income in a certain time period with all of the expenses which were incurred in that time period o This has nothing to do with receiving or writing a check  Cost principle: o If we are assuming we have a going concern we are going to report stuff at what it cost.  Be conservative: o Understate earnings rather than overstating them  Materiality: o 1 dollar in a billion dollar company is immaterial Look at the conceptual framework stuff on TWEN Business 101 Outline:  Financial Activity: o Get money from investors and/or creditors  Investing Activity: o Once we have money we put it to work: buys equipment, supplies, 3    Assets: something that has future economic value to your company Operating Activity: o Manufacture, sell, employee, etc. Assuming we’ve done well, i.e. revenues exceed expenses, we’ll have extra money. What do we do with this? o We can reinvest the money o We can payback the lenders o We can issue dividends 1) Income Statement: Revenue – Expenses = Net Income (Loss) This is the first story that the investors, creditors, etc. want to know. This is sort of a moving picture of your business? 2) Balance Sheet: Assets = Liabilities + Shareholder’s Equity Investors, creditors, etc. also want a snap shot at any one time: what are you assets (own) and what are your liabilities (owe) at a point in time? The difference between assets and liabilities = stockholder’s/owner’s equity Stockholder’s Equity: Contributed capital + retained earnings Statement of Retained Earnings: Beg. Retained Earnings – Dividends + Net Income = Ending Retained Earnings 1) Balance Sheet: Assets = liabilities + shareholder/owner equity 2) Shareholder owner equity = contributed capital + retained earnings 3) Beginning Retained Earnings – Dividends + Net income = end retained earnings 4) Statement of cash flow: explanation of the cash going in and out of the company GET ALL OF THESE FORMULAS FROM THE BOOK. Once the company gets all of this info, how can investors and creditors be insured that the information is reliable, relevant, comparable and consistent? AUDITORS 4 Auditors:   Everyone wants to get an opinion from the auditors saying that there financial statements are a fair representation o This is an ―unqualified opinion‖ How do auditors come to this conclusion? o They apply the GAAS: General Accepting Auditing Standards?  Under SOX, the accountants no longer determine GAAS  Instead the Public Company Oversight Board creates the standards The biggest effect of SOX is expand the requirement of internal controls: o Internal controls: make sure that there are systems in place to reduce the risk of error. Often this has to do with segregating tasks so that stuff gets checked and double checked. o Auditors not only have to look at the statements, they also have to look at the controls in place to ensure that the financials were o The Auditors now have to:  Audit the financials  Independently audit the internal controls in place  Evaluate management’s statement about the controls in place o How much does all of this cost?  More than twice as much  Chapter 2: Accounting      We must write down every economic event which effects are business Double entry book keeping utilizing debits and credits This was invented over 500 years ago This is unlike law school: there are true truths here True Truths: o 1) Assets = Liabilities + stockholder’s equity o 2) Debits = Left o Credits = Right  All these words mean are location: do not attribute anything good or bad to either of these words o 3) When you record a transaction the debits (left) must equal the credits (right) What are entries? o A writing down in words and in numbers in journals which are kept chronologically (computer) Journal Recording is all about: o Analyze o Recall o Record   5 Illustration #1 on pg. 36: Larry capitalized his LLC with 10K: Do the problems 2A and 2B. Finish the reading and the next assignment. Week #2 August 31, 2006 Analysis for Journal Entries: Was there a measurable economic event? What is it and what accounts does it effect? Record it with debits and credits, applying the right rules. You report an increase in an asset with a debit. You report a decrease in an asset with a credit. You report an increase in a liability/equity with a credit. You report a decrease in a liability/equity with a debit. You report an increase in revenues with a credit. You report a decrease in revenues with a debit. You report an increase in expenses with a debit. You report a decrease in expenses with a debit. THESE ARE MIRROR IMAGES (CHECK ON YOUR RULES) Journal Entries It doesn’t matter too much how you label the accounts: just make sure you know what types of accounts are assets and what types are liabilities. Journal first and then use this info to create the balance sheet and other documents. 6 Ledger: List assets from increased liquidity to decreased liquidity List liabilities from earliest due date to latest due date Make sure that you carry over your assets, liabilities and owner’s equity from previous months: these don’t go away with time Income statement accounts, unlike balance sheet accounts MUST go away. This makes sense if you think about it because we don’t want our revenues from one month to carry over to the next month: we want to know how much we make EACH month. Balance sheet accounts on the other hand our like a checking account: if we have 10K in it as the end of May, we have 10K in it on the first day of June. Closing Entries We set up a temporary account: P & L This account is just used to close out the revenues and expense SO: The debit in the revenue becomes the credit in the P & L SO: The credit in the expense account becomes the debit in the P & L account The P & L account then gets closed with the opposite of whatever it is being put in the owner’s equity account. We then take this number, which is our net income, and put it into our balance sheet. Chapter 3: The Accrual System of Accounting Cash basis system: You just watch how the cash flows in and out of your accounts. This is what you do for your checking account and your personal income taxes. GAAP does NOT recognize this sort of accounting. They say that it does not accurately represent the economic picture of the company. Conservatism: Error on the side of being cautious when you present financial information. SO: Report too little revenue and too many expenses. 7 It is not about when the order is placed or even when the check comes in: it is when the good or services are delivered. 1) Conservatism RULE: Revenue is not recognized until the service is rendered or the goods are delivered, i.e. off the shipping deck. HYPO: You do a bunch of legal work for a client in month A. The client does not get billed until month B. The bill is 50K. You have to record this as revenue in month A. 2) Matching RULE: Record as an expense everything that you have done to help generate the revenues within that same period of time; match your expenses with the revenues they helped to generate. HYPO: Your workers have to work overtime to get all the paintings out on Dec. 31. You need the revenues so you’re not in default on a loan. The checks are already written so the workers won’t get paid for the overtime until next month BUT these employment costs are still an expense for December. Match the expense with the revenue it generates. If you incur an expense associated with a generation of revenues in reporting period A, but the expense is not paid until month B, you still have to report the expense in month A. This is the situation above. 3) Is it possible in the world of business to get money before you actually do the work? YES. HYPO: You receive a retainer check from your client. HYPO: You require a deposit upfront, on Dec. 31st. You aren’t going to do the work until January. You cannot record this revenue until January. In December, you record the receipt of this check as a debit to cash. You balance this by recording a credit under a liability as a deferred revenue: you have an obligation to do work now. At the end of January, you have the right and the obligation to record the revenue in the month that you did the work. You credit revenues and then you debit the deferred revenue account. 4) Is there any possible situation where you make a payment before you incur the expense? YES. HYPO: You want to rent a studio. The lessor requires a year in advance to be paid. We write a check to her. We credit cash. What do we debit to match it? We debit assets, because we are creating the economic benefit of occupying the studio. We could call this ―prepaid rent.‖ As time passes and we use up the rent, the asset expires. An expiring asset is an expense. We record an increase in expenses with a debit. We debit rent expense. We match this with a credit to prepaid rent. 8 One side of the entry will always be on a balance sheet account and one side of the entry will always be in an income statement account. You will NEVER debit or credit cash when you are doing these ―adjusting‖ entries because you are adjusting internally, not externally. Cash is only external. Adjusting entries are to make sure that revenues are recorded when the work is done and expenses are recorded when the stuff is used to generate revenues. Also: Revenues are recorded even if they go unbilled and/or uncollected, i.e. as is the case with law firm billing. Do problem 3 next time. Week #3 September 7, 2006 (Problem 3 and Chapter 4) Review: Assets = Liabilities + Stockholder’s/Owner’s Equity Stockholder’s/Owner’s Equity = Contributed Capital = Retained Earnings Beginning Retained earnings + net income – dividends = ending retained earnings Revenue – Expenses = Net Income How do we generate these documents? We start off by writing down economic events in journal entry form. Once that is completed for a given time period these events are then moved or ―posted‖ to the ledger. This is the disk that holds the names and the summary of all the activity in every account that the business has, i.e. types of revenue accounts, expense accounts, cash accounts, etc. At the end of each reporting period we have to close the revenue and the expense accounts. (Income sheet accounts.) Why do we do this? 1) We have a time-period assumption: if you don’t turn the revenues and expenses into zeros, you will overstate these figures for the next time period. 2) The process of closing your’re able to transfer the net effect of revenues minus expenses into retained earnings. We do NOT close out the balance sheet accounts. These are permanent accounts that kick over into the next reporting period. 9 Accrual System of Accounting: 1) Periodocity: We are going to report in artificial periods of time the results of operations. 2) Conservatism: Error on the side of underreporting revenues and overreporting expenses. a. Therefore: i. We don’t recognize revenue, we don’t write it down, unless the work is done, i.e. delivered the product, shipped the product, performed the service, etc. 3) Matching: We match all of the expenses with the revenues that they helped to generate. If you are a CEO you have to make sure that you write down the correct transaction during the correct period. If you don’t, you could be held liable/found guilty. Scenarios: 1) Do work in 2005 and get paid in 2006. You have the right and the obligation to record the revenue in the period that you do the work. Accounts: Accounts receivables, cash, revenue 2) Incur an expense to generate revenue in 2005 but not paid until 2006. Match expenses to the period that they are used to generate revenue. 3) Get paid before work is done. You get paid in December of 2005 but you don’t do the work until 2006. Accounts: Cash, deferred revenue, revenue Report it as deferred revenue in the year that you get paid Report is as revenue in the year that you do the work 4) Expenses paid in 2005 generate revenue in 2006. Example: Pre-paid rent Accounts: Pre-paid rent, cash 10 You need to report ALL economic events, i.e. writing checks and getting checks, when they happen. BUT: Remember that this will not always be an expense or revenue in that same period too. Sometimes it will be something else, i.e. deferred revenue or prepaid rent. Accounts Payable = liability Deferred Revenue = liability You have an obligation to perform work which you have not yet done, i.e. you’re liable to someone. Asset = future economic benefit Pre-paid rent = asset Security deposit = asset (you have the right to get the money back in the future) Problem 3 (handout in class) DEBITS AND CREDITS CAN BE OF THE SAME TYPE, I.E. TWO ASSETS. Chapter 4: Inventory and the Cost of Goods Sold We take a focused look at a particular part of an income statement. We are focusing on merchandising businesses: businesses engaged in buying good and then selling them. Susie’s Shoes: She buys shoes from Nike and other manufacturer’s and then sells them. Inventory: good purchased or produced and held for sale. Sales: revenues generated from selling goods Cost of Goods sold: these are our expenses incurred in the purchase or production of goods sold Two Types of Inventory Accounting: 1) Perpetual: Every time you have an event that affects your inventory, you account for it by making a journal entry. Companies that have high price, low 11 units sold, do this type of accounting. However, more and more companies are adopting this system due to computers and bar codes. a. A physical inventory is conducted at the end of the reporting period. 2) Periodic System: Only periodically do you account for your inventory. a. Periodically you need to go in and count it. When inventory is sold it ceases to be an asset and it turns into an expense: a cost of goods sold. This is good so long as you are selling it for more than your costs. We are going to focus on a periodic system: he will not test us on the difference between the two systems. Diagram Cost of Goods Available for Sale = Beginning Inventory + Purchases Cost of Goods Sold = Cost of goods available for sale – Ending inventory Example: Susie’s shoes Beginning inventory: The number of shoes that are sitting in your store (you know from the previous inventory count) Purchases: She buys some more shoes from the manufacturers. Ending Inventory: What’s left in stock when she’s at the end of the period. How do we calculate the cost of goods sold? 1) Specific identification method: track each item so you know exactly what the cost of each one sold is a. You have to do this for non fungible items, i.e. art b. This is somewhat out of favor because it can be subject to abuse. Most companies don’t use it. 2) Cost Flow Assumptions a. These are just assumptions: they have nothing to do with what really is left in the wharehouse. b. You can choose among these if you have fungible items. i. FIFO: First In, First Out 1. The first stuff that came in the door, is the first stuff to go out. So that your ending inventory is assumed to be the most recently stuff purchased, i.e. that’s the cost of the goods. ii. LIFO: Last In, First Out 12 1. What’s left is the stuff that was bought the earliest. The barrel picture: the stuff that gets put in first is the stuff on the bottom. iii. Weighted Average Cost 1. Picture a gasoline tank with multiple shipments in it. It all just gets mixed together so you don’t know what’s what. Problem 4A FIFO: The first ones went out first so that the most recent ones are the ones that are there still. We have 100 bought on 8/15 and 100 from the ones bought on 6/15. The total cost then is $5,500 LIFO: We assume 100 of the remaining 200 are the BI and the other 100 are from the next oldest purchase. The total cost is $4,100 based on this method. Average: this always falls between LIFO and FIFO. No one is ―right‖ because GAAP allows all three. BUT: You can’t switch from one assumption to the other, you need to stay consistent. DO the journal entries and the adjusting entries for 4B, tax effect and planning and read next chapter for next time, just skim the disclosure and tax matters. Week #5 September 14, 2006 We’re going to spend some more time finishing up the inventory discussion and then move on to 4B, and the new reading for today. Review of Inventory:  Two Methods: o Perpetual Inventory method  You take account of EACH transaction that effects inventory  More popular now that we have computers o Periodic  You don’t use an inventory account, you use a purchases account. Then you have to count all of the stuff at the end of the month. o Cost of Good Sold in a Periodic System  Beg. Inventory + Purchases – Ending Inventory = COSG  This figure goes on an income statement:  SALES – COGS = GROSS PROFIT 13      GROSS PROFIT – OPERATING EXPENSES = NET INCOME Beginning Inventory: This is off of the balance sheet, i.e. inventory doesn’t go away. You add to this every purchase you’ve made during the period, i.e. the last six months Ending Inventory: Go out and count the chickens. Use LIFO, FIFO, or average. INFLATION: What happens when prices go up, i.e. we’re in a period of inflation? o A private company would like to use LIFO: the higher priced purchases are deemed to be the first sold so that the COSG is higher and the net income is lower. This means fewer taxes. o A publicly traded company would NOT want to do this because they want their earnings to be as high as possible. o A highly leveraged company might NOT want to do this either. These companies would instead want to use FIFO: They keep the COSG low to keep the net income higher.  Legal Consequences of Inventory  An error in inventory can result in a number of misstatements, i.e. net income is misstated.  These get self-corrected on the balance sheet over a period of 2 years BUT it is still a big deal: o If you’re a publicly traded company, this is big trouble.  The stock tanks and the CFO and CEO could be liable.  Attorneys need to have Problem 4B: Notes  Deferred Revenue = liability account o This is what we have if we promise to do work, i.e. get paid in advance  Salary and Wages = Expense account  Bonuses = expense account  ―obligation to pay‖ = bonus payable = liability account  ―paid for on credit‖ = accounts payable = liability account  The problem told us we are using the periodic system so we report purchases of inventory in the ―purchases‖ account  Waiver of phone charges is NOT a measurable economic event  Interest payable = liability account  What are the adjusting entries? o There are four scenarios (above) where we need to make adjusting entries o We have two of those situations in this problem:  Here, we incurred the expense before we paid, i.e. as with interest accruing on a loan 14  Also, we paid for our insurance before we were actually insured, i.e. prepaid COSG is an expense account  IF THEY MADE SALES: HOW DID THEY GET PAID? IF THEY PAID FOR SOMETHING: HOW DID THEY PAY? Expenses and revenues get closed out at the end of each month (income statement accounts) Balance sheet accounts carry over Relationships Among Costs, Assets, and Expenses Costs → Assets → Expenses Assets = unexpired costs Expenses= expired costs Costs generate assets As an asset expires and is used up it turns into an expense: the economic benefit is used up over time Sometimes: Costs → Expenses This is the case with wages, utility expenses, i.e. stuff that does not ―rest‖ as an asset, it just gets used up right away Chapter 5: Fixed Assets and Depreciation Fixed Asset: Useful life of over a year Example: Equipment, building, etc. How do we reflect their expiration? Historical Cost: This is the price that you paid along with incidental costs like installation etc. THIS DOES NOT CHANGE 15 We always use the historical cost because this is the most reliable way to report the value of an asset Appraisal is less reliable We always assume that an asset will have some residual value, i.e. salvage/residual value The salvage value goes into the calculation of the depreciation Depreciation: Cost – Salvage Value Example: You buy a building. Debit building and credit cash (assuming you paid in cash). The cost of the building as generated an asset which will expire over the course of its useful life. This is called a depreciation expense. This requires an adjusting entry. Asset account: Accumulating Depreciation-Bldg. *This is a permanent account on the balance sheet: it never closes. *This is a contra account: an off-setting account. How do we calculate the depreciation entry? You can never depreciate below salvage value Three Methods: 1) Straight Line Depreciation a. You make a determination of what the useful life of the asset is (IRS guidelines but we’d we told) b. You make a determination of what the salvage value is c. Cost – Salvage Value / Useful Life of Asset i. Example: If the asset is worth 100K and it has a salvage value of 20K and a life span of 10 years, the Accumulated Depreciation-Bldg. entry is 8K each year. 2) Sum of the Years Digits 16 a. This is accelerated so the asset depreciates faster in the early years, but the life is the same length b. A company might want to write off more in the earlier years so they can decrease their taxes, OR they might want to depreciate an asset if its likely to be obsolete in the next few years c. n(n + 1) /2 is your denominator d. Then each year in the life is the numerator, starting with the life and going down by one each year i. Example: IF the life is 5 years. The denominator is 15. And we depreciate at 5/15, 4/15, etc. 3) Double declining balance a. Straight Line Rate of depreciation x 2 = 2X b. 2X x Book value c. This method means that you will have to use a lesser rate of depreciation for the last entry just so you don’t go below the salvage value d. This means that some of the later years will not have any depreciation, i.e. entry of 0 Book value = cost – accumulated depreciation of the asset What do you do when you sell something? Zero out the asset Zero out the associated accumulated depreciation Record how you got paid Record the gain or loss  Example: o We want to sell an asset for 150K in cash. We are going to debit cash. We are going to credit the asset (building). So we have a debit of 150K and a credit of 100K. How do we balance our equation? o First we need to get rid of all of the accumulated depreciation associated with building. SO: We debit this account to cancel it out on the balance sheet. o Selling the building is not part of your general business so it is not ―revenue‖ but instead we call it ―gain on sale.‖ o The gain here is 130K (SO: Not just the difference between the cost you paid and the money you got). What if we sell the building for 60K? o Our gain is only 40K.  Gain = Sales price – book value 17 What happens if you sell something in the middle of the year? You need to update the depreciation for that part of the year, i.e. if it’s half of a year, make sure you tack on an extra ½ of depreciation. Week #5 September 21, 2006 (class cancelled) Week #6 September 28, 2006 (chapters 6 and 7) Chapter 6: Other Asset and Liability Issues A. Receivables  Accounts receivable o Normally these are ASSETS o This is money that customers owe you  Most companies sell on credit to some extent  You would limit your business if you didn’t  BUT: You do have to balance, i.e. don’t be too lenient with your credit policy o ―Delinquent‖ if not paid on time o If they are not paid within 2 pay period the account becomes ―uncollectible‖ o An uncollectible account receivable becomes an EXPENSE called a ―charge off‖ o Accounts to Use  Expense account: Uncollectible Accounts Expense/ Bad Debts account  Contra account: Allowance for Doubtful Accounts o Need to subtract doubtful accounts from account receivables in order to get the net realizable amount Example: We made some sales. We already did the work. We debit accounts receivable and we credit revenue. What happens when the sale goes bad and we cannot collect the account receivable? What we have to do insure we have to match with all of our revenues all of the expenses that were incurred to help generate the revenues. THUS: We estimate how much of our accounts receivables are going to go bad. We make an estimate with a journal entry AT THE TIME THE CREDIT IS EXTENDED. You debit bad debts expense and you credit allowance for doubtful account/bad debts. Once you KNOW that you can never collect the debt, i.e. the customer is bankrupt, then you credit the accounts receivable and debit the allowance account. The allowance account is thereby reduced to zero. 18 In accounting for receivables there are two possible entries: you ALWAYS make the estimate entry. The second entry is only made if the debt is actually uncollected. SO: The accounts we use are accounts receivable, revenue, bad debt expense and allowance for bad debt What’s the cost of extending credit? The risk that you might never collect it. This cost is incurred when you extend the credit. We do this by estimating based on the best information available to you. Usually one of two methods is followed:  If company is brand new it’s hard because they don’t have any past info to base their estimate on.  If it’s a company that’s been around for awhile there are two options: o The volume of credit sales the company makes and based on history, say that x% goes bad each year, OR o x% of accounts receivables that goes bad every year Contra asset account: this is a permanent account B. Intercompany Ownership      Investments Companies invest in other companies Companies don’t want to keep their cash in a checking account, so they invest it in securities of another entity You might be interested in a company strategically, i.e. you might want to take it over in the future OR at least gain control of it Example: You like some bonds that are being issued by GM. They are 20 year bonds and you invest in 100K worth of bonds. You write a check. You credit cash and you debit investment in GM bonds. You always make this entry. Then we have to make an entry to account for the our intent, i.e. hold or sell. If we intend to hold them until maturity we just make this interest. BUT: What if you are investing in these same bonds NOT to hold them to maturity but to sell them on the market? If you intend to sell them in the short term, you make the first entry but you also make another entry when you close your books at the end of the period. If the FMV of the security has changed, you need to ―mark it to market‖ by doing an entry with the unrealized gain account and valuation account. Debt Securities o A contract agreement to repay plus interest o If you intend to hold until maturity you don’t care what the market does   19  o BUT: if you are only holding it as a short term investment you must mark it to market  If the security goes up or down, this has to be reflected in the valuation and unrealized gain/loss accounts  BUT it is unrealized because it’s not sold  When you make a sale, there is a realized gain/loss account  Contra account: Valuation Account  This goes on the balance sheet so it is a permanent account o The other account in this entry is:  Unrealized loss/gain on Trading securities Equity Securities o Ownership interest in corporation o There is no holding until security with equity securities, i.e. no promise from corp to buy it back o If you are investing in equity securities AND you are buying less than 20% of the company, you treat the journal entry just like one for a debt security o If you are buying a chunk of the company between 20%-50% you record the investment and then every year you adjust the value of the investment but you don’t mark to market o If you buy more than 50%, the financial statements have to be consolidated (group the buyer’s and seller’s financial statements together  EXAM question on table on page 120 o There are different accounting methods based on how much of the company one owns, i.e. based on control o If over 50%, parent and sub relationship  The parent then has to prepare consolidated financials in addition to the subs all preparing their own  The consolidated financials show the overall condition of the entire entity  This is where accounting tricks can go on, i.e. you buy exactly 50% of the company and thus don’t have to consolidate the financials and thus can hide your debt. This can be really important if your bank requires a certain asset to liability ratio (which they often do).  BUT: The auditors will get you by looking at whether you effectively exercise control, and if you do, you’re going to have to consolidate the financials.  Internal transactions are therefore not shown  Management also might need to discuss the specific subs which will have a material effect on the consolidated statements since this can be obscured by the consolidated statements: the auditors will make you do this o C. Goodwill and Other Intangible Assets 20     Goodwill is a big deal. o Mainly comes up in the context of acquisitions, i.e. not generated from a favorable newspaper article. Pooling v. Purchase Accounting o In a transaction where you exchange stock, you used to have the ability to pool no matter the value of the stock. All you would do in pooling is combine the balances in the various accounts, i.e. just add up cash, etc. o Why? This allowed you to avoid having to record entries that you would otherwise have to record if you ―purchased‖ the company. o What’s the premium: goodwill? o Why do you NOT want to record goodwill? It’s an asset BUT it will amortize (depreciate) which will turn it into an expense. This then reduces your income which reduces your earnings per share. BUT: Pooling accounting is no longer allowed. SO: You have to use purchase accounting. o This means you have to recognize the goodwill. o The issue then becomes whether you overpaid, i.e. was the premium too high, if so the expense associated it is going to take a big bite our of your income o There was a trade off with this: There is no mandated amortization now. o Now, companies must make an annual evaluation to determine if some of that good will should be amortized. o Companies have to do an annual impairment test: this is subjective o Financial statements have lots of footnotes: the footnotes is where the amortization/impair review process is discussed. o This review process generates big bucks for accountants, but takes it away from the lawyers, i.e. no debate over pooling v. purchase any more. o The auditors are going to scrutinize this review. E. Leases and Other Long-Term Obligations    Operating Lease o Payments are expenses Capital Lease o Treated as an asset on the lessee balance sheet o Payment is a liability SO: You can’t try to disguise a purchase by calling it a lease and thus not have the entries on your balance sheet: it will be deemed a capital lease if the practical effect is to entity the functional equivalent of ownership 21 Stock Options (Not in the book but Professor said important)  The 2000 scandals (Worldcom, Enron) were all about the CEOs and CFOs really cooking the books  What’s going on with stock options? Not this sort of cooking the books, but ―back dating‖  Stock options are compensation tools for companies that are short on cash: you attract talent with options, i.e. currency when the corp goes public  Incentivize the employees by tying their personal financial success to the company’s success  Terminology: o Grant: You have a right to acquire stock in the future o Size of Grant: Option to buy a certain number of shares o Strike Price: Typically market value when the option is granted o Vesting: The company wants to put some golden handcuffs on you. They want to keep you around with the option incentive, not have you leave right away. So, the options vest over a period of time, i.e. out of 20K shares, 4K vest every year. o Term of Option: how long you can exercise the option for; the option expires after this time  Backdating o Example:  Date of hire is June 15th  He gets 20K options  The market price on June 15th is $10  Instead of making the strike price the FMV on the day of the grant, the company backdates the option so as to give it an earlier strike price.  They give employee options with the price on June 1st when the price was $5  This puts the employee in the money right away  This is NOT illegal  What is illegal? Not reporting it.  Now you have to disclose option grants within 48 hours so as to eliminate this ability to back date.  The cost of stock options is a compensation expense and it needs to be shown on the books: this is to ensure that you are comparing apples to apples  You have to book this as an entry which finds its way into the financial statements  When you backdate and don’t report, you will have to go back and reevaluate stuff from an auditing standpoint.  Invariably this means that the compensation expense goes up and the earnings have to restated downwards.  Then, the stock takes a hit and lawsuits are filed.  There’s debate over this: some people say that we should stick to the ―old way‖ and just stick to reporting it in the footnotes. o Some say that this is just a huge amount of extra work that is unnecessary. 22 o Others say that it is much more straightforward this way and it’s not going to negatively effect stock price. Loss Contingencies    You are going to be heavily involved in this area of your client’s reports if you are a corporate attorney o The big issue is: When and how do you disclose litigation? When do you report in financial statements risk associated with litigation? o You have to discuss this in the footnotes AND sometimes make a journal entry. When do you book? o If it’s probable that you’re going to lose a lawsuit AND you can reasonably estimate the cost you HAVE TO book the loss with a journal entry. When do you just put it in the footnotes? o If it’s probable that you’re going to lose but you cannot reasonable estimate the cost you do NOT have to book the loss BUT you do have to put it in the footnotes. o Same if you know the loss but aren’t sure if the loss is probable. This is where the battle is: o Auditors want lots of disclosure: be conservative so that the auditors are not at risk. This is what they want. o Management wants no disclosure, and especially no book entries. They fight for no disclosure beyond footnotes. o Lawyer has to find a balance between making their client happy and not exposing the company (or themselves) to liability.  This is where the big bills are made for lawyers. What about contingent assets, i.e. you’re the plaintiff in a huge lawsuit? o You’re lawyers think you’re going to win and you’re going to make a ton of money. o It’s probable that you going to win AND you can measure the win. o What do you do? o NOTHING: you never book potential income, you only book potential liability o This is the principle of conservatism: cover your but    We’ll do chapter 7 and cash flow chapter next week. Chapter 7: Capital Accounts  Owner’s equity is really broken up into different accounts. There are three groups of accounts, that which is: o Contributed capital directly from owners o Generated by operations over time o Subject to adjustment due to events designated as contributing to other comprehensive income 23    General Principle: The sum of the balances in all the capital accounts for any entity at any moment in time is equal to the entity’s total assets minus total liabilities. Contributed Capital and Distributions o Capital o The amount paid in for the stock (par or stated value, see below)  Par Value  Some states don’t use par value anymore because they have adopted MBCA and just use ―stated value‖  If there’s no par value, we only need to use one account to show the shareholder contribution to capital, i.e. capital stock account  If there is par value we need two accounts: o Capital stock account o Additional paid in capital (amount in excess of the # of shares x par value  Separate accounts for each class of stock, i.e. common, preferred, etc. o Distributions/Dividends  You cannot issue dividends if you are insolvent OR if you fail the cash flow test, i.e. can’t pay debts as they become due  Dividends can be paid in stock or cash  CASH: Three accounts are used in two transactions; when the dividend is declared and when it is actually paid. o Retained earnings o Cash dividend payable (this is a liability account) o Cash  STOCK: There is no substantive economic event; it is just a rearranging. o So, the size of the pie is the same, the slices are just a different size now. o Example: 100 shares with market share of $4. A dividend in stock equal to one full share for each share outstanding is granted. There are now 200 shares with market share of $2. o No liability account is created here as with the cash dividend.  Types of Dividends:  Large stock dividends  Small stock dividends  Stock splits  Reverse stock splits  From a shareholder’s perspective:  CASH dividends are income  STOCK dividends cause the basis to go down Retained Earnings 24 o This account states the cumulative amount of earnings the corporation has generated over time minus the cumulative amount of such earnings that have been paid out to the shareholders in the form of dividends. o It’s the stuff that the company keeps to reinvest in itself. Week #7 October 5, 2006 (missed for Berkeley flight) Accounting For Lawyers 10/5/06 Chap. 7 and 9 EXAM TIP: Will not test on our ability to write journal entries. Instead, make sure you are able to recognize what has happened economically by looking at a journal entry. For Exam be able to: - Evaluate economic events in the life of business (by understanding double entry bookkeeping.) o When a company gets a check: revenue increases and there is a double entry. - Understand that when an asset increases, another account decreases—there is a double entry. o It may increase liability by issuing a promissory note. - Understand the accrual system to analyze a financial statement given to you on the exam. - Understand where accounts go in financial statements. (he might list 20 accounts in alphabetical order and ask us to turn that into a balance sheet. Example: ―A/R‖ where does it go? Assets. What kind of asset? Current asset.) Chapter 7 Capital Accounts: Stockholder’s Equity Two Components: Contributed Capital, and Retained Earnings 1. Contributed Capital a. Consists of: “Capital stock” and “Additional paid in capital”: state legislatures concerned with having separate legal capital to protect creditors. You must set a legal PAR value in stock b. Journal Entry: i. Cash 1000 Capital Stock ($1 par value) 100 (legal capital) Additional paid in capital 900 (this is how you protect creditors) c. Limitations: i. Under the old laws, companies could not issue stock in exchange for services. 25 Hypos: What does the balance statement look like, assuming the above entry is the only entry? Assets: 1000, Contributed capital: 1000 Assuming the company purchases something for $1000 on notes payable. Cash 1000 Notes Payable 1000 What does B/S look like? Assume company purchases dividends for 1000 with cash: Dividends 900 Cash 900 What does B/S look like? Bottom Line: Concept of legal capital and par value has no significance and does NOT protect creditors. (but it still exists in Delaware) Model Business Corporation Act (EXAM FLAG!!!) - Most states have adopted this. p. 146-147 (old rules in terms of what legal capital was supposed to do) Look for a recurring theme… §6.21 Issuance of shares a) b) c) Board’s job is to determine is the consideration is adequate and that determination is conclusive. Theme: Board is given all power as opposed to concepts of legal capital. Board has discretion, but board has business judgment responsibility. A board member has a responsibility of due care in his cooperation of the corporation. (p. 148) Issuance of Shares is a matter of concern to shareholders. §640 Distributions to Shareholders:  Can make distributions subject to an Incurrence Test §6.40(c)1-2: (“Incurrence Test:” calculated after giving effect to the transaction. This is listed in the loan convenants) 1. No distribution where company would not be able to pay its debts, OR i. Look at current assets as compared to current liabilities. 2. Where the Corp.’s assets would be less than the sum of its total liabilities plus the amount that would be needed. 26 i. This is not necessarily a financial statement issue. You can make this judgment on appraisals. Although, financial statements might look better. Test example: Board goes to a lawyer and says ― we want to make a huge distribution in dividends.‖  Answer: Under Model Corp. Act, Board has discretion but is limited in certain respects. Cash Dividends (p. 156):  Dividends are a reduction to retained earnings unless you declare dividend to be paid later. So debit retained earnings when delcared and credit liability to be paid later.  Stock Dividends  The effect of stock dividends is: take a part of retained earnings and permanently put it in capital stock accounts.  Stock Splits v. Reverse Stock splits o Split: doubles the # on stock certificate o Reverse: splits the # of shares on a shareholder’s stock’s certificate in half.  Must note change par value. o Why do this?  If stock price has gotten too high, and it is out of the range of the small investor, then company might want to split stock  Where company is threatened to be D-listed. By splitting, they can reduce stock price.  o Misc.:  It does not change the value of the company at all!  Some companies just want to have a high stock price. EXAM PRACT’ICE: Problem 7-A Chapter 9: Statement of Cash Flow (SOCF) Many times lenders, shareholders, and other parties will require statements of cash flow. Statement of Cash Flow (SOCF):  Not an accrual statement.  Designed to inform the reader of information not easily extracted from the financial statement (Financial liability). o Ie. “How is the company managing the cash in the business?”  Page 210- shows how financial statement is broken down. 27 o Financing activities: involvement with shareholders o Investing Activities o Operating Activities: how much cash did the operation throw out during that recording period. How do we prepare SOCF? (EXAM FLAG- be able to transfer something from accrual basis to cash flow statement. Do the numbers relate to investing, operating, or financing?) 1. Direct Method (example on 212): a. The table on p.212 reports the entries from accrual to cash flow statement (pg. 36 and 44, Larry’s law firm) i. Page 44: Larry received cash for doing work $5000 = reported under operating activities. ii. Page 36: Larry wrote a check for some office supplies, which creates current assets = reported under operating activity. iii. Page 44, transaction 10: invested on library $500 = reported under investing activities. 1. Balance sheet CASH needs to reflect the same NET increase in Cash on the SOCF. (see page 46) 2. Indirect Method (see page 214) a. Operating Activities: i. First, Start with Net Income of business. (see page 49) ii. Look to see which operating costs were not related to income. 1. For example, when purchasing supplies you increased assets, not income statement activity. iii. Think what happened to generate this increase or decrease. For next lecture: start studying on page 216-218. October 12, 2006 (Chapter 8) Problem 7A: The answer is mainly right but we would also want to consider the liabilities (when are they due?), the accounts receivables (when are they likely to be collected? What is the mix of accounts?) Also, accounts receivables and inventory are both going up. Is this a good thing? Retained earnings are going up too so this could be an indication that the company is doing okay. BUT: We still need to dig deeper. We would want to see some more financial statements. Why is the inventory going up? Is the product not selling well, are they making bad purchasing/manufacturing decisions? 28 SO: A simple balance account leads to a ton of questions. GOOD EXAM QUESTION Problem 9A Cash Flow Statement: Direct     Operating Activities o Collections from customers o Paying for phone bill Investment activities o Purchase of trailer o Investment in trading securities Financing Activities o Mortgage loan (they GET cash with a loan) THEN: To get the net increase/decrease in cash you net these all together When you use the direct method you need to pay attention to each entry where cash was involved. If cash was involved in that event, you plug it in. You need to look at the actual transactions. We must report all of the cash that was generated from the operations of the business. THEN: Did the company part with any cash with connection to operations? This is paying bills, etc. Cash Flow Statement: Indirect If he asks us to use the indirect method, we start with net income (given) and two balance sheets. OPERATIONS: We start with net income and then ―reconcile‖ to cash. We compare the two balance sheets to determine what the non-cash items are. In order to get the cash number we have to reconcile the non-cash items back into the net income amount. We either have to add back the number or subtract a number to get the cash. *So is this like balancing your check book: you want to know how much cash you have in your account at any given time? WE’RE RECONCILING NET INCOME ON THE ACCRUAL BASIS TO CASH PROVIDED FROM OPERATIONS 29 FINANCING AND INVESTING ARE THE SAME UNDER BOTH THE DIRECT AND THE INDIRECT METHODS Operations: revenues and expenses Investments: fixed assets Financing: borrowing money, issuing stock, paying dividends, paying interests on loans Cost of Goods Sold and Cash Flow Statement Beginning Inventory + Purchases = Cost of goods available for sale Cost of goods available for sale – ending inventory = COSG Financial Statement Analysis EXAM MATERIAL Liquidity and Activity Ratios All about comparison: with other businesses, other industries, other periods, etc.  Working capital o A measure of the resources an entity has available to operate its business on a day to day basis. o Current assets – current liabilities = working capital  Current assets:  Cash  Accounts receivable  Inventory  Prepaid insurance, rent, etc.  Investments  Current liabilities  Payables that are due within 1 year Working capital to sales ratio o You have to be given this information o This is one way to assess the adequacy of working capital o Dependent upon whether you are high volume, low priced items OR low volume, high priced items  30      Current ratio o Ratio of current assets to current liabilities: CA/CL  ―Current‖ is within the year  These numbers are going to be on all financial statements because the current ratio is something that everyone wants to look at o For most businesses the optimal current ratio is 2 o BUT: You also have to consider what KIND of assets you have, i.e. is it cash or is it all pre-paid rent? This might make a big difference. Quick Ratio/Acid Test Ratio o We only look at those assets that can be quickly liquidated, i.e. cash already is liquid and accounts receivable within 3 months  SO: Current assets – inventory – prepaids / CL  This gives one a better focus on the company’s ability to pay liabilities in the short-term o Most businesses want a minimum quick ratio of 1 o KNOW THESE FOR THE EXAM Inventory Turnover ratio o Current year’s COGS/ (Beginning Inventory + Ending Inventory) /2  If you divide this by 365 you know how fast your inventory is turning over, i.e. every 30 days  Its good if you have a fast turnover rate because it means that it is turning into revenue o This is used to measure the liquidity of the business, i.e. how fast the inventory is moving in and out o This is critically important information and will likely be a part of any board meeting for a company that has inventory, i.e. not service o The optimal number really depends on the type of business, i.e. milk vs. used cars Accounts Receivable Turnover Ratio o Credit Sales / (Beginning accounts receivable + ending accts receivables)/2  Divide this number by 365 to get days sales outstanding  If the DOS is growing, it will cause the board some concern and they might need to estimate a greater bad debt reserve o Allows one to see how fast accounts receivable are collected: they’re not worth anything if they aren’t collectible o This is very important: board always look at this every meeting Debt to Equity Ratio o Basically how much debt a company has in relation to their equity o Certain ratios are desirable dependent on certain industries and certain market conditions  *Some industries really might want to debt/cash flow ratios. They don’t care about the equity ratio. In fact, we’ll probably see this more.  Cash flow: Earnings before interest, taxes, depreciation and amortization (EBITDA) 31 o Measures the entity’s borrowing capacity, i.e. the level of comfort a lender or potential lender can have in the entity’s ability to repay the loan Profitability and Performance Ratios    Gross Profit Margin o Gross profit / sales Profit Margin o Is the entity getting a lot or a little out of its sales effort? o Ratio of net income to sales Interest Coverage Ratio o Ratio of earnings before interest and taxes (EBIT) /interest expense o Lenders want to know if you have earning to pay your interest obligations to them. o The lower the ratio the more concerned you should be. Fixed Charge Coverage Ratio o Tests the coverage for other fixed charges in addition to interest, i.e. lease payment Preferred Dividend Coverage Ratio o Dependent on whether any debt ranks higher than this dividend o Test to see whether earnings are going to cover the dividends Earnings Per Share o Total earnings during the period after taxes and interest deducted (EBIT) divided by the number of shares o You want your number to grow every quarter so that analysts will recommend the stock Price-Earnings Ratio o Ratio of price per share to earning per share o A high PE could suggest that investors are optimistic about your business or maybe industry as a whole because it is growing hugely  BUT it could also mean that the stock is way overvalued o This is looked at often by people who follow stocks PEG Ratio o Price earnings Ratio/ growth rate in the company’s earnings o A low PEG ratio is good Return on Equity, Investment and Assets o Equity:  EBIT / stockholder’s equity  Return on equity is the amount the business earned on the capital owned by its shareholders  Ways to enhance: o Speeding inventory and receivables turnover o Shedding less productive assets o Increase sales volume or price o Decreasing expenses 32       o Increase borrowing o Buy back shares o Investments:  EBIT /equity and long term liabilities  Return on investment is the amount a business earned on both the equity held by its shareholders and the capital supplied by lenders on a long term (over one year) basis o Assets:  EBIT/ equity, long term liabilities and short term liabilities  Return on assets is the amount a business earned on ALL of its resource This sort of ratio analysis often just raises more questions than it does provide answers. SO: The SEC requires a narrative to go along with the financial statements (for publicly traded companies). Management’s Discussion and Analysis (MD & A)  The MD&A must address: o The company’s liquidity o Capital resources o Results of operations o Information relating to trends and uncertainties o Any material off-balance sheet arrangements  This provides soft info which not everyone thinks is a good idea  Companies need to disclose their critical accounting policies, often including: o Inventories o Fixed assets o Accounts receivables o Revenue recognition o Goodwill and other intangible assets o Investments in marketable securities o Derivative instruments o Loss contingencies (especially environmental liabilities) o Defined benefit retirement plans DO the problem in chapter 8 and we’ll go over them next time October 19, 2006 EXAM: Generate A Cash Flow Statement: How do we tackle this problem? 33 Start with the investing and financing because this it the same for direct and indirect methods. Just record the cash that goes in and out of the company Direct Methods  Cash flows from investing activities o Payments for investment in securities : ($30,000) o Payment for investment in equipment: (75,000) o Collection of payment for sale of machine: 25,000  Net cash used for investing: (80,000) Cash flows from financing activities o Payment for retirement of bonds: (63,000) o Receipt upon issuance of capital stock: 25,000 o Payment of dividends (67,000) (where did this come from?)  Net cash used for financing: (105,000) Cash flows from operating activities o Sales on account: 664,000*  Where did this number come from?  We started with accounts receivables of 57K, we had sales of 670K, we ended up with 63K. 57K + 670K – 63K o Interest Revenue: 15,000 o Total cash receipts: 679,000 o Payments for inventory: (375,000) o Salaries and Wages: (62,000) o Insurance (6,000)  There was some prepaid insurance too but only 6K was paid in cash o Interest (15,000) o Income Taxes (47,000) o Total cash payments: (505,000)  Net cash provided from operating activities: 174,000   Net Change in cash: (11K) Previous cash balance: 46K Ending cash balance: 35K Operations = everyday expenses and money made Assume all the sales were made on account: SO they were made on account and then they get collected later Assume all inventory is bought on account. 34 Indirect Method   Same for investing and financing activities Operations is the only thing that’s different Start with Net income Net Income: 120,000 Adjustments: Increase in accounts receivable: (6K)* Gain on sale of machine: (5K)* Decrease in inventory: 8000* Increase in accounts payable: 7000 Decrease in wages payable: (2000) Depreciation: 40000 Decrease in PPI: 6000 Increase in income taxes payable: 3000 Loss on retirement of bonds: 3000 *These had nothing to do with cash: the gain on the machine was not a cash gain, the increase in accounts receivable was not a cash gain, etc. We want to reconcile back to the cash balance. RULE: Dividends are ONLY shown on the statement of retained earnings. SO: If you’re given a balance sheet and an income sheet you need to generate the retained earnings statement. We need to know if any dividends were issued: Beginning Retained Earnings + Net Income = Ending Retained Earnings 193K + 120K = 313K BUT: We know from our balance sheet that the ending retained earnings was really 246K. SO: We know that the rest of it went to dividends. Notes on Chapter 16:  The auditor works for his client BUT o Auditor has a bigger function; he serves more than one master  He serves the shareholders  He needs to make an independent analysis of the finanicial statements to make sure that they fairly represent the financial situation of the company o He serves regulators if the company is publicly traded 35        The lawyer o The lawyer is accountable to the client  BUT: he is also accountable to others now that SOX is in effect Lawyers have an affirmative duty to report material violations of securities laws Briefly this chapter is about: o Legal opinions  You will help your client solicit an opinion letter from the auditor  Your goal is to get a clean opinion  There is a tension though because the auditor wants to know EVERYTHING and you as the lawyer don’t want them to know ANYTHING  The auditor wants to know about pending lawsuits o The lawyer fears that telling the auditor this stuff will disclose confidential info, will be deemed an admission, will foreclose a possible defense, etc.  Cost: The bigger the scope of the audit the more expensive it is Before SOX though it was simple: you had a duty of confidentiality to your client o You still do BUT it is more complicated with SOX Even after SOX though, there is no affirmative duty to start an investigation: you just respond to your client’s request for investigation TEW (pg. 421): Absent litigation, there is no obligation on the attorney to affirmatively come forward with information. Willkie Farr (pg. 423): This case is all about privilege and work product. The privilege is gone once information has been disclosed to the auditor. EXAM: This sort of stuff (privilege, lawyer’s role, etc.) will likely be on the final. READ CHAPTER 16 Come up with questions for next class when we are going to have a speaker. Review chapter 16 and think about the questions after the cases. (Notes from Melissa because I don’t get this stuff) October 19, 2006 Cash Flow Statements Review 1. First→ Investment Activities→ tracking the ins and outs of cash related to investing activities. Items 1-6 below balance sheet. Don’t include something unless you wrote a check for it. No difference here b/w direct and indirect method so don’t need to do it again on the final. a. Land purchased by using a note payable is not related to the flow of cash. 36 b. Sale of machine is an investment activity. Book value is relevant to check in the income statement for an income or loss, but not important for the cash flow statement. 2. Second→ Financing Activities a. Raising money for issuance of stock, redeeming bonds, paying dividends b. Don’t record dividends anywhere except statement of retained earnings i. Beginning retained earnings $193 (ending retained earnings from last year are the beginning for this year) ii. + net income $120k iii. = ending retained earnings of $313k iv. But this number is not $246k which is the retained earnings for 2007, this means there was a payment of dividends v. So you know that the difference equals the payment of dividends of $67k 3. Third→ Operating Activities (this is the only place where direct and indirect method differ) a. How much cash did get from operations? Running business every day generating revenues and expenses b. Walk down the income statement to put this together c. Make assumption that every sale a company makes was on account d. Sales Revenue i. We know there is a balance in AR of $57k in 2006 and at the beginning of 2007. At the end of 2007, balance was $63k ii. Balance was increased by the amount of sales revenue $670 which would give a $727k receivable balance, but we know this wasn’t the balance at the end of the year, it was $63k. Therefore the difference is the amount of cash that has been generated from sales in A/R so that is $664k e. Interest revenue i. how much of this is cash? No interest receivable account on balance sheet, so every dollar of interest that came in must have been cash f. Gain on sale of machine i. We calculated a gain, but didn’t get a check, already accounted for this sale in the investing activities. ii. So is not included in operating activities→ non cash gain g. Cost of good sold 37 i. When dealing with must thing of inventory b/c that is what it was before ii. Also need to assume that when you are dealing with inventory purchases, make assumption that you buy all of your inventory on account and don’t pay cash for it. iii. Inventory→ periodic and perpetual iv. On balance sheet have an inventory account with beginning balance of $92k and end of the year was $84k v. As inventory expires it becomes COGS vi. In perpetual every time you buy or sell inventory you record it. vii. We know that COGS is $390k viii. Increase an expense with a debit and decrease an asset with a credit so Inventory account starting at $92k, and it is credited with $390k. So much have a debit in inventory account for $382k. if debit inventory then must credit account payable ix. Accounts payable had an opening balance of $31 and ending of $38. Corresponding credit of $382 in the accounts payable account. Which would leave $413k in accounts payable but that is not the ending balance so somewhere we must have debited the accounts payable account for $375k. You would reduce accounts payable by paying them with a check. So the corresponding credit is to cash of $375. x. Therefore know that the cash payment for inventory purchases was $375 h. Salary and Wages i. There is a salary and wages payable account, beginning of year $9k and end of year $7k. ii. By looking at income statement know that we had a sales and wages debit of $60k and a credit of $60k to salaries and wages payable iii. That would leave us with $69k in salary/wage payable. But we know the ending number is $7k so need to debit the account $62k. that means you credit cash for $62k b/c paid salaries out. i. Depreciation i. Debit depreciation expense, credit accumulation depreciation. No cash involved. ii. So it is always not listed in cash flow stmt 38 j. Insurance i. Prepaid insurance is an asset account, balance at beginning was $18k and end was $12k. reduction in prepaid insurance is a recognition that asset has expired and turned into an expense ii. So during year had to be journal entry crediting prepaid insurance for $6k and debiting insurance expense for $6k iii. At some other point in time had an insurance expense that was actually paid out in cash so debit insurance expense and credit cash for $6k k. Interest i. No interest receivable account→ immediately tells you the interest expense was all generated with a check. Wrote a check for the interest expense l. Income Taxes i. Income taxes payable on balance sheet ii. Opening balance of $5k iii. Closing balance of $8k iv. Total income tax expsense for year was $50k v. Had to be a journal entry to record this vi. Debit to interest tax expense and credit to income tax payable for $50k vii. That would leave $55k at one point in time in income tax payable viii. But were reduced by $47k to get down to ending balance of $8k ix. Reduce this liability by paying the IRS, writing a check. x. Debit income tax payable for $47 and credit to cash of $47k m. Loss on retirement of bonds→ not recorded, we redeemed bonds for $3k more than we issued, so we generated a loss, but accounted for this in the financing and that is the only cash part. Loss in recorded on income statement but not on the cash flow stmt. 4. Indirect Method for Operating Activities a. Start with net income and we reconcile it with cash. Do this by comparing changes in those accounts that bear on the income statement b. Net income $120k c. List adjustments to reconcile, doesn’t matter what adjustments you do first 39 d. Increase in accounts receivable of $6k e. Take away things that were added to net income that had nothing to do with cash f. Inventory went down, company must have sold more inventory than it bought, excess over what we sold is an increased expense, but did not write a check for that excess, so have to add that back in p.218 Table 9-4 is helpful. Inventory is an asset account. g. Increase in accounts payable h. Depreciation was taken out of net income but to get to cash must add it back i. Bonds→ when you redeem bonds you have two components, the cash that comes in or goes out. **focus on the journal entries Direct Cash Flows from Operating Activities  Cash receipts o from Sales in A/R $664k o from Interest $15k  Total Cash Receipts $679k  Cash payment for o Inventory purchases <$375k> o Salaries and Wages <$62k> o Insurance <$6k> o Interest <$15k> o Income Taxes <$47k>  Total Payments <$505k>  Total Cash provided from operations $174k Indirect Cash Flows from Operating Activities  Net Income $120k  Adjustments o Increase in Accounts Receivable <$6k> o Gain on sale of machine <$5k> o Decrease in inventory $8k o Increase in Accounts Payable $7k o Decrease in Wages Payable <$2k> o Depreciation $40k o Decrease in prepaid insurance (asset) $6k o Increase in income taxes payable (liability) $3k o Loss on retirement of bonds $3k 40  Net cash provided by operating $174k Cash Flows from Investing Activities  Payments for investment in securities <$30k>  Payments for investment in equipment <$75k>  Collection for payment for sale of machine $25k  Net Cash Used in Investing Activities→ <$80k> Cash Flows from Financing Activities  Payment for retirement of bonds (bonds are debt) <$63k>  Receipt upon issuance of capital stock $25k  Payment of dividends <$67k>  Net Cash Used in Financing Activities <$105k> Ch. 16 Loss Contingencies  Tension b/w auditors and lawyers if something should be disclosed  Auditor o Works for the client, but has a bigger function, serves more than one master (shareholders of company, regulators (SEC), client)  Lawyer o Only focus is the client but with Sarbanes it has gotten a little more complex o Isn’t just client you serve, may have an obligation to disclose confidential info about client. o Have an affirmative duty to report material violations of security flaws o What auditors are looking for is anything that could rise to the level that they have to dramatically expand scope of audit or they can’t issue a clean opinion but what lawyer wants to do when comes to threatened litigation is to keep your mouth shut. Fear is that something you say or write could prejudice a defense that your client may have. o If scope of an audit is enhanced that is more money out of client’s pocket that doesn’t want to pay o ABA stmt of policy starts with premise of confidentiality  TEW case o Company’s lawyer became aware of some financial difficulties, argument was that lawyer had duty to disclose that client was in trouble 41 o Court said no duty, b/c this had nothing to do with litigation and just the potential for insolvency o No obligation to come forward o Absent the threat of litigation, no duty to disclose  Willkie Farr Case o Attorney/client privilege o Ernst and young wont’ give clean opinion unless get more info but lawyer doesn’t want to disclose info cause can be used against company. So give hypotheticals to get a clean opinion. Later when there is a suit, want all info that Willkie farr gathered. o Once any material is disclosed to Ernst and young, the privilege is gone.  Scope of privilege  Has it been waived o Second you as a lawyer talk to auditors you run the risk of losing the privilege Week #11 October 26, 2006 Guest speaker from Ernst & Young: Jeff Rosen “Audit”  Audit financial statements o Materiality: audits don’t have to be exact  3-5% is a good place to start, i.e. if the mistake involves 35% of income than it is material  BUT it can really depend on earnings per share and what the guidance was  REALLY: you need to look at the mistake BOTH quantitatively and qualitatively to see what kind of effect its going to have o As an attorney you need to understand this  Example: Junior associate messed up when he wanted to stop the printers for a 20K mistake on an 800 million balance sheet  Under SOX: public companies now have to assess their internal controls AND THEN have auditors express an opinion on that assessment.  Whistle-blowing hotline/email 42  Two signers on checks  Separation Auditors and Lawyers  Auditors have to assess legal claims and other matters to see if they should assess any liabilities with regard to those matters  The auditors need to talk to inside and/or outside counsel to discuss these liabilities  Legal letter requests o Asking counsel for info on all of the lawsuits  Inside counsel will keep the board minutes and the auditors read these  Auditors have to make fraud inquiries of management and the audit committee o The CEO and the CFO have to tell the auditors of anything they know of that impacts the financial statements  Contractual interpretations  Stock options o It’s good practice to run any significant agreements by either the in-house accounting department or the auditor  Comments on 10K  Audit committee charters  SOX pre-approval process for non-audit services o Non-audit services  Tax work  Financial due diligence, i.e. in an acquisition  Valuation services  Internal audit work: look at the internal controls and report to management o SOX says that non-audit services:  1) Must be approved by the audit committees, AND  2) Must not be provided by the outside auditing firm if SOX so provides, i.e. tax and due diligence is okay  The concern here is that companies will cater too much to getting non-audit business (which is more valuable) and try to please companies with the audits  Comfort letter o The underwriters want all of the numbers that are in the registration statement to be verified by the accountants 43 SOX  Partner rotation  5 years on one client and then rotate  Some talk about firm rotation but he says this would be bad because more mistakes would get made  The legacy knowledge is important: the continuity  CEO and CFO have to certify the financial statements now  Much longer and more robust audit committee meetings  In-house counsel is at these meetings.  CFO has a big say in what firm gets hired for outside counsel: know something about accounting and you have a better chance of getting hired Privilege and Disclosure to Auditors  SEC doesn’t have much sympathy for the attorney client privilege  The auditors will have to issue a qualified opinion if they don’t see everything  Once this is explained the company hands over whatever the auditor wants to see  The auditor and SEC can have certain documentation standards, i.e. labeled attorney-client privileged, partner’s eyes only, etc. o Auditors see a lot of highly confidential info o The accountants are much more in charge than before SOX o The only place where the company still has some power to resist auditors requests is if the company is private  He has had to get GC involved but he’s never had a situation where the privilege issue turn into a problem for the The rules have changed: the accountants are more in control now. Regardless, everyone is a professional so that the atmosphere can be very collegial. EXAM: Some of this might be on the exam but he will bring it up again in the review session. Next class: read the two chapters on finance Week #12 November 2, 2006 (Chapters 10 and 11) 44 Overview of 10 and 11  Time value of money  Valuation of debt and equity interests  Broad overview of other valuation principles  Valuation techniques What are we concerned with?  Homework problems from chapter 10  Apples tree parable  Discussion of valuation of bonds (stuff from outside the reading)  Discussion of a debt offering in the public market Problems on Page 258 a) Rachel is saving money for her son’s college education. What is the future value of 10K in 10 years out if you invest at 9%? a. If interest compounds annually? i. Looking at our Table 9-1 we get 2.367. The future value of 1 dollar is 2.367, so that the future value of 10K is 23, 670. b. If interest compounds semi-annually? i. This means that we get interest on interest faster so that our number is going to be higher. ii. Double the periods and cut the interest rate in half. This means that our interest rate is going to be 4.5%. Since the table only goes by whole percentage points we have to average 4 and 5%. We get: 2.427 x 10K = 24, 270 b) L won a prize: 15K now or 1800 paid at the end of each year at the next ten years. The 1800 can be deposited and at 12%. Whether the present value of the stream of payments is greater/lesser than 15,000? a. We are calculating the present value of an annuity. We should use table 94. b. 5.65 x 1800 = 10, 170 c. The better deal for L is to take the 15K. c) You won 1 million in lotto. You get 50K for 20 years. What is the present value of this? The interest rate is 7%. 10.594 x 50K =530K a. SO: You didn’t win a million, you only won 530K roughly. d) We want a million at age 65. We have an 8% rate of return. Thus, it will take 9 years to double one’s money (72/8). a. 56: 500K b. 47: 250K c. 38: 125K d. SO: If you invest 125K at 8% return rate at the age of 38 you will have 1 million by 65. e) What would a reasonable investor pay for a 1K ten year bond that pays 120 a year in interest. The discount rate is 8%. 45 a. We need to determine the issue price of the bond. b. What is the present value of the return of principal? Intersection of 8% interest and 10 periods: .463. We need to multiply this by the amount of the principal (1K). The present value of the principal is 463. c. To this we need to add the present value of the annuity. d. Table 9-4, intersection of 8% and 10 years: 6.710. Multiply this by 120 to get: 805 e. 1268 is the issue price of the bond (805 + 463). The investor is willing to pay more than the face value of the bond because the rate of return is greater than the market rate (12% vs. 8%). f. You are going to pay more or less for the bond depending on the relationship between the face rate of interest. f) Investment opportunity will pay 400 for first 10 years and 600 for next 15 years. What is the present value of the opportunity with 8% discount rate? a. We have two separate annuities here: i. 6.710 x 400 = 2684 (first 10 years) ii. 8.559 x 600 = 5135 (next 15 years) 1. BUT: This is it’s value at the start of the 15 year period. We need to take the value back to the today. To do this we need to go back 10 more years. We use table 9-2 and get: .463 x 5163 iii. 2684 + 2379 = 5063 g) Yield on 10 year US treasury bond is 5%. Company A is a start up. Company B is a household name company. Look at the scenarios and see what the discount rates should be: the higher the risk, the higher the discount rate. Company A is higher risk than Company B so that there discount rate is going to have to be higher. They both have to be higher than the US treasury rate. a. General RULE: The cost of capital is more expensive for a start-up because they are riskier. b. Greater risk = higher discount rate, i.e. you don’t want to pay as much today Yield: Rate you get back on your money. Nothing is more risk free than a government security: they print the money. When you invest in a bond it means that you have excess cash lying around and you are looking around for a way to put it to work. Components of a bond: you get your principal back and interest on that principal. The question is: what is the value today of the right to receive these two components? The Rule of 72: Divide 72 by the rate of interest to find out how many years it will take to double your money. 46 Annuity: a stream of equal payments over a certain time period Compound interest: you get interest on your interest Old Man and Tree Parable  There are a number of ways that you can value a business. o Accountant: Wants to look at the assets. But this is NOT a good way to value the company: it is about record keeping. o The valuation should be based on earnings or cash flow.  You don’t value a business based solely on liquidation value, i.e. what you can sell the assets for  You don’t value a business based on 1 year’s earnings  Problem: o 50 dollars a year for 5 years  3.352 x 50 = 167.60 o 40 dollars a year for 10 years  5.019 x 40 = 200.77  Present: .497 x 200.77: 99.78  SO: The present value of the tree is 267.38  What if the discount rate applied was 8% o 50 dollars for 5 years  3.993 x 50 = 199.65  40 dollars a year for 10 years  6.710 x 40 = 268.40  Discount back to year 1: 268.40 x .681 = 182.67 Bonds  10K bond debt instrument at 8% interest (coupon rate) o The bond is due in four years, i.e. that’s when you get a return of principal. o The market/effective rate is also 8%. o This means that the issue price should be 10K. o You get this by using the tables and combining the present value of the principal and the present value of the interest.  What if the market rate is 10% o The bond is going to be LESS than face value, i.e. under 10K. o The journal entry will reflect this: we debit both cash and a ―discount‖ account. o What this REALLY reflects is additional interest expense. It will have to show up on the income statement somehow. What happens is the overall discount gets amortized over time, i.e. some of the discount is allotted to each year.  What if the market rate is 6%? o The bond is going to be MORE than the face value, i.e. a premium.  Show and Tell: Deal Book for a Private Placement for Salem Communication 47  Companies can issue debt in a private placement or a public offering This is very similar to an IPO You need to hire underwriters, investment bankers, etc. They help you prepare the prospectus which is given to investors You sell bonds just like you do stock: road show to all the big cities with the big investors.  Based on the road shows you build a whole book of levels of interest.  You want to get a level of interest which is oversubscribed, i.e. you have more buyers than you do bonds.  You can negotiate at this point. o Who buys bonds?  Institutional investors often have debt funds.  Insurance companies. o High yield debt: junk bonds, i.e. when the risk with the company is higher o A newer company has to issue bonds with a higher interest rate, i.e. they will give you a bigger payback than a more established company because the risk is higher o The underwriters get some of the money. What do lawyers have to do with this? o If you’re representing a client you will work on putting the prospectus together, deal with the auditors (comfort level), deal with the underwriters, o If you go in-house and you’re the GC you are going to have to write an opinion letter saying that the deal is good. o Sometimes an outside counsel does this but they don’t like to and it would be very expensive for the client. o o o o o Next class: read chapter 17 and work on 17(a). Try to research one of the companies a little more if you can. Look at the Arthur Anderson situation. Be active because he’s getting reviewed. Week #13 November 9, 2006 (chapter 17) This chapter should really be called: actions have consequences There were MAJOR consequences as a result of the What should we do with this material? 1) Reinforce and bring home some of the basics regarding accounting 2) Take a look at accounting principles and related ethical considerations 3) Take an indepth look at one of the companies: Worldcom a. We’re going to look at the culture of the company as well as the actual accounting practices 4) Look at SOX and what it is that congress tried to do to fix the problems 48 Accounting Basics    There is True Truth in double entry bookkeeping: there are rules that HAVE to be followed BUT there are also areas for discretion: GAAP o GAAP is not inviolate; it lends itself to making judgments What happens if you make bad judgments? o If you get in the habit of being aggressive in your accounting, it has a snowball effect  If you overestimate earnings one quarter, you need to do it again the next quarter o Taking a consistently aggressive position can be looked as sending a message from the top that it’s okay to approach the line a little bit closer next time  Its a question of culture If there are all these risks, why are we tempted at all to be aggressive? o With public companies, people want the stock price to be high:  Stockholders  Option holders  Management  Founders even want it to be high at the IPO phase so that they can have a big pay day What about with private and public companies? o These companies might be competing with other companies that are using aggressive o Incentive compensation plans o Lenders In today’s world the company might be tempted to do aggressive accounting but the auditors are NOT tempted: they are against it    What can a company do? o “Income smoothing”  You show a nice steady quarter to quarter pattern instead of volatility  This might not be wrong but it also could be alright if its properly disclosed  Investors and others just need to know what’s going on, i.e. it can’t be hidden o “Big Bath”  You take a big hit earlier than you should so that later periods look better “Wine Before Its Time” o A mechanism to recognize revenues early  49   Example: Sell lawnmowers in the winter and recognize the revenue even though you don’t deliver them until the spring. o This is NOT testing the line: you are crossing the line here o Revenue recognition is the biggest area of concern for auditors: everyone wants to boost their revenues so it is the area of biggest temptation  Example: You sell goods with a full refund option. The sale doesn’t really take place until the 90 days expire. The company can record revenue until this time. o This is really important for companies that have low volume high ticket items  Example: Med device company sales 4 robots that perform surgery. Now they come out with a new model. The purchaser of the 4 wants to trade in and the company says they’ll work something out. The company cannot recognize this revenue because the trade in is going to effect this. Off Balance Sheet Financing o EXAM o You structure an investment in another entity so that you can treat it under the equity method instead of the consolidation method, i.e. you own 49% instead of 50% o Why?  Because you want to hide the stuff on the entity’s balance sheets, i.e. all the debt. Pro Forma Reporting o Its not GAAP but you say if we didn’t include X, this is what our numbers would be. o This is okay but it is very restricted. o This sort of abuse can rarely happen today because there are so many restrictions.    Material: o Would the difference influence a reasonable investor o There’s no clear percentage rule on this  Sometimes the materiality threshold could be really low Lawyers need to watch for when their client indicates that they are going to be aggressive, i.e. manipulate the figures so that they meet guidance, so that they meet lender requirements, etc. o You get near the end of the quarter and your client is a publicly traded company and they want to recognize a big deal early so that they meet guidance  EXAM o You’re a private company and you manipulate earning so that you have the proper ratios to stay out of default on your loans. Once the bank finds 50  this out you’re not going to get money from them and then you’ll have a bad reputation in the lending community.  EXAM Lawyers are going to be involved with negotiating the loan agreements: As a lawyer you need to know what the covenants are and to talk with your client as the quarter ends or the year ends and see how they are doing regarding the covenants What Crosses the Line?  Failing to Account for a Sales Discount: Seller sells stuff for 10K on credit. He offers the buyer a 2% discount if the buyer pays within 10 days instead of 30. The seller needs to account for this 2% discount, not doing so would artificially inflates sales figures. o This is what happened in Pearson/Penguin. They did this to try to hide the fact that they were offering discounts to some retailers and not others.  This adds up over time: it added up to 163 million Lender’s Failure to Account for Risk of Default: Lender makes loans and recognizes the revenue but does not account for the risk of bad debt. Instead of treating all bad debt as an expense they recognized some as assets, saying that they had a right to repossess the property. They debited some account called ―Other Assets‖ when they credited accounts receivable. This showed that they had a lot of assets that they didn’t have. When it got to 100 million people started wondering what these other assets were. o This is what happened in Mercury Finance o Ask for your clients financial statements: look at the balance statements and compare year to year on accounts. If you see an account going up or down by a large number ask why? If you can’t figure it out, ask your client. If they can’t follow up with the auditor. This is how big problems get uncovered. Making an expense an asset: AOL was spending lots of money to build traffic and build a base of subscribers. They chose not to record these as expenses but rather to defer these costs. What they should have done is debited ―subscriber base expense‖ and credited cash: this would have immediately hit their income statement. Instead they set up some sort of a deferred account which they said that they were amortize later on. The problem is this account showed up as an asset. This overstated their income by a huge amount. o There is some justification for this practice, i.e. if a company buys a truck to use over time. BUT: here there was no evidence that the expenditures would result in long term gains, i.e. that they were an investment.   51 Audit Failure  Phar-Mor: o Low price seller who was hugely successful with over 3 billion in revenue. The problem was that they had very deceptive numbers: their prices were so low that they were loosing money. o This company had weak internal controls so that this didn’t get caught on the books.  §404: SOX now puts the burden on management to assess their internal controls AND to have this assessment reviewed by the auditors o One of the big problems here was that the internal people used to be the auditors: they knew how to undermine the practices AND the auditors were not truly independent.  § 206: SOX prevents this now by saying that if there’s internal guy from the firm the firm has to withdraw for at least a year. This is bad especially in a publicly traded company.  This can be a challenge for businesses who used to use accounting firms as a way to attract top talent, i.e. CFOs, etc. o Accounting firms used to make more money from consulting services than it did from accounting services.  This can be a huge COI because the auditors don’t want to upset the client and not get their consulting business.  SOX says you can’t do this. Enron o Biggest scandal, very high profile: used to have a ball park, did playboy spreads, etc. o Very complex facts that we won’t get into too much o When you make an investment in another entity and it’s below the 20% level of investment, you don’t have to consolidate that entity’s financials with your financials. o Enron had all of these investments: Enron just valued their OWN stuff without any third party standard. This artificially increased their earnings a lot.  Ethical Problems pg. 464 a) New FASB standard which normally has to be implemented within one year of issuance although early implementation is encouraged. CFO knows that implementation will hit income. CEO says a. What should you say? Tell the client that it’s going to happen in a year regardless. What they can do is to it know but also show it pro forma, i.e. what it would be like without implementation of the rule. b. This is the safest bet. 52 b) Nuclear plant is going to expire in 15 years and its going to cost a lot. Do we need to allocate this over 15 years or do we just take a big hit in 15 years? We need to allocate. c) Company uses LIFO inventory method (Last ones in first ones sold). Prices are up and CEO says to buy a lot of stuff to artificially take a hit to income so that income is high the next year. For this year: cost of goods sold is high for the year so that income is low for the year. For next year the COSG will be low because it will be based on the oldest inventory and thus income will be high. a. You’re loading up on inventory for no business reason: just manipulating the accounts. b. This is no good: tell your client not to do it. We’re going to finish this next week. We are going to conduct a review next week. To prepare for the review focus on:      The provisions about the consolidation of financial statements (chapter 6). Review the discussion about the model business corporations act, i.e. duties of director, test to pay dividends. Review the chapter on financial statement analysis as it relates to the ratios. We’re going to go over several of the ratios because they’ll be fair game for the final. Review cash flow statements. Review this chapter Week #14 November 16, 2006 He will be here two weeks from today for a more thorough review Review:  Debits and credits are fixed but GAAP is flexible: there is a lot of room for judgment  In the abstract it is not a bad thing to be aggressive but it can be risky  Risks: o If CEO is aggressive it sets the tone for the whole company o Snowball effect; if you make an aggressive judgment in one quarter, you have to do it next quarter too  Pressures on Management o Public Co.  High stock price  IPO to get pay day for founders  Price increase for holders of stock options 53   o Private Companies  Don’t want to miss any bank covenants, i.e. ratios, etc.  This can cause default, increase in interest rates  Incentive compensation programs What can we as lawyers do? o First, don’t rely on the accountants to point out all of the problems  You are more valuable if you can watch for some of this stuff yourself o Lawyers should watch for:  Look at the account titles: are there any odd ones  Take a skeptical look at the MD & A  Watch for quarters where you know that your client may be close on guidants  Know the loan covenants for your clients SARBOX o A LOT of the audit committee’s time goes to section 404 o Accounting firms used to make a lot more money from consulting work than they did on auditing work: SARBOX says you can’t do all of this outside work Worldcom  What did this company look like the day before it filed for Chapter 11 protection: o The last financial statements they filed showed 30 billion in annual revenues o Market cap of 180 billion (stock price x shares o 104 billion in assets o 60K employees Then they filed for chapter 11 o The word was out about what they’d been doing o They had overstated their pretax income by 7 billion over the course of 3 billion o Market cap went to 0 o Employees lost jobs and their 401K plans were zapped This affected their 20 million retail customers: BIG clients like the DOD History o They had a simple business model o They grew quickly after AT&T was split up o Bernie Ebers was main guy: he had no telecom experience o They went public in 1989 by merging into an existing public co. o They grew like crazy through the 90s o Changed name to Worldcom in 1995 o They made all of their acquisitions with stock: this is another reason they wanted to keep their stock price high o Their CFO won a big award from a financial magazine o Ebers became one of the 400 richest guys in America    54   o 1999: they had their first deal that they couldn’t consummate  Antitrust stuff was in the way o This company was no longer in a position to grow by making deals o They were going to have to learn to grow in an organic way o Employees said that they noticed Ebers didn’t know what to do after this: he didn’t know how to operate the company Company’s Culture o General ledger compiled info from all over: the info was not always compatible o Different HQ were all over the place, i.e. HR, legal, etc. o None of the company’s senior lawyers were at the business HQ  The lawyers were not in the CEO’s inner circle  You need to figure out a way to become your client’s counselor: not just their hired gun o The company did not have written policies  Under SARBOX 604: publicly traded companies HAVE to have a code of ethics. This provision is a direct result of the Worldcom culture. o Compensation: Financial, accounting, investor relations were the areas getting the big bucks o No effective place to report problems  SARBOX 301.4: There has to be an anonymous whistleblower number/email, etc.  NOW: The internal audit department has to report to the audit committee Accounting Shenanigans o The key to this company was increasing market value  Ebers wanted to be the number one stock on wall street: warning bells  That is not an appropriate model of business expense  Your client’s goal needs to be to make money: NOT just have a high stock price o Know your client’s business philosophy o After the tech bubble burst there was a lot more pressure on management because competition increased o Expenses/ Revenues: As long as revenues kept growing it was okay  The company hung its hat on this ratio and this is why Wall Street  BUT: When there was more competition after the tech bubble, revenues started to go down  Ebers was always concerned about himself: he was concerned that HE would lose everything o The CFO said that all they could do was get creative through the magic of accounting  Started to release expense accruals: you record the expense when you recognize 55       Without any justification he said that expense accruals were too high, i.e. he said the expenses were overestimated  Management was upset by some of this but they weren’t allowed to question  They just reduced their expenses on the books  They reduced their accrued expenses by 3.3 billion  When the bills ultimately came in they had to add back in the expenses BUT the hit was taken later o He finally ran out of accruals to reverse so he came u  Started putting expenses down as assets  Created the ―Construction in Progress‖ account  This made the ratio look good for wall street  He moved 550 million of line expenses into an asset account What about the internal audit department, where were they? o They reported to the CFO o They did not audit the financial statements at all o They just made sure that the employees were complying with the cost controls, i.e. you can’t fly first class o Cynthia Cooper tried to look at the financial statements but CFO got mad o She got a friend of hers in IT to help her and she got o She told the audit committee and the finally fired Ebers and the CFO Independent Outside Auditors o They said they only took their orders from the CFO  This is a major red flag o They were grossly negligent o They weren’t let into all of the data and they never said anything o Their computer program and their personnel told them it was a maximum risk audit but they treated it like moderate risk Where was the board? o Know the culture of the boardroom  Go to board meetings  Even if you’re not senior partner just try to get invited  Try to figure out the culture of the board  Are they all friends of the CEO?  Are they a rubber stamp board?  How do the board members exercise their duty of care? o The worldcom board was just a bunch of friends o Ebers was both CEO and chairman  There’s a movement to separate this Their Downfall: o SEC sent an ―RFI‖ (request for information) o The SEC wanted to know why their ratio looked good while all of their competitors ratios were going down o Nasdaq stopped trading on the stock They new the risk was maximum but they only conducted a moderate risk audit Lawyers: 56  o Know the metrics your company goes by o Know a bit about their competitors and know how they track with your client EXAM  Our job would be to create the cash flow statement (or at least provide info on it)  Assume you buy stuff on credit unless its prepaid rent or something like that  We will get calculators as part of our exam packet 57