meganmail@gmail.

com Final Review 4/22 8am Final Exam 5/9 1:30pm

I. Financial Statements

A. General

1. Who Uses Financial Statements

a) External Decision Makers:

(1) Investors – look for stock appreciation and/or dividends

(2) Creditors – looking for creditworthiness of the company, whether they will be
able to pay interest and repay the principal.

b) Internal Decision Makers:

(1) Managers – look to see if projecting are followed

(2) Managers use Financial Statements as a measure of company’s

performance (often bonuses based on performance)

(a) Basically looked at for guidance in making decisions.

(3) Marketing and Credit managers use customer’s financial statement to decide
whether to extend credit.

(4) Purchasing managers use supplier’s Financial Statements to decide whether

suppliers have the resources to meet the demand for products.

(5) Employees’ union and human resources managers use Financial Statements
as a basis for contract negotiation (pay rates)

c) When Financial Statements are missing

(1) anytime a company does not provide the lawyer with all the financial
statements, the lawyer should begin to start asking probing questions
because missing financial statements may indicate a desire to hid
disappointing results or perhaps the business lacks sufficiently complete or
reliable books and records.

B. Balance Sheet—*problem on pg 87.*

1. Assets

a) The assets of a business shown on the balance sheet are of two basic types.

(1) Tangible or Intangible property interest or legal right of the business, (What
you own)

(a) Examples: cash; receivables, whether represented by formal notes or

not; inventories; land; buildings; equipment; patents, trademarks, and
copyrights; accumulated depreciation

(b) Current Asset—Used within a year

i) cash, short term investment, accounts receivable, notes receivable,

inventory, supplies, prepaid expenses

(c) Longterm Asset

i) longterm investment, equipment, buildings, land, intangibles

(d) Fixed Asset

i) property, plant, and equipment

(e) Accumulated Depreciation

i) Contra Asset account – displayed as an offset to asset accounts, as

opposed to being separately stated as accounts themselves

(2) 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 time
beyond the current year.

(a) Example: a prepaid subscription to a business periodical the cost of

which will be recognized as an expense over the subscription period.

(3) Some items listed in the assets section of the balance sheet fall in both
categories.
(a) Example: A building represents tangible property owned by the business.
At the same time, 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

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accounting

b) Liabilities

(1) Liabilities represent the obligations of a business to persons other than the
owners of the business.

(2) Liabilities may be actual cash obligations payable at some time in the future,

(a) Examples: accounts payable, notes payable, dividends, bonds, and

mortgages. These liabilities may be recognized by formal, written
instruments such as promissory notes or they may be based on oral
agreements or other informal understandings.

(3) Current Liabilities

(a) accounts payable, accrued expenses, taxes payable

(4) Longterm Liabilities

(a) Any debt longer than 12 months (stuff you don’t have to pay until the
future)—i.e. bonds payable, notes payable.

(5) Some liabilities represent prepaid revenues (also called deferred income or
deferred revenue). This type of liability arises where money has been
collected in advance of rendering a service or delivering goods.

(a) Until that revenue is “earned” and included in the computation of

income or loss for the period, the amount collected is shown as a liability.

(6) Accrued liabilities are created when a business recognizes currently an

expense even though there may be no present legal obligation to pay the
item as of the balance sheet date.

(a) Example: the recognition of the salaries and wages earned by employees
through a balance sheet date that falls in the middle of a payroll period.

c) Owners’ Equity

(1) Owners’ equity is the residual claim of the owners of the business on its
assets after recognition of the liabilities of the business.

(2) Owners’ equity represents the amounts contributed by the owners to the
business, plus the accumulated income of the business since its formation,
less any amounts that have been distributed to the owners.

(3) contribution capital is NEVER included into revenue (always contributed

capital!)

(4) Equation

(a) OE= Assets- Liabilities

(5) Retained Earnings

(a) Includes ALL the net income from year to year (at the end of the balance
sheet, all added up)
(b) Formula: Beginning Retained Earnings + Net Income/or loss – Dividends
Paid = Ending Retained Earnings

(6) Examples of Owners’ Equity

(a) common stock, retained earnings, additional paid in capital,

d) Balance Sheet Equation

(1) Assets = Liabilities + Owners’ Equity

2. T Account

a) Left side (Debit)/Right side (credit)

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b) Asset Side

(1) If you have an increase in assets, you will have a decrease in credit.

(2) If you have a decrease in assets, you will decrease your credit.

c) Liabilities Side

(1) If you have increase in liabilities or OE, it will be a credit.

(2) But if you have a decrease in liabilities or OE, then it will be a debit.

d) Example Problem 2A (pg 40)

Jack & Jill formed J&J Corp, operating bike repair shop, biz began 7/1 and the following
transactions occurred in July. Prepare journal entries, T-Accounts, and balance sheet as of 7/31
for J&J:
(1) (a) Jack pays $5K to J&J in exchange for stock. (b) Jill transfers land to J&J,
$5K value for stock.
(a) Cash (A +) $5000
OE (OE +) $5000
(b) Land (A +) $5000
OE (OE +) $5000
(2) J&J buys tools/supplies for $1200 charging purchase to its account.
A/P (L +) $1200
**Note: tent would be on balance sheet, but little supplies (pens) could be written off as
an exp.
(3) J&J orders $5K in equipment, terms allow order to be cancelled until time of
delivery (next spring)
**NO entry NO accounting b/c they can still cancel the order
(4) J&J borrows $6K from bank, 1yr note @ 10% interest.
Money (A +) $6K
Note Payable (L+) $6K
(5) Equipment delivered and J&J pays for it.
Equipment (A +) $5000
OE (OE -) $5000
(6) J& pays ABC $400 on its account.
DR A/P (L -) $400
CR Cash (A -) $400
(7) J&J sells one of its repair stands for $500, what J&J paid for it, Sam gives
J&J a note payable in 30 days.
A/R (A +) $500
Stand (A -) $500

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C. !

1.

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2.

3.

4.

D. Income Statement

1. Generally

a) The income statement sets forth the primary components of net income or loss
for the year.

b) It is a “flow statement” in that it reports the income for a period of time, typically
one year

c) The primary components of the income statement are revenues, expenses,

gains, and losses.

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d) Net income/loss is reported on balance sheet in OE section in the retained

earnings.

e)

f)
2. Revenues and Gains

a) Revenues include the primary source of earnings of the business, such as the
proceeds from sales of products for manufacturers or merchandising
operations and the revenues received for services rendered by service-type
businesses.

(1) Miscellaneous items such as dividends and interest from investments

(2) decrease in liabilities is a revenue**not sure
b) Gains is typically used to refer to the results of transactions that occur other
than in the ordinary course of business.

(1) Gains represent the amounts realized on sales of assets in excess of the
book value of the assets sold. Book value = basis

(2) For example, if a machine having a book value of $30,000 is sold for
$75,000, there is a gain of $45,000.

3. Expenses and Losses

a) Expenses are the costs incurred and consumed by the business in generating
the revenues of the business.

(1) The principal expenses of most businesses include such items as:

(a) cost of goods sold; salaries and wages; depreciation; rent; advertising;
insurance; repair expense; interest, and income taxes.

(b) increase in liabilities is an expense**not sure

(2) Depreciation Must use Matching Concept

(a) costs producing the components, including wear and tear on machine,
are matched against revenues produced by selling them

(b) example: company buys machine to make component – estimates will

produce 1,000 in life. If company produces 100 during first year,
machine cost allocable to the 100 components the company sold has
expired and account would record and match the potion of the
machine’s cost associated with the 100 to the revenue produced from
the 100.

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b) The term “losses” usually refers to losses from sales of property or other events
( e.g., litigation or fires) not in the ordinary course of business.

4. Net Income

a) The revenues and gains for the year, less the expenses and other losses, equals
the net income or loss of the business for the year.

b) Certain unusual or nonrecurring amounts included in determining net income, if

material, must be separately reported in the income statement.

(1) The amounts that must be shown separately are any “extraordinary gains or
losses” and the operating results and gain or loss from certain discontinued
operations.

(2) If any of these items exist, the income statement will first show the net
income or loss before these items.

(3) The items included in net income requiring separate disclosure will next be
separately stated reduced by any income tax effect associated with these
items

(4) Net income or loss will be computed as the total of all these items.

c) Additionally, certain items that were previously not included in determining net
income must now be reported on the income statement.

(1) These items are referred to as items of “other comprehensive income”

(2) The income statement would then end with an amount of comprehensive
income that includes both net income and the other items of comprehensive
income.

d) The income statement normally shows certain earnings per share calculations
based on the income for the year.

(1) The earnings per share amount is frequently used by analysts in reviewing
stock values of companies.

(2) Basic Earnings Per Share

(a) Will always be HIGHER than diluted earnings per share (doesn’t account
for everything, such as stock options)

(3) Diluted Earnings Per Share

(a) Worst case scenario, if all convertible stock were converted and all stock
option exercised (b/c these things dilute the earnings per share).

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5. Retained Earnings

a) Includes ALL the net income from year to year (at the end of the balance sheet,
all added up)
b) Formula: Beginning Retained Earnings + Net Income – Dividends Paid = Ending
Retained Earnings

c) Net income from the income statement results in an increase in ending retained
earnings on the statement of retained earnings.

d) Ending retained earnings (from statement of retained earnings) is one of the 2

components of stockholders’ equity on the balance sheet.

e)

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(1)

6. Accounting Methods

a) Cash Basis Accounting

(1) revenue recorded when cash received, expenses recorded when cash paid.

(2) CANNOT be used with publicly traded companies

b) Accrual Accounting—**problem on page 87**

(1) assets, liabilities, revenues and expenses recognized when the transaction
has accrued, NOT necessarily when cash is paid or received.

(2) Good for professionals. If you send bill to client and client doesn’t pay, you
can book the income, but then you can get a deduction for bad debt.

(a) If you were on cash basis, then you CANNOT book this income, so if
your client ultimately doesn’t pay, then you CANNOT get a deduction

c) Accrual v Deferral

(1) Accrual: Some events should be realized during a current period even
though the payment in respect of that even will not be paid or received until
some future period.

(a) Ex: buying on credit, payment plans for services rendered up front, etc

(2) Deferral: Some events should not be realized until some later period even
though the payment for that has been received already

(a) Ex: pre-payment for services/goods, retainer fee

(3)
d) Revenue Principal – company recognizes revenues when:

(1) Delivery has occurred or service rendered

(2) There is persuasive evidence of an arrangement for customer payment

(3) Price is fixed or determinable

(4) Collection is reasonably assured

E. Statement of Changes in Owners’ Equity—aka statement of retained earnings

1. General

a) The statement of owners’ equity summarizes the changes in the owners’ equity
accounts for the period covered by the income statement (typically 1 year).

b) Represents owner’s or shareholder’s interest in the company and reflects

contribution of capital by shareholders.

c) Shareholder’s equity increases when the enterprise succeeds, and shrinks, or

may disappear entirely when the business struggles.

d) The beginning balance of owners’ equity is set forth followed by:

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(1) any additional amounts invested by the owners,

(2) the net income or loss of the business for the period, and

(3) any distributions to the owners that reduce the owners’ equity.

e) As an alternative to reporting them on the income statement, components of

“other comprehensive income” may also be reported on the statement of
owners’ equity. These amounts are then totaled to produce the ending balance
of owners’ equity.

2. T Account

a) On the t account, Owners’ Equity is always on the liability side (right side)

3. Equation

a) Contribution of capital + accumulated net earnings – dividends paid to owners =

reinvestment into the biz
b) Basically tracks contribution of capital, accumulated earnings, and dividend
paid out.
F. Statement of Cash Flows

1. General

a) Provides detail about the changes in the business’ cash balance for the period
covered by the income statement—Shows companies inflows and outflows of
cash during period which shows the company’s ability to generate cash

b) Tells you whether company has enough cash to pay its short term obligations
(suppliers)

c) Banks and lenders look at cash flow (sometimes investors too)

(1) Looks at actual Cash and actual Expenses (not A/Rs, etc)

d) Income does not equal cash

(1) A business can have a strong earnings record and yet be suffering from a
shortage of cash because all of the income has not been converted into
cash and because of the need to use the available cash to replace assets or
expand the business.

2. 3 main parts of the Statement of Cash Flows

a) Operating Activities

(1) The first section shows cash flow from operating activities. This includes the
cash generated by the primary income producing activities of the
business (cash received from the sale of products or services less the cash
paid out for ordinary expenses incurred in generating the sales as well as
interest and tax payments) plus interest and dividends received on
miscellaneous investments.

(2) In this section, the statement of cash flows typically starts with net income
and makes two adjustments.

(a) First, noncash expenses such as depreciation expense are added back
to income. The depreciation deducted in computing net income does not
involve any current payment of cash. It is simply an accounting
allocation.

(b) The second adjustment modifies income for changes in certain current
assets and liabilities. For example, net income includes all sales for the
year. But not all sales are immediately collected in cash. If the business
extends credit to its customers, some sales will be represented by
accounts receivable (cash to be received in the future). If the balance in
accounts receivable has increased during the period covered by the
financial statements, this increase must be subtracted from net income
to convert the sales component of net income to an amount reflecting
the actual collections on account of sales, which is the correct amount to
include in the cash flow from operations.

b) Investing Activities

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(1) This includes the cash flow from the purchase and sale of operating assets
(buildings, machinery, patents, etc.) and the purchase and sale of
investments (buying and selling stocks and bonds, making loans, and
receiving repayment on loans).

c) Financial Activities

(1) This includes amounts received from issuing debt instruments or selling
stock and amounts paid out to repay loans or repurchase stock.

(2) It also includes amounts paid out as dividends on a corporation’s stock, but
not the amount paid as interest on loans, which is included in computing the
cash flow from operating activities.

3. Direct vs. Indirect Method

a) Direct Method

(1) reports cash effects of each operating activity

b) Indirect Method

(1) starts with accrual net income on Income Statement and converts to cash
basis.

(2) Most companies use the indirect method (like Costco)

(3) It’s almost backwards as they adjust expenses that don’t reflect cash

(4) Remember Matching Principal (must match revenue with expense)

(a) So if you depreciate equipment over 5yrs, you need to match expected
revenues you’ll receive from the machine over those 5yrs.

4. Relationship Among the Statements

a) The change in cash on the statement of cash flow is added to the beginning of
the year balance in cash to arrive at end of year cash on the balance sheet.

b) !

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II. GAAP

A. General

1. There are areas where the requirement to follow certain GAAP rules varies
depending on whether the reporting entity in question is a “public business entity.”

a) Generally, a public business entity is one that is subject to filing requirements of

the Securities and Exchange Commission (or voluntarily files its financial
statements with the SEC). It also includes companies that have securities
traded, listed, or quoted on an exchange or over the counter market.

b) Not for profit entities and employee benefit plans are not “business entities” for
this purpose.

c) A “private company” is an entity other than a public business entity, a not for
profit entity or an employee benefit plan.

2. Qualities of GAAP

a) Primary Qualities of Accounting Information: Relevance and Reliability

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(1) Relevance: Accounting info is capable of making a difference to the users of

the info – must be timely and provide info before it loses its capacity
influence decisions – (1) make predictions on future events and (2) assess
current conditions) or has (3) feedback value to evaluate past decisions

(2) Reliability: Three qualities – (1) neutrality, (2) verifiability and (3) validity

b) Secondary Qualities of Accounting Information:

(1) Comparability: Enable users to compare the economic traits of one company
to another

(2) Consistency: Accountants used the same procedures from one period to the
next rather than from one company to the next

B. Standard for Accountants

1. PCAOB: FASB originally made all the rules, but was replaced by the Sarbane Oxley
Act of 2002, and now they’re replaced by Public Accounting Oversight Board
(PCAOB)
2. PCAOB is funded by the company issuing the stock, but the committee is
comprised of independent disinterested members.

3. SEC are the enforcers for all financial institutions.

a) They oversee all the financial statements the companies disclose.

b) SEC reviews financial statements, investigate them, and try them.

c) Securities Act of 1993 – regulates NEW issue of stock

d) Securities and Exchange Act of 1934 – regulates disclosure once these shares
are publically traded.

e) These Acts prohibit MATERIAL misrepresentation or omission in documents that

are prepared for the public.

(1) Note: this applies to inside counsel, you should know what your
accountants are doing.

4. American Institute of CPAs (AICPA)

a) This is like the ABA for lawyers, it’s an advocacy group that promotes uniform
licensing (deciding how you can become a CPA and enforces CPA conduct).

5. GAAP (Generally Accepted Accounting Principles)

a) These principles MUST be followed by anyone who prepares financial
statements (rules and conventions accountings/management have to obey by
when preparing statements).

b) Provides standards of practice and standard of professional conduct of CPAs.

C. Environmental Assumptions

1. General

a) Accounts make several assumptions concerning the financial environment

2. Periodic Reporting Assumption: Report info in discrete periods of time – daily,

yearly, etc.

3. Unit of Measurement Assumption: Report info in terms of its value US Currency

4. Going Concern Assumption: Assume that unless there is reason to believe that a
business will be liquidated that it will continue indefinitely into the future

5. Separate Entity Assumption: assume that each economic entity is separate and
distinct unit

a) Consolidated Companies: accountants consolidate financial statements of

different corporations when the corporations are part of a single economic entity

6. Conservatism Assumption: Conservative basis to state information

a) Rationale: assumption that investors and lenders who use financial statements
should not be misled about vitality of the entity

b) Example – companies traditionally expense the costs of organizing a business

as quickly as possible rather than recording the costs of on the balance sheet as
an asset

7. Implementation Principles: Cost Principles and Realization Principles

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a) Cost Principle: Initially record assets at their initial cost (e.g. company makes
purchase cost reflects the true value of asset; cash – record asset received as
the amount of money paid for it and noncash – record the asset acquired by the
value of either the asset given up or asset acquired)
(1) Example – ABC buys van for $24,000 – accountant records van at its
$24,000 cost
(2) Trades van for used jeep – record cost of jeep as either value of jeep or value
of van – whichever is more easily ascertainable
b) Realization Principle: Specific criteria as guide when deciding when to record
revenue
(1) Reasonable Assurance of Collect: do not record revenue until reasonably
assured of collecting on sale
(2) Substantial Completion: do not record until seller has performed most of its
obligations
c) Matching Principle: Record expenses at same time as they record the revenues
the expenses helped produce
(1) Record from a sale revenues, also record the expenses that were made in
completing the sale
(2) Example – ABS sells inventory item for $10, records expenses related to the
same (e.g. costs of making the item) at same time

D. Definition of Accounting Terms

3 1. Accounting Entity: Either the unit for which the accounting is done (e.g. partnership
Requirements or corporation)

for Asset
2. Economic Events: Financial events or transactions the accountant reports in
1) Control
monetary terms (e.g. sale)

2) Future 3. Assets: Resources that have probable future economic benefits; assets must: **3
benefit
Requirements for Asset**

3) Transactio a) Have probable future economic benefits

n for b) Be under the control of the company
Measure c) Are the result of past transactions (and not just anticipated)—transaction for
ment
measurement

4. Liabilities: Probable future sacrifices of economic benefits; creditors’ claims against

the company; to be classified:

3 a) Requires the company to transfer an asset

Requirements b) Known to whom the asset must be transferred and

for Liabilities
c) The result of past transactions

1) Involve a 5. Equity: Residual interest in the assets of a business minus the liabilities consisting
present of business owner’s interest in the company

duty
a) Sometimes called stockholder’s equity, net assets, net worth or net book value

2) Obligates b) Value of Assets – liabilities = equity

the entity
c) Value of assets in financial statements is based on original cost and not their
3) Transactio current value – so equity is portrayed in financial statements is not at all
n for necessarily the fair market value of the business because of the distortions

Measure 6. Revenues: inflows of assets or reductions of liabilities during a particular

ment accounting period if they arise in the ordinary course of business

a) Example – fees earned by a law firm BUT not sales of desks at the law firm

b) Arise from: (1) primary earnings activity of the company and not from incidental
or unrelated investment transactions and are (2) recurring and continuous

7. Expenses: Outflows of assets or creations of liabilities in the ordinary course of

business (e.g. salary law firm pays an associate)

8. Gains: Increases in equity from peripheral or incidental transactions – do not result

from the operations of business (e.g. law firm selling desk)

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9. Losses: decreases of equity from peripheral transactions

10. Capital Contributions and Distributions:

a) Contributions: Increases in equity from asset contributions or liability reductions
by the owners of a company (e.g. if an investor buys stock of ABC from
company itself)

b) Distributions: opposite – decreases in equity (e.g. law firm distributing its profits
to its partners and a corporation paying dividends to shareholders)

11. Account: Place where accountant store economic data – similar to checking
accounts

a) Used for all categories of assets, liabilities, equity, revenues, expenses, gains
and losses

b) Example – corporation stores aggregate amount of cash its own in its cash
account and total dollar value of machinery it owns in machinery account

12. Debit and Credit:

a) Debit: entries to the left side of the ledger – increases asset, expense and loss
accounts AND decreases liability, equity, revenue and gain accounts

b) Credit: entries to ride side of ledger - decreases asset, expense and loss
accounts AND increases liability, equity, revenue and gain accounts

c) Example

Date Account Ref. Debit Credit

1/1/10 Note Payable: Stanley 100.00

Cash 100.00

(To record payment of the note)

E. Basic Accounting Equation

1. 2 Options

a) Assets = Liabilities + Owner Equity; or

b) Assets - Liabilities = Owner Equity

2. Theory: An asset is always claimed by either the corporation’s owners or the

creditors of the corporation

a) Example – corporation has $300,000 assets and liabilities of $240,000 – has

owner’s equity of $60,000 so if it dissolved, the first $240,000 would go to the
creditors and the remainder would belong to the owners of the corp.

3. Double Entry Accounting: based on premise that accountants must record every
transaction that occurs with at least two components so that assets minus liabilities
always equal equity and debit always equals credit (debit one, credit another)

4. Accounting Period: Time on which the accountant reports – usually one year

5. Financial Statements: information reported – standardized by AICPA

a) Balance Sheet: listing all asset, liability and equity accounts of a business on a
particular date
b) Income Statement: financial statement showing company’s income (revenues,
expenses, gains and losses) for the counting period – reports amount of activities
achieved over a discrete period of time

c) Statement of Cash Flows: shows companies inflows and outflows of cash during
period

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d) Statement of Retained Earnings: details changes in company’s retained earnings

account during accounting period

F. Footnotes

1. General

a) Financial statements include a number of footnotes. One critical footnote

describes the significant accounting policies adopted by the issuer of the
financial statements.

(1) Sometimes there are many areas where alternative accounting treatments are
available for material items included in the financial statements.

b) The footnote on accounting policies alerts the readers to which of the alternative
accounting procedures have been adopted by the issuer in question.

c) The footnotes set forth additional detail about certain components of the
statements and also set forth information that cannot be included on the face of
the financial statements.

(1) Examples include detailed discussions about a company’s obligations under

long-term leases, the company’s retirement plans, and contingent liabilities.
The footnotes should be carefully studied by anyone reviewing financial
statements.

d) The notes sometimes explain why management chose a particular accounting

principle from among the acceptable alternatives. The notes help a reader assess
how the applicable accounting principles and policies affected the numbers in
the financial statements.

III. Auditing

A. General

1. All publically traded companies have to be audited by one of the big 4 firms.

2. Auditors MUST be independent – must NOT have ties to that particular company &
must be a member of one of the big 4.

3. Financial Statements are prepared by the Management.

a) Includes: Balance Sheet, Statement of Cash Flow, Statement of

Shareholder’s Equity, and Statement of Income.

b) Auditors come in and review the financial statement then issue an Opinion of the
statement.

c) If auditors did NOT get all 4 of the statements above, then they CANNNOT issue
an Opinion.

B. Introduction to GAAS

1. Types of Opinions:

a) Unqualified Opinion: must be able to state that the FSs have been prepared in
accordance with GAAP and the principle of consistency has been adhered to –

(1) Used if no restrictions on auditor’s exam and no material deficiencies in FSs

b) Subject to Opinion: If cannot render an unqualified opinion due to the fact that
the outcome of some material unresolved matter is dependent on future
developments outside management’s control (e.g. pending lawsuit for account
receivable)

c) Except for opinion: qualified opinion saying not in agreement with one or more of
the accounting principles used or the scope was too limited

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(1) Used only if deficiencies in principles or audit was material enough to require
mentioning but not of such magnitude to require a disclaimer or adverse
opinion

d) Disclaimer of Opinion: issued when has great uncertainty about FSs, scope was
severely limited or company’s records are so inadequate that cannot render an
opinion on the fairness of the statement

e) Adverse Opinion: FSs do not present fairly the position of the company – must
be convinced did not follow GAAP or company was inconsistent in treated
specific items

IV. Financial Statement Analysis

A. General

1. Footnotes

a) Look in the footnote section on page 17

2. Request financial statements for more than one accounting period

3. Look for the report from the independent accountant or auditor

a) best report to prefer is an unqualified audit opinion

b) you should look out for any material weaknesses in internal control over financial
reporting that either management or the independent auditor have identified.

B. Annual Reports

1. General

a) Annual reports summarize an enterprise’s financial and operational activities for

the most recent calendar or other fiscal year.

b) SEC regulations require registrants to include the following in their annual report:

(1) audited financial statements

(2) quarterly financial data

(3) historical summary of selected financial data for the most recent 5 yrs or the
registrant’s life if < 5

(4) description of the business

(5) business segment info (if applicable)

(6) info about executive officers and directors

(7) historical data about the market prices

(8) management’s discussion and analysis of co’s financial condition

c) Required Disclosures

(1) Business Profile: contains mission stmt

(2) Financial Highlights: quantitative info on sales and revenues, income or loss
per ownership unit, balance sheet items, financial ratios.

(a) presented in the light most favorable to co condition

(b) nonrecurring or unusual items may have caused fluctuations that will not
be reflected here.

(3) Letter to the Owners: chair or BOD write letter to SH

(4) Operational Overview: summarizes the co’s normal business fxns → co’s
products, markets and key financial data

(5) Historical Summary of Financial Data: 5 yrs

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(6) Management’s Analysis: management’s predictions regarding the results of

operations, capital resources, and liquidity

(7) Management’s Report: says that management assumes responsibility for

(a) preparation, fairness and integrity of co’s financial statements

(b) the maintenance of a system of internal controls

(c) establishment of an independent audit committee to oversee

C. Analytical Techniques

1. General

a) The most common procedures that accountants and financial analysts use to
evaluate an enterprise’s financial statements include:

(1) trend analysis,

(2) common-sized analysis and

(3) financial ratios.

2. Trend Analysis

a) involves comparing financial statements for an enterprise overs several periods

3. Common Sized Analysis

a) consists of reducing a financial statement to a series of percentages of a given

base amount, such as net sales or total cash flow for the period.

(1) ex: you find the percentages of net sales, and compare that to prior years, or
comparable companies

4. Financial Ratios

a) asses the financial health of an enterprise. Financial Ratios fall into 4 groupings:

(1) liquidity ratios

(a) provide info on company’s ability to cover its anticipated operating

expenses and meet short term debt obligations

(2) leverage or coverage ratios

(a) provide info on co’s ability to cover its anticipated operating expenses
(like payroll) and meet debt obligations in short and long term.

i) coverage ratios: also measure the relative claims that creditors and
owners hold on the company’s assets

(3) profitability ratios

(a) assess how effectively the business operates

(4) activity ratios

(a) provide info about how effectively using its assets

b) Lawyers use financial ratios in contracts and loan agreements and to evaluate
business transactions

5. Analytical Terms and Ratios

a) Working Capital

(1) Current Ratio: The excess of current assets over current liabilities. The more
working capital you have, the better.

(2) If the current liabilities exceed its current assets, the firm shows a negative
working capital

b) Financial Ratios

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(1) Liquidity Ratios

(a) help an accountant evaluate a business’s ability to pay its short-term

obligations.

(b) The most commonly used liquidity ratios include the current ratio and
the acid test
(c) Current ratio: a current ratio of <1 may suggest a problem, 2 or abv
suggest satisfactory liquidity. Too high may also suggest a problem that
business is not replacing long-lived assets.

i) Equation: current assets / current liabilities

ii) e.g. 25000000 (current assets) / 20000000 (current liabilities = 1.25

iii) e.g. 10,000,000 (current assets) / 5,000,000 (current liabilities) = 2.0

iv) must qualify to type of industry, seasonal business etc. (e.g. banks
usually need greater liquidity)

(d) Acid Test: compares so-called quick assets to current liabilities. short
term, considers only cash including cash equivalents (like mkt securities
or accounts receivable)

i) equation: (cash and equivalents + short term investments +

receivables) / current liabilities

ii) ignores prepaid expenses and inventories

iii) ratio of 1 will be satisfactory

iv) assumption in this test is that the co will not be able to sell any more
inventory

(2) Leverage Ratios

(a) debt to equity, debt to total assets to assess the overall ability to pay its
debts (long-term analysis)

i) Leverage: the greater the proportion of debt, the more highly

leveraged the co.

ii) Debt to Equity ratio:

(1) formula: total liabilities/total owners’ equity

(2) debt to equity ratio provide lenders with some indication about the
likelihood that the business will repay a loan.

(3) creditors get paid before Shareholders in any liquidation

iii) Debt to Total Assets: compare debt to sum of debt and equity

(1) formula: total liabilities / total assets

(a) total assets = liabilities - assets

(2) definition of debt can vary

(3) Net Book Value

(a) the difference between the company’s assets and its liabilities as
reflected in the company’s accounting records, usually expressed as an
amount per outstanding common share or other ownership interest.

i) formula: net book value attributable to common shares/common

shares outstanding

ii) net book value per common share (which has issued preferred stock):
subtract preferred stock’s liquidation preference

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(4) Cautions and Applications

(a) balance sheets are not stated at market value (because the balance sheet
only shows what the asset is worth when it is acquired and does not take
into account appreciation or depreciation), so the ratios are only as good
as the balance sheet

(b) business’ net book value does not reflect what a buyer might pay for the
business.

D. Measurement of Income

1. The Income Statement: can use this to predict how the company will perform in the
future

a) Results of Operations – states the operating results for a particular period

(1) should pay attention to unusual or nonrecurring items which affect the
income statement in one period but which will not affect subsequent periods.
(e.g. mergers)

(2) transactions that do not directly relate to operations:

(a) e.g. selling a manufacturing plant → should company create

“Extraordinary Item” account for this unusual transaction in the income
statement for the current period?

(b) including it on the income statement may lead some investors who only
look at net income to falsely reach conclusions about a co. when
comparing to previous yrs’ operations.

b) Accounting Changes

(1) Changes in an accounting principle

(2) Changes in accounting estimates

c) Prior Period Adjustments

(1) When there is a correction of errors in previously issued financial statements

and requires an enterprise to restate the prior period financial statements. It
bypasses the income statement connoting the fact that a direct entry to
Retained Earnings adjusts the results from a prior period bc an item which
the company realized currently really belongs in a prior period. This process
presents a problem: may cloud the accuracy of a particular income statement
by excluding such an item from the entire series of income stmts.

(2) GAAP limited prior period adjustments to corrections of errors in financial

stmts for a previous period. Must correct as soon as discovered cannot
amortize over some period of time.

(a) company debits or credits the appropriate asset or liability accounts and
records a corresponding adjustment directly to the beginning balance in
the Retained Earnings account.

(b) such treatment does not affect income statement

(3) e.g. yr 1 = improper recognition of 100,000 revenue in txns on open acct

which included a rt of return. If only expenses include: 60,000 in cost of
goods sold, 15,000 in sales commissions which were prepaid, co must
eliminate the 25,000 profit from retained earnings.

Inventory 60,000
Prepaid Sales Commission 15,000
Retained Earnings 25,000
Accts Receivable 100,000

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(4) Discontinued Operations: distinct business that a co decides to sell or

eliminate (e.g. sub, division, dept or joint venture). Getting rid of the whole
line of business.

(a) to qualify:

i) co must clearly distinguish component’s assets

ii) operating results and activities from the co’s other assets

iii) operating results and activities (not only physically but operationally,
but also financially)

(b) must report in 2 sep components before income from “extraordinary

items”

i) income or loss from discontinued operations: include

(1) segment’s operating income or loss less applicable incomes taxes

for the period from the beginning of current yr to date.

ii) gain or loss on disposal:

(1) reflects the income or loss from divesting the segment less
applicable income taxes.

(a) must estimate if will not occur until after the end of the yr to
the disposal date.

(c) If co expects loss from disposal: co must include estimated loss in the
net income for the yr

(d) If co expects gain from disposal: co must wait until it realizes the income
which usually occurs at the closing of the disposal date to recognize
revenue.

(e) Activities that do not qualify:

i) asset disposal incident to a co’s evolution such as eliminating a line of

business

ii) transferring production or marketing activities from one location to

another

iii) phasing out a product line or service

iv) other changes that technological improvements may occasion.

(5) Extraordinary Items: gains or losses from transactions other than the sale,
abandonment of a business segment that qualify as both unusual in nature
and infrequent in occurrence.
(a) To qualify:

i) must possess a higher degree of abnormality and not relate to or only

incidentally relate to a co’s ordinary activities.
ii) infrequent requirement: co must not reasonably expect the
transaction to recur in the foreseeable future.
iii) must consider the nature of the business to determine infrequency or
unusualness.
(b) GAAP: says gains and loses from extinguishing debt is extraordinary
items without regard to frequency and other requirements.
(c) “extraordinary items” appear in a sep section on the income stmt after
discontinued operations and following the caption “Income before
Extraordinary Items”

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d) Comprehensive Income

(1) requires enterprises to report an all inclusive comprehensive income for an

accounting period in a full set of financial statements and as prominently as
the other financial statements.

(2) comprehensive income is divided into net income and other comprehensive
income

(a) net income includes the revenues, expenses, gains, and losses that give
rise to income from the continuing operations, discontinued operations,
and extraordinary items

(b) other comprehensive income includes certain gains and losses that the
codification requires an enterprise to include in comprehensive income,
but exclude from net income for an accounting period.

2. Ratio Analysis—look at page 303 in book for how to compute answers

a) General

(1) Look out for erroneous income statements or balance sheets because they
can produce misleading financial ratios.

b) Coverage Ratios

(1) Definition: measures the extent to which income (usually determined before
interest and taxes) covers certain payments related to an enterprise’s long-
term debt.

(2) Times Interest Earned (a type of coverage ratio)

(a) ratio of earnings to interest charges

(b) provides indication about how much the co’s earnings can decline
without endangering the interest payments

(c) add back to net income interest charges and income taxes

(d) e.g. if co has net income before taxes 500,000 and interest charge of
250,000, it would cover its interest 3 times

i) (500,000 + 250,000) / 250,000

(3) Debt Coverage

(a) Definition: determines how many times a co can cover both interest and
current portion of long-term debt.
(b) e.g. previous example debt coverage = 1.5
i) (500,000 income before taxes + 250,000 interest) / (250,00 interest +
250,000 principal of debt)
(4) Dividend Coverage

(a) Definition: ratio of net income after interest charges and taxes to regular
dividends.
(b) tells you how much the co’s net income can ↓ without jeopardizing the
regular dividend payments.
(c) e.g. 200,000 net income / (10,000 shares * $4 per share) = 5.0 times

c) Profitability Ratio

(1) General

(a) assess how effectively a business operates

(2) Earnings Per Share

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(a) Definition: probably the most important comparison btw current

accounting period and that in a prior period. (goes on the income stmt) –
footnote 1 usually tells you how computed.

i) the ratio “net income per common share” shows the net income
attributable to co common shares.
ii) to compute: (net income – preferred stock dividends) /common shares
outstanding
iii) FASB issued SFAS No. 128 Earnings per Share to simplify the
standards for computing and to conform to int’l standards.

(1) “basic earnings per share” now replaces the “primary earnings per
share”
(a) describes the amount of earnings for the period available to
each share of common stock outstanding during the period.
(b) income / common shares outstanding
(2) “diluted earnings per share” replaces “fully diluted earnings per
share”
(a) amount of earnings available to both each share of common
stock outstanding and each share that would have been
outstanding
(b) dilutive potential common shares: such as options, warrants
and convertible securities, give the holder the right to acquire
common shares either during or after the end of the reporting
period.

(3) Price-Earnings Ratio

(a) compares the mkt price of the common shares to the earnings per share.
(b) mkt price / earnings per share

(4) Return on Sales

(a) net income / sales

(b) gives indication of efficiency
(c) the higher the return on sales, the more profitably and efficiently the co
sells goods.

(5) Gross Profit Percentage

(a) reflects the profitability form selling products, ignoring operating

expenses.
(b) gross profit = sales – cost of goods sold
(c) GPP = gross profit / sales

(6) Operating Profit Margin

(7) Returns on Assets

(a) net income / avg assets

(b) higher the return of assets, the better management uses its resources in
the business.

(8) Returns on Equity

(a) how successfully is management utilizing owner’s capital.

(b) total SH equity – net income = SH equity at the beginning of the yr.

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(c) (SH equity at beginning of yr + SH equity at the end of yr) / 2 = avg equity.
(d) net income / avg equity = Return on Equity

d) Activity Ratios

(1) General

(a) compare amounts from balance sheet and the income stmt to see how
effectively the co utilizes its resources. (important in asset-based lending)
(2) Receivables Turnover:

(a) ratio of credit sales to avg accounts receivable provides some measure of
the liquidity of the accounts receivable.
(b) credit sales / avg accounts receivable
(c) e.g. if co gives customers 30 days to pay their bills, but receivables
turnover indicates that on avg company collects its receivables every 50
days → suggest inefficiencies in the co’s collection process
(3) Inventory Turnover:

(a) cost of goods sold / avg inventory

(b) avg inventory = simply avg the opening and closing inventories
(4) Asset Turnover:
(a) sales / avg assets
(b) indicates how many of dollars sales the co generates for each dollar of
assets that the co owns

E. Ratio Analysis/Statement of the Cash Flows

1. General

a) with growing reliance on borrowing, creditors and investors have to rely

increasingly on ratios based on cash flow info.

b) For Cash Flow Analysis look at page 308

c) debt to equity ratio and current ratio are most important, 3rd is the cash flow
to current maturities of long term debt. Cash flow to total debt ranked 9th.

2. Liquidity and Coverage Ratios

a) help assess a company’s ability to meet its debt obligations in the short and long
run, pay dividends, cover anticipated operating expenses.

b) cash interest coverage: assess company’s ability to generate enough cash from
operations to pay its interest payments.

c) debt service coverage: ability of company to meet and retire its debt
obligations.

d) Cash dividend coverage: demonstrates the company’s ability to pay dividends

with cash generated from operations after payment of taxes and interest

e) Cash flow from ops to capital expenditures ratio: company’s ability to

purchase its current capital assets with cash flows from operations.

3. Profitability – info about ability of company to provide its investors with a return on
their investment.

a) cash return on investment: information on cash-generating ability of company’s

assets.

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b) cash flow per common share: most important for closely held company., info
about how much cash the company generated from every share of common
stock outstanding

(1) like earnings per share based on accrual accounting (so can’t disclose in the
financial statements to avoid confusion)

4. Quality of Income – ability of a company to generate cash from the amount it reports
as income from operations. How quickly can convert net income to cash.

a) cash quality of income ratio: a company that takes a long time to receive cash
from its sales and promptly pays its expenses would generate low ratio.

b) cash quality of income before interest, taxes and depreciation: more accurately
reflects the effects of interest, taxes and depreciation on net income

V. Legal Issues with Shareholder’s Equity and Balance Sheet

A. Limitation on the Issuance of Shares

1. Legal Capital System: sought to provide minimal protection to a corporation’s

creditors

a) this system prohibits corporations from issuing shares for less than par value
(which is an arbitrary amount made in the article of incroporation)

(1) this requirement ensures that creditors could readily ascertain the amount of
resources that the original shareholders committed to the business and that
would offer some “cushion” to creditors

(2) ensures that corp would charge each shareholder at least a minimal equal
amount when issuing stock.

(3) Where the price of the security fell, par value would have to be reduced so
that people would still be willing to pay for it

b) water stock: if a corporation issued shares for less than par value
(1) corporate statutes may impose liability on shareholders that do not pay at
least par value for their shares.

(2) some jxn permitted creditors to recover ONLY if the issuance of watered
stock amounted to a misrepresentation (those who relied on can recover)

c) Lawyers devised ways to circumvent the legal capital system

(1) can issue shares with low par values

2. Conception of Par Value

a) Sets a floor on stock price

b) insure the debts of creditors.

c) So par can't be paid back to shareholders until creditors are paid.

d) This gives rise to the concept of a legal capital requirement which limits the
ability of the corporation to make distributions to shareholders

B. Distributions and Legal Restrictions

1. All these laws make sure people do not get defrauded by companies

2. In every state, statutes limit corporation’s ability to distribute assets to shareholders

(protect residual SHs)

a) Whether a corporation can pay dividends depends on the state law of

incorporation—for example some states say A corporation can't pay dividends
when it becomes insolvent

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b) Statutory restrictions on distributions flows from two sources: corporate law and
creditors’ rights statutes.

c) when you have a negative earnings, you cannot issue dividends or do

redemptions under California law

3. State laws generally require that dividends may only be paid out of surplus. The
question now becomes, how do state laws direct us to value our assets?

4. The legal capital system traditionally divides surplus into two components: capital
surplus and earned surplus.

a) these surplus tests basically limit the assets a corporations can distribute to
shareholders to the amount by which total shareholders’ equity exceeds stated
capital.

5. Randall v Bailey says that when issuing a dividend because a company has a
surplus, the company may take into account property that has appreciated but there
is an unrealized gain, when determining if there is a surplus and issuing a dividend

a) NY Court allowed the corporation's physical plant to be reappraised upward

without any realization event

b) This allows surplus to include unrealized appreciation

c) The Rule from the case is that:

(1) You can "always" issue dividends

(2) BUT if you "fudge" the asset values, you will have to give shareholders notice
(earned surplus by definition excludes unrealized appreciation); footnotes

d) Under GAAP however, Assets should not be written up above costs

(1) Rationale is that there is no objective method of valuation

6. Most modern corporate statutes apply one or more insolvency tests to determine
whether a corporation can lawfully distribute assets to shareholders, and whether or
not some other test applies.

7. Sophisticated lenders enjoying sufficient bargaining power began using contractual

provisions, often referred to as restrictive covenants, to protect their interest.

C. Drafting and Negotiating Agreements—Obligation for Lawyers**Important section

1. List of Principles When Drafting Agreements

a) Completely Mutual Terms are Not Necessarily Even—or Best For Your Client

(1) It is important to know when representing either the rich or the poor party
because a mutual and parallel clause impose greater restrictions or fewer
benefits for your client.

2. When Relying on Past Agreements, Be Careful Which Document You Choose

3. Long Forms are not Necessarily Superior

a) If your client controls the situation, the less said the better because your client
will be constrained by a longer agreement.

b) If your client is not in control, it is better to get a lot more in writing

4. Make Sure the Mechanics Work

a) the agreement and calculations must be accurate

5. Clear the documents with the client’s accountant

6. If your client is in control use a bottom line concept. If the opponent is in control use
a top line concept.

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a) bottom line allows the client to shape the outcome by appropriate selection of
accounting methods and estimates.

b) top lines are less susceptible to manipulation through creative accounting

7. The longer the term of the agreement, the less important the control of accounting

8. Use proper accounting terminology

9. GAAP may not be best for your client

10.GAAP is not a static set of principles

VI. Revenue Recognition

A. General

1. most companies try to recognize revenue as soon as possible and defer expenses
for as long as possible.

2. Company cannot recognize revenue until the enterprise has substantially completed
performance in a bonafide exchange transaction.

a) businesses normally can recognize revenue when they exchange goods or

services for cash or current claims to future cash and deliver the goods or
substantially perform the services that entitle the enterprise to the promised
consideration

3. Matching Principle

a) matching seeks to offset expenses against related revenues wherever possible in

determining the net income

4. Due Diligence

a) lawyers often perform due diligence to determine whether a prospective

transaction will further their client’s best interests. During this process, the
attorney investigates an underlying business in an effort to obtain a deeper
understanding about the business’s future prospects.

b) An attorney who fails to spot and investigate an improper or fraudulent revenue

recognition can fact personal liability for malpractice.

B. FASB Revenue Recognition—New

1. In 2014, the FASB issued a comprehensive replacement of the prior rules on revenue
recognition from contracts with customers.

2. core principles that an entity should recognize recenue to depict the transfer of
promised goods or services to customers in an amount that reflects the
consideration to which the entity expects to be entitled in exchange for those goods
or services. To apply this principle, a company would,

a) identify the contract with the customer

b) designate the separate performance obligations in the contract

c) determine the transaction price

d) allocate the transaction price to any separate performance obligations

e) recognize revenue when the enterprise satisfies a performance obligation

C. Schemes to Recognize Revenue Deceptively

1. Fictitious sale

2. sham transaction

3. related party arrangements

4. prematurely recognized revenue

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5. non monetary sale agreements

D. Financial Fraud

1. all financial fraud involve income measurement issues, either

a) premature revenue recognition or

b) improper expense deferral

2. Enron fraudulently recognized revenue from a Nigerian barge agreement. as a result

the energy trader recorded 12million in profit even though the firm promised to
repurchase the barges, and therefore retained the risk of loss.

3. In response to accounting scandals, congress enacted SOx which gives rules to

lawyers who practice before the SEC to report evidence of financial fraud.

4. Form 8-ks help prevent fraud because they require companies to disclose certain
restatements.

5. When an attorney actively participates in financial fraud, criminal charges can be

filed.

E. Requirements for Revenue Recognition

1. a company can recognize revenue only

a) when realized or realizable, and

b) earned—this ensures that the company has substantially accomplished the

earnings process.

2. SEC says there are four ways to recognize earnings

a) the evidence must persuasively demonstrate that an arrangement exists

b) the enterprise must have delivered the product or performed the services

c) the arrangement must contain a fixed or determinable sales price

d) the circumstances must reasonably assure collectability.

3. Recognition can perpetuate fraud—How to manipulate the Numbers pg 368

a) fictitious sales

b) backdating transactions

c) turning back computer clocks to record revenue in an earlier period.

d) prematurely shipping goods or sending items not ordered

e) shipping goods to a warehouse

f) selling goods to customers that lack the financial ability to pay

g) recording sales when the transaction remains subject to contingencies

F. Incentives for Companies to Overstate Revenues—pg 368

1. for publicly traded companies, the financial markets tendency to focus on the most
recent quarterly results can encourage managers to inflate or smooth earnings in an
attempt to produce or maintain a higher market price for the business’s securities,
often so that the executives can profit from stock options.

2. higher market price may also enable an enterprise to use overvalued ownership
interests as currency in corporate acquisitions.

3. management’s desire to obtain a loan or more credit can also provide motivation for
prematurely recognizing revenue and overstating accounts receivable

4. a desire to postpone addressing financial difficulties or to avoid violating a restrictive

covenant can also explain financial frauds for both public and private businesses.

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5. When there are warranties and rebates—Enron

a) companies will recognize revenue, even though there is a warranty that the
company will promise to repurchase the item if something goes wrong.
b) Enron fraudulently recognized revenue from a Nigerian barge agreement. as a
result the energy trader recorded 12million in profit even though the firm
promised to repurchase the barges, and therefore retained the risk of loss.

G. Warning Signs to look out for

1. unrealistic financial goals and revenue targets

2. large transactions at the end of an accounting period

3. transactions involving related parties

4. unusual or complex transactions

5. auditor changes

6. stray invoices or monthly statements

7. high employee turnover—unexplained resignation in the accounting department

8. a stern tone at the top of management will serve as a deterrent to fraudulent financial
reporting. a relaxed tone will increase the probability.

VII.Contingencies

A. General

1. Involves what companies should do in regards to how they should accrue

conditional expenses and losses, which may or may not even occur. Uncertainty
exists as to whether the enterprise will incur any expense or loss.

a) the dilemma is when there is a contingent loss or expense contributed to revenue

production in the current period, because the matching principle requires an
enterprise to match expenses with the revenues that they helped to produce.

b) If the enterprise does not charge the loss or expense against income in the
earlier period and the loss or expense subsequently occurs, the business ill
regret the failure to charge the item against income in the earlier period to which
it belonged

c) But if the enterprise accrues the loss or expense and then it never actually
materializes, the company will rue having accrued it in the earlier period.

2. If it is probable (“likely”) that a liability will be incurred and it is possible to estimate

reasonably the amount of the liability, the contingent liability is treated like an
estimated liability. The estimated loss is accrued as an expense and is credited to a
liability account pending final resolution of the matter. Thus, if a company has a
lawsuit arising out of an injury on the business premises and it is determined that the
company will likely be required to pay $150,000 to the claimant, the company would
record an expense and liability as follows:

a) General Liability Expense $150,000

b) Liability for Future Claims Resolution $150,000

3. For Footnote discussion, look below.

4. Contingent liabilities can arise out of litigation and other claims against the company
and tax audits (loss contingencies).

5. If the business decides to accrue the expense or loss in the current period, then the
enterprise will debit a current expense or loss account and credit an accrued liability.

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6. Example is if there is a company that makes cruise ships. They guarantee that the
ship will maintain a certain speed for 10 years. If it doesn’t then they will refund
$250k. Matching principles would say to offset income in year 1. But if it happens in
year 7, and they did not account for the contingency, they would have to offset
income in year 7.

B. Process—Using Footnotes

1. If the contingent liability is probable but it is not possible to estimate reasonably the
amount of the probable loss, information about the contingent liability would be
disclosed in the footnotes to the financial statements, but no expense would be
accrued and no liability would be recorded.

2. Where the likelihood of loss from the contingency is remote (“slight”), there is no
entry in the financial records and there is no disclosure of the contingency in the
footnotes to the financial statements.

a) (Certain types of guarantee arrangements under which the business has a

potential obligation to perform are disclosed categorically in the footnotes even if
the likelihood of performing under the guarantee is remote.)

3. Where the likelihood of realizing a loss associated with a loss contingency is

“reasonably possible” ( i.e., more than remote but less than probable), no entry is
made in the financial records but there is disclosure about the contingencies in the
footnotes to the financial statements.

4. When a company knows internally that there might be an issue, but it is unclear if
their wrongdoing will be identified, no disclosure or accrual of a loss contingency is
necessary unless it is probable that a claim will be asserted and it is reasonably
possible that there will be an unfavorable outcome on the claim.

5. Eron did not disclose the contingencies in the footnotes

C. Materiality

1. contingent liabilities are subject to the qualification of materiality. If the

contingencies, even if incurred, would not be material, no disclosure or accrual of
liabilities will be made except for a general reference in the footnotes to the fact that
the company is exposed to various future items that, even if incurred, will not be
material.

2.
D. Unliquidated liability

1. a company has incurred an expense or loss attributable to the current period but
uncertainty remains as to the exact amount.

2. must estimate the likely amount

3. if can’t estimate, disclose in the footnote

E. Fixed Liability

1. when companies have a fairly sound guid as to the percentage of the total potential
refunds because of prior years, the liability should be treated as a fixed liability
uncertain as to the amount, rather than a contingent liability

a) this is because they are ale to estimate to a reasonable accuracy the charge
against current income in the current period.

F. MD&A

1. Contingent liabilities should be discussed in the MD&A section. There is a higher

standard of disclosure a registrant could theoretically observe.

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G. Definitions from FASB

1. Gain Contingency

a) your client expects to receive a reward but you don’t book gained contingencies
due to conservative principle
b) company should disclose gain contingencies but should not overstate the
likelihood of the contingency to materialize.

2. Loss Contingency

a) if there has been a loss or impairment of an asset or the incurrence of liability OR

it’s probable that there will be a loss or incurrence of liability and

b) you can reasonably estimate the amount, and

c) the event occurred on or prior to the date of the financial statements, the
company must accrue an amount for this loss and also disclose it.

(1) event has to occur prior to the date of financial statements = date that
financial statements are being examined

(a) if the event/discovery of event occurred after the date of financial

statements but prior to statements being issued, then must disclose and
put in footnote

(2) attorney has to make assessment as to likeliness, if probable then see if able
to estimate an amount

(a) if all these conditions are met, then must book the liability (FASB rule says
that co should at least book the low range of the liability)

(b) if can’t estimate an amount, then just disclose (doesn’t matter when the
event occurred)

i) disclosure shall indicate the nature of the contingency, and give an

estimate of the possible loss or range of loss or state that such an
estimate cannot be made.

(3) Likeliness (FAS defn) (618)

(a) Probable: the future event is likely to occur.

(b) Reasonably Possible: chance of event occurring is more than remote but
less than likely.

(c) Remote: change of event occurring is slight.

(4) ABA defn (652) – diff from FAS

(a) probable: an unfavorable outcome for the client is probable if the

prospects of the claimant not succeeding are judged to be extremely
doubtful and the prospects for success by the client in its defense are
judges to be slight

(b) remote: unfavorable outcome is remote if the prospects for the client not
succeeding in its defense are judged to be extremely doubtful and the
prospects of success by the claimant are judged to be slight.

(5) Examples of loss contingencies: when co has loss contingencies, they set up
reserves.

(a) collectibility of receivables

(b) obligations related to product warranties and product defects

(c) risk of loss or damage of company’s property by fire, explosion or other

hazards.

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(d) threat of expropriation of assets

(e) pending or threatened litigation

(f) actual or possible claims and assessments

(g) guarantees of indebtedness of others.

H. What Attorneys Should Do When Dealing with Contingencies and Auditors

1. Whatever the attorney becomes aware of, the attorney is obligated to inform their
client of the issue.

2. attorney agrees to tell client, and the auditor looks to the client, way of dealing with
the issue so that attorney doesn’t have go directly to the auditor that something has
to get disclosed— concerned with confidentiality issues.

3. What an attorney can tell a client:

a) request info and representations from company’s management about

contingencies

b) request corroborating evidence from the company’s accountant

c) search for footnotes

VIII.Exam

A. Know Definitions

1. Difference between balance sheet and income statement

B. Know GAAP and why its important, but Don’t really need to know Accounting standards
and auditing principles section.

C. Financial Statement Analysis** Important

D. Liabilities for lawyers—legal issues for lawyers

1. What are the obligations for lawyers

2. What would a lawyer do when they are in a certain situation

a) look at the footnotes

b) due diligence in hopes of noticing something glaring—recognition of revenues

problem for example

c) go to your client’s accountant to ask questions. do this without breaking any

confidentiality agreements

d) report up the board

e) resign

E. Expense Recognition** Important

1. How you can manipulate the numbers with revenue recognition

2. Explain why companies skirt the recognition program

a) Rebates

b) Warranties

3. Relates to cash vs accrual accounting

a) The implication of accrual accounting when it comes to recognition

b) Small companies can use cash. Big companies must use accrual. Public
companies must use accrual

c) Fraud is committed with accrual accounting

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d) Depreciation is not a cash expense. Just offsets income from an asset over time.
Companies try to depreciate assets faster so they lower their net income and pay
less income tax

4. Difference between what a public and small private company’s obligations

F. Contingencies

1. Has a material impact

a) When does something become material

b) When it becomes material they have to report it

G. Random

1. EBITA—what is it

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