Accounting-for-Lawyers PDF

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Accounting Lecture Note for Lawyers...

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ACCOUNTING FOR LAWYERS A complete set of financial statements includes: 1. Balance Sheet 3. Statement of Cash Flows 5. Accompanying Notes

2. 4.

Income Statement Statement of Changes in Owner’s Equity

BALANCE SHEET Definition: Static picture of a company’s financial position – a snapshot. A continuing ledger of everything that has happened in a company from the beginning until present. Issued by a set date. Statement of Net Worth: Assets – Liabilities = Net Worth/Equity Three sections to a balance sheet: 1. Assets (Right Side) 2. Liabilities (Left Side) 3. Equity or Net Worth (Left Side) * Assets = Liabilities + Equity (Right and left sides must be equal/balanced) ASSETS Definition: Anything a company owns that has economic value. a. Tangible assets  land, equipment, cash b. Intangible assets  patents, trademarks, goodwill (sometimes GW is seen as its own category) Determining factors of an asset: 1. Control resource 2. Reasonably expect resource to produce a future benefit 3. Obtained resource in a transaction such that the resource is measurable How are assets valued on the balance sheet? At historical cost  Price paid to acquire the asset a. Easier to ascertain b. Less subjective than current FMV c. This is beginning to change Ordering: Listed on the balance sheet in order of decreasing liquidity, from current assets to long-lived assets. Liquidity  Refers to a company’s ability to convert an asset into cash, with assets more quickly convertible into cash being viewed as more liquid than others. 1.

Current Assets  Expect to convert into cash or use within one year (short-term) a. Cash b. Marketable securities  Stocks and bonds used as short-term investments c. Notes receivable Amounts due to the entity, within the year, under promissory notes d. Accounts receivable  Amounts due the entity, within the year, from customers e. Inventories  Goods held for sale or resale f. Prepaid expenses  Things paid for in advance for the year. Listed in declining liquidity ẍ: insurance, rent, retainers, advertising 1

2.

Long-Term Investments/Noncurrent Assets  Not expected to convert into cash or use w/in year a. Stock and bonds, which entity expects to hold b. Notes receivable, which are not due within the year c. Accounts receivable, which are not due within the year d. Prepaid expenses, which cover more than just one year

3.

Fixed Assets (Also Noncurrent Assets) Tangible property other than inventory that is used in the operations of the business and expected to be used for more than one year (permanent part of business) ẍ: Land, buildings, plant, equipment, machinery, furniture, fixtures

4.

Intangible Assets ẍ: Patents, copyrights, trademarks, goodwill

LIABILITIES Definition: Debts that a company owes or expects to owe Arise from borrowing, purchases on credit, breaches of contract, torts Current liabilities are due with one year Long term liabilities are due in more than one year Determining factors of a liability: 1. Must involve present duty or responsibility 2. Must obligate entity to provide future benefit 3. Must have arisen from a transaction that has already occurred so that obligation can be measured Ordering: 1.

2.

Current Liabilities a. Notes payable  Money borrowed under promissory notes b. Accounts payable  Amounts owed for purchases on credit c. Accrued liabilities or wages  Money owed for services already performed d. Portions of long-term debt due within the year e. Taxes payable f. Unearned revenues  Amounts the entity will have to refund if it does not perform the required services (ẍ : retainers) Long Term Liabilities a. Secured claims  Liabilities for which the borrower has pledged assets as collateral b. Long term notes payable c. Bonds payable d. Lease and mortgage obligations e. Pension plan obligations

Current Assets – Current Liabilities = Working Capital EQUITY 2

Definition: Residual claim of the owners on the assets of the business after recognition of the business’s liabilities Net worth / Equity = Assets – Liabilities Assets > liabilities = positive equity Liabilities > assets = negative equity Net income increases equity Net losses reduce equity Powerpoint slides regarding equity of sole proprietorships, partnerships, and corporations, ltd p/s, llc, llp/s Three Shareholder Equity Accounts [Legal Equivalent in Brackets]: 1. Capital Stock / Common Stock [Stated Capital / Legal Capital] 2. Additional Paid-in Capital or Paid-in Capital in Excess of Par Value [Capital Surplus] 3. Retained Earnings [Earned Surplus] What is par value? Arbitrary number at which a corporation decides not to sell its stock below that number. If stock is sold at par value  money goes into capital stock account If stock is sold above par value  the amount in excess of par value goes into additional paid-in capital ẍ:

Investor pays $100 for one share of stock with a par value of $10. Balance sheet: Assets

Liabilities / Equity

Cash + $100

Capital Stock + $10 Add Pd in Capital + $90

What if no par value is assigned? Corporation can allocate b/w the Capital Stock Acct and the Additional Paid-in Capital Account. Amount allocated to Capital Stock Acct  Stated Value Amount of purchase price above state value  Additional Paid-in Capital If no allocation is made, the entire price goes into the Capital Stock account. Restriction of distributions: Corporations cannot distribute earnings (dividends) below capital stock account. Distributions can also be restricted by restrictive covenants. What are retained earnings? Net income / net loss Can be a negative number  Accumulated Deficit Account reduced upon payment of dividend. Insolvency: Most corporate statutes prohibit distributions of assets to shareholders if business is insolvent 1. Balance sheet insolvency a. Debts are greater than assets b. Results in a negative equity 2. Cash flow insolvency  a. Assets aren’t easily liquidated b. Current liabilities are greater than current assets 3

INCOME STATEMENT Definition: Shows the extent to which equity has increased or decreased over a period of time. Revenues – Expenses = Net Income (or Loss) AKA  Statement of Earnings or Statement of Operations Publicly traded companies must report their annual income stmt on form 10K and must issue updates quarterly on form 10Q After the period of time is over, income statements are added into the balance sheet (as retained earnings), then set back to zero, and started over Three parts to income statements: 1. List of revenues 2. List of expenses 3. Difference is Net Income or Net Loss What are revenues? Assets received from essential transactions of selling goods or performing services Cash or non-cash Increase assets and decrease liabilities What are gains? Results of transactions that occur other than in the ordinary course of business/non-essential transactions Increase assets and decrease liabilities What are expenses? Costs incurred and consumed by the business in generating revenues. Assets used in producing revenues. Decreases assets and increases liabilities. What are losses? Decreases in assets or increases in liabilities from non-essential activities, those outside the ordinary course of business.

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CASH BASIS / ACCRUAL METHOD / DEFERRAL Cash Basis: * Focus on movement of cash / based on when cash changes hands * Allocates revenues/expenses to period when received/paid * Actual delivery of goods or services irrelevant / receipt of benefit of payment irrelevant Accrual Method: * Reports revenues when they are earned, even though no cash has been received for the good/service * Reports expenses when they are incurred / benefit received, even though payment for the good/service has not been made * Allocating revenue/expenses to the income statement in the period before cash changes hands Accrued Income  Business earned by substantially completing the work, but has not yet been paid Accrued Expense  Business received economic benefit from expense, but expense not yet paid Deferral: * Waiting to report revenue/expense until it is earned/incurred even though cash already changed hands * Allocating revenues or expenses to the income statement in period after cash changes hands Deferred Income  Business received cash, but not recognized as revenue until later accounting period when the business actually earns the cash Deferred Expense  Business paid cash, but payment will not be recognized as expense until some future period when business obtains benefit from expense

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STATEMENT OF CASH FLOWS Provides detail about the changes in the business’s cash balance for the period covered by the income statement Net difference b/w cash in and cash out  Can have positive or negative cash flow Reports changes in cash and cash equivalents Replaced Statement of Changes in Financial Position Divided into three parts: (1) Operating Activities (a) Transactions associated with sales of goods and services i) Cash from sales, less ii) Cash for expense to produce sales iii) Interest and tax payments (b) Interest and dividends received on miscellaneous investments (cash inflow) (c) Interest payments to lenders and other creditors (cash outflow) (d) Catch all category (2) Investing Activities (a) Purchase and sale of operating assets / long-lived, capital assets  buildings, machinery, patents (b) Purchase / sale / returns received on investments  stocks, bonds, loans (3) Financing Activities (a) Issuing debt instruments or selling stock and amounts paid out to repay loans or repurchase stock (b) Amounts paid out as dividends on corporation’s stock (not amounts paid as interest on loans) (c) Cash from borrowing money; (d) Cash from investors; (e) Cash paid to investors Cash Equivalents: 1) Enterprise able to convert equivalents to cash readily 2) Equivalents’ maturity dates do not exceed three months (measured from when investment acquired) ẍ: Cd’s, T-bills, commercial paper, money market accounts; 6 month cd with 3 months left to maturity works – as long as it matures w/in 3 months Four steps: 1) Cash at start of period, plus 2) Cash received during period, less 3) Cash paid during period, equals 4) Cash at end of period (Ending cash is beginning cash for next period) Two Methods: (1) Direct Method (2) Indirect Method Difference is how cash flows from operations is determined; Cash flows from investing & financing activities is determined in the same way under both methods Direct Method: 1) Determines how much cash was paid or received in connection with each account during period 2) Easiest method  take cash from Balance Sheet, go thru T-accts to determine what you did with the cash, and take from the T-accts and put into the Cash Flow Stmt Indirect Method: 1) Uses Net Income for the period as the starting point 2) Makes adjustments to Net Income to reflect cash transactions (Operating, Investing, Financing) a) Not all revenues and expenses represent cash flow b) Changes appear on Balance Sheet result in cash flow that is not reflected on the Income Stmt 6

DEPRECIATION Non cash item Capitalization  Payment by a business, whether on a purchase or an extraordinary repair, will not be recorded immediately as an expense but will initially be recorded as an asset (capital asset) and will eventually be recognized as an expense thru depreciation/amortization Capital Expenditure  Expenditures that increase the life of the asset beyond the original estimated life or expenditures that otherwise improve the quality or the productivity of the asset ẍ : extraordinary or unusual repair costs, legal advice, investment banking, M&A fees Tangible Assets  Depreciate Intangible Assets  Amortize Natural Resources  Deplete * Land cannot be depreciated, amortized, or depleted Three things you need to know in order to depreciate: 1. Cost  including freight costs, installation costs, real estate commissions, title insurance, legal fees 2. Useful Life  Period of time over which the asset is expected to be used; could be measured in time, hours of operation, etc 3. Salvage/Residual Value  Amount expected to be realized at sale once useful life is over; scrap value Methods of depreciation: 1. Straight Line Method 2. Accelerated Methods a. Declining Balance Method i. Double declining balance ii. 150% declining balance b. Sum of the Years’ Digits Straight Line Method: (Total Depreciation) Original Cost - Salvage Value -------------------------------------Estimated Useful Life in Years

=

Depreciation Expense Per Year

ẍ : 100,000 cost, 10,000 salvage value, 6 years useful life 100,000 – 10,000 ----------------------- = 15,000 6

15,000 x 6 = 90,000 total depreciation

ẍ : Same as above but after 2 yrs, you discover useful life is going to be 8 yrs not 6 yrs Original depreciation was 15,000/yr, so after 2 years you will have depreciated 30,000. 90,000 – 30,000 = 60,000 60,000 ---------

=

10,000

10,000 x 6 = 60,000

60,000 + 30,000 =

90,000 6 7

ẍ : Same but after 2 years, you decide useful life is 4 years Already depreciated 30,000. 90,000 – 30,000 = 60,000 60,000 --------= 30,000 depreciation for years 3 and 4 each 2 ẍ : Same but after 2 years you upgrade & spend 20,000 on the asset, which increases useful life to 8 yrs 60,000 left to depreciate: 60,000 + 20,000 = 80,000 80,000 ---------6

=

13,333 depreciable cost for each of the remaining 6 years

ẍ 100,000 cost, 10,000 salvage value, 225,000 miles 100,000 – 10,000 ---------------------= 0.4 = 40 cents per mile depreciation 225,000 Drive 40,000 mi/yr

x

40 cents

=

16,000 depreciation per year

Accelerated depreciation methods: This results in the recognition of greater depreciation expense in the early years and less depreciation expense in the later years. Often deemed to be appropriate when the earnings potential of an asset is consumed more rapidly in the early years of the asset’s use. If you have greater depreciation expense in the first years, assuming other factors stagnant, your tax liability would be less in the first years. Though this would eventually catch up to you, considering the time value of money, putting off costs so that you can invest money today is usually preferred. Additionally, companies can maintain, legally, two separate books: taxable books and accounting books. Double Declining Balance: Double amount of depreciation upfront based on a declining depreciable base 1 ---------------- x Depreciable Base x 2 = Yearly Depreciation Useful Life Continue this formula for each year of useful life. ẍ:

100,000 cost, 10,000 residual value, 6 years useful life Year 1: 1/6 x 100,000 x 2 = 33,333 100,000 – 33,333 = 66,667 Year 2: 1/6 x 66,667 x 2 = 22,222 66,667 – 22,222 = 44,445 Year 3 1/6 x 44,445 x 2 = 14,815 44,445 – 14,815 = 29,630 Year 4 1/6 x 29,630 x 2 = 9877 29,630 – 9877 = 19,753 Year 5 1/6 x 19,753 x 2 = 6584 19,753 – 6584 = 13,169 Year 6 13169 – 10,000 = 3169 13,169 – 3169 = 10,000 * Y6: Can’t depreciate so much as to leave base at less than residual value.

150% Declining Balance: 8

Take formula for double declining method and multiply by 1.5 instead of 2. Sum of the Years’ Digits: ẍ: 100,000 cost, 10,000 residual value, 6 years useful life 6 + 5 + 4 + 3 + 2 + 1 = 21 Y1: Y2: Y3: Y4: Y5: Y6:

6/21 5/21 4/21 3/21 2/21 1/21

x x x x x x

90,000 90,000 90,000 90,000 90,000 90,000

= = = = = =

100,000 – 10,000 = 90,000 base 25714 (Depreciation amount for Year 1) 21429 17,143 12,857 8571 4286 ----------90,000

How do you account for depreciation on journal entries and balance sheet? Year 1 Jan 1 Equipment 100,000 Note Payable 100,000 Dec 31 Depreciation Expense 25,714 Accumulated Dep Equip 25,714 Balance Sheet :

Cash Equipment Less Accumulated Dep

80,000 100,000

74,286

Only time you will see a liability listed on the asset side

Unit of Production Method (chapt IX?) – do you include installation costs in depreciation totals? Yes. Note problem 9.3A, pg 551

9

INVENTORY Goods business holds for sale to customers in regular course of business (including what’s in warehouse, etc) Four types of inventory methods: 1. Specific Identification Method 2. Average Cost 3. FIFO 4. LIFO Two different types of companies: 1. Merchandising  Sales goods manufactured by others (retail) 2. Manufacturing  Produces goods to sale (usually to retail) They have three types of inventory: (1) raw materials, (2) works in progress, (3) finished goods Beginning Inventory  Inventory on hand for sale at beginning of accounting period Ending Inventory  Inventory on hand at end of accounting period Beginning Inventory + Inv Purchased/Manufactured - Cost of Inv/Goods Sold = Ending Inventory Formula to determine what you sold: COGS = Beginning Inventory + Inventory Purchased/Manufactured - Ending Inventory * Revenue - COGS = Net Income or Loss Arising from Sales (Doesn’t account for overhead)

Methods for Tracking Inventory: 1. Periodic Method  Physical count of inventory done periodically; helps account for theft Retail Method 2. Perpetual Method  Electronic running total of inventory; doesn’t acct for breakage/theft Inventory on Balance Sheet: Assets are valued at their cost to the business Product cost is the sum of all expenditures and charges directly or indirectly incurred in bringing inventory to its present condition and location Inventory is expensed in the accounting period in which it is sold Period costs include some overhead costs and are expensed in the current accounting period Lower of Cost or Market: Typically inventory is listed at its cost to the business, but if it is valued at a lower amount than it actually cost, the balance sheet can show FMV instead of actual cost. Therefore, inventory can be valued at less than its cost. Things causing FMV to be less than cost: physical damage, deterioration, obsolescence, decline in prices Market Value = Replacement Value The cost at which the inventory would be replaced by the business under current conditions. Just b/c FMV is lower than original cost doesn’t always mean the inventory will be valued at FMV. If inventory that originally cost $100 can now be purchased for $85, the lower market value of $85 would be used to determine the book value of the inventory. However, if the replacement value were $105, no adjustment would be made and the inventory would remain at its original valuation of $100. **Cannot increase 10

value of inventory above original cost. If book value is reduced due to above, the amount of the reduction is treated as either: 1. An addition to COGS for that period or 2. A loss shown on the Income Statement Cost of Goods Sold: - An expense - Cost of manufacturing or purchasing inventory often varies over time Specific Identification: - Keeps track of each individual item and its exact cost - Applies to unique and highly valuable goods - Not for interchangeable inventory or high volume inventory ẍ : Automobiles FIFO  First In, First Out: - Assumes goods are sold in the order in which they were purchased; oldest sold first - Advantages: Income is higher b/c you are selling goods that are older and therefore cost less. Balance sheet looks more like its value b/c your current inventory is on your Balance sheet - Disadvantages: Artificially inflates Net Income. Selling goods at today’s prices but COGS is from a previous period – doesn’t match. LIFO  Last In, First Out: - Assumes goods most recently purchased are sold before those previously purchased - Advantages: Income Stmt accurately portrayed  matching revenues and expenses Deflates Net Income b/c COGS is rising and by “selling” new inventory first, you are selling higher priced inventory. - Disadvantages: Balance sheet is off b/c you are tracking inventory using obsolete costs. Balance sheet is carrying older i...