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Accounting for Non-accountantsWhat Every Attorney Should Know

Deloitte Financial Advisory Services LLP

September 18, 2008

1Copyright © 2008 Deloitte Development LLC. All rights reserved.

Objectives

! Financial Accounting Basics

– Be familiar with the objectives and qualities of Financial Reporting

– Identify the different components of a set of financial statements

– Understand the basics of the accounting process and systemincluding selected business cycles

– Perform basic journal entries and T-account analysis

– Understand basic principles and concepts of generally acceptedaccounting principles (GAAP)

What is Financial Reporting?


What is Financial Reporting?

! Means of communicating to investors and others, directly orindirectly, information about an enterprise’s financialperformance including its resources, obligations andearnings.

! Common forms of financial reporting

– Corporate annual reports/SEC filings

– Prospectuses

– News releases

– Management’s forecasts

– Other descriptions of its plans or expectations

– Descriptions of an enterprise’s social or environmental impact

Source: CON 1, Objectives of Financial Reporting by Business Entities


Objectives of Financial Reporting

! Provide information useful in

– Investment and credit decisions

– Assessing cash flow prospects

! Provide information about

– Enterprise resources, claims to those resources, and changes inthem

– Economic resources, obligations and owners’ equity

– Enterprise performance and earnings

– Liquidity, solvency, and funds flows


Who Uses Financial Reporting Elements(how and why?)

! Competitors

! Taxing Authorities

! Underwriters

! Regulators (e.g., SEC)

! Labor Unions

! Business Researchers

! Teachers

! Students

! The Public

! Financial Press

! Debt Rating Agencies

! Attorneys

! Shareholders and owners

! Lenders

! Suppliers

! Potential Investors

! Creditors

! Employees

! Management

! Directors

! Customers

! Financial Analysts

! Brokers


Financial Reporting Concepts

! Primary Qualities – make accounting information useful indecision making

– Accounting information used for Financial Reporting should be:

! Relevant

– Predictive Value

– Feedback Value

! Reliable

– Representational Faithfulness

– Verifiable

– Neutral

Source: CON 2, Qualitative Characteristics of Accounting Information


Financial Reporting Concepts

! Secondary Qualities

– Comparability/Consistency

– The significance of information, especially quantitative information,depends to a great extent on the users ability to relate it to somebenchmark:

! Comparability

– The quality of information that enables users to identify similarities in and differencesbetween two sets of economic phenomena

! Consistency

– Conformity from period to period with unchanging policies and procedures

Source: CON 2, Qualitative Characteristics of Accounting Information

The basic financial statements


Components of Financial Statements

! A full set of financial statements includes:

– Balance Sheet (2 years) – Financial position at the end of the period

! The Balance Sheet is a “snapshot” at a point in time. The remainingcomponents of financial statements reflect period activity

– Income Statement (3 years) – Financial operations for the period

– Statement of Comprehensive Income (3 years) – for the period

– Statement of Stockholders’ Equity (3 years)

! Report of net worth and equity activity

– Cash Flow Statement (3 years) – Sources and uses of cash duringperiod

– Notes to the financial statements

1 – Per SEC Regulation S-X Article 3, Financial Statements of a public company must be filed quarterlyand annually. In addition, they must be audited annually and reviewed quarterly by independent auditors

2 – Often included within the Income Statement or Balance Sheet. For purposes of this presentationcomprehensive income is not discussed and is assumed to be equal to net income


What are the 10 Elements of FinancialReporting?

"#Assets

$#Liabilities

%#Equity (Net Assets)

&#Distributions to owners

'#Investments by owners

(#Revenues

)#Expenses

*#Gain

+#Losses

",#Comprehensive income


Balance Sheet Elements – Assets

! Probable future economic benefits obtained or controlled byan entity as the result of past transactions or events.

– Presented on the balance sheet in order of liquidity (cash first)

– Commonly presented at historical cost, net of depreciation

! Exceptions

– mark-to-market securities

– Goodwill

– some inventory


Classification of Assets

Assets

TangibleAssets

(physical)

Intangible Assets

(not physical)

CurrentAssets

(<1 year)

Non-CurrentAssets

(>1 year)

CurrentAssets

(<1 year)

Non-CurrentAssets

(>1 year)

examples! cash! accounts receivable! inventory

examples! property! plant! equipment

example! prepaid insurance

expense

examples! copyrights! patents! licenses! goodwill


Balance Sheet Elements – Liabilities

! Probable future sacrifices of economic benefits arising frompresent obligations to transfer assets or provide services inthe future as a result of past transactions or events


Classification of Liabilities

Liabilities

KnownAmounts

Estimated Amounts

Current Liabilities(<1 year)

Non-CurrentLiabilities(>1 year)

Current Liabilities(<1 year)

Non-CurrentLiabilities(>1 year)

example! litigation accrual

example! accounts! payable

example! notes! payable

example! product warranty

liability


Balance Sheet Elements – Shareholders’Equity

! The residual interest in the assets of an entity that remainsafter deducting its liabilities (also referred to as “networth”).1

! Beginning Balance Stockholder’s Equity+ Net Income– Dividends paid+ Change in Capital Structure

Ending Stockholder’s Equity

1 Source: SFAC 6, Elements of Financial Statements


Balance Sheet Elements – Shareholders’Equity

! Distributions

– decrease ownership interests and include not only cash dividendswhen declared (or other cash withdrawals by owners of non-corporate entities) but also transactions such as reacquisitions of theentity’s equity securities and distributions "in kind" of non-cashassets.

! Investments

– by owners establish or increase ownership interests in the entity andmay be received in the form of cash, goods or services, orsatisfaction or conversion of the entity’s liabilities.

Source: CON5, Recognition and Measurement in Financial Statements of Business Enterprises, paragraph56


Example: Balance Sheet Example(as of 12/31/07)

137,600Total Noncurrent Assets

$ 165,000Total Assets

100Patents

500Goodwill

1,000Equity Investments

Other Noncurrent Assets:

136,000Total PPE

(32,0000)Less: Accumulated Depreciation

Noncurrent Assets

Property, Plant, and Equipment:

18,000Land

80,000Buildings

55,000Machinery

15,000Furniture

27,400Total Current Assets

2,400Prepaid Expenses

10,000Inventory

(net of allowance of $240)

12000Accounts Receivable

$ 3,000Cash

Current Assets

Assets

106,000Total Stockholders’ Equity

$ 165,000Total Liabilities & Stockholders’ Equity

50,000Retained Earnings

55,000Additional Paid-In Capital

1,000Common Stock

Stockholders’ Equity

59,000Total Long-Term Liabilities

Long-Term Liabilities

15,000Notes Payable – less current portion

12,000Capital Lease Obligations

32,000Total Current Liabilities

1,000Deferred Revenue

1,000Warranty Reserve

20,000Accounts Payable

$ 10000Current Portion of LT Deb

Current Liabilities

Liabilities & Stockholders’ Equity


Some things to look for on the Balance Sheet

! How liquid are the assets?

! What is the quality of the assets?

– A/R Turnover, Return on Assets, Return on Equity

! How leveraged is the company?

! Can they meet their current and future obligations?

! What is the breakdown between short-term and long-termdebt?


Income Statement Elements

! Revenue

– Inflows or other enhancements of assets of an entity or settlementsof its liabilities from delivering or producing goods, renderingservices, or other activities that constitute the entity’s ongoing majoror central operations

! Gains

– Gains are increases in equity (net assets) from peripheral orincidental transactions of an entity and from all other transactions andother events and circumstances affecting the entity except those thatresult from revenues or investments by owners.

Source: SFAC 6, Elements of Financial Statements


Income Statement Elements

! Expenses

– Outflows or other “using up” of assets or “incurrence” of liabilitiesfrom delivering or producing goods, rendering services, or otheractivities that constitute the entity’s ongoing major or centraloperations.

! Losses

– Losses are decreases in equity (net assets) from peripheral orincidental transactions of an entity and from all other transactions andother events and circumstances affecting the entity except those thatresult from expenses or distributions to owners.



Example: Income Statement(For the Year Ended 12/31/07)

$ 22,620Net Income

% 0.23Earnings per Share (100,000 issued and outstanding)

(10,530)Effect of Change in Accounting Principle – net of tax

10,000Gain on Extraordinary Item – net of tax

31,350Provision for Income Taxes

(50,000)Loss on Discontinued Operations – net of tax

73,150Income from continuing operations before extraordinary item and effect of change in accounting principle

104,500Income from continuing operations before taxes, extraordinary item and effect of change in accounting principle

(2000)Interest Expense

100Income from Equity Investments

Other Gains/(Losses):

106,400Total operating expenses

Operating Expenses:

70,000Sales, General & Administrative Expenses

29,400Restructuring Charges

6,400Depreciation and Amortization

600Bad Debt Expense

212,800Gross Margin

200,000Cost of Goods Sold

$ 412,800Revenues


Some things to look for on the IncomeStatement

! Is the company profitable?

– Gross Margin

– Income from Continuing Operations

– Net Income

! What portion of the income is from non-recurring/non-operating transactions?

! Which expense items seem out of line?

! How do operations and performance results compare to:

– Previous years (vertical and horizontal analysis)

– Competitors/Industry

! How have earnings per share changed?


The Statement of Cash Flows

! Shows net cash flows provided by or used in its operating,investing, and financing activities

! Cash includes cash equivalents

– Cash Equivalents are short-term, highly-liquid investments that areboth:

! readily convertible to known amounts of cash and

! so near their maturity that they present insignificant risk of changes invalue because of changes in interest rates. Generally, only investmentswith original maturities of three months or less qualify under that definition.

Source: SFAS 95, Statement of Cash Flows para. 8


Statement of Cash Flow Ingredients

Operating ActivitiesCollections From

Customers Interest, Other

Investing ActivitiesCollections on Loans, Saleof Productive Assets, Other

Financing ActivitiesIssuance of Long-Term

Debt and Equity

Inflow

s

Operating ActivitiesPayments to Suppliers,

Employees, Interest,Income Taxes, Other

Investing ActivitiesPurchase of ProductiveAssets, Debt, or Equity

Financing ActivitiesPayment of Dividends and

Loans, Acquiring ownEquity Securities, Other

Outflo

ws

Pool of Cash


Example: Cash Flow Statement Example

! (For the Year Ended 12/31/07)

$ 1,800Increase in cash

$ 3,000Cash – end of period

1,200Cash – beginning of period

3,000Net cash from financing activities

(1,000)Dividends paid

4,000Proceeds from sale of common stock

Cash Provided By (Used In) Financing Activities

(20,000)Net cash from investing activities

Cash Provided By (Used In) Investing Activities

(20,000)Additions to property, plant, and equipment

18,800Net cash from operations

(10,220)(Increase) Decrease in Net Operating Assets

6,400Depreciation and Amortization

Adjustments to reconcile net income to cash flow from operations:

$ 22,620Net Income

Cash Provided By (Used In) Operating Activities


Some things to look for on the Cash FlowStatement

! Did the company’s cash position change significantly?

! How is the company using its cash?

! What were the sources of the company’s funds?

! Comparison of Income Statement to Cash Flow Statement:

– Strong income from continuing operations versus weak Cash Flowprovided by operating activities


Notes to the Financial Statements

! Overview of the business

! Significant Accounting Policies

– Revenue Recognition

– Principles of Consolidation

– Property, Plant & Equipment

– Intangible Assets and Goodwill

! Segment Information

! Discontinued Operations

! Business Combinations

! Debt Offerings and Credit Risk

! Income taxes

! Related Party Transactions

! Financing

! Stock Option Plans

! Leases

! Subsequent events

! Commitments

! Contingencies

The double-entry system ofaccounting


The Accounting Equation

! The accounting equation can be used to keep track ofchanges in the amounts of assets, liabilities, andshareholders’ equity.

! The following is the accounting equation:Assets = Liabilities + Equity


Double-Entry Method of Accounting: Debitsand Credits

! DEBIT (Left-Side, Positive, Dr.)

– Increases:

! Assets

! Expenses & Losses

– Decreases:

! Liabilities

! Revenues & Gains

! Equity

! CREDIT (Right-Side, Negative,Cr.)

– Decreases:

! Assets

! Expenses & Losses

– Increases:

! Liabilities

! Revenues & Gains

! Equity

! You deposit a check at your bank for $1,000.

! Shows up as a CREDIT on your bank statement…Why?

! The statement is from the bank’s perspective – it now has a liability on its books because it owes you $1,000.

! The bank would book the following entry:

Dr. Cash $1,000

Cr. Deposit Liability $1,000

Example: Bank Account



! The T-Account (General Ledger)

Beginning Balance

Debits Credits

Ending Balance

Account Name Account Number

DebitsIncreases in assets

Increases in expenses

Decreases in liabilities

Decreases in revenues

Decreases in equity

CreditsDecreases in assets

Decreases in expenses

Increases in liabilities

Increases in revenues

Increases in equity



! T-Accounts – Method of presenting the effect of journalentries on a particular account. This method only showsONE side of each journal entry, but is an effective way tovisually present accounting information

e 15,000

30,000 c

5,000 d

b 40,000

a 10,000

CreditDebit

Account: Cash (#10010) -#Beginning balance of account 10010 – Cash(carried-forward)

.#To record the receipt of $40,000 from Customer A

/#To record bonus payment of $30,000 paid toCEO

0#To record payment of $5,000 for purchase of twocomputers

1#Ending balance of account 10010 – Cash


Example: The Double-Entry Method ofAccounting

! To expand its production line, Crystal Computers borrows$100,000 from National Bank.

– Question: How would Crystal Corporation journalize thistransaction?

! Answer:Debit Cash 100,000Credit Notes Payable 100,000

– Question: How would National Bank journalize this transaction?

! Answer:Debit Notes Receivable 100,000Credit Cash 100,000


Example: The Double-Entry Method ofAccounting

! To increase sales, Crystal Computers purchases $5,000 ofadvertising space in the local newspaper.

– Question: How would Crystal Corporation journalize thistransaction?

! Answer:Debit Advertising Exp. 5,000Credit Cash 5,000

– Question: How would the local newspaper journalize thistransaction?

! Answer:Debit Cash 5,000Credit Advertising Rev. 5,000

How are financial statementsprepared?


The Basic Accounting Cycle

8. PrepareFinancial

Statements

1. Economicevents

occur

2. Thetransactions

generatesource

documents

3. Recordtransactions in

accountingrecords, usingjournal entries

(Debits &Credits)

4. Post journalentries toGeneralLedger

5. Prepare

Trial

Balance

6. Postadjusting

journal entries

7. PrepareAdjusted Trial

Balance

The BasicAccounting

Cycle


Generating Financial Statements

! Entry (Economic event occurs; generates sourcedocuments)

! Subsidiary Ledger (Transaction recorded using journalentries)

! General Ledger (Detail of journal entries for variousaccounts)

! Trial Balance (Net value of postings for all accounts)

! Financial Statements


Accounting Process – Sub-ledgers

! Assets

– Cash and Cash Equivalents

– Accounts Receivable

– Prepaid Expenses

– Inventory

– Investments

– Property, Plant and Equipment

– Goodwill

! Liabilities

– Accounts Payable

– Accrued Expenses

– Deferred Revenue

– Debt

! Revenue/Gain

– Sales

– Interest Income

– Gain on Sale of Investments/Assets

– Loss on Sale of Investments/Assets

! Expense/Loss

– Cost of Goods Sold

– Selling, General and AdministrativeExpenses

– Interest Expense

! Equity

– Owner’s Equity (Common Stock, PreferredStock)

– Retained Earnings

! Comprehensive Income

– Unrealized holding gains/losses

– Foreign currency translation gains/losses


Accounting Process – General Ledger

! Definition

– The main accounting record of any business that uses double entrybookkeeping

– It is a summary of all the transactions that occur in a business

– The balance sheet and income statement are both derived from thegeneral ledger


Accounting Process – Trial Balance

! Definition

– A worksheet in which all the balances of the general ledger areshown in a two-column format (either debit or credit)

– The trial balance is prepared each financial period as a summary ofthe prior period’s activity

– Total debits and credits should ALWAYS equal (if they do not, thenadjusting journal entries are made to correct errors or mistakes)


Example: Trial Balance

Debit Credit

Cash 3,000

Inventory 5,000

Accounts Payable 1,000

Long-Term Debt 3,000

Sales 7,250

Salaries 1,500

Overhead 2,000

Interest Income 750

Interest Expense 500

Total 12,000 12,000


Accounting Process – Financial StatementPreparation

! After the Trial Balance has been completed and alladjusting entries are made, the financial statements mustbe prepared

! The financial statements will reflect the company’s positionat the close of the period (or periods) to date

Accounting concepts


Financial Statement Concepts: What isGAAP?

! “Generally Accepted Accounting Principles”

! Accounting principles determined by the accountingprofession to have substantial authoritative support

! Promulgated by the American Institute of Certified PublicAccountants (AICPA) and Financial Accounting StandardsBoard (FASB)

! Establishes one set of accounting concepts, standards, andprocedures to be used by all accountants and members ofthe financial community


Financial Statement Concepts: What is IFRS?

! “International Financial Reporting Standards”

! Issued by the International Accounting Standards Board

! More than 100 countries, outside of the U.S., require andpermit IFRS reporting

! Rapid movement towards a single set of global accountingstandards and adoption by the U.S.

! On August 27, 2008, the SEC announced approval of aproposed roadmap and new rules that would require U.S.companies to file financial statements using IFRS instead ofU.S. GAAP starting in 2014. Some U.S. registrantsoperating globally would be able to begin filing statementsin IFRS for fiscal periods ending after December 15, 2009.


Cash vs. Accrual Methods

! Cash – accounting measures the financial impact of eventsand transactions based on when the cash is paid orreceived.

! Accrual – accounting attempts to measure the financialimpact of events and transactions when they occur and notsimply when the cash consequences of those events andtransactions take place.

– The accrual method is the most common method used by companiesand is required by GAAP, except in the case of other comprehensivebases of accounting.



Pro Forma vs. Historical Financial Statements

! Pro Forma – provides information about the continuingimpact of a particular transaction by showing how it mighthave affected historical financial statements if thetransaction had been consummated at an earlier time.

! Historical – measure income or present a financial positionfor past events. The information as reported in historicalfinancial statements is a summarized presentation of theoperations of the business during a specific period of time.


Forecast vs. Projected Financial Statements

! Forecast – Prospective financial statements that present, tothe best of the responsible party’s knowledge and belief, anentity’s expected financial position, results of operations,and cash flows.

! Projection – Prospective financial statements that present,to the best of the responsible party’s knowledge and belief,given one or more hypothetical assumptions, an entity’sexpected financial position, results of operations, and cashflows. A financial projection is sometimes prepared topresent one or more hypothetical courses of action forevaluation.


Financial Statement Concepts – Materiality

! A measure of the significance of a transaction or event. A transaction isconsidered material if its omission or misstatement would affect thejudgment of a reasonable person relying on the financial statements

! SEC Staff Accounting Bulletin No. 99 expresses that exclusive relianceon certain quantitative benchmarks to assess materiality in preparingfinancial statements and performing audits of those financial statementsis inappropriate; misstatements are not immaterial simply because theyfall beneath a numerical threshold

! Qualitative factors must be considered

– Masking changes in earnings or other trends

– Hiding a failure to meet analysts’ expectations

– Changing losses to profits

– Compliance with loan covenants


Financial Statement Concepts – GoingConcern

! Financial Statements are generally prepared assuming theentity is a “Going Concern”

! Assumptions include:

– Entity will continue to operate indefinitely

– Entity will continue to meet its obligations as they become duewithout substantial disposition of assets outside the ordinary courseof business


Revenue Recognition

! Revenue generally is realized or realizable and earnedwhen all of the following criteria are met:

– Persuasive evidence of an arrangement exists

– Delivery has occurred or services have been rendered

– The seller’s price to the buyer is fixed or determinable

– Collectibility is reasonably assured

Source: SAB 101 & SAB 104 – Revenue Recognition in Financial Statements


Contingencies

! Definition“a contingency is defined as an existing condition,situation, or set of circumstances involving uncertainty as topossible gain or loss to an enterprise that will ultimately beresolved when one or more future events occur or fail tooccur. Resolution of the uncertainty may confirm theacquisition of an asset or the reduction of a liability or theloss or impairment of an asset or the incurrence of aliability.”

Source: SFAS 5, Accounting for Contingencies


Contingencies (cont.)

! Losses

– Generally reflected in financialstatements when loss is:

! Probable that a liability has beenincurred

! The amount of loss can bereasonably Estimated

– If the loss is ReasonablyPossible

! Disclose the nature of thecontingency and the possible lossor range of loss

– If the loss is Remote

! No disclosure is necessary unlessfor certain contingencies

! Gains

– Generally not reflected in financialstatements prior to the actualreceipt of assets which are readilyconvertible to cash

Summarized from SFAS 5, Accounting for Contingencies, FIN 14, Reasonable Estimation of the Amountof the Loss and SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises


Overview of Key SEC Filings

! Form 10-K – Annually, audited financial statement withnotes, and Management’s Discussion & Analysis

! Form 10-Q – Quarterly, reviewed financial statements,MD&A

! Form 8-K – Filed for significant events

! Form S-1 – Initial registration proceedings

! Other Filings


Accounting References and Resources

Websites

American Institute of Certified Public Accountants(www.aicpa.org)

Association of Certified Fraud Examiners(www.cfenet.com)

Financial Accounting Standards Board(www.fasb.org)

Public Company Accounting Oversight Board(www.pcaob.org)

IFRS Resources (www.ifrs.com) Securities and Exchange Commission(www.sec.gov)

U.S. Department of Justice (www.usdoj.gov)

Publications

Wiley GAAP 2006: Interpretation and Application ofGAAP

Montgomery’s Auditing

Accountants’ Handbook, Volumes I and II Intermediate Accounting, Kieso, Weygandt andWarfield

Question?


Speaker Contact Information

! David PiperPartner

Deloitte Financial Advisory Services LLP202 378 [email protected]

! Kristin BoneSenior ManagerDeloitte Financial Advisory Services LLP

202 879 5304

[email protected]

About Deloitte

Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separateand independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu and itsmember firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.

Copyright © 2008 Deloitte Development LLC. All rights reserved.

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