interpreting the abacus financial literacy for lawyers
TRANSCRIPT
Interpreting the AbacusFinancial Literacy for Lawyers
Enron Disaster - 2001
• Large energy company in US• Largest US corporate bankruptcy at time• $63.4 billion in assets lost• Complex and confusing financial
statements, unethical practices, and misrepresentation of earnings and modifying the balance sheet to indicate the business was going well financially
• Lead to closure of one or largest accounting and audit firms in world Arthur Anderson.
Valuation issues…
• How valuations can go wrong• Local accountant acting for vendor selling a
business prepared valuation• Purchase price advised to my client, but when I
prepared my own valuation, price was well overstated anything reasonable.
• I knew other accountant well and discussed valuation basis he used. It was same as mine but through discussions I identified he made a mistake with financial numbers and adjusting profit.
• Even though admitted he had calculated wrong, vendor was “emotionally attached” to wrong valuation price and wouldn’t reduce sale price.
Why is financial literacy so important for lawyers
• Drafting of wills for clients involved in partnerships/businesses
• Administering estates• Family law where business entities
involved• Disputes such as partnership dissolutions• Advising on purchase or sale of a
business• Anywhere where valuations of businesses
are involved• Buying into a law firm
Today's session
• As you can see financial literacy is extremely important
• And even more important is to be aware that figures you are looking at can be misleading, both unintentionally and intentionally, or actually wrong
• An understanding of the numbers, or financial literacy, is as important to you as it is to me, and anybody relying on numbers from big banks to small share investors
• Lot to cover so I am available after this session or come see me at stall outside at morning tea to chat or get my contact details
Financial Literacy Topics Today
• Partnership Financial Statements• Valuations• Calculating Personal Income
Partnership Financial Statements
• Overview– Balance Sheet– Partners current accounts– Profit and Loss
• What can be misleading
ASSETS
CURRENT ASSETS
Deposits $200.00 $200.00
Trade Debtors $145,000.00 $135,000.00
Stock on Hand $30,000.00 $20,000.00
Total CURRENT ASSETS $175,200.00 $155,200.00
NON CURRENT ASSETS
Land & Buildings $439,800.00 $470,800.00
Plant & Equipment $75,000.00 $80,000.00
Motor Vehicles $55,000.00 $60,000.00
Office Furniture & Equipment $15,000.00 $10,000.00
Intangible Assets $35,000.00 $35,000.00
Total NON CURRENT ASSETS $619,800.00 $655,800.00
INVESTMENTS
Shares $20,000.00 $65,000.00
Total INVESTMENTS $20,000.00 $65,000.00
Total ASSETS $815,000.00 $876,000.00
LIABILITIES
CURRENT LIABILITIES
Overdraft $30,000.00 $35,000.00
GST $10,000.00 $11,000.00
Trade Creditors $60,000.00 $50,000.00
Total CURRENT LIABILITIES $100,000.00 $96,000.00
NON CURRENT LIABILITIES
Equipment Loan $80,000.00 $85,000.00
Provision for Leave $15,000.00 $20,000.00
Total NON CURRENT LIABILITIES $95,000.00 $105,000.00
Total LIABILITIES $195,000.00 $201,000.00
Net Assets $620,000.00 $675,000.00
PARTNERS FUNDS
MR SMITH
Capital Account $200,000.00 $200,000.00
Current Account $100,000.00 $125,000.00
Total $300,000.00 $325,000.00
MRS SMITH
Capital Account $200,000.00 $200,000.00
Current Account $120,000.00 $150,000.00
Total $320,000.00 $350,000.00
Total PARTNERS FUNDS $620,000.00 $675,000.00
INCOME 2013 2012
Sales - Department 1 $1,200,000.00 $1,350,000.00
Total INCOME $1,200,000.00 $1,350,000.00
Cost Of Sales
Opening Stock $41,000.00 $43,000.00
Purchases $805,000.00 $1,104,000.00
Less: Closing Stock ($39,000.00) ($41,000.00)
Total Cost Of Sales $807,000.00 $1,106,000.00
Gross Profit $393,000.00 $244,000.00
Less : EXPENSES
Advertising $1,000.00 $950.00
Bank Charges $3,000.00 $2,850.00
Cleaning $3,000.00 $2,850.00
Computer Support $5,000.00 $4,750.00
Depreciation $45,000.00 $42,750.00
Sundry Expenses $3,000.00 $2,850.00
Super Cont - Employees $11,000.00 $10,450.00
Wages - Employees $100,000.00 $95,000.00
Work Cover $3,000.00 $2,850.00
Telephone $4,000.00 $3,800.00
Total Less : EXPENSES $178,000.00 $169,100.00
Operating Profit $215,000.00 $74,900.00
Interest Received $1,000.00 $3,000.00
P/L Sale of Motor Vechile ($4,000.00) $15,000.00
Net Profit/(Loss) $212,000.00 $92,900.00
Share of Profit
Mr Smith $106,000.00 $46,450.00
Mrs Smith $106,000.00 $46,450.00
$212,000.00 $92,900.00
What can be misleading…Balance Sheet
• Asset values often at purchase price, not current value– Land, Buildings often understated (but watch recent
valuations)– Plant and Equipment can be easily overstated as worth
less than depreciated value
• Are all assets partnership assets, or are some assets missing – private house or rental property on balance sheet – plant and equipment listing (depreciation schedule) not
complete– shares
What can be misleading…Balance Sheet
• Depreciation rates used are tax rates (may also mean have an asset pool)– Accounting rates– Tax Rates– Real rates
• Goodwill – is this shown– often purchased goodwill is (but historical
value)– How do you value this? (discuss later)
• Are equity accounts correct– really equity, or also current accounts?– Represent actual ownership interests?
What can be misleading…Partners current accounts
• These are undrawn profits, and will be called different things in different entities (such as beneficiary accounts in trusts, or retained earnings in companies)
• These may be in same portion as owners equity (if drawings are kept in same portion as equity), but often they are not, such as if partners tax payments or private expenses are paid through the partnership and allocated to each partner)
• Watch also loans to and from partners, which can also occur and be shown on financial statements for a number of reasons.
• Need to payout current accounts and loan accounts first on winding up or dissolution
What can be misleading…Profit and Loss Statement
• Depreciation – is this tax depreciation or real depreciation
• Owners abnormal payments such as large superannuation, or higher/lower wages than commercially realistic
• Sales not banked (Cash)• Profits up but cash backwards or business
struggling. Investment in working capital• Borrowing expenses – tax claim over 5
years in financial statements
What can be misleading…Profit and Loss Statement
• Provisions such as employee entitlements– These are recorded in many different ways, or often not
recorded at all so hidden liability of business– If recorded, watch for long service leave as sometimes
recorded per computer system which accrues from day 1, but not payable until after certain periods of employment
• Leasing– Most businesses will put leasing through profit and loss,
while public companies have to record finance liability– Watch for prepayments of leasing for tax reasons
pushing profit down– Watch for undisclosed liability of lease finance over
value of leased assets (leasing called off balance sheet financing)
What can be misleading…Profit and Loss Statement
• Capital items put through profit and loss– For tax purposes small businesses can claim an
immediate deduction for capital items up to $6,500 (used to be $1,000). Many accountants may simply leave these items in expenses, rather than show on balance sheet and depreciate. Can substantially reduce profits.
• Low profits but cash situation growing (non cash items on profits and loss)– Depreciation and employee entitlement provisions not
cash payments. Actually future cash payments. For example depreciation is wear and tear on assets, so really allocation to replacement of plant and equipment.
– Loss on scrapping of equipment
What can be misleading…Profit and Loss Statement
• Difference accounting profit to taxable income for partnerships– Different tax and accounting depreciation– Items not deductible (entertainment, private
use vehicles)– Employee super not claimable until paid– Prepayments for non small businesses (over
$2m in sales)
Financial Literacy of Financial Statements Summary
• Profit and loss is area for major concern for many reasons
• Different accountants prepare financial reports on different basis– Some tax basis– Many just accept clients financial statements and
prepare tax returns– Few like Kennas do high level QA checks on financial
statements to verify accuracy so financial statements and tax returns are more correct than otherwise would be
– Be aware though still not audit, so relying on clients to accurately record financial data and where not cost effective for Kennas to do detailed review, we do big picture checks on major risk areas.
– Extreme situation – bank feedback occasionally on balance sheets they see that don’t balance.
Financial Literacy of Financial Statements Summary
• And always can have risk of fraud or misrepresentation in financial statements, especially where there is a relationship breakdown (marriage, partnership).
• So lot of ways disputes can arise
Financial Literacy for Business Valuations
• This may be required for Family Law matters, partnership disputes, or transfer of businesses.
• High risk area with many potential areas for differences
• Risk is shown by limited people in CQ willing to do business valuations
• Kennas does many valuations for lawyers in these areas
Financial Literacy for Business Valuations
• Valuation methodologies– Main basis is around future earnings to value
business– There are other rule of thumb methods
• Once value business using future earnings, can deduct value of tangible assets (vehicles, equipment, etc) to arrive at goodwill figure
Financial Literacy for Business Valuations
• First issue is arriving at future earnings– Use prior years as basis– What is real profit– What adjustments should be made– Are payments to associated people reasonable– What effect (if any) should expected future events shape
the future earnings used to value a business
• Next major issue is what risk factor should be applied.– Rick factor is return factor (eg term deposits 4%, property
say 8% to 10%, businesses???)– How is this calculated. Often through rules of thumb,
educated guesses.– Kennas methodology uses a patented formula and
process to calculate risk factor, which has been accepted in courts.
Financial Literacy for Calculating Personal Incomes
• Again this can be a difficult area but it is becoming a bit easier with recent changes in reporting in tax returns
• The issue is what is someone’s real income
• Clouded because of salary packaging and way information is (or is not) recorded in tax returns
Financial Literacy for Calculating Personal Incomes
• Salary packaging used to hide away real income, as all that was shown in tax returns was the reduced wage received, and additional benefits or packaged benefits were hidden. This meant people received Centrelink or tax benefits based on the reduced income.
• Current situation is in a persons individual tax return these days salary packaging is generally disclosed, so that persons real income is shown, and salary packaged benefits are taken into account for a range of Centrelink and Tax reasons.
Financial Literacy for Calculating Personal Incomes
• Superannuation paid by an employer for an employee above the 9% super guarantee amount employers have to pay (now 9.25%) is meant to be reported on PAYG Payment Summaries and in a persons Tax Return. However in some situations can be higher amount than 9% if this is the norm (eg some government positions)
• An amount for certain other packaged benefits is also calculated and included on PAYG Payment Summaries and shown in a persons Tax Return. However this amount needs to be explained further.
Financial Literacy for Calculating Personal Incomes
• Reportable payments to show on PAYG payment summaries– Fringe benefit amounts less than $2,000 are excluded– For amounts over $2,000 you report a grossed up
amount which is 1.8692 times the fringe benefits value. This in effect shows a pre tax amount (using the top tax rate) that would have had to been paid in wages to arrive at the same amount in the employees hands.
– The period this covers is 1 April to 31 March and is shown on the financial year PAYG payment summary
– Some benefits are excluded from reportable payments such as 100% work use laptops and mobile phones (these would have been tax deductions to the employees). Also remote accomodation excluded.
– Also some car benefits (subject to recent possible rule changes) are calculated using a a statutory formula method, not based on actual costs.
Financial Literacy for Calculating Personal Incomes
• Other situations where a persons real income can be hidden– Non commercial wages being paid by a
business to an associated employee– Negative gearing being used to push down a
persons taxable income (and this is now added back by the Tax Office and Centrelink in a range of areas)
The end of the Abacus…
• While the Abacus is no longer with us, we now have many more tools to deal with numbers
• As can be seen, financial literacy is a very important skill for all professionals
• Big part includes being aware of what can be misleading or not showing the full picture.
• If you have any questions…– Darren Smith– Kennas Chartered Accountants