financial statements 101: accounting fundamentals … · agenda •introduction •presentation...

Financial Statements 101:

Accounting Fundamentals for

Lawyers

September 15, 2011

Agenda

• Introduction

• Presentation

• Questions and Answers ― (anonymous)

• Slides ― now available on front page of Securities Docket

– www.securitiesdocket.com

• Wrap-up

Webcast Series

• Approximately every other week

• September 16: Resolving Corporate Investigations with DPAs & NPAs

Panel

Jeff Litvak, CPA/ABV/CFF, ASA

Senior Managing Director

Forensic and Litigation Consulting, FTI Consulting

Ken Mathieu, CPA/CFF/ABV

Managing Director

Forensic and Litigation Consulting, FTI Consulting

Jeff Litvak, CPA/ABV/CFF, ASA

Senior Managing Director, Forensic and Litigation Consulting

Ken Mathieu, CPA/ABV/CFF, MBA

Managing Director, Forensic and Litigation Consulting

Math For Lawyers:

Accounting and Finance Fundamentals: Accounting 101

6

Agenda

• The Analysis of Financial Statements

• Management Discussion and Analysis

• Ratio Analysis

• Notes to Financial Statements

• Accounting Literature/GAAP/IFRS

• Other Matters

7

Financial Statements

• Balance Sheet

• Income Statement

• Cash Flow Statement

• Management Discussion & Analysis

• Notes to Financial Statements

8

Generally Accepted Accounting Principles (GAAP)

• To facilitate the comparability of financial statements among

business entities and with respect to a particular business entity

over time

• Defines standards of practice and professional conduct for

accountants

• May influence the definition of negligence for accountants

8

9

Balance Sheet

• A static picture of the financial position of an individual or

business at a particular point in time

• A financial photograph

• Displays the financial status of the organization from inception

to the specified date

• Consists of three different sections:

– Assets

– Liabilities

– Equity

10

Sample Balance Sheet

XYZ Corporation Balance Sheet

As of January 31, 20XX

Assets Liabilities

Cash 20,000 $ Accounts Payable 40,000 $

Accounts Receivable 40,000 Accrued Liabilities 30,000

Inventory 60,000 Notes Payable 10,000

Current Assets 120,000 Current Liabilities 80,000

Land 50,000 Bonds Payable 80,000

Buildings & Equipment 140,000 Pension Liability 40,000

Less: Accumulated Total Liabilities 200,000

Depreciation (10,000) Equity

Owners Equity 100,000

Total Assets 300,000 $ Total Liab & Equity 300,000 $

11

Income Statement

• Displays the financial condition of a business or individual

over a limited period of time

• Comparable to a movie versus a snapshot

• Primary components of income statement

• Revenues

• Expenses

• Gain/(Losses)

12

Sample Income Statement

XYZ Corporation Income Statement

For the Year Ending December 31, 200X

Revenues:

Sales Revenue 300,000 $

Service Revenue 45,000

Total Revenue 345,000 $

Expenses:

Cost of Goods Sold 180,000 $

Compensation Expense 60,000

Depreciation Expense 15,000

Supplies Expense 4,000

Insurance Expense 3,000

Rent Expense 7,000

Total Expenses: 269,000 $

13

Statement of Cash Flows

• Measures the financial viability of an entity

– An entity’s ability to meet its debts as they come due

– Depends on the way in which cash in the business is managed

and the way in which it flows through the business

• Accrual method of accounting obscures the actual inflow and

outflow of cash

• GAAP requires an entity to prepare a statement of cash flows

as part of its financial statements

14

Categories of Statement

• Cash Flows from operations

– Transactions associated with sales of goods and services

• Cash flows from investing activities

– Cash an organization pays to acquire investments or long-lived, capital assets

– Cash received as a return on those investments

• Cash flows from financing activities

– Relates to liabilities and equity accounts – cash received by borrowing money, cash received from investors (stock sale), and cash paid out to investors (dividends)

15

Direct Method

XYZ Corporation Statement of Cash Flows

For the period ending May 31, 200X

Cash Flow from Operating Activities

Collections from Customers 5,000 $

Payments to Suppliers (500) $

Payments for Research (250) $

Net Cash Provided by Operating Activities 4,250 $

Cash Flows from Investing Activities

Payments for Investment in Furniture (250) $

Payments for Investment in Library (500) $

Net Cash Used by Investing Activities (750) $

Cash Flow from Financing Activities

Receipts upon Issuance of Common Stock 10,000 $

Net Cash Provided by Financing Activities 10,000 $

Net Increase (Decrease) in Cash 13,500 $

17

Management’s Discussion and Analysis (MD&A)

• Ratio analysis raises as many questions as answers

• SEC requires public companies to provide a narrative discussion of the trends and analysis that management sees the financial statements to reveal, as well as those that management believes the financial statements may not reveal

• To fill in between the lines

• Often written by lawyers – always reviewed by them

18

Management’s Discussion and Analysis (MD&A)

• Designed to provide investors with an insider’s view of an

entity’s financial condition, performance, and prospects

• Requires discussion of an entity’s liquidity, capital resources,

results of operations, and information relating to trends in and

uncertainties about aspects of the business

19

Ratio Analysis

• Conventions used to analyze the financial condition and

performance of an entity

• Series of comparisons of bits of information on financial

statements designed to investigate trends in aspects of a

business and the entity’s capacity to operate the business

over time

• Ratios are working tools for analysis, not absolutes

20

Ratio Analysis

When reviewing ratios, you must:

• Consider unique characteristics of the business being analyzed

• Compare the same ratios for the same entity at different periods in time

• Compare the ratios to other entities in the same industry

• Compare the ratios to other entities possessing similar economic characteristics

21

Liquidity and Activity Ratios

• Assess the ability of the entity to pay its short term debts

when they come due

• Assess efficiency of asset management

– Current Ratio

– Inventory Turnover Ratio

– Accounts Receivable Turnover Ratio

– Debt-to-Equity Ratio

22

Current Ratio

• Rule of thumb for most entities, the current ratio should

be around 2.0

• Too High – inefficiency problem

• Too Low – liquidity problem

Current Assets

Current Liabilities

23

Current Ratio

2007 2006

10,737 $ 8,254 $

17,086 $ 10,473 $

0.63 0.79

Assets 2007 2006 Liabilities 2007 2006

Cash 567 $ 239 $ Short-term Borrowings 7,385 $ 1,715 $

Receivables (net of doubtful accounts) 5,197 3,869 Current Portion of long-term Debt 722 1,418

Inventories 4,096 3,506 Due to Altria - 607

Deferred Income Taxes 575 387 Accounts payable 4,065 2,602

Other Current Assets 302 253 Accrued Liabilities 4,814 3,980

Total Current Assets 10,737 $ 8,254 $ Income Taxes 100 151

Total Current Liabilities 17,086 10,473 $ $

Consolidate Balance Sheet

Kraft Foods Inc. and Subsidiaries

24

Inventory Turnover Ratio

• The speed at which inventory is sold over time

Current Year's Cost of Goods Sold

[Beginning Inventory + Ending Inventory]/2

25


Inventory Turnover Ratio

2007

Net Sales 37,241 $

Cost of Goods Sold 24,651

Gross Profit 12,590 $

24,651 $

[4,096 + 3,506] / 2 = 6.49


Cash 567 $ 239 $ Short-term Borrowings 7,385 $ 1,715 $





Total Current Assets 10,737 $ 8,254 $ Income Taxes 100 151

Total Current Liabilities 17,086 10,473


$ $

26

Inventory Turnover

• Inventories turned 6.49 times this year

• 365 / 6.49 = 56.28 days to turn inventory

• Ratio is used to asses how well the inventory levels are

being managed

• Slow inventory

– Diverts available cash

– Open for obsolescence/spoilage

– Increases financing needs

27

Accounts Receivable Turnover

• Determines the speed of collection of A/R

Credit Sales

[Beginning A/R + Ending A/R] /2

28

Accounts Receivable Turnover

2007

Net Sales 37,241 $

Cost of Goods Sold 24,651

Gross Profit 12,590 $

37,241 $

[5,197 + 3,869] / 2 = 8.22


Cash $ 567 $ 239 Short-term Borrowings $ 7,385 $ 1,715





Total Current Assets $ 10,737 $ 8,254 Income Taxes 100 151

Total Current Liabilities $ 17,086 $ 10,473



29

Receivables Turnover

• Average number of days the receivables are outstanding

– 365/8.22 = 44.43 days

• If payments are due in 60 days – fine

• If payments are due in 30 days - trouble

30

Accounting Humor

31

Debt-to-Equity Ratio

• Measures the borrowing capacity of the entity

• Level of comfort a lender can have in the entity’s ability to

repay indebtedness

• Entities with high ratios are called “Highly-leveraged”

Total Debt

Owners’ Equity

32

Profit Margin

2007 2006 2005

Net Sales 37,241 $ 34,356 $ 34,113 $

Cost of Goods Sold 24,651 21,940 21,845

Gross Profit 12,590 12,416 12,268

Marketing, administration, and research 7,809 7,254 7,138

Asset impairment and exit costs 452 1,002 479

Gain on redemption of United Biscuits investment - (251) -

Gains on divestitures, net (15) (117) (108)

Amortization of intangibles 13 7 10

Operating Income 4,521 $ 4,749 $

2007 2006 2005

4,331 $ 4,521 $ 4,749 $

37,241 $ 34,356 $ 34,113 $

11.63% 13.16% 13.92%

33

Gross Margin

2007 2006 2005

Net Sales 37,241 $ 34,356 $ 34,113 $


Gross Profit 12,590 12,416 12,268

Marketing, administration, and research 7,809 7,254 7,138

Asset impairment and exit costs 452 1,002 479

Gain on redemption of United Biscuits investment - (251) -

Gains on divestitures, net (15) (117) (108)

Amortization of intangibles 13 7 10

Operating Income 4,331 $ 4,521 $ 4,749 $

2007 2006 2005

12,590 $ 12,416 $

12,268 $

37,241 $

34,356 $

34,113 $

33.81% 36.14% 35.96%

34

Variation Analysis



2007 2006 2005

Net Sales 37,241 $ 34,356 $ 34,113 $


Operating Expenses 8,259 7,895 7,519

Interest Expense 604 510 636

EBIT 3,727 $ 4,011 $ 4,113 $

% of Sales 10.01% 11.67% 12.06%

Income Tax 1,137 951 1,209

Net Earnings 2,590 $ 3,060 $ 2,904 $

% of Sales 6.95% 8.91% 8.51%

35

Interest - $1,000

Net Profit $3,500

Gross Profit $20,000




Operating Profit $5,000

Incremental Profit $10,000

Operating Profit $5,000

COGS - $80,000 COGS - $80,000 Var. COGS - $78,000 COGS - $80,000

Operating Expense - $15,000

Var. Oper. Expense - $12,000

Operating Expense - $15,000

Taxes - $500

Measuring Profit

Gross Profit Net Profit Incremental Profit Operating Profit

Sales $100,000 Sales $100,000 Sales $100,000 Sales $100,000

36

Notes to Financial Statements

• Identify significant accounting policies

• Accounting standards require information about the accounting

principles & methods used and the risks and uncertainties inherent

in significant methods

• SEC rules governing MD&A require disclosure about trends, events,

or uncertainties known to management that would have a material

impact on reported financial information.

• Identify business dependencies & significant events

• May identify ability to continue as a “going concern”

• Identify related party transactions, litigation & claims

• May identify or highlight need for further investigation

of “off-balance-sheet” items

37

Notes to Financial Statements:

Examples of Related Party Transactions

• The Company leases a manufacturing facility from a

shareholder and executive officer of the Company.

Total rent expense associated with this lease in 2001

was $750,000.

• The Company has a $2 million non-interest bearing

note payable to a shareholder that has been

outstanding since 1990.

38


Example of Off-Balance Sheet Items

• The Company has investments in unconsolidated entities

principally to support its business model of growing earnings

and cash flow with minimal asset risk.

• The State Environmental Agency identified contamination of

groundwater adjacent to the Company’s manufacturing facilities

caused by the Company’s defective underground chemical

storage tanks. The total estimated aggregate cost to treat the

contaminated soil cannot be determined at this time.

• The Company is involved in pending litigation in the usual

course of business. In the opinion of management, such

litigation will not have a material adverse effect on the

Company's consolidated financial position, results

of operations or cash flows.

39


Example of Business Concentrations Note

• The Company obtains key components for its product from one

supplier

• The Company’s ten largest customers accounted for approximately

50% of net sales in 2001.

40


Examples of Going Concern Note

• The Company’s ability to continue as a going concern is

dependent on its ability to obtain additional capital to finance its

operations.

• The Company has sustained significant losses which may impair

its ability to continue as a “going concern.”

41

Accounting Rules/Conventions


GAAP (Generally Accepted Accounting Principles)

• The “rules” of accounting

• Comprised of standards and procedures for reporting financial

information accepted as appropriate because of their universal

application

• “Gray areas”

42

Selected Accounting Concepts – US GAAP


• Matching Principle

• Historical Cost Principle

• Conservatism

• Full Disclosure

• Materiality

• Going Concern Assumption

• Accounting Estimates

43

Matching Principle


•Efforts (expenses) matched in the same period as accomplishments

(revenues)

•“Let the expense follow the revenue”

•The expense should be recognized when that expense makes its

contribution to revenue

44

Historical Cost Principle


•Price paid/value surrendered for an asset

•Generally the value most often used as a basis for accounting records

•Cost is definitive, objective and fixed

•Cost has disadvantages

• May not reflect “value” of asset

• May distort comparisons between periods

45

Conservatism


•When in doubt, choose the solution that will be least likely to overstate

assets and income

•Merely guides the accountant in difficult situation

•Does not suggest the accountant should understate assets or income

46

Full Disclosure


• Necessary because of numerous alternative accounting treatments

• Reveal any facts of sufficient importance to influence the judgment of an

informed reader

• Common disclosures

• Presenting account balance (e.g., Debt)

• Parenthetical disclosure

• Note disclosure

47

Materiality


Difficult concept:

“Is this item large enough for users of the information to be

influenced by it?”

- FASB Statement of Financial Concepts No. 2

48

Going Concern


Assumption that the business enterprise will not continue as a going

concern

• “Liquidation” assumes business will not continue

• Liquidation affects asset values

49

Accounting Estimates


Expectations of future performance requires the use of accounting

estimates in financial statements

Utilized in a variety of areas

• Bad debt provisions

• Warranty expense provisions

• Inventory Obsolescence

• Etc.

50

Contingent Liability Reserves

Accrue Liability Footnote Disclosure

Reasonably Possibly Remote

Amount Reasonably Estimable

Probable

51

International Financial Reporting Standards (IFRS)

History

• Previously known as International Accounting Standards (IAS).

• IAS were issued by the International Accounting Standards Committee (IASC)

between 1973 and 2001

• Adopted by the International Accounting Standards Board (IASB) in April 2001.

• IASB continued to develop the standards under the new name of International

Financial Reporting Standards (IFRS).

52


Impact on US Companies

• In 2002, US Financial Accounting Standards Board and the IFRS

agreed to work towards reducing differences between US GAAP and

IFRS (the Norwalk Agreement).

• In August 2008, SEC Announced a decision to publish a proposed

Roadmap that would outline to steps for US issuers to adopt IFRS

• Largest 20 companies in their industries would be allowed to report

under IFRS as soon as 2010.

• All companies filing with the SEC would be required to follow IFRS

by 2014.

53


Impact on US Companies

• The SEC published a paper exploring a possible method of

incorporating IFRS into US GAAP

• http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-

plan-paper-052611.pdf

• In February 2010, the SEC approved a new timeline that anticipates

2015 as the earliest possible date for the required use of IFRS for U.S.

public companies. http://www.sec.gov/rules/other/2010/33-9109.pdf

• IFRS.org has resources for understanding the transition to IFRS.

http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-paper-052611.pdf









http://www.sec.gov/rules/other/2010/33-9109.pdf




54


SEC Possible Method of Incorporation


Incorporation of IFRS through the framework described in this Staff Paper would have the

objectives of achieving the goal… of providing for a U.S. issuer complying with U.S. GAAP

also to be in a position to assert that it is compliant with IFRS as issued by the IASB…

The framework is presented to illustrate that:

1. The decision faced by the Commission in an effort to achieve a single set of high quality,

globally accepted accounting standards is not necessarily a binary decision (i.e., either to

require the use of IFRS by all U.S. issuers immediately or not);

2. Incorporation of IFRS is not inconsistent with the SEC maintaining its ultimate

authority over U.S. accounting standard setting; and

3. There are potential ways to accomplish the broad objective of pursuing a single set of

high-quality, globally accepted accounting standards while minimizing cost, effort, and

other transition obstacles.




55


Reasons for adoption of IFRS:

• Greater Comparability for Investors – 2/3 of US investors own securities in

foreign companies reporting in IFRS, which makes the need for common

accounting language increasingly important.

• Lower Costs – Currently, foreign private issuers are required to file financial

statements either US GAAP or provide a reconciliation from local accounting

principles (often IFRS) to U.S. GAAP. This would reduce costs associated

with this requirement

56


Main Differences between US GAAP and IFRS as cited in the Wall Street

Journal:

Source: PricewaterhouseCoopers

57

Concluding Remarks

• It is important to consider the financial statements taken as a whole to

evaluate a firm’s position

• Liquidity

• Leverage

• Profitability

• Asset Management

• IFRS is the new standard public companies will likely be reporting under

in the near future

Questions?

Thank You for Attending This Webcast

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