Accounting and finance for lawyers in a nutshell, 5 edition

THE BALANCE SHEET The balance sheet, also called the statement of financial position, sets forth the assets,liabilities, and owners’ equity the investment of the owners of a business as

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JESSE H CHOPERProfessor of Law and Dean Emeritus,University of California, Berkeley

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The Ohio State University

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Professor of Law Emeritus, University of Michigan

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University of California,Hastings College of the LawLARRY D KRAMERPresident, William and Flora Hewlett Foundation

JONATHAN R MACEYProfessor of Law, Yale Law School

ARTHUR R MILLERUniversity Professor, New York UniversityFormerly Bruce Bromley Professor of Law, Harvard University

GRANT S NELSONProfessor of Law, Pepperdine UniversityProfessor of Law Emeritus, University of California, Los Angeles

A BENJAMIN SPENCERProfessor of Law,Washington & Lee University School of Law

JAMES J WHITEProfessor of Law, University of Michigan

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COPYRIGHT © 1995 WEST PUBLISHING CO

West, a Thomson business, 2002, 2006

IIIToJoseph and Lisa Meyer

FOREWORD TO THE FIFTH EDITION

The accounting world and accounting rules continue to change reflecting both changes

in the business environment and refined thinking about how transactions and eventsshould be presented in financial statements The fifth edition reflects the keydevelopments that have occurred since the fourth edition

As in the case of both the third and fourth editions, the FASB adopted further changes

to the rules regarding transfers of receivables and servicing rights and obligations, whichcontinues to be a hot topic Chapter 5 has been updated to reflect these further changes

Changes to the rules for the consolidation of “variable interest entities” were duscussed

in the fourth edition Since then, the FASB has continued to refine these rules

Since the rules regarding goodwill created in connection with business acquisitions wereamended to require an annual quantitiative impairment review for goodwill rather than

an automatic amortization of goodwill, companies have been concerned about the timeand cost involved in performing these impairment reviews As discussed in Chapter 8, theFASB has introduced a new concept for testing goodwill

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A company now first undertakes a “qualitative” assessment to determine if it is morelikely than not that an impairment of goodwill has occurred If that is not the case, it isnot necessary to undertake the quantitative testing of goodwill for impairment

The requirement to present total “comprehensive income” in addition to the traditionalnet income continues to receive focus by the FASB The FASB adopted new standardsallowing companies to elect between preparing one continuous statement that presentsboth net income and comrephensive income or preparing two statements, one for netincome and one immediately following that presents other comprehensive income andcomes to a total that includes all the components of comprehensive income

Aside from these substantive changes, one of the biggest developments in accounting

in the United States was the issuance by the FASB of a codification of accountingstandards that came out while the fourth edition was in production The individual FASBstatements and interpretations and other sources of official accounting guidance in theUnited States have been incorporated into a consolidated set of accounting rules TheFASB now periodically issues accounting standards updates that amend the codification.The fifth edition has been revised to reflect the new citations to the codification There isalso a cross reference table in the appendix that cross references between the old FASB(and APB) pronouncement

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numbers that were covered prominently in prior editions and the new codificationreferences.

As always, I trust that this fifth edition will continue to provide law students, lawyers,and other readers with a sufficient understanding of the basics of accounting and finance

so that they can better appreciate the significance of accounting and its importance in thecommercial and legal world

CHMNorwalk, CT

October 2012

ACCOUNTING AND FINANCE FOR LAWYERS

FIFTH EDITION

OUTLINE

FOREWORD TO THE FIFTH EDITION

Chapter 1 The Basic Financial Statements

A The Balance Sheet

1 Assets

2 Liabilities

3 Owners’ Equity

4 The Balance Sheet Equation

5 Balance Sheet Format

B The Income Statement

1 Revenues and Gains

2 Expenses and Losses

3 Format of the Income Statement

C The Statement of Owners’ Equity

D Statement of Cash Flows

b Prepaid Expenses

3 Depreciation Expense

4 Recognizing Cost of Goods Sold

E Revenue and Expense Accounts

F Closing the Books

G Preparation of Financial Statements

Chapter 3 Generally Accepted Accounting Principles

A Sources of GAAP

1 Pre-Codification Official Pronouncements of the FASB and Its Predecessors

a FASB Statements and Interpretations

b APB Opinions

c Accounting Research Bulletins

d Enforcement of Official Standards

2 Other Sources of GAAP

B Governmental Regulation of Accounting

1 SEC

2 Regulatory Agencies

C Income Tax Accounting

D Some Fundamental Accounting Concepts

1 Historical Cost

2 Measuring Fair Value

3 The Going Concern Assumption

4 Yearly Reporting

5 Revenue Recognition and Matching

6 Conservatism

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7 Materiality and Cost–Benefit Analysis

Chapter 4 Recognition of Revenues and Expenses

A Revenue Recognition

1 Sale of Goods or Services

2 Revenue From Services

a Specific Performance Method

b Proportional Performance Method

c Completed Performance Method

3 Long Term Contracts

4 Revenue Recognized With the Passage of Time

5 Revenue Recognized Based on Receipt of Cash

6 Completion of Production

7 Changes in Market Value

8 Asset Writedowns

B Matching

1 Direct Matching

2 Immediate Write–Off

3 Systematic and Rational Allocation

Chapter 5 Current Assets and Liabilities

a Percentage of Sales Method

b Aged Receivables Analysis

5 Financing and Sales of Receivables

F Short Term Borrowings

1 Interest on Notes Payable

2 Currently Maturing Amounts of Long Term Debt

G Accrued Liabilities

H Deferred Revenues and Deposits

I Estimated Liabilities

J Contingent Liabilities

Chapter 6 Accounting for Inventories

A Determining Physical Quantities on Hand

1 Periodic Inventory System

2 The Perpetual Inventory System

B Determining Inventory Values

1 Specific Identification

2 Cost Flow Assumptions

a First In, First Out Method

b Last In, First Out

c Average Cost

d Application to Perpetual Inventory Systems

e Retail Inventory Methods

C Applying Lower of Cost or Market

2 Exchanges for Other Property

3 Acquisitions of Multiple Assets

c Declining Balance Method

d Units of Production Method

e Depletion of Natural Resources

f Other Methods

C Repairs and Improvements

D Disposal of Fixed Assets

E Impairment of Fixed Assets

Chapter 8 Intangible Assets

A Identifiable Intangible Assets

1 Types of Identifiable Intangible Assets

a Patents

2 Accounting for the Purchase of Identifiable Intangible Assets

3 Initial Accounting for Internally Created Identifiable Intangible Assets

a Research and Development

b Computer Software Costs

4 Accounting for Identifiable Intangible Assets After Acquisition

B Goodwill

Chapter 9 Accounting for Investments

A Investments in Bonds

1 Acquisition of Bonds at Face Value

2 Acquisition of Bonds at a Discount or Premium

a Straight Line Amortization of Bond Discount or Premium

b Effective Interest Method of Amortizing Bond Discount and Premium

3 Changes in Value After Acquisition

4 Impairments of Loans

B Accounting for Stock Investments

1 The Cost Method

a Dividend Income

b Changes in Value After Acquisition

c Stock Splits and Stock Dividends

2 The Equity Method

3 Consolidated Financial Statements

4 Consolidation of Variable Interest Entities

C Derivatives and Other Financial Instruments

1 Definition of Derivatives

2 Accounting for Derivatives

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a Fair Value Hedges

b Cash Flow Hedges

c Foreign Currency Hedges

D Other Investments

1 Land

2 Cash Value of Life Insurance

3 Sinking Funds and Other Permanent Funds

Chapter 10 Accounting for Long Term Debt

A Forms of Long Term Debt

B Accounting for Long Term Debt Issued at Par Value

1 Issuance on an Interest Payment Date

2 Issuance of Bonds Between Interest Payment Dates

C Accounting for the Issuance of Bonds at Other Than Par Value

1 Bonds Issued at a Discount

2 Bonds Issued at a Premium

D Bond Issuance Costs

E Retirement of Bonds Prior to Maturity

1 Actual Retirements

2 In–Substance Defeasance

F Restructuring of Long Term Debt

1 Restructuring With No Gain or Loss

2 Restructuring With Recognition of Gain

G Convertible Debt

1 Conversion—Book Value Method

2 Conversion—Market Value Method

3 Induced Conversions

4 Debt Issued With Stock Warrants

H Stock Treated as Debt

1 Mandatorily Redeemable Stock

XVI

2 Obligations to Repurchase Shares

3 Certain Obligations to Issue Shares in the Future

Chapter 11 Accounting for Leases

A Introduction

B Characterizing and Accounting for Leases

1 Accounting by the Lessee

2 Accounting by the Lessor

3 Changes in the Terms of a Lease Originally Treated as a Capital Lease

Chapter 12 Accounting for Other Long Term Liabilities

A Accounting for Income Taxes

1 Temporary Differences

a Types of Temporary Differences

b Deferred Tax Liabilities

c Deferred Tax Assets

d Analysis of Deferred Taxes

e Multiple Period Effects

2 Net Operating Losses

3 Valuation Allowances on Deferred Tax Assets

4 Reporting Deferred Tax Liabilities and Assets in the Balance Sheet

5 Intraperiod Tax Allocation

6 Permanent Tax Differences

B Accounting for Retirement Plans

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1 Defined Contribution Plans

2 Defined Benefit Plans

a Components of Pension Expense

(i) Current Service Cost

(ii) Interest Cost

(iii) Amortization of Transition Cost

(iv) Prior Service Cost

(v) Actuarial Gains and Losses

(vi) Expected Return on Plan Assets

b Pension Assets and Liabilities

c Under- or Over-Funded Status

d Disclosures

C Accounting for Other Post–Retirement Benefits

Chapter 13 Accounting for Stock and Stockholders’ Equity

A Contributions to Capital

1 Contributed Capital Accounts

2 Issuing Stock for Cash

3 Issuing Stock for Noncash Property

4 Stock Subscriptions

5 Stock Issuance Costs

6 Disclosures About Capital Structure

B Accounting for Retained Earnings

C Accounting for Dividends and Other Distributions

1 Key Dates Related to Dividends

D Other Adjustments to Retained Earnings

1 Prior Period Adjustments

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2 Appropriations

E Accounting for Treasury Stock

1 The Cost Method

2 The Par Value Method

H Other Comprehensive Income

Chapter 14 Partnership Accounting

A Capital Accounts

B Defining a Partner’s Interest in Profits and Losses

1 Allocating Individual Items of Income or Loss

2 Recognizing Different Forms of Partner Contributions

a Allocation for Services

b Return on Capital

c Residual Income and Loss Sharing Ratios

C Admission of New Partners

1 Transfer of Partnership Interests

a No Adjustments to Partnership Net Assets

b Adjusting Partnership Net Assets

2 Contribution to the Partnership

a No Adjustment to Partnership Capital Accounts

b The Goodwill Method

c The Bonus Method

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D Retirement of Partners

1 Goodwill Method

2 Bonus Method

Chapter 15 Accounting for Business Combinations

A Acquisition Method of Accounting

1 Recording the Acquisition

2 Effects of the Acquisition Method on the Income Statement

3 Accounting for Acquisition Costs

4 Recording Adjustments in Stock Acquisitions

Chapter 16 Earnings Per Share and Financial Ratios

A Earnings Per Share

1 Basic Earnings Per Share

2 Diluted EPS

a Effect of Stock Options

b Effect of Convertible Securities

b Debt to Asset Ratio

c Times Interest Earned

d Times Fixed Charges Earned

A Separately Reported Components of Income

1 Extraordinary Items

2 Discontinued Operations

3 Income Statement Reporting

4 Other Comprehensive Income

5 Effects of a Change in Accounting Principle

B Segment Reporting

1 Reporting on Operating Segments

2 Reporting on Foreign Operations and Export Sales

3 Information About Major Customers

4 Products and Services

C Interim Financial Statements

Chapter 18 Corporate Finance—Valuation

A Valuation of Securities

1 Valuation of Bonds

a Mechanics of Bond Value Calculations

b Determining Market Interest Rates

c Bonds With Additional Features

2 Valuation of Preferred Stock

a Nonredeemable Preferred Stock

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b Redeemable Preferred Stock

c Rate of Return for Preferred Stock

d Preferred Stock With Additional Features

3 Valuation of Common Stock

a Constant Dividends

b Dividends Growing at a Constant Rate

c Present Value Analysis

d Price/Earnings Multiples

e Determining the Required Rate of Return

B Cost of Capital

1 Determining a Company’s Cost of Capital

2 Use of Cost of Capital in Capital Budgeting

C Valuation of a Business

1 Discounted Cash Flow Analysis

a Estimate the Cash Flows for a Projection Period

b Terminal Cash Flow

c Determination of Discount Rate

d Computation of the Value of the Firm

e Example

2 Multiples Analysis

3 Asset Values

Chapter 19 International Accounting Issues

A Accounting by U.S Businesses Operating in Foreign Countries

1 Foreign Currency Transactions

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2 Translating Foreign Currency Financial Statements

B Accounting Rules in Other Countries

Appendix A The Sarbanes–Oxley Act of 2002

1 The Public Company Accounting Oversight Board

2 Registration of Auditing Firms With the PCAOB

3 Regulating Auditing, Quality Control, and Independence Standards

4 Required Independence of Auditing Firms

5 Requirements Related to Audit Committees of Public Companies

6 Responsibilities of Senior Management for Financial Reports

7 Improved Financial Disclosures

Appendix B Time Value of Money

1 Future Value of $1

2 Present Value of $1

3 Future Value of an Annuity of $1

4 Present Value of an Annuity of $1

5 Irregular Cash Flows

Appendix C Cross Reference Table Selected Accounting Standards Compilation Equivalents of Pronouncements Referenced in Prior Editions

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CHAPTER 1 THE BASIC FINANCIAL STATEMENTS

The main subject matter of this Nutshell is financial accounting Financial accountinginvolves the process of recording transactions in the accounting records of a business andperiodically extracting, sorting, and summarizing the recorded transactions to produce aset of financial statements Financial statements are the primary means by whichbusinesses communicate financial information to various users When a business issues acomplete set of financial statements, there are four individual statements that aretypically prepared This chapter will introduce and describe the basic financial statements.Various items and concepts introduced briefly in this chapter will be discussed in moredetail in later chapters A general familiarity with the output of the financial accountingprocess should assist in understanding the accounting process and the issues that arise inthe preparation of the financial statements

A THE BALANCE SHEET

The balance sheet, also called the statement of financial position, sets forth the assets,liabilities, and owners’ equity (the investment of the owners) of a business as of aparticular point in time (typically, the end of the fiscal Year) The balance sheet is a

2

snapshot as of the date it is issued A sample balance sheet is shown in Exhibit 1.1 In atypical balance sheet, the assets are listed on the left hand side On the right hand sideare listed the liabilities of the business and the owners’ equity accounts

Exhibit 1.1

Balance Sheet

1 ASSETS

The assets of a business as shown on the balance sheet are of two basic types Onetype of asset is a tangible or intangible property interest or legal right of the business,something that one normally expects in response to the question, “What do you own?”Examples of this type of asset are cash (e.g., currency, coins, bank balances),receivables, whether represented by formal notes or not, inventories, land, buildings andequipment, patents, trademarks,

3

copyrights, etc The other type of asset listed on a balance sheet is a “deferredexpense” or “deferred charge.” The concept of deferral will be discussed in Chapter 2 Fornow, it is sufficient to note that a deferred expense or deferred charge is a cost incurred

by a business where the business expects to benefit from that cost over a period of timebeyond the current year An example would be a prepaid subscription to a businessperiodical the cost of which will be recognized as an expense over the subscription period

Some items listed in the assets section of the balance sheet fall in both of the abovecategories A building represents tangible property owned by the business At the sametime, the cost of the building represents a type of prepaid or deferred expense that will

be recognized and deducted in computing net income over the life of the building through

a process called depreciation accounting (discussed in Chapter 7)

2 LIABILITIESLiabilities represent the obligations of a business to persons other than the owners ofthe business (although owners may also be creditors, particularly in the case of acorporation) Liabilities may be actual cash obligations payable at some time in thefuture, such as accounts payable, notes payable, bonds, and mortgages These liabilitiesmay be recognized by formal, written instruments such as

recognizing a contingent liability for possible future litigation claims).

3 OWNERS’ EQUITYOwners’ equity is the residual claim of the owners of the business on its assets afterrecognition of the liabilities of the business Owners’ equity represents the amountscontributed by the owners to the business, plus the accumulated income of the business

5since its formation, less any amounts that have been distributed to the owners

The manner in which owners’ equity is reported in the balance sheet depends on thelegal form of the business (sole proprietorship, partnership, corporation, etc.) Forcorporations, the accounts in owners’ equity typically include capital stock, representingthe par or stated value of stock that has been issued, additional paid-in-capital,representing the amount paid for stock in excess of its par or stated value, and retainedearnings, representing the cumulative or running balance of the net income of thebusiness less any distributions of dividends to the owners Certain specialized accountingprocedures may also require recognition of amounts that are treated as additions to, orsubtractions from, owners’ equity

4 THE BALANCE SHEET EQUATIONThere is a fundamental relationship that exists among the three components of thebalance sheet That relationship is expressed as follows:

Assets = Liabilities + Owners’ EquityThis is a very useful relationship to remember when trying to understand how atransaction will affect the financial statements If you know, for example, that atransaction will cause an asset to increase, then one or more of the following must alsooccur to maintain the balance sheet equation:

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another asset will be decreased, a liability will be increased, or owners’ equity will beincreased Thus, an increase in cash could result from the disposition of another assetsuch as the collection of a receivable, the creation of a liability such as a note payable to

a bank, or an increase in owners’ equity as the result of, for example, an additionalcontribution by the owners

5 BALANCE SHEET FORMATBalance sheets are typically prepared in a classified format like the one shown in Exhibit1.1 In a classified balance sheet, the assets are grouped in two categories The currentassets are listed first Current assets are those assets that will generally be converted

into cash or consumed by the business within the coming year They include cash,marketable securities, receivables, inventories, and prepaid expenses The long term ornoncurrent assets are shown next Long term assets include property, plant, andequipment, long term intangible assets such as patents, long term investments, andmiscellaneous deferred charges.

In the liabilities section of the balance sheet, current liabilities are generally shown first.Current liabilities are those liabilities that will be paid within the coming year.1 Theyinclude accounts payable,

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short term notes payable, accrued expenses, and the portion of long term debt that willmature in the next year The long term liabilities are listed next Long term liabilitiesinclude long term notes, bonds, and mortgages Preparation of the classified balancesheet facilitates financial analysis by segregating the short term or current assets andliabilities from the long term assets and liabilities As we will see, a number of frequentlyused financial analysis techniques involve computations that segregate the current andlong term assets and liabilities

B THE INCOME STATEMENT

The income statement, also called the statement of results of operations, sets forth theprimary components of net income or loss for the year It is a “flow statement” in that itreports the income for a period of time, typically one year, ending on the date of therelated balance sheet The primary components of the income statement are revenues,expenses, gains, and losses A sample income statement is shown in Exhibit 1.2

8Exhibit 1.2

(20,000) Compensation Expense

(30,000) Income Tax Expense

(10,000)

Net Income $ 15,000

1 REVENUES AND GAINSRevenues include the primary source of earnings of the business, such as the proceedsfrom sales of products for manufacturers or merchandising operations and the revenuesreceived for services rendered by service-type businesses Also included in revenues aremiscellaneous items such as dividends and interest from investments (of course, interestand dividends may be the primary source of income for financial companies) Althoughusage varies, the term “gains” is typically used to refer to the results of transactions thatoccur other than in the ordinary course of business Gains represent the amounts realized

on sales of assets in excess of the book value of the assets sold Book value refers to theamount at which the assets are carried in the financial records For example, if a machinehaving a

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book value of $30,000 is sold for $75,000, there is a gain of $45,000 These types ofgains may or may not be shown separately from the other revenues of the businessdepending on the amount and nature of the gains

2 EXPENSES AND LOSSESExpenses are the costs incurred and consumed by the business in generating therevenues of the business The principal expenses of most businesses include such items

as cost of goods sold, salaries and wages, depreciation (the cost of fixed assets likefurniture and fixtures treated as consumed in the current period), rent, interest, andincome taxes The term “losses” usually refers to losses from sales of property or otherevents (e.g., litigation or fires) not in the ordinary course of business

3 FORMAT OF THE INCOME STATEMENTThe revenues and gains for the year, less the expenses and other losses, equals the netincome or loss of the business for the year Most businesses simply show all the revenuesand gains as a single amount and then subtract all the expenses and losses grouped intoseveral major categories to compute the net income or loss for the year This is referred

to as the single step form of income statement Exhibit 1.2 is a single step incomestatement Some businesses calculate various subtotals before computing the final netincome or loss Thus, the income statement may first subtract costs of goods

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sold from sales and report the resulting amount of gross profit or gross margin Next,operating expenses are subtracted to produce a subtotal called operating margin, or netoperating margin Then, other revenues, gains, expenses, and losses are shown and thefinal net income or loss number is computed This is referred to as a multiple step income

statement For internal or management reporting purposes, there will be extensivelymore detailed categorization and breakdown of revenues and expenses The use of thesingle step or multiple step format is optional.

Certain unusual or nonrecurring amounts included in determining net income, ifmaterial, must be separately reported in the income statement The amounts that must

be shown separately are any “extraordinary gains or losses” and the operating resultsand gain or loss from certain discontinued operations A more detailed discussion of theseitems can be found in Chapter 17 If any of these items exist, the income statement willfirst show the net income or loss before these items The items included in net incomerequiring separate disclosure will next be separately stated reduced by any income taxeffect associated with these items (see Chapter 17 for how to determine the taxattributable to these items) Net income or loss will be computed as the total of all theseitems Additionally, certain items that were previously not included in determining netincome must now be reported on the income statement These items are referred to

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as items of “other comprehensive income” and include, for example, certain foreigncurrency translation amounts (see Chapter 19) and unrealized gains or losses onsecurities that are not held for sale (see Chapter 5) The income statement would thenend with an amount of comprehensive income that includes both net income and theother items of comprehensive income As discussed in Chapter 17, the items of othercomprehensive income can be reported prominently on another statement instead ofshowing them on the income statement

The income statement normally shows certain earnings per share calculations based onthe income for the year The earnings per share amount is frequently used by analysts inreviewing stock values of companies For companies with complicated capital structures,these earnings per share calculations can become quite complex Earnings per sharecalculations are discussed in greater detail in Chapter 16

C THE STATEMENT OF OWNERS’ EQUITY

The statement of owners’ equity summarizes the changes in the owners’ equityaccounts for the period covered by the income statement The beginning balance ofowners’ equity is set forth followed by any additional amounts invested by the owners,the net income or loss of the business for the period, and any distributions to the ownersthat reduce the owners’ equity As an alternative to reporting them

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on the income statement, components of “other comprehensive income” may also bereported on the statement of owners’ equity (see Chapter 17) These amounts are thentotaled to produce the ending balance of owners’ equity

D STATEMENT OF CASH FLOWS

The last major financial statement is a statement of cash flows that provides detailabout the changes in the business’ cash balance for the period covered by the incomestatement As will be discussed below, income does not equal cash A business can have

a strong earnings record and yet be suffering from a shortage of cash because all of theincome has not been converted into cash and because of the need to use the availablecash to replace assets or expand the business The statement of cash flows is designed togive additional information about the sources from which cash is derived and how thecash is used ASC 230 sets forth the rules for the preparation of statements of cash flows

The statement of cash flows is divided into three main parts The first section showscash flow from operating activities This includes the cash generated by the primaryincome producing activities of the business (cash received from the sale of products orservices less the cash paid out for ordinary expenses incurred in generating the sales aswell as interest and tax payments) plus interest and dividends received on miscellaneousinvestments

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In the section setting forth cash provided by operations, the statement of cash flowstypically starts with net income and makes two adjustments First, noncash expensessuch as depreciation expense are added back to income The depreciation deducted incomputing net income does not involve any current payment of cash It is simply anaccounting allocation Adding back the depreciation (and other similar noncash expensesand revenues) is necessary to convert net income to a cash flow figure

The second adjustment modifies income for changes in certain current assets andliabilities For example, net income includes all sales for the year But not all sales areimmediately collected in cash If the business extends credit to its customers, some saleswill be represented by accounts receivable (cash to be received in the future) If thebalance in accounts receivable has increased during the period covered by the financialstatements, this increase must be subtracted from net income to convert the salescomponent of net income to an amount reflecting the actual collections on account ofsales, which is the correct amount to include in the cash flow from operations Similaradjustments are made for changes in inventory, accounts payable, and other currentasset and liability accounts

The second section in the statement of cash flows is the cash flow from investingactivities This includes the cash flow from the purchase and sale of operating assets(buildings, machinery, patents,

14etc.) and the purchase and sale of investments (buying and selling stocks and bonds,making loans, and receiving repayment on loans)

The third section is the cash flow from financing activities This includes amountsreceived from issuing debt instruments or selling stock and amounts paid out to repayloans or repurchase stock It also includes amounts paid out as dividends on acorporation’s stock, but not the amount paid as interest on loans, which is included incomputing the cash flow from operating activities.

A simple form of cash flow statement is shown in Exhibit 1.3

Less: Changes in Net Current Assets

and Liabilities Resulting from

Total Cash Used in Investing

In addition, the footnotes set forth additional detail about certain components of thestatements and also set forth information that cannot be included on the face of thefinancial statements Examples include detailed discussions about a company’sobligations under long term leases, the company’s retirement plans, and contingentliabilities The footnotes

16should be carefully studied by anyone reviewing financial statements

2 SUPPLEMENTAL DISCLOSURESCertain supplemental disclosures are also made by the issuer For example, full financialstatements are typically provided for two or sometimes three years in order to permitanalysis of trends over time In addition to the full financial statements, an issuer willinclude a supplementary table that sets forth certain key items from the financialstatements for a longer period of five, ten, or twenty years

3 MANAGEMENT’S DISCUSSION AND ANALYSIS

At least for companies that are required to file financial statements with the Securitiesand Exchange Commission, another important part of the financial statements is a sectioncalled “Management’s Discussion and Analysis.” This provides management’s explanation

of operating and financing matters for the company as well as additional detailedfinancial figures This discussion is very useful in helping to understand the basic financialstatements and what they mean

4 AUDIT REPORTFinally, the audit report is a key element of audited financial statements When financialstatements are audited, an independent auditor must

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include with the financial statements a report or opinion This report does three things

It sets forth the scope of the audit work conducted and indicates whether there were anylimitations on the scope of the audit procedures performed by the auditor The report alsosets forth certain inherent limitations in any audit and puts the reader on notice that theexistence of an audit does not guarantee that the financial statements are accurate in allrespects The audit report then sets forth the auditor’s opinion about whether thefinancial statements are presented fairly in accordance with “generally acceptedaccounting principles.” To the extent that any problems were uncovered by the audit andwere not corrected by management, the report sets forth information about the itemsthat the auditor believes should be handled differently and, if possible, the effect that theitems have on the financial statements

In and around 2001, major accounting scandals came to light at a number of thebiggest companies resulting in massive losses to shareholders (including employeeshareholders) among others This triggered major changes in certain accountingprinciples that were felt to give management too much room to manipulate financialstatements and hide underlying problems in the financial condition of these companies Inaddition, the auditing function in the United States came under fire because of the failure

of the audit process to detect problems in the financial statements This resulted in thepassage of

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a new law called The Sarbanes–Oxley Act of 2002 This new law (often referenced bythe acronym “SOX”) incorporated a number of features intended to make the financialreporting process more reliable Included in the law were provisions that substantiallychanged the policing process over the audits of public companies as well as theresponsibility of senior management to make sure that financial statements fairly presentfinancial position Appendix A summarizes the key elements of SOX

_

1 For certain businesses that have an “operating cycle” longer than one year, thedistinction between current and noncurrent for purposes of a classified balance sheet isbased on the length of the operating cycle rather than one year So, if a business has anoperating cycle of fifteen months, a current liability would be one payable within fifteenmonths The operating cycle of a business is the time that it takes to complete all thesteps necessary to earn and collect income from the business’s operations (e.g for amanufacturing business, it would be the length of time from the acquisition of rawmaterials through the production process, the sale of the finished goods, and thecollection of the amounts due) See Chapter 5 for a more detailed discussion of currentassets and liabilities

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CHAPTER 2 THE ACCOUNTING PROCESS

Having described in Chapter 1 the end result of the financial accounting process, thebasic financial statements, Chapter 2 will now describe the accounting process itself.What follows is a summary of the major steps in the accounting process of a typicalbusiness This discussion will include the steps through which the underlying transactionalinformation is entered into the financial records and eventually makes its way to thefinancial statements This chapter will also discuss the concept of accrual accounting andthe special accounting entries and procedures required by accrual accounting

In reality, modern computerized accounting systems eliminate much of the paper-basedelements of the older accounting systems Further, many of the steps that will bedescribed below are not “visible” to the naked eye with the new systems However, thesemodern computerized accounting systems are all built on the same basic underlyingstructure that is described in this chapter

A SOURCE DOCUMENTS

The first step in the accounting process is the collection of the raw data reflecting thetransactions of the business and economic events affecting the business This raw datacomes in a variety of forms

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often evidenced by source documents Source documents are documents generatedeither externally or internally that provide information necessary to recording accountinginformation They may be byproducts of transactions or they may be specially created tofacilitate the accounting process

For example, a business will receive a number of checks as well as currency and coinrepresenting the proceeds from current or past sales At the end of the day, the checksand cash amounts are deposited in the bank In addition to the actual cash and checks,the business will typically receive “remittance advices” accompanying collections receivedthrough the mail (e.g., the copies of invoices or monthly statements mailed with thechecks) and will generate some type of cash register tape for sales made on thepremises The remittance advices, cash register tapes, and bank deposit slips allrepresent source documents that are used by the accounting department to record in thiscase information about sales and collections

Similarly, in the case of purchases, there will be purchase orders, receiving reports,invoices, and the check register that will provide information about purchases of materialsand supplies and the payment for such items Other types of transactions of a businesswill each have their own set of source documents

In double entry bookkeeping, every transaction recorded by the business involves one ormore “debit” entries and one or more “credit” entries The debit entries must alwaysequal the credit entries for each transaction recorded More will be said about debits andcredits below.

To illustrate a journal entry, assume that a business purchases land for a total purchaseprice of $100,000 with $25,000 being paid immediately in cash and $75,000 being paid bythe business issuing its note payable in that amount The journal entry for thistransaction would be as follows:

The references to “Land,” “Cash,” and “Notes Payable” are to different “accounts”maintained by the business A separate account is established for each principal asset,liability, and component of

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owners’ equity of the business Accounts also exist for the principal categories ofrevenues and expenses The journal entry thus identifies the accounts affected by atransaction and the dollar amounts to be entered in these accounts

Note that the debit items equal the credit items This must always be true Theconvention is that the debit entries are offset to the left of the credit entries in thejournal An actual journal entry would also have associated with it the date of the entryand in some cases, a description of the transaction that produced the entry In a similarmanner, all of the other transactions of the business and other events affecting theaccounting records would be recorded in the journal with the debits always equaling thecredits This format for journal entries will be used throughout this nutshell to illustrateaccounting for different events and transactions

A very small business might use one general journal to record all of its transactions Formost businesses, however, it is necessary to use a series of specialized journals each ofwhich records transactions of a similar nature that recur frequently Thus, a businessmight have a cash receipts journal, a cash payments journal, a sales journal, a purchases

journal, and a general journal (the general journal being used to record all of thetransactions that do not fit in any of the special journals) Although the actual format ofthe special journals varies from

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that of the general journal, the underlying concept of the journal entries remains thesame

C LEDGERS AND POSTING

Periodically, the transactions that have been recorded in the journals are “posted” tovarious ledger books A separate ledger page is maintained for each account that thebusiness has The ledger is used to consolidate all of the accounting entries that havebeen made in each of the accounts of the business Thus, the ledger for the cash accountincludes all the entries increasing or decreasing the cash account For illustrativepurposes, the separate ledgers for each account are frequently represented by “T-accounts.” The land purchase transaction recorded above would be posted to the ledger(as represented here by T-accounts) as follows:

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With the help of the T-accounts representing the ledger, we can now expand on theconcepts of debits and credits and explain the significance of posting the journal entry oneither the left or right hand side of the T-account (the left and right hand sides of the T-accounts represent two columns in the ledger—one for the debit entries and one for thecredit entries) The terms debit and credit are merely labels that are used in describingthe process of recording accounting transactions A debit entry is a left-side entry and acredit entry is a right-side entry In the journal entry for the land purchase, the debitentry is set off slightly to the left of the credit entry and the credit entry is similarly to theright of the debit entry In posting this journal entry to the ledger, the debit entry to theLand account for $100,000 has been posted to the left hand side of the Land T-account.The credit entries for Cash and Notes Payable have been posted to the right hand side ofthose T-accounts

By convention, debit or left-hand entries are used to show an increase in an assetaccount or a decrease in a liability or owners’ equity account The debit entry to Landmeans that the Land account has been increased, which would be the expected result of

a purchase of land Credit or right-hand entries are used to show a decrease in an assetaccount or an increase in a liability or owners’ equity account The credit entry to Cash,

an asset account, means that the Cash account has been decreased The credit entry toNotes Payable, a liability account,

25means that Notes Payable has been increased as result of the purchase of the land

In order to further the understanding of accounting entries and debits and credits, theaccounting entries for several common business transactions by a corporation (CompanyJ) follow:

Company J sells 10,000 shares of its common stock ($1 par value) for $50,000

Company J purchases inventory on open account credit for $20,000

be discussed below

Company J sells inventory that was originally purchased for $5,000 It is sold on openaccount for $8,000 Two entries are needed to record this transaction.

This debit entry increases accounts receivable, an asset The credit entry increases thesales revenue account, which also represents an increase in owners’ equity This entryillustrates a feature of “accrual accounting.” In accrual accounting, revenues are recordedwhen they are earned and expenses are recorded when they are incurred without regard

to whether any present cash receipt or payment is occurring

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As will be discussed below, GAAP requires the use of accrual accounting

The second entry related to the sale is as follows:

The credit decreases the inventory asset account and the debit increases the expenseaccount called cost of goods sold The increase in cost of goods sold is also a decrease inowners’ equity that offsets the increase in owners’ equity resulting from the revenue onthe sale transaction (i.e., the profit on the sale is the difference between the salesrevenue and the cost of the goods sold)

Company J pays a portion of its accounts payables

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made directly into a computerized accounting database one time If the business needs

a chronological listing of transactions similar to a journal, the computer can prepare areport providing such information If a listing of all transactions affecting an account, i.e.,

a ledger report, is needed, the computer prepares such a report Nevertheless, the basicconcepts underlying the development of the database for the accounting information and

the process that the computer uses to prepare various reports is essentially the same asthe concepts underlying the manual accounting procedures described above andillustrated in later chapters of this book.

D ADJUSTING ENTRIES

The accounting entries that are illustrated above are all triggered by some type oftransaction or event usually involving a third party In addition to these types oftransactions, there are also a number of entries in the books that must be made without

an external transaction to trigger the recording process These types of entries are calledadjusting entries Adjusting entries are usually made at the end of the period for whichfinancial statements will be prepared The adjusting entries are required because withoutthem, the balances in a number of accounts would not show the correct amounts at theend of the reporting period There are several classes of adjusting entries that sharesimilar characteristics

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1 ACCRUED REVENUES AND EXPENSESOne type of adjusting entry results from the need to “accrue” certain revenues andexpenses in order to compute net income of a business on the accrual basis The accrualmethod, as distinguished from the cash receipts and disbursements method ofaccounting, reports revenues when they are earned even though no cash may have beenreceived and reports expenses when they have been incurred even though no payment ofcash has been made in connection with such expenses The recording of the salesrevenue and the related accounts receivable illustrated in section C above is oneexample of the use of accrual accounting Revenue is recognized when a sale is made,not when the cash is collected

“Accrued revenues and expenses” are examples of the use of the accrual method ofaccounting that also necessitate adjusting entries The accrual of a revenue or expense atthe end of an accounting period is the recognition of a revenue or expense even thoughthere has been no receipt or payment and no prior recording of the transaction Therecognition of sales revenue and a related receivable (asset) at the time of a sale is anaccrual of revenue that is recorded during the accounting period at the time of atransaction However, the use of the term accrual is usually applied to revenues andexpenses that are not normally recognized in the financial books until the end of theaccounting period

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a Accrued Revenues

To illustrate the accrual of revenue, assume that Company J holds a $50,000 notereceivable (an asset) bearing interest at a rate of ten per cent per annum payable

annually The note is dated July 1, 201x, and interest is payable on each July 1 during theterm of the note The business maintains its books on a calendar year basis At December

31, 201x, no interest has been received on the note However, as of that date, Company

J has earned interest of approximately $2,500, one half of the $5,000 interest paymentthat will be made on July 1 of the following year Therefore, Company J will “accrue”

$2,500 of interest revenue on December 31, 201x, to reflect the revenue that has beenearned but not yet received This interest revenue is accrued revenue The adjustingentry that would be made on December 31, 201x, would be as follows:

Accrued Interest Receivable $2,500

This entry “adjusts” the financial records to recognize the accrued interest revenue andcreate a corresponding asset Similar accruals of revenue may be necessary for suchthings as rent and other types of revenue that are earned with the passage of time

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b Accrued Expenses

Certain expenses are incurred with the passage of time even though such expenseshave not yet been paid These expenses must be recognized as they are incurred Therecognition of these expenses that have been incurred but not yet paid involves theaccrual of the expense and typically the creation of a related liability

Assume that a business pays its employees every other Friday On December 31, 201x,the employees have worked one of the two weeks in their current payroll period If thetotal payroll that will be paid on the next payday is $25,000, then the business shouldaccrue compensation expense on December 31 in the amount of $12,500 That is, thebusiness should recognize the compensation expense that has been earned by itsemployees on December 31 even though that compensation is not payable until the nextFriday (Note that payroll taxes and similar items related to payroll would be accrued aswell but this illustration will be limited to the basic payroll.) The necessary adjustingentry to record the accrued compensation would be as follows:

accrue over time and income taxes that must be accrued as of year-end even though theyare not payable for several months), and estimated liabilities (for example, the estimatedexposure on outstanding warranties of businesses that extend warranties in connectionwith the sale of products).

c Accounting for Actual Receipt of Payment

The adjusting entries that are illustrated above must be kept in mind when the actualreceipt of cash or payment of cash later occurs in order to avoid misstating the relevantrevenues or expenses For example, when the interest payment on the note receivablediscussed above is received, the full $5,000 will not be reported as revenue Rather, theentry to record the receipt of the interest would be as follows (assuming no furtheraccrual of interest revenue on the note has occurred during the current year):

d Reversing Entries

In actual practice, many businesses employ an additional procedure known as a

“reversing entry” to simplify the accounting for an actual cash receipt or payment after anadjusting entry has been made to accrue revenue or expense This process makes itmuch simpler for the appropriate accounting personnel who handle the routinetransaction recording to ignore the adjusting entry process To illustrate, assume that thebooks for 201x have been closed (a process that will be described below) and it is nowthe first day of business in the following year For many of the adjusting entries that weremade at the end of 201x, “reversing entries” will be made to

34eliminate the accrued revenue or expense and the related asset or liability.

Thus, for the interest revenue that was accrued in 201x, a reversing entry would berecorded in the next year as follows:

This eliminates the interest receivable (asset) account Immediately after this entry,interest revenue for the new year will actually show a negative (debit) balance of $2,500.When the interest payment is actually received on July 1, the appropriate accountingclerk can record the normal entry for receipt of interest as follows:

When the $5,000 credit entry is made to the interest revenue account, the balance inthe account immediately following the cash receipt will be $2,500, the $5,000 credit lessthe $2,500 that was debited to the account in the reversing entry process A similarprocedure could be followed for the accrual of compensation expense and for otheraccrued revenues and expenses

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2 DEFERRED REVENUES AND EXPENSESAnother type of adjusting entry involves the opposite of the accrual of revenue orexpense These entries create deferred revenues and expenses In some situations, cash

is paid before an expense has been incurred or cash is received before revenue has beenearned This results in prepaid (deferred) revenue or expense and usually necessitates anentry to defer the recognition of the revenue or expense to some point in time later thanthe receipt or payment of cash

a Deferred Revenues

To illustrate deferred revenue, assume that a business receives, on December 1, 201x,

a semi-annual rent payment of $30,000 giving the payor the right to use the rentedproperty for the period from December 1, 201x, through May 31 of the following year Onthe date of receipt, none of the rental revenue associated with the $30,000 payment hasbeen earned, it is prepaid rent There are two approaches for dealing with this prepaidrent

Under one approach, the following entry would be made at the time of receipt of the

$30,000 payment: