Accounting for Lawyers Mundstock Accounting is backward looking Finance is forward looking to make future decisions Balance sheet

et o Assets = liabilities + equity o Snapshot of the financial position -- As of a certain date: the close of its FY - Basic GAAP o Modern accounting is called a dual entry accounting system o Each discrete event gives rise to two or more entries o T Account Left (debit) | Right (credit) o Sum of debits = sum of credits o Segregation - Example equipment rental Assets Liabilities Cash Note payable 100,000 T 9,000 (rent) T 110,000 10,000 (rent) | 70,000 Account payable (ordinary course of business) 5,300 | 3,600 (salary) 340 T 1,630 210 | 340 | 340 6,450 Unearned revenue Prepaid rent T 10,000 (rent) 9,000 T 3,000 Dividends payable Equipment T 2,000 180,000 T Dividends Office supplies 2,000 T 1,630 T Utilities payable Accounts receivable T 270 800 T 210 Salary expense Revenue 3,600 T T 6,100 Repair expense | 6,450 340 T Rental expense Utilities expense T 3,000 270 Equity Common stock T 100,000 - If we have prepaid rent of 9,000 for three months, that is not an expense, rather an asset. At the end of the month, it will become an expense. - Equipment purchase financed by cash and note payable - Principle of conservatism if the equipment is worth more than it was bought for, dont recognize it -

You recognize the revenue when youve earned it; you recognize the expense when youve consumed it o You can have cash without revenue, and expense without payment so that companies cannot manipulate their balance sheet by e.g. holding off payments Expenses reduce equity; revenue increases equity Salary expense goes in an income statement, which would ultimately end up in equity Repair versus capital expenditure:

The Profession of Accounting - Accountants have a duty to the public CPA (certified public accountant) o They dont have confidentiality with clients o When they discuss something sensitive nature, they need to have outside counsel present so that it comes within the lawyers-client privilege - Accounting is timing o FY o The premise of accounting is that the business is a going concern so how a transaction is recorded depends on timing: e.g. capital expenses can be depreciated and amortized over ten years versus current expenses Q. 13 should there be one accounting standard or two: one for financial experts and one for the public There are detailed work papers behind every number in the financial documents Does every company need a GAAP financial statement, done by a CPA firm? No. E.g. when you apply for a loan, you are giving the bank a balance sheet-lite and an income statement-lite Technical language=if you understand the rules of accounting, you can understand a lot; if they were in simple English, thed be a lot more complicated and less precise. - Chapter 2 is Finance o A dollar today is not the same as a dollar tomorrow If you have a choice of paying/taking a dollar today as opposed to a dollar tomorrow, youll always pay/take a dollar tomorrow/today Interest rate for FV Discount rate for PV o Rent is payable in advance; interest is payable in arrears - Chapter 3 is Valuation o FMV x r = NOI NOI = net operating income r = cap rate FMV = fair market value o FMV = NOI / r

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Cap rate Bonds Coupon is interest rate At face = stated principal amount = par Bonds are long term securities, i.e. they are publicly traded debt Lease If there is an asset with significant residual value The business objective to capture use for economically useful life

Tax and Accounting Leasing versus owning - The client wants to capture the use value of the property - You can make the financing and leasing do the same job - Tax is focused on form: - GAAP is focused on substance: doesnt matter if you call it a lease or financing o We look at - You like deductions for tax purposes but not for accounting purposes o So you want a deduction that Leverage - Negative leverage - The nightmare of leverage - Positive leverage the magic of leverage o Instead of investing 100 for 10 return, borrow 80@8% and invest 20 at a 10 return. - This is what drives real estate finance

The Balance Sheet

Lawyers like to form entities for each part of the business But accountants focus on the entire business If you own more than Book value (on the asset side); the face value (on the liability side) Outstanding shares o The articles of incorporation state how many class A shares are authorized. If you want more shares authorized, amend the articles. The board issues a stock when the board by resolution issues the stock. o Capital structure = e.g. o Outstanding shares are authorized, issued, and held by a shareholder (not the corporation). o De-issue: buyback outstanding stock and de-issue o Treasury shares

Divorce example

Income Statement
When can you book revenue for a sale? o E.g. cost is 60, sale price is 100 The three categories are o Full accrual; installment accrual; no accrual Full: If paid 100, book 40 as revenue Full: If not paid, but client has good credit (e.g. AAA), then accountants let you book 40 as revenue, and each year interest revenue until paid No: If not paid, and buyer has less than perfect credit, then accountants wont allow you to book revenue until paid Installment: If paid in installments, then allowed to book portion of installments as revenue, e.g. paid 20, so book 40%: paid 20/book 8; paid 20/book 8; until paid in full No: If installments and bad credit, paid 20, paid 20, paid 20, paid 20/book 20, paid 20/book 20. The aacounting firm certifies the income statement; if materially mistaken, the accounting firm is sued.

Revenue recognition/realization - Tax has distinction - Accounting does not - In a manufacturing business with inventory, youll see utilities, salaries, raw materials, insurance etc. involved in manufacturing. When do you expense these costs? When the item is sold. Before that, these expenditures go into an inventory account. When the item is sold, it goes into expenses. - A profit is only an accounting concept (doesnt mean that the business made money). You can have cash and no profit; you can have earning and no cash Accounting is focused on the timing of recognition of revenue and expenses. The receipt of payment doesnt matter. Copper in the mine Amortization as depreciation of intangibles (dont confuse with amortization of principal in loan in an amortization schedule , the principal is reduced over time CONSIDERABLE TIME ON EXPLAING THIS POINT) - Coal mine: expenditure associated with experts amortized over time - Loan: The investment banker, legal fees are amortized over the term of the loan [UNRELATED RANT ON SOMETHING CONFUSING IN THE TAX CODE]

You cant claim depreciation of a crane as an expense if its used to build a building that will depreciate and be claimed as an expense. [SOME QUESTIONS]

Inventory
FIFO or LIFO FIFO or LIFO for fungible stuff Prices generally rise; so FIFO widgets are cheaper than LIFO Tax code: if FIFO inventory for GAAP, then the same for tax o But if youre privtely held, it doesnt matter Most companies dont care about revenue on income statement, they want to save taxes. Further ECMH says that the market understand what revenue means and GAAP requires you to note in footnote But small companies care about revenue; often they have *pass through+ so they dont pay taxes anyway; so they do LIFO

Capitalization level depends on inventory turnover. Ideally, youd want inventory to turnover quickly. [This is called cost accounting?] Case: Thor Power Facts: Extra inventory, no financial value; accountants said recognize the loss; For GAAP, book loss taken but parts not destroyed; For tax? Holding: Compliance w/ GAAP doesnt produce the presumption that youre in compliance with tax. You cannot boot strap your Revenue cannot be recognized until the inventory is sold Mark-to-market in the context of inventory: write-em-down to market, dont write-emup to market Accounts receivables: recognize 95% as history dictates no matter good or bad credit; the 5% offset goes to a doubt account, which is a contra account. o If obligor goes bankrupt, write-em-down to what you expect to get out of bankruptcy proceeding, e.g. 5 cents on a dollar Balance sheet ong o Marketable securities are marked to market average of high and low at the end of year (difference between what theyre worth and what ___ is going to be the gain or loss on marketable securities)

The company cannot manipulate them (if they could, they wont be marketable securities) If you own 25% of Microsoft, you have too much control of Microsoft: you pick up as income or loss your share of the companys income or loss. Big enough to control but not big enough to consolidate More than 50% consolidate for GAAP purposes (80% for tax purposes): pick up all the assets or liabilities in balance sheet and revenue on the income statement but in order for it to work, you need to have an offset for the remaining; so its a two-step process

Microsoft Income Statement - See footnote 2 for accounting changes - SFAS 133 fancy accounting standard about derivative instruments that GAAP requires to state separately on shareholder equity; only 50 or so accountants in America understand it.

Cash Flow Statement

Absent fraud, you cant manipulate cash flow But cash flow divided into three categories: operations (accounts receivables), financing, investing o Operations (get your gaap revenue from accounts receivables and cashify it if you got paid but didnt earn it for gaap purposes, then put the extra cash on your cash flow and vice versa) Inventory o Financing (Microsoft is repurchasing its stock) long term debt, stock issuance, repurchase o Investing short term debt Page 144 example - Orthodontist as corporation, stock pledged to secure debt, balance sheet is prepared on a cash basis, see opinion letter on 145: standard, peculiar, (non-GAAP). Whats significant is not on it? Accounts receivables! Since this is cash based, it doesnt have accounts receivables, but receivables could be significant. - Receivables associated with a service business are softer than receivables associated with a manufacturing businesss. Page 152 problem - Cash flow statements of Micrsoft on p. 376 - Explain every line in the cash flow statement 2002 o Net cash from operating activities indirect method: -

net income deferred taxes (the different between tax on GAAP revenue and tax revenue)

Revenue Recognition
staff accounting bulletin you can recognize revenue when specific evidence of an arrangement exists (note engagement, but not contract, which is less specific). o E.g. if you have an unwritten contract which requires writing pursuant to the statute of frauds, this is not a contract but still an arrangement. The sellers price is fixed and determinable Collectability is reasonably assured (dont book revenue that is fictitious)

Problem D (p. 160) - 3. No (concerned that this will be abused) - 4. Layaway sales? No. But the deposit is revenue. - 5. Membership fees? Before the end of the year, cancel and get money back. No.

Related Parties
Look back to: Short term securities Long term securities Other

3 ways of strucnturing Rule 1 off balance sheet o P has a 5% stake and no ability to influence o Income or loss of T doesnt directly affect the income statement of P o P has income when T declares a dividend payable to s/h of record, P has GAAP income as of the day its payable o The stock gets marked to market but the earnings of the T dont have any direct impact on the earnings of the P. Rule 2 o P has influence but no control of T o Equity method of accounting: Investment adjusted for proportional income or loss; and dividend Rule 3 on balance sheet o More than 50% stake, GAAP requires consolidation

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(under tax law, there is something called consolidated tax returns but you need 80 percent.) If you consolidate, you put the Ts entire assets and liablities on your balance sheet, regardless of how much you own. Special expense for the income or loss that isnt yours. How do you deal with dividends from P to T: do nothing

Rules versus principles - Mechanical compliance didnt get the correct result: i.e. fairly representing the financial of a company