Accounting Outline

Accounting Outline ALWAYS ASK: 1) What has happened: is there a measurable economic event? 2) What accounts are affected? 3) Which way of the accounts moving? Overview:   Accounting tells a story that investors, creditors, suppliers, purchasers, government, etc. want to know The story must be: o Reliable o Relevant o Comparable o Consistent GAAP: Generally Accepted Accounting Principles *Accrual system of accounting NOT cash basis FASB: Financial Accounting Standards Board Assets = unexpired costs Liabilities = Money that you owe or work that you have to perform Revenues = Money that you have generated from sales Expenses = Money that you used up to produce revenues; expired costs Four Main Financial Documents 1) 2) 3) 4) Cash Flow Statement Balance sheet Statement of retained earnings Income statement Formulas: DEBIT = LEFT 1 CREDIT = RIGHT 1) Cash Flow Statement: Determined based on the Income statement and the balance sheet 2) Balance Sheet: ASSETS = LIABILITIES + OWNER’S EQUITY Owner’s Equity = Contributed Capital + Retained Earnings *Remember: the Balance Sheet accounts get carried over each period! 3) Statement of Retained Earnings BEG. RETAINED EARNINGS + NET INCOME – DIVIDENDS = END. RETAINED EARNINGS 4) Income Statement Measures revenues and expenses to give you the “bottom line” *Bottom line can either be net income or a net loss REVENUE – EXPENSES = NET INCOME (NET LOSS) *Remember: income statement accounts go away at the end of the period! We want to know how much revenue we produce in each period. Accrual Method Basics Matching Principle: Match your expenses with the revenues they helped to generate, i.e. they should be in the same period. Principle of Conservatism: Be conservative; it is better to understate earnings than overstate them! 2 General RULE: Revenue is not recognized until the service is rendered or the goods are delivered. SO: Often you need to make “adjusting entries” Four Accrual/Deferral Scenarios: 1) You get money before you do the work, i.e. a legal retainer. a. Debit cash when you get the cash. Credit a liability: “deferred revenue” (an obligation to work). When you do the work, debit the deferred revenue account and credit the revenue account. 2) You do the work before you get paid. a. You HAVE to record the revenue in the period that you do the work. Debit accounts receivables and credit revenue. When you get the cash, debit cash and credit accounts receivables. 3) You incur an expense to generate revenue in 2005, but you don’t pay for the expense until 2006 a. Credit accounts payable and debit expenses. When you pay the bill, credit cash and debit accounts payable. 4) You pay for expenses in 2005, but the revenue those expenses are used to generate does not occur until 2006, i.e. pre-paid rent. a. Credit cash and debit pre-paid rent. When you’ve generated the revenues associated with those expenses, debit expenses and credit pre-paid rent. Cost of Goods Sold General Principle: When inventory is sold, it ceases to be an asset and becomes an expense. This is fine so long as you are selling the item for more than its cost. SALES – COGS = GROSS PROFIT GROSS PROFIT – OPERATING EXPENSES = NET INCOME SO: An error in inventory can result in misstated income. Count the chickens carefully! Depreciation “Fixed asset:” useful life of over a year, i.e. building, car, etc. Land does NOT depreciate! General Principal: As you use your assets, their useful life gets used up until all that is left is their salvage value. You therefore have a depreciation “expense” each period. 3 Straight-line Depreciation: Cost – Salvage value ___________________ = X Useful Life X = the amount of depreciation each year When you sell an asset: Gain/Loss = Sales price – Book value Intercompany Ownership Less than 20% RULE: Investments in the stock of another entity less than 20% of the total voting shares of that entity are presented on the balance sheet at fair value. SO: Valuation fluctuations are recorded in a separate contra account and then a gain/loss is taken at sale. 20-50% RULE: Investor reports the initial investment in the investee company and then the investment is adjusted each year to reflect changes in the owner’s equity of the investee. *This is where accounting tricks can go on: company A buys exactly 50% and then technically doesn’t have to consolidate. This way they can hide their debt in another company. BUT: The auditors might get A by looking at who controls the investee company. 50% Plus RULE: This is a parent-sub relationship where the financial statements have to be consolidated. *Parent might also need to discuss particular subs which have a material affect on the numbers, i.e. in the MD & A. Model Business Corporation Act General RULE: The board has discretion regarding when to issue dividend BUT they are constrained by the financial condition of the company. Dividend Tests: The Board cannot make a distribution where: 1) The company would be unable to pay its debts as they become due, OR 2) The company’s assets would be less than its liabilities 4 Cash Flow Statement *Not an accrual statement. It is designed to inform the reader of info not easily gleaned from the financial statements. REMEMBER: 1) How did the company get money? 2) What did they do with the money? a. Investing activities? b. Operating activities? ASSUME INVENTORY AND STUFF THAT CAN BE BOUGHT ON CREDIT IS BOUGHT ON CREDIT. RENT, ETC. IS PAID FOR IN CASH. LOOK FOR THE ACCOUNT ON THE INCOME STATEMENT AND THEN TO FIGURE OUT IF IT CAME IN CASH, CREDIT, ETC. LOOK FOR A “RECEIVABLES” ACCOUNT ON THE BALANCE SHEET Financial Statement Analysis & Ratios *This is all about comparison with other businesses, industries, periods, etc. “Current” = within the year “Speedy” = cash and accounts receivable in 3 months or less Current Ratio: Current Assets ÷ Current Liabilities *For most businesses 2 is optimal Quick Ratio: Speedy Assets ÷ Current Liabilities *For most businesses a minimum of 1 Inventory Turnover Ratio: COGS ÷ ((BI + EI) ÷ 2) = X THEN: Take 365 ÷ X to get how often the inventory turns over, i.e. every 30 days Accounts Receivables Turnover Ratio: Credit Sales ÷ ((BI + EI)/2) = X THEN: Take 365 ÷ X to get how often the accounts receivables are collected Debt to Equity: Total ÷ Debt Equity 5 Debt to Capital: Total Debt ÷ (Total Debt + Equity) *Ratio analysis often raises a LOT of questions. That is why the SEC requires public companies to explain stuff in the MD & A. MD & A:  Company’s liquidity  Capital resources  Results of operations  Trends and uncertainties  Any material off-balance sheet arrangements Auditors, Lawyers & Loss Contingencies Auditor’s Purpose RULE: Auditors help ensure that the information on the financial statements conforms to GAAP and that it is reliable, relevant, comparable and consistent. Independence RULE: The auditor needs to make an independent analysis of the financial statements to make sure that they fairly represent the financial situation of the company. *Auditors serve the companies BUT also shareholders and regulators “Unqualified Opinion”: An opinion from the auditors saying that the financial statements of the company are a fair representation of the company’s financial condition. GAAS: Generally Accepted Auditing Standards *Now determined by the Public Company Oversight Board “Internal controls”: Systems in place to reduce the risk of error, i.e. two signers on a check, whistle-blower hotline, etc. Non-Audit Work RULE: Non-audit services 1) Must be approved by the audit committee, AND 2) Must not be provided by the audit firm unless allowed under SOX, i.e. tax okay Auditor/Lawyer Tension: The auditors want to know ALL of the info and the lawyer doesn’t want to disclose ANY info. Privilege RULE: Once material is disclosed to the auditor, the attorney client privilege is lost. 6 Loss Contingencies *As a lawyer, you are going to be heavily involved in this area of your client’s reports: when do they have to disclose a possible loss, i.e. lawsuit? The auditors are going to want this info! Booking RULE: 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. Footnote RULE: If only one of these criteria is met, you have to disclose it in a footnote. Potential Income RULE: You never book potential income. SARBOX § 201: Services Outside the Scope of Practice of Auditors  Your auditor can’t perform non-audit services such as o Book keeping o Appraisal/valuation o Management/HR  POLICY: We don’t want the auditors trying to woo clients to give them all this extra more profitable business by finessing the audit.  Some stuff can be performed with pre-approval by the audit committee o Tax services § 206: Conflicts of Interest  The public accounting firm will have to withdraw for at least a year if one of their guys was the CEO, CFO, CAO, controller, etc. for the company. o Independence! § 301.4: Corporate Responsibility-Complaints  There has to be an anonymous whistleblower phone number/email § 303: Improper Influence on Conduct of Audits  Officers, directors, others can’t seek to improperly influence an auditor § 404: Management Assessment of Internal Controls 7    Management has to implement internal controls Management has to assess those internal controls The Auditors have to assess Management’s assessment of the internal controls o This is REALLY expensive! § 406: Code of Ethics for Senior Financial Officers  Publicly traded companies have to have a code of ethics  This provision was a direct result of WorldCom § 407: Disclosure of Audit Committee Financial Expert  Companies must disclose whether they have a financial expert on their audit committee  If they don’t, they have to explain why not Accounting Shenanigans: Actions Have Consequences REMEMBER: Although there are some “true truths” in accounting, there is a lot of room for discretion in implementing GAAP. *Overly aggressive accounting has a snowball effect: you inflated earnings last quarter and now you have to do it even more this quarter. PLUS: It affects the culture of the whole company and pushes everyone closer to the line. Pressure on Management:  Stockholders want high price  Option holders want price increase  Founders want a big IPO  Competition with other companies  Lenders and Loan covenants  Incentive compensation programs (private co.) Income Smoothing RULE: By “massaging the numbers,” i.e. being careful when you take losses and gains, you show a nice steady quarter to quarter pattern instead of volatility. *Some degree of income smoothing is going to be okay with your auditor Materiality RULE: Something is material if it is important to a reasonable investor in making an informed investment decision. 8 “Wine Before Its Time:” A mechanism for recognizing revenues early Example: You sell lawnmowers in the winter and recognize the revenue even though you don’t deliver them until the spring. Example: You sell goods with a full refund option which lasts 90 days. You recognize the revenue when the sale is made. This stuff IS crossing the line! A Case Study: WorldCom  Culture o CEO Bernie Ebers o The headquarters for the different departments were all over the place o The lawyers were not in Ebers’ inner circle o The company lacked written policies o Ebers wanted to be the #1 stock on wall street  This is NOT an appropriate model for business growth History of Growth/Fall o The company hung its hat on the expenses/revenues ratio: they were okay when revenues were going up and up o BUT revenues started to fall when the tech bubble burst o The CFO said all they could do was get creative with the accounting o They started to release expense accruals, i.e. he told people the estimate expenses were too high without any justification  They just reduced their expenses on the books  THEN: 3.3 billion hit had to be taken all at once when the bills came in and the expenses had to be added back in o They also started putting expenses down as assets, i.e. “Construction in Progress” Downfall o SEC sent a Request for Info: why did they look good while rest of industry was suffering? Where were the auditors? o The internal auditors didn’t get this because they reported to the CFO o They didn’t audit the financial statements at all, they just made sure that employees were following cost controls, i.e. no first class tickets o Outside auditors  They just took orders from the CFO  They were grossly negligent Where was the Board? o They were all friends o Ebers was both CEO and Chairman 9    