Accounting for Lawyers

August 30, 2001 Difference between accounting and auditing: Accounting: preparation of the financial information (from books and records). Mgmts responsibility (ongoing recordation and analysis of the underlying transactions) o Done according to GAAP (as promulgated by A!"). #he guiding principle for all statements (if $e all prepared our statements differently% $ould not be able to compare to other statements% of same company or others). Pro&ides the basis for comparison Auditing: independent e'amination (And &erification) of financial information (after the fact) o Designed to root out misstatements% un&erifiable information% etc. o Gi&es a (Certified Statement) (the highest statement). #his does not reflect on health of company% only accuracy of financial information in statements and they accurately reflect the underlying transactions. o *enders a report on the fairness and proper recording of the info on the stmts% &erifies they are presented according to GAAP (or says so if other$ise). o Ultra Morris Case: failure to pro&ide duties to ensure stmt $as presented fairly and in accordance $ith GAAP led to liability for accounting firm (ne&er physically &erified in&entory reports% $hich $ere falsified) o +ptions for accounting *eport: Unqualified Qualified opinion: e'cept for (inade,uate records% departure from GAAP% could not obser&e in&entory% etc) the statements present fairly- .ould ha&e been un,ualified e'cept for the enumerated ,ualifications (need to specify the condition creating the ,ualification). o Done according to GAA! (Generally Accepted Auditing !tandards) /omparability% protection to reader of stmt kno$ing auditing standards ha&e been met: Auditing person must be proficient (done by ,ualified people) 0ndependence of auditor: ha&e no financial interest in company being audited% no incenti&e to make report look good. 1&en if the accounting firm is o$ed money by the comp% cant certify it because that is an incenti&e to keep co. sol&ent so they get paid. Professional care must be used at all times !tandards of field $ork: Ade,uately planned and super&ised 0nternal control planned o Determines that acti&ity $2in the co is separated enough that 3 person cant be stealing% etc. !trength of internal controls determines ho$ far the auditor must 1': A* clerk records the credits% opens the mail% prepares the deposit to bank% make entries into books 4 "AD /+5#*+6. 5eed to di&ide up responsibilities so others all kno$ $hat each is doing and can detect $hen things are missing2fishy. !+: need internal control sur&ey to determine ho$ much auditing they must do. #he better the control the less auditing needed. /o&ers not 7ust theft% but incorrect entries that $ould lead to inaccurate statements !ufficient e&idential matter is to be obtained through inspection% obser&ation and outside confirmation.

o 8a&e to be a$are of potential liabilities% etc% to ensure that the statements are as conser&ati&e as possible. 8a&e to find out from outside sources the effect of certain contingencies on the statements% etc (e': find out from engineer cost of en&ironmental cleanup% find out from la$yer effect of class action% etc) "asic elements of auditing: o Auditor collects and e&aluates financial data o Purpose: determine and report on the fairness of the representation of the info of the financial info Must include contingent liabilities% such as pending la$suits% etc. Must be in GAAP so easily comparable to other years and entities o Must be independent o 190D15/1 :!1D "; A:D0#+* (+5 05A6) 1ntitys docs *epresentations from mgmt /ommunication and &erification from third parties% obser&ations and tests by the auditor 1': &erify accounts recei&able (the biggest asset usually)% check $ith banks on certain info% etc. 0ndication of poor performance: dont pay payroll ta'es due to go&t (using < for operating costs) o 5o limits on auditors e'amination% uses sampling to test the accounts

Auditors Reports: #ypes of *eports o Unqualified Report (aka: /ertified or /lean *eport) #hree main findings: free of material error presents fairly in conformity $ith GAAP. o Qualified .ould be un,ualified except for the effects of the matters to $hich the ,ualification relates. #he statement presents fairly% is free of material error and in conformity $ith GAAP% as far as auditor can tell% e'cept for certain portions +* there is some uncertainty as to portions he can not% for $hate&er reason% substantiate (unable to count in&entory% etc). Departure from GAAP may be a reason for a ,ualification if it is minor= if it is se&ere may re,uire an ad&erse opinion. o Adverse Materiality generally accounts for the difference bet$een an ad&erse opinion or an un,ualified opinion Amount of error in relation to o&erall si>e of company. 0f the error is relati&ely large% it is ad&erse% if relati&ely small% 7ust a ,ualified. (e': ? mil to 0"M or GM is ,ualified% ? mil to Mom @ Pop is ad&erse) #he material amount affects the statement o Disclaimer of Opinion #he auditor does not $ant to e'press an opinion ($alks a$ay). :sually $here he has not performed an e'amination sufficient in scope to enable him to form an opinion. !epte"ber #, 2001 +pinion of 0ndependent Auditor (the (*eport of the 0ndependent Auditor)) o 6ists $hich statements he is e'pressing an opinion of (and implicitly $hich he is not% such as footnotes)

o 6ists t$o years he e'presses an opinion on (this year and the year being compared to% last year). Prior year is for comparison. o 1'plains ho$ Audit conforms $ith GAA! (generally accepted auditing standards) :ses test basis 1&idence supports amounts Assesses accounting principles used and significant estimates used by mgmt (e': estimates of bad debts% $hich is then tested by the auditor) 1&aluates o&erall presentation o Must include the statement (.e belie&e that our audits pro&ide a reasonable basis for the opinion e'pressed abo&e) .8+ is the report made to o +nly made to the Directors and !hareholders% but can be sued by anyone they can foresee relying on itA

$ptions for !"a%% &usinesses o /ompilation: auditor familiari>es himself $ith the business and its practices and determines statements are free from material errors 6imited to presenting in the form of financial statements% information that is the representation of the mgmt. Does not audit or re&ie$ the financial statements% and e'presses no opinion on them. o *e&ie$: makes in,uiries into the staff% $hat type of bookkeeping they ha&e% looks at "oard minutes% looks at subse,uent e&ents 6imited to in,uiries of /ompany personnel and analytical procedures applied to financial data. !ubstantially less in scope than an independent audit. 5o opinion is e'pressed as to the financial statements taken as a $hole +nly statement that can be relied on is the 3BCD% not the 3BCEs (only 3BCDs are audited) (1,uity): $hat the stockholders (o$ners) o$n o *eally a debt to the shareholders (a liability). #he liabilities to the outside creditors and the shareholders ha&e to be e,ual to the assetsA

.hen does an attorney use financial informationF estates% representing companies% di&orce% partnership agreements% purchase2sale of business% representing creditors% 5otes on statements usually omit the %BBBs (dollars are in thousands% e'cept per share amounts) P@6 !tatements for a period of time (usually one year% but can be less as $ell) iscal year: can run for $hate&er period you choose% can end on month other than Dec. 'ntroduction to (AA) *+,- 1. #he $ay to handle transactions. (!et by A!" ( inancial Accounting !tandards "oard)) o !ets the rules o Makes sure the info is reliable and rele&ant o /onsistency and comparability (internal and e'ternal) o .hat must be included in the financial statements o Directed at management because mgmt responsible for the statement (then 7ust audited according to GAA! by the independent auditors) Assumptions that a reader of the statement can make

o .e are talking about separate entities (each entity must ha&e o$n statement% can not combine t$o separate entities for one statement) o #he entity is a going concern (comp is e'pected to continue ongoing operations) irst sign it is not planning on continuing business is they stop paying payroll and sales ta'es (using the go&ts money for daily operations) !ets $hat the operating cycle may be o 3G months= must end at the end of a month. (Matching) o the e'penses to create the income are put into the same period the re&enue generated by those e'penses Estimates o Permitted in certain cases% must be backed up by mgmt $ith good financial data Historical cost o Generally% this is $hat is used= .hat $as paid for the asset% $hat $as the cost of the assetF .e do not re&alue assets e&ery year (especially buildings)% keep same figures on the balance sheets ( o!er of cost or mar"et) o temporary in&estments (stocks2bonds2in&entory) are recorded Accrual #asis o Put the liabilities and assets on the books $hen the transaction occurs. :sed to match income and e'penses Consistenc$ o /urrent and longCterm assets and liabilities should be separated. Must recogni%e all the contingent lia#ilities o !end confirmation to the la$yer in,uiring as to contingent liabilities% such as la$suits Materialit$ o ? mil more important (material) to mom @ pop than 0"M

+o"ponents of t,e financia% state"ents generally o intended to communicate information o uses historical basis o the interest of creditors and o$ners is sho$n o a statement encompasses: the accountants opinion (opening letter) the #alance sheet &' statement( income statement Statement of surplus( retained earning statement Cash flo! statement )ootnotes o Assets are either purchases or ac,uired from selling products% are assets that $ill benefit future periods (the machine $ill produce $idgets for years to come) irst thing a comp does is get money from in&estors% uses that money to buy a machine to produce $idgets (the fictional generic item) o ia#ilities: +bligations of the comp /reditors o #he bank 6end 3 for e&ery 3%G%H or I e,uity puts in- (norm no$ 3:GCI% 3:3 is scary% G:3 is ridiculous)

o #he go&t o Purchases not paid for immediately (accounts payable) Equit$ #he P@6 of the 1arned surplus o An accumulation of the comp since day one% less di&s paid. !tatement of P@6 or 3G months (or interim statements for each month) Revenue: 0ncome from sales or ser&ices rendered E*penses: #hose costs necessary to produce the items to sell or operate the business (supply the ser&ice $hich produces the re&enue) Are matched (recorded in) the same period the income is recorded +et income: *e&enue minus e'penses

o o o

/$$01$02! irst thing the bank looks at o !ho$s $hich rules of GAAP the statements follo$ (and $here they depart) 0f depart% and material% has to be in opening letter% then footnotes it% and indicates $hat the diff in the statement $ould be if they had follo$ed GAAP (Summar$ of Significant Accounting &olicies)% such as a description of the business o $hat the comp does o $hat subsidiaries they o$n (consolidation) o cash and cash e,ui&alents o principles of consolidation o the in&entory method o property plant and e,uipment fi'ed assets% sub7ect to depreciation 6and is a fi'ed asset% but 5+# sub7ect to depreciation o 0ndicates depreciation method o 1mployee benefit plans o .hat income ta'es or refunds are due% are ta' audits coming up and $hat issues ha&e been raised. 1': e'pense an item instead of capitali>ing and depreciating it (spreading the cost of e,uipment o&er its useful life). May be a liability. o 1arnings per share o /apital stock o /ontingencies (91*; 0MP+*#A5#) 1': pending la$suits% pending assessments by ta' auditors Management letter o Does not go in the statement% goes to management o 0! 5+# PA*# + #81 A:D0#+*! !#A#1M15#AAA */'1AL 23A4. o #ells management that there is a $eakness in internal control that needs correction. Auditor then e'pands audit to make sure the $eakness in internal control is co&ered by his testing. !epte"ber 13, 2001 &$$5522)'1( *see +,apter 2.

Double 1ntry bookkeeping: o 1&ery transaction has t$o entries% a left sided (Debit) and right side (/redit) entry. o MAP: "alance !heet accounts Assets 4 6iability J 1,uity 6eft *ight 6eft *ight 6eft *ight (J) (C) (C) (J) (C) (J) (Debit) (/redit) (Debit) (/redit) (Debit) (/redit) 0ncome !tatement Accounts 1'pense Account *e&enue Accounts 6eft *ight 6eft *ight (J) (C) (C) (J) (Debit) (/redit) (Debit) (/redit)

1ach entry is made in a 7ournal% each 7ournal has many legers in it representing more specific items% each 7ournal represents a #Caccount% each #Caccount is labeled by company as appropriate +$6102R '106'0'72 for A!!20 A++$610!: A credit to an asset account reduces the amount of cash in the accountA o All credits are decreases% all debits are increases Due to double entry system% each side of the balance sheet ends up e,ual. 0,ree basic 8uestions for e&ery transaction o ,hat has ta"en placeF Purchase an asset% make a sale% etc. o ,hat accounts are affected #$ the action ta"enF .here does the thing $e purchased go% $hat account% $here does the purchase price come from% etc o -n !hat direction does the account move. .hich accounts $ent up and $hich $ent do$nF 28uity: consists of o Paid in capital (money to start the business) o 1arned surplus: accumulated profits% stays on the books year after year% increased by future profits of each year% decreased by di&idends paid (stock and cash di&idends) Liabi%ities: o *ecorded in t$o $ays: short term and long term (one year cutoff) (current and nonCcurrent) o irst is accounts payable% then notes payable in short and long term (the current portion of long term liabilities are short term). Assets o *ecorded in order of li,uidity% from cash to least li,uid )rofit 9 Loss !tate"ent o *e&enue (K) comes first% then e'penses (;)% income is K L ;. Measured o&er 3G month period (ends on last day of a month% unless special industry% ie garment). 4A0+:'1( Accrued e'penses must be matched against the income in the same period of time. /an not ha&e last years e'pense recorded against this year% or ne't years re&enue recorded in this year. !epte"ber 20, 2001 /eneral edger o Assets (on the right) al$ays separated from liabilities and o$ners e,uity (on the left)

o All debits are on the left% all credits are on the right% ":# this does not mean all credits are a J or debits are al$ays a C o 0ypes of accounts (see # GC3 on p 3M and handout) Asset Accounts /ash 0n&entory 5otes recei&able 1,uipment actory2Plant 6and Accounts recei&able 0n&estments +ther assets ia#ilit$ accounts Accounts payable (the purchase of goods not paid for right a$ay= do not pay in same period goods are recei&ed) 5otes payable o &endors $ant more than mere trade creditor status o banks lend money O!ners Equit$ accounts *etained 1arnings (corp) (earnings from day one minus di&idends paid) +$ners e,uity (corp) /apital accounts (partnership) "efore making an entry% the bookkeeper or controller should ask the 0:R22 ;62!0'$1! o ,hat too" place. o ,hat accounts does it effect. o ,hich !a$ do those accounts move.

Accrua% Accounting GAAP does not recogni>e the cash method% although the federal go&ernment does for income ta' purposes. o Most businesses (small ones at least) use the cash basis. #his does not affect their borro$ing ability so long as the amount being borro$ed is 3:3 or less of debt: e,uity Done for (Matching Purposes) o #he e'pense is recorded in the same period in $hich the income is reported o .ithout this% $e lose the ability to compare the statement to other companies and prior years of same comp Recognition v0 Reali%ation o *ecogni>e the transaction at the time the e&ent takes place (e': $hen truck lea&es the $arehouse% $hen goods arri&e) o *eali>e the transaction (for matching purposes) $hen payment made or recei&ed #his is done for sales ta' purposes% some entities re,uire you use for ta'ing purposes $hen the sale arri&es at the buyer% not $hen it lea&es your $arehouse Accrual & Deferral Accrua%: o !ome e&ents should be reali>ed during a current period e&en though the payment in respect of that e&en $ill not be paid or recei&ed until some future period. 1': buying on credit% payment plans for ser&ices rendered up front% etc

Deferra% o !ome e&ents should not be reali>ed until some later period e&en though the payment for that has been recei&ed already 1': preCpayment for ser&ices2goods% retainer fee !till ha&e t$o entries% but one of them $ill be going into a deferred2accrued account. o 1': buyer paying $ith credit for ser&ices you already rendered: Accounts recei&able gets a credit (left side entry) and income account recei&es a debit (right side entry% on opposite sides of the e,uation% a debit to an income account is an increase in that account% see table GCH for map of the e,uation) 5+#1: if interest charged on accounts2notes recei&able% the interest is income (credit to income) and a debited from the accounts2notes recei&able. o 1': paying your lease in ad&ance: +riginal payment (<N%BBB for% say% H mos) is an asset (left side debit entry in the preCpaid rent account) and reduces the cash account (right side credit to the cash asset account) As months pass% the preCpaid rent assets account is right side is credited for proCrated amount (<G%BBB) and the e'pense account is left side debited (a debit in an e'pense account is an e'penditure by you% e&en though it is termed a debit) for the <G%BBB #his results in matching the e'pense $ith the same period the benefit is deri&ed from that e'pense. o 1': paying an assistant in a professional firm ;ou pay her salary e&ery month (an e'pense% left side debit entry) that is matched by an entry in the cash account (right side credit entry) Profit @ 6oss statement (P@6) (5+M05A6 A//+:5#!) o Revenue: income reali>ed from the sale of goods2ser&ices% e&en if in form of notes2accounts recei&able o E*pense: e'penses generated that period to produce the re&enue% only the parts actually reali>ed% e&en if other amounts remain paid out in ad&ance in form of preCpaid rent% for e'. +ominal accounts: o (/losed) to e,uity (surplus) (or capital accounts in a partnership) o 5ominal because not left on the books year after year (is >eroed out and not carried o&er) #he assets2liabilities2e,uity accounts are carried o&er year to year% are the beginning of the ne't years balance statement 1rial 2alances o /redits to the liabilities and e,uity "ust e,ual debits to the assets. o Ad7ustments may then be made for depreciation% etc Retainers o /ash recei&ed in period 3% but firm committed to pro&ide ser&ices in the future Payment recorded as a debit (left side) to the cash account on the asset side% and as deferred income on the liability side (right side credit entry to a deferred income account). #he deferred income is a liability because you (o$e) <O%BBB in ser&ices to the client for the paymentA #his should be a two<step process% the first step recording the increase in cash and a re&enue of the same amount% the second step sho$ing a reduction in re&enue and an increase in deferred income to sho$ the money is not actually earned yet. #his could be circum&ented by a single step sho$ing increase in cash and increase in deferred income% but this may not tell the $hole story if someone $as to read the sheets. As ser&ices are pro&ided% the cost of those ser&ices is deducted from deferred income and added back to re&enue% reducing the liability by that amount and increasing e,uity (retained earnings) by the same amount. rom !ch$aeber (not in book) o 5ot paying payroll2sales ta'es% so approaching bankruptcy-

1'ample Payroll is <HBB2$eek ed $ithholding: OB !tate $2h ta': 3B /ity $2h: 3B !oc sec: 3O Medicare: O #otal ta'es: <PB% <NB of $hich you are credited for on your .G (the fed% st% city) o 0n payroll account: <HBB debit (an e'pense) from the cash account <PB of this is paid to the &arious go&ts <G3B paid to employer o +n balance sheets HBB right side credit from cash account 6iability for ta'es (ta'es payable account% preCpaid ta'es% deferred ta'es% etc) 1'pense for G3B actually paid to employee o /ompany is the escro$ for the go&t $ith respect to the ta'es $ithheld% directors are personally liable to the go&t for that amount. "ill for that liability is sent to all directors% e&en if all pay% go&t keeps itA !o be sure not o&erpaying for the liability as an entityA $ctober 1, 2001 (6egislati&e #hursday) Accounting for 0n&entory /+G! (/osts of Goods !old) 0n&entory appears on "+#8 the balance sheet and the income statements "iggest asset in most businesses% also most susceptible to fraudulent reportingA o #he Ultra Morris case: company claimed /anadian in&entory= accountants ne&er inspected it= comp has lied to accountants= accountants $ere sued and lostA o aking it creates a fake profit )rofit 9 Loss !tate"ent o /+G!: /ost of in&entory (opening of period) (x) Purchases (during period) (y) 4 combined in&entory (x = y) !ubtract ending in&entory (left o&er at end of period) (>) ' J y L> 4 /+G! o so% if lie about ho$ much you ha&e left (>)% this results in a lo$er /+G! QQQQQraising in&entory lo$ers the /+G!QQQQQQ sho$s a better profitA QQQQQdecreasing in&entory increases the /+G!% reduces the profitQQQ #AK 0MP60/A#0+5! if ta'ed on profitsAAAA Also% may $ant to reduce profits this year to sho$ big boost for ne't year% or (sa&e) the profits for ne't year to demonstrate to bank steady increases in profitA Recording in?entory o 5o set $ay to buy it (maybe R0#% may be in ad&ance% may be $hene&er process are right) o ":#% there is a set $ay to record it on the balance sheet 0s carried as a current asset ($ill probably be sold (li,uidated2used) $ithin one year) #he ending in&entory (>) is $hat is recorded as the current asset (the historic &alue% not the market &alue)

3Stale goods4 are not included in the ending in&entory% these $ould be reflected in the /+G! (e': parts no longer marketable% etc) Perpetual 0n&entory (#"D) o +nly used for large items o Allo$s more immediate profit determination (interim P@6 statement) *ecording in&entory o Al$ays done at historical &alue% only modified if actual in&entory is someho$ enhanced Periodic in&entory o !mall items% can not be identified indi&idually% can only be a profit determination at the end of an in&entory period (not at interim periods% as in perpetual in&entory) o +ne entry made for all the same type of in&entory you purchase (e': 3BBB light bulbs this month for 3.BB% 3BB ne't month for 3.3B). o )ungi#le goods: each one is same as all the others% doesnt matter $hich is sold (e': $heat% $omen) Accounting for the in&entory in /+G! #$o types of recording in&entory% must e'plain in footnote $hich method is being used o irstCinCfirstCout *eplacement cost is in in&entory ($hich is no longer at current price) During inflationary periods this results in a sho$ing of a bigger profit (so higher number left in remaining in&entory% lo$ering /+G! and raising profit) o 6astCinCfirstCout :sed in times of inflation to satisfy matching of costs and re&enue Matches replacement cost to the sale (not to the in&entory% but to the current cost) During deflationary periods (rare) using this method increases profits because remaining in&entory is at higher historic price% increasing remaining in&entory% lo$ering /+G!% increasing profitA .hich method of in&entory recording you use $ill be dictated by underlying business needs. o ;ou are allo$ed to make one change (from 60 + to 0 +)% but ha&e to sho$ $hat effect that change $ould ha&e had on prior year reportsA 0ncome ta' implications ++#5+#1! 6o$er of cost or market (6/M) o Must record price at the lo!er of price or mar"et o #his is in accord $ith GAAPs principle of conser&atism

$ctober @, 2001 -nventor$ (cont) General o 5ote% $hen using 0 + or 60 +% depending on $hether $e are inflationary or deflationary times% one $ill result in a higher in&entory than the other. #his has implications beyond the balance sheet% such as insurance co&erage re,uirements (and the cost of the co&erage). 0f you sho$ a higher le&er (<<) of in&entory% need more co&erage (e&en though the same number of items is there% ho$ you &alue them may ha&e insurance implications) o .hat kind of recording for in&entory ( 0 + or 60 +) is noted in a footnote. 0f you change method% you must indicate $hat the results $ould ha&e been for years past if that method had al$ays been used. o 0n&entory% as a current asset% should turn o&er se&eral times per year (bet$een G and O% normally)

Accounts Receiva#le A current asset (e'pected to be collected $ithin a year) /ixed Asset and depreciation )i*ed asset: items the purchase of $hich benefit future periods (PP1% &ehicles% etc) o Done by depreciating the asset o&er a period of time 5ote: land does not depreciate% although the buildings on it do. Also% the appreciation of the land is not reflected on the balance sheet because $e use historical cost o +ne part of the balance sheet mgmt (usually) has control o&er (decides ho$ to depreciate the items). Capitali%ing the Asset o .hen $e put a depreciating item on the balance sheet% only designate part of the cost as an e'pense% or decreasing asset% e&ery year. o .hen $e capitali>e a machine% e&erything accompanying that machine is also capitali>ed (e': special $iring2duct$ork2platform for machine is capitali>ed same as the machine is) Depreciation o Amount of the e'penses for the year% $ith a contra account set up (an account that decreases the asset) .e dont take the machine (a fi'ed asset or separate account fore machinery) that cost <3B%BBB% the original cost stays on the account originally put in (left side entry)% the depreciation amounts go into the contra account (accumulated depreciation) (right side amount). #he depreciation account is (matched) by a left side entry into depreciation e'pense% $hich is matched% by a right side entry into the P@6 account. !o% still ha&e matching principle: 3B%BBB for machine in fi'ed asset account matched by $hate&er account you paid for it $ith% accumulated depreciation (contra) account is matched by the P@6 account. our entries for the machine in the first year% t$o for e&ery subse,uent year. /ontra account is not a liability ($e dont o$e anybody the depreciation)% but is 7ust a reflection of the depreciation because the fi'ed asset account is not changed to sho$ the depreciation. !ee p SB and SI of book. o Mgmts choice of method to depreciate on e&ery fi'ed asset% e*cept the building. or the building% the go&t dictates HB years as the period of depreciation. o /ost of land includes $hate&er efforts it takes to make the land Tbuildable (grading% le&eling% remo&ing obstructions% etc.) Life of "ac,inery (for depreciation purposes) o actors: 8o$ long other machines ha&e lasted o /an not depreciate belo$ scrap ?a%ue ($hich is determined at the beginning% not the end% of the machines life) !o contra account ne&er completely $ipes out fi'ed asset account% most things still ha&e some sal&age or scrap &alue at end of useful life. o -f machines sold for greater value than depreciated value5 that e*cess must #e recorded as a profit. #he depreciated &alue of the machine is its book &alue% anything o&er book &alue is a profit. o Depreciation should match the useful life of the items being depreciated. 1'% computers depreciate ,uickly% machines take longer. 5ote: $ou creating your o$n soft$are: can capitali>e all stuff going into the making of the soft$are (put all of the e'penses% such as payroll% supplies% etc.% in a fi'ed asset account). Can no! depreciate those e*penses o&er time. 0 $ou 2U6 the soft$are from someone else% that is an e'pense% no depreciation. Methods of depreciation (p SS)

5+#1: things depreciate ,uicker up front% e'cept in straight line. Also% may use different methods for ta' @ accounting purposes. Also% 7ust as method of recording in&entory affects balance sheet% so does choice of method of depreciation !traig,t Line 4et,od o #he (simplest) method of depreciation. 1&ery year the same amount (a percentage of the original price) is depreciated. 1'% 3BBB machine% scrap &alue of 3BB% depreciable base of PBB% 3BU depreciation% depreciate PB per year until you hit 3BB (cant depreciate past scrap &alue) 1': opening accumulation is >ero (first year)% depreciation for the year is PB (3BU of depreciable base)% accumulated depreciation at end of year is PB. second year opening accumulated depreciation is PB% depreciation for year is PB (straight line% same amount e&ery year)% and accumulated depreciation at end of Gnd year is 3MB. !11 1KAMP61 +5 PAG1 SM !u" of t,e Aears Digits 4et,od o !ee pages SMCMB% including chart on p MB. Doub%e Dec%ining &a%ance 4et,od o "ase for the doubling amount is the book &alue (depreciated &alue)% not on the historical &alue.

Depletion2amorti>ation (similar to depreciation) :sed for intangible assets (dont ha&e a physical presence% but assets $ere e'pended for it% such as good$ill or a patent). Also used for oil and gas. o (/ood!ill) is the amount you pay for a business o&er and abo&e its book &alue. Go&t no$ allo$s depreciation of good$ill o&er 3S years% for both ta' and GAAP purposes. :sed for a (!asting asset) o 1': gas2oil. 0f you o$n a $ell% there is only so much oil you can get from it. 1&ery day there is less% so e&ery day the $ell is $orth less and no $ay to replace it. 1&ery year the &alue of the $ell is $ritten do$n. *andom professor thoughts here: Mortgage fees to secure a mortgage (such as legal fees) Capitali%ed and depreciated over 7 $ears or length of mortgage% $hiche&er is lesser. Accounts Recei?ab%e (p MO) /ash basis is not acceptable for GAAP (need to match re&enue to e'pense% receipt of cash may be separated from e'penses to create the goods2ser&ices sold by many months% not an accurate picture to only sho$ $hen cash recei&ed (not able to compare to other companies or other time periods of same company)) /ost of financing may be built into price directly% or put into agreement adding finance charge% or selfC financed (at loss of potential re&enue to seller). Are not 3BBU collectable% so ha&e to account for this someho$ tooA o /ontra account set up against accounts recei&able. A schedule (the (agent)) is used to sho$ ho$ much $ill be collected in each of BCHB% HBCNB% NBCPB and o&er PB days% once gets o&er PB days start to consider $riting them off (decision ultimately made by credit dept based upon past e'perience% is a mgmt discretionary decision). .hen to $rite off is based on e'perience of industry and past history of your company. o 0n the contra account goes the amount you $rite off. #he contra amount also goes in the accounts recei&able to sho$ reduction in that account. o +n the P@6 is a category Tbad debts $hich sho$s the amounts $e dont e'pect to collect for that period. Page MM: (allo$ance for doubtful accounts) $ctober 11, 2001 Depreciation (cont) #he spreading of costs of fi'ed assets o&er time

05A6 1KAM: D5+. D+:"61 D1/60505G P1*/15#AG1 D1P*1/0A#0+5 M1#8+D

+redit Accounts Allo$ance for doubtful accounts 8a&e to (age) the accounts o !et out a schedule of the e'pected accounts recei&able and kno$ from history ho$ much comes in during each period BCHB days K comes in H3CNB days ; comes in N3CPB V comes in +&er PB days: A comes in% mgmt may $rite off a certain percentage through a contra account. 4arBetab%e !ecurities *) CD. !hort term & long term is GBU threshold (for small businesses)% more than IBU is #hose secs a comp buys and hopes to earn an in&estment income in (interest or appreciation) o 1hese earnings are not operating income5 are sho!n at #ottom of &' or 2al Sheet as 3non8operating income9 GAAP re,uires that this asset be $ritten do$n at "arBet% if it subse,uently increases $e ha&e to increase the account to reflect the change o Must be ad7usted each year /reate a &aluation account% a contra account 6ong term in&estments o More than GBU and less than OBU of the stock of a company o #$o methods of recording the in&estment At your cost (the investor:s cost) Ad7usted each year to reflect his share of the in&estees (the comps) earnings Any di&idends are not recorded as income here but rather are reflected in the capital accounts (your percentage of the earnings). #he e,uity Method (/AA& method) 5ot ad7usted for market &alue More than OBU of comp o "uyer is called the parent% seller is no$ a su#sidiar$ o Parent has influence o&er the board of directors% has the most stick and elects the "oard. +fficers appointed2elected by "oard of Directors o Parent and subsidiary maintain separate books% but sho$ consolidated statement /onsolidated statement (need for 2L'4'1A0'$1!) o Sho!s #oth parent and su# on same sheet5 #ut "eeps data separate and distinguisha#le (attributable to each comp). o Also sho!s a consolidated statement com#ining #oth comp:s. 8a&e to cancel out interCcompany items (liabilities) and reflect this is in the assets of the comp o$ed the money #his is only done in a parent2sub relationship (more than OBU o$nership) Also ha&e to take out loans bet$een companies in a consolidation Writing off intangible assets (deri&ati&esFFF) 1'ist separate from other assets of the comp (e': patents% copyright% trademarks% franchise licenses% good$ill) #he cost is capitali%ed (put into an asset account% can be sold separately from the business)

o /osts are amorti>ed o&er period of time they $ill benefit the company (e': patents are amorti>ed2depreciated at a straight line o&er 3S year period) o /osts that are incurred no$ but benefit future periods Good$ill: o /ant be sold by itself% merely represents the e'cess purchase price o&er the assets of the comp. *ecorded at cost (true market &alue of intangibles ne&er sho$n on the books) Amorti>ed o&er IB years (GAAP) (3O years for #a')

Leases and %ong ter" ob%igations Operating lease: treat the e'pense as rent Capital lease: the lessee basically ac,uires the prop% the lease is a financing operation o #hese items are capitali>ed% put in an asset account and depreciated our criteria for needing to capitali>e a lease: (in,uiry: do you really o$n the prop) o Does the lessee o$n the prop at the end of the leaseF o Does the lessee ha&e the option to buy at less than M9F o Does the lease term co&er more than SOU of the economic life of the propF o Does the total P9 of the payments to be made e,ual PBU of the M9 of the propF Payments are both current and long term liabilities o #he current portion of long term debt is a current liability (due $20 3G months) )ension p%ans Defined benefit plan o 1mployers obligation is defined in an amount of benefits to be paid o 6ooks for$ard to $hat the employee $ill make $hen he retires (the benefit) Defined contribution o 1mployer makes a certain contribution each year based upon his salary (an amount e,ual to a percentage of salary) Loss +ontingencies :sually comes from the attorney% mgmt may kno$ about them also !et up the liability ahead of time (as a contingency) e&en though you are uncertain of the amount. 0s a deferred e'pense and liability on the balance sheet% footnoted. (see p 3BS) o 0ncludes kno$n la$suits% both pending and not yet filed o 0ncludes stock options as $ell $ctober 1C, 2001

/apital Accounts
/apital account in a partnership is the same as retained earnings in a corp o 0s only one for the $hole pship

!tock
!ee /orp in (preferred: cum% nonCcum% participating% nonCparticipating. /ommon: par% noCpar) o 1'cess o&er par &alue goes into (paid into capital) account o !tated &alue 4 number of shares Q par &alue o 6egal capital: minimum threshold for being allo$ed to make distributions% is at least stated &alue. o !C/orp: pass thru ta'ation (same as pships) (on DCform for filing ta'es) o /C/orp: double ta'ation )ar 7a%ue and Lega% +apita% Par &alue: a dollar &alue specified in the charter that establishes the minimum price for $hich a share of stock may be issued and $hich is set aside for the protection of creditors.

6egal /apital (!tated /apital): the aggregate par &alue of all outstanding shares plus additional paid in permanent capital o ;ou $ant to start a business% need <3B%BBB to get started% $ant to sell shares. /an sell shares in any denomination (3 share $orth 3B%BBB or 3B%BBB $orth 3 or 3BB $orth 3BB= decision based on $hat $e think is marketable). 0P+s normally start at the <GBCOB range. Anything o&er <3BB is normally less marketable. .e $ant to sell 3BB shares at <3BB to raise the capital. 0n&estors are $illing to take on ;2usiness Ris": (the risk that the business $ill be unsuccessful and fail). #his risk is compensated for by normal return. Do not% ho$e&er% $ant to take on ;start8up: risks (the risk that the promoter can not raise sufficient funds to get the business started). Eatered stocB: stock that is diluted by the issuance of other shares for less than par &alue. o 0n order to protect in&estors% la$ came to say that you could not pay less than par &alue% and if you did you $ould be liable for the difference. (an e'ception to limited liability= could be enforced by comp or other shareholder) o /ould of course still pay more than par &alue% but you $ouldntAA 0f you did% you $ould suffer the same conse,uences of $atered stock. #here are times you $ant to pay more than par &alue: subse,uent offerings (0P+ $as at 3BB% price of those shares no$ $orth GBB% ne$ shares $ill no$ be sold at GBB% e&en though par $as 3BB) ($ill pay more $hen M9 is more than par &alue) 8o$ to record sale on balance sheets (3BB original shares at par &alue OB later at M9) o Par &alues (paid in capital) 4 3O%BBB (3OB shares at par &alue of 3BB) o /apital surplus (amount recei&ed by the company in e'cess of par &alue) 4 O%BBB ((OB Q (GBBC3BB)) o *etained earnings (profits earned but not distributed to shareholders) 4 3B%BBB (3B%BBB $as original cost% doubled to GB%BBB% 6egal capital rule is to protect creditors% $ho cant sue you directly (as a shareholder) so long as you dont buy $atered stock .hy $ould you $ant to sell stock for less than par &alueF 5ecessity: o ind that you cant sell shares for par &alue% but still need more money. 0t should not be necessary to do this if you use a subscription agreement (therefore argument failsA) !ubse,uent offerings: o 0P+ of 3BB shares for <3BB (<3B%BBB raised). +&er time% company loses money% is no$ $orth only <O%BBB (each share no$ $orth only <OB). .ill not be able to sell ne$ shares for par &alue (<3BB)% $ould only be able to get going rate (<OB). 0t could no$ be fair to allo$ sales under par &alue% e&en though illegal (that is the going rate% but cant reCissue no$A) Gi&e a gift o May $ant to charge friends less% or e&en gi&e a$ayA #his reason &alidates the par &alue rule% is the true concern behind par &alue: intentional $atered stockAA +ther intangib%e consideration (kno$Cho$% good$ill% etc) o 1': t$o people starting a business% one pro&ides the kno$ ho$% the other the funds (may $ant to split it all OBCOB% and no reason they shouldnt be allo$ed to). 8o$e&er% under traditional capital rules% $ould all ha&e to pay par &alue% allo$ing scientist to take for free is $atered stock that dilutes financiers assetsA 8as same look as a gift (ho$ do you &alue the input of any one person% especially $hen there are many shareholdersA). o 5ot the assets themsel&es (such as copyrights% patents etc.% $hich are really assets) /onsideration other than cash gi&en (alternati&e assets offered)

o 1': share bought for <3BB $orth of e,uipment (is Tfree% that is% no cash paid). Most state la$s (as $ell as M"/A WN.G3(b) on p MN) allo$ issuance of stock for assets other than cash (e': property). 5+# all property is acceptable though o Promisory note of the purchaser (an 0+:) is not acceptable in many states. 8o$e&er% third part$ note is acceptable. !o% 0"M could pay for a Microsoft stock $ith a G1 bond% but not $ith its o$n bondA 8as to be more than an 0+:% has to be an actual asset. o /ant use the promise of a future ser&ice (past ser&ice is still ok). Modern trend is to allo$ anything the company finds acceptable (see M"/A) (mo&e to$ards "R*) o Problems $ith this: 9aluation: ho$ to place a proper price tag on the property. 0f $rong &alue assigned% result is the same as $atered stock. o !olution: "oard has to perform a &aluation of any consideration recei&ed to assure it is ade,uate (M"/A W N.G3(c)) Problem $ith the solution: 5ot a scientific $ay% no check on discretion of directors in &aluing consideration. (Directors can be insincere and be protected by the "R*) o WN.G3(b): determination by the "oard of Directors is conclusiveAA o /omment: s2h protection comes from the Directors fiduciary duties (can still be liable for the breach of the fid dutyA). o #hese solutions are necessary to ensure limited liability: only directors can be liable for bad &aluation (&iolation of fid duty)% s2h $ho ga&e the poorly &alued consideration (and all subse,uent shareholders) no$ al$ays co&eredA 0nsol&ency test: WN.BI o "d. of Dir. decides the di& to gi&e% but cannot render the corp insol&ent by gi&ing the di& 1,uity insol&ency test "alance sheet test: assets must e'ceed liabilities after payment of the di& (ca&eat: allo$s accountants to use current &alue of assets% not 7ust the &alue they put on the books) Par &alue as protection for /reditors !tate la$s ha&e rules on $hen a corp is permitted to pay di&idends or make other distributions to shareholders. o 0f a comp has a lot of debt% it is not fair to allo$ a corp to take all of its assets and gi&e them to s2h% thereby stiffing the creditors #hree main categories of protections for creditors (three tests) 3) 0nsol&ency test A comp can not make a distribution if the comp is not sol&ent or $ould be rendered insol&ent as a result of the distribution A brightCline rule. T0nsol&ent 4 (Equit$ -nsolvenc$) (#he inability to pay debts as they become due.) G) 1arned surplus test a comp can only pay a dist out of its cumulative retained earnings (the earned surplus) All of its profits L all of its distributions (both measured from day one% can only pay out of money its earned% or profit)

0f this test is strictl$ applied: 0f it has ne&er made a profit% or e&en has been losing money% it cant pay di&idends until it makes up the lossesA ":#% most states allo$ for nimble di&idends: di&s that are permitted to be paid out of recent earnings% usually this years and last years earnings ($hen considered as one unit) e&en if there is no surplus. 1ssentially% ha&e to make a profit for t$o years in a ro$ before di&s allo$ed. H) 0mpairment of /apital test (aka: the T"alance !heet #est) /an only make di&s out of its surplus !urplus 4 assets L (liabilities% aggregate par &alue% and often preferential li,uidation rights) !imilar to earned income test ($hich looks to the income statement for aggregate earnings). ":#% this test looks to the balance sheet (but in reality can look to almost anything% see cases on pp PO @ PN) "alance sheet is not final say on surplus% can freely re&alue assets Randall v0 2aile$ (middle of page PO) 8istorical &alue on balance sheet is irrele&ant for determining if a surplus e'ists. /an freely restate the &alue of assets in order to increase the surplus on the balance sheet (assets L liabilities 4 e,uity). 0ncreasing assets ($hile maintaining liabilities) results in greater e,uity (surplus). 8a&e to actually restate the balance sheet though (and that has collateral implications and conse,uences in and of itself) <lang v0 Smith )ood ' Drug Centers (p PN) or D1% all $e need is a (real surplus.) #he market &alue of the assets has to be greater than the liabilities and the aggregate par &alue. 5o need to actually restate the balance sheet% 7ust ha&e to make a determination by the board of directors that a surplus e'ists% and then can make a di&idend. (is a pr&t determination% no need to alter balance sheet and its attendant ratios% etc) o M"/A W N.IB(c): allo$s both the e,uity insol&ency test and the balance sheet test 0n these methods% some &alue is maintained in the comp% keeping assets a&ailable (setCaside) for the protection of creditors.

1ffect of any distribution Any distribution has the same effect of di&=s% and should therefore be go&erned by the same rules (and are in most states) o M"/A W 3.IB(N) (see page 3BP): direct or indirect distribution Tdistribution does not distinguish bet$een di&s and other distributions (is defined broadly) .hy is it all the sameF Di&idend is a periodic cash payment. !pecial di&idend is the same thing% e'cept only paid one time (not periodically) Di&idend of a bond is the same thing (is a debt obligation% the incurrence of indebtedness% an 0+:). o 5o real difference bet$een the comp gi&ing you cash or a bond (both are distributions). 0nstead of actually gi&ing 3B% promising to gi&e 3B. .hen to apply the legal capital tests (limits on distributions) Apply $hen bond is gi&ing% or $hen paidF +r% does it count #oth timesF ($hat is a distribution) o Policy args +nly today: no difference bet$een cash and bond

+nly $hen payments made: comp doesnt ha&e money to pay di&idend (interest) no$% but $ill $hen actually made (or &ice &ersa). Di&idends are not supposed to be guaranteed% this rule pre&ents circum&enting that principle o 8istorically: applied both o Modern trend: only $hen issued (treat bond same as cash) ,illiams v0 +eve"o! (p 3BI) +fficial comment to M"/A W 3.IB (on page 3BP) 1$02: !hare di&idends (stock di&idend) is fundamentally different than other di&idends% does not fall under the rubric of the abo&e material% $ill be addressed later in the semester. A reCpurchase is the same as a distribution (comp is gi&ing assets to its shareholders). Money no$ in s2h hands and not touchable by creditors (same effect as any other distribution). +nly allo$ed to the same amount other distributions $ould be allo$ed. o 1': 3BB shares% original capital 3B%BBB% 33U return% no$ $orth 33%3BB. use the 3%3BB to buy back 3B shares. !2h has 3B shares% before purchase $orth 333 each (3%33B in s2h portfolio). 0f doesnt sell his 3B shares back% comp buys else$here% no$ has PB shares ($orth P%PPB)% s2h has 32P of comp (instead of 323B)% $hich is 3%33B (same &alue in portfolio). 0f s2h $ants the di&idend% can sell one share to the comp (then has 3BU again)% comp is $orth P%PPB (s2h has PPP in stock% 333 in cash% 3%3BB total). *1!:6#: no diff bet$een repurchase and di&idend (or holding onto stock $2o di& being offered)A /an make o$n di&idend by selling one share. #his $orks in re&erse too (can use the di&idend to purchase an additional share% rein&esting in company).

Accounting for stock sales Mo&e part of the retained earnings into stated capital% di&idends deducted from retained earnings Paying Di& Date of declaration% date of entry o #$o entries% one for $hen declared (no$ a liability) and one for $hen paid (comes out of assets and decreases liability). Mutual fund di&s: o "uy mutual fund after di& paid to a&oid ta'es on the di&A "ank 6oans .ant 3:3 :: debt:e,uity le&el% so may re,uire personal loans of stockholders be restated as permanent capital to pre&ent the loan being dra$n do$n outside of insol&ency. $ctober 2F, 2001G4'!!2D +LA!!G 2R'1! 1$02! << +as, f%ow state"ent day 1o?e"ber 1, 2001 Aging: $rite off the recei&ables after a certain point (HB% NB% PB% 3GB days% then $riting off portions after 3GB). 5et 0ncome: first entry on a cash flo$ statement o Add back anything that you $rote off% depreciated o 0n&estment o inancing: amount recei&ed for debt goes on cash statement% sale of stock% amounts paid out to repay loan% di&s paid by corp% /ash items not affecting income o /on&ersion of marketable secs to cash o /ollection of $ritten off debts

/urrent liabilities o All payments $ithin 3G months% longer than that is a long term liability

inancial Analysis *atio analysis: for the purpose of comparing that number to prior years and similar companies (or industry standard). o 6i,uidity ratio (the (/urrent ratio) 3G month cutoff) $orking capital% amount by $hich the current assets e'ceed the current liabilities. (May ignore items such as in&entory% e&en though turned o&er H or I times per year% and therefore also re,uire a second ratio% the assetCtest ratio% or (,uick ratio)). inancial condition of corp in comparison to other years2corps #ells: does the corp ha&e the ability to pay its debts o 0n&entory ratio: ho$ often the in&entory is turned o&er per year% $ant at least G:3% better to ha&e I:3. 8igh ratio can be good (high sales) or bad (conser&ing cash and not buying in&entory). 6o$ ratio can be good (storing up in&entory for future sales in inflationary times) or bad (not making fre,uent sales) !22 )A(2 1F@ 8a&ing a large in&entory% you should $ant a large ratio or an assetCtest ratio AssetCtest ratio ((,uick ratio)): use current assets2liabilities% o 3.B (3:3) is considered good o Acti&ity *atio 0n&entory and accounts recei&able are the biggest mo&ements (acti&ities) 0n&entory turno&er 6o$ turno&er: cash not coming in as fast% or planned buildup 8igh turno&er: cash coming in fast% or lo$ le&el of in&entory (think R0#) +*M:6A: see page 3OO 0n&entory turno&er 4 cost of sales 2 a&erage in&entory o A&erage in&entory 4 (opening J closing in&entory) 2 G 5+#1!: lo$ turno&er may indicate holding in&entory for sale later or lo$ sales% high turno&er sho$s good li,uidity or good marketing Accounts recei&able ratio: 4 /redit sales 2 a&erage accounts recei&able o #urno&er: HNO 2 result (tells you ho$ many days it takes to turn o&er (pay) the accounts recei&able) o Debt to 1,uity ratio: 6191*AG1 "anks usually $ant 3:3 *eal estate may be much greater (3B:3% higher le&erage) because of inherent appreciation of real estate (especially once impro&ements2fi'tures added to the land) :se Tbridge loan to build structure% then seek a permanent mortgage. 0ncome ratios (go on the income statement) o Gross profit ratio: 4 gross profit 2 sales sho$s the margin $e are selling our goods at. 8igher ratio sho$s better use of in&entory2technology2efficiency2producti&ity% or purchase of lo$er cost in&entory% etc. 6o$ margin sho$s inefficiencies% may as $ell not be in business (all for naught) pro&ides basis for comparison to past2others2industry o 5et profit ratio 4 net profit 2 sales

":#% is after a certain amount of sales @ general administrati&e e'penses (!G@A) ha&e been factored in. /osts of sales includes all sorts of stuff (factory% in&entory% etc)% and general admin e'penses are e'penses of the comp outside the costs of sales #his is 1$0 to be compared to other companies% because too many &ariable (the e'penses) for each company% not $orth comparing. o Difference bet$een gross and net: factoring in of selling and G@A e'penses !G@A e'penses different in e&ery company% can al$ays alter these later but can not affect gross profit by making admin changesA (think of gross as the constant% net as the result of many &ariables). #rend Analysis (goes in the MD@A) /omparing ratios for succeeding years. o Are sales2gross profit2e'penses impro&ingF Are you meeting e'pectationsF 0s e&erything in line $ith prior years and e'pectationsF 1'pectations no$ made by outside analyst firms (e': irst /all) as $ell as mgmt. Due to fi'ed nature of much of your o&erhead% as sales go up operating e'penses (as percentage of sales) should go do$n. !ee page 3NB 1o?e"ber C, 2001 *emainder of +, D and 10 #rend analysis (cont) 1arnings Per !hare o 5et income 2 $eighted number of a&erage shares for the year +nly di&ided by /+MM+5 !8A*1!% not con&ertible options or preferred stock. !ee book for better e'planation o +nly done for public companies% not rele&ant for closely held companies o Measured after income ta'es% carry for$ard losses artificially inflate this number% must be discussed in MD@A. Price to earnings ratio (P21) o *elates to current market price to earning per share 1': price 4 IB% earnings per share 4 G% P21 4 GB Also referred to as the (Multiple) 8igher ratio (typically) sho$s comp is doing good. or gro$th companies% high P21 reflects optimism comp $ill gro$ into that number% or ha&e some other asset in reser&e that someday $ill bring great re&enue to compA (Alternati&ely% may reflect stock being o&erCpricedA) /ash flo$ ratio o /ash flo$ statement: 51$E 0:'! /$R 23A4G"issed c%ass t,at dayH 1': stock sale(profit is a profit item% but sale itself is a cash item% as $ell as repaying loans% etc) o !et up of accruals: cash outflo$s that doesnt hit cash flo$ statement% such as di&idend payments o *epresents the cash in and cash out% ad7usts for accruals2recei&able2purchases of fi'ed assets o *eturn of e,uity: sho$s ho$ the assets help generate profit. o Di&ide cash flo$ 2 operation /ash co&erageo /ash debt 2 profit Measures ability to meet the current and maturing debt Guideline for ho$ much of a di& to pay /ash flo$ pro&ided by operations o Mo&ing the operations into a cash flo$ statement o 0ndicates if can pay di&2repay o$ners% etc

4anage"ents Discussion and Ana%ysis *4D9A. 5ot re,uired by !1/% but 7ust about e&ery public company has it (part of the 3BCE) o inancials are historical &ie$s of results for prior period% does not address any information as to $hat $ill happen in the future ((hard) numbers% hard info)% ha&e no &alue looking for$ard. o +n the other hand% managements analysis of the numbers (soft numbers% soft info) tells you $hat $ill happen in the future. 1mphasis is on future performance as e'trapolated *e,uires disclosure of material trends2info that $ill effect future numbers. 1': impending loss of patent. o Discusses the uncertainty of the going concern% doubts as to $hether the comp can remain in business Also sho$s ho$ these doubts $ill be remedied !ub7ects co&ered !11 "++D o 6i,uididty o /apital resources o e'penditures for plant and e,uip o trends and threats (competition% loss of patent% obsolescence of in&entory% increased demand% etc) o prosepecti&e info about kno$n uncertainties making the past info not indicati&e of future operations o unusual items: pending la$suits o inflations effect on operations o result of operations: unusual e'penses in operation of company ($hy the net ratio is useless as a comparison% because each comp has its o$n unusual stuff each year) $hy gross profit $ent up2do$n !G@A prices 0ncome ta'es (including carry for$ard losses that artificially reduced ta'es this year) o foreign e'change effects o ne$ products2prices coming do$n the pipe% effect of such o en&ironmental matters o $hat effects recent changes $ould ha&e had on prior years o pending transactions: is comp for sale o ne$ products #ime 9alue of Money see /orp inance ormula #able and /orp inance 5otes on page H !11 A6!+: p 3MG L 3MH in book sometimes need to determine if lump sum today is $orth more than a stream of payments o&er time $ith interest $hen used: o negotiating settlements (in lieu of lump sum $hich $ould bankrupt a comp and result in not getting any payment) o drafting contracts and agreements o purchase of business% lottery $innings% etc D5+.: o Present 9alue o uture 9alue *ule of SGs o annuities actors o :tility: use of money no$ & later o *isk: $ill you get the money in future% or no$ if re,uire in full (may force into bankr% etc)

 Annuities 1o?e"ber 1F, 2001 +,apter 11 !tatements are the hard numbers% MD@A are the soft numbers (ta' effects% e'ternal &aluation of money in foreign countries% $hat the future holds% ne$ products% etc: the general background of the numbers= only for public comps) 9A6:A#0+5 (cont) rom book &alue% no$ ha&e to determine $hat the market &alue is of each asset o 0n&entory: last in first out% may &alue old in&entory based on current rate to reflect reality. 0f been using 60 +% be sure clients insurance co&ers market &alue of the in&entory% not the book &alueA #he +ld Man and the #ree Parable (notes from /orp. in.X9elasco) 9aluation is about taking as much information as possible into considerationA 8ere% old man looking to sell tree for best offer. o irst offer: <OB (the sal&age &alue of tree as fire$ood) !al&age 9alue: #he amount e'pected to be obtained $hen an asset is disposed of at the end of its useful life. Must consider other possible uses in &aluing a company. +ne other possible use is to stop making the asset produce and sell it off in parts. 81*1% *e7ected because tree $orth more by selling apples than by selling for fire$ood. o !econd offer: <3BB (re&enue of one seasons sale of apples) 81*1% re7ected because tree $ill continue to produce apples in the future. o #hird offer: <3%OBB (re&enue this year times ne't 3O years) 0gnores the time value of money. +ne dollar today is $orth more than one dollar tomorro$% and much more than one dollar ne't year. o ourth offer: <3%OBB ($illingness to pay based on last offer) .hile $illingness to pay is a &ery important concept (if you get more than it is $orth% $ho caresAA). ":#% one persons $illingness to pay tells us &ery little about &alue o ifth offer: <SO (the book &alue of the tree) #he &alue of an asset on the companys books (the accounting records). ":#% book &alue does not e,ual market &alueA 0s based on historical cost and accounting principles. "ears little relation to reality. o !i'th offer: <GGO (after an analysis of the re&enue stream to be generated% considering also e'penses) *e&enue may be <3BB per year% but has appro'imate e'penses of <OB per year. #herefore: income is <OB. A6!+% income stream is risky% some years more% some less. *eally is <IO on a&erage for ne't fifteen years. #815% discount the income stream to present &alue% get <GGO. o /ounter offer: <GSB (based on factors left out by si'th) 0ncome statement not necessarily best figures to use. 5eed to consider cash flo$% not accounting income. o inal compromise: <GOB (the Tbest offer% not necessarily the perfect offerA) 6esson: taking e&erything into consideration% should come to the same conclusion no matter ho$ figured. M+*A6: methods are useful as tools% but good 7udgment comes not from methods alone% but form e'perience. And e'perience comes from bad 7udgmentA +ne bad assumption can take you pretty far a$ay from the truth (can change the ans$er drastically). #ip: o +nly buy a business based on $hat you see on the books (not on offCbook cash sales).

o Also look at P21 multiple $hen buying stock% but this is predicated on the industry% no such thing as a bright line. "alance !heet 9aluations "ook 9alue: assets o&er liabilities o ":#% assets ha&e to be sho$n at their historical cost% some may ha&e market &alues far greater. o P6:!% intangible assets may be $orth far more than the book &alue (e'. /oke: good$ill% shape of bottle% etc) Ad7usted book &alue o !ome assets are ad7usted for inflation2appreciation2depreciation2market &alue o 6iabilities are ne&er ad7usted% are put in at true &alue 5et "ook 9alue o #ake same balance sheet% but remo&e intangible assets uture 1arnings 1stimate 1o?e"ber 2D, 2001 /hapter 3H 0naccurate reporting o #hose $ho rely on the auditors reports are able to sue him for his negligence% e&en though not other$ise pri&y to him (no$ ha&e a relationship to that statement &ia your reliance on it). 0nternal control o irst thing you do $hen auditing :sually in&ol&es the mo&ement of cash through the company% should be more than one person responsible for e&ery cash transaction (to reduce chance of theft). Di&ide tasks to make more than one person responsible for the incoming2outgoing cash /onfirmations sent out to accts payable2recei&able% e&en $here >eroCbalances (to make sure checks arent being misdirected and apportioned to a payable account% for e'ample) *estrictions on $ho can be an auditor (M:!# "1 05D1P15D15#) o /ertifier cant be related to company% nor can spouse2family o /ant o$n stock in comp o /an be la$yer to comp o /ant be o$ed money by comp o /ant o$e money to the comp (e': loan) o /ant accept employment during audit (or be promised employment after audit) o /ant be o$ed substantial fees by the comp Auditors legal responsibility o +thers rely on auditors assurance of no misstatements% all procedures proper% etc Monroe v0 Union (p GOB) o Action against an auditor o 5ot $rongful conduct if follo$ professional standards under GAA! and report internal control deficiencies and ad7ust scope of audit based on these findings. Dont ha&e to mention internal control problems if you ad7ust your audit to correct for them. ailure to detect fraud does not open auditor to liability. raud o Detecting fraud is hard% but once any possible fraud is found scope of audit has to be e'panded to test almost e&erything% &ery e'pensi&e taskXMoral: dont do e&en little frauds because theyll cost you a lot in auditing fees and the threat of getting a ,ualified2ad&erse opinion.

Dece"ber #, 2001 6a$yers $ork co&ers each of the applications: o Purchase of a business o 1state planning2ta' o 6oan apps by client o Matrimonial o /laims estimation2settlement e&aluations /ontingencies o #hreatened or o&ertly pending litigation /an be by ser&ice of process% or simply oral threat based on reasonable likelihood of actual suing :nasserted claims .+*D! *emote: slight chance o 5o need to accrue or disclose *easonable: more likely than remote o !hould be accrued and disclosed Probable: likely to occur o !hould be accrued and disclosed o Accrual and disclosure: need to estimate the contingency 0f cant estimate% disclose and gi&e a range 1&en if liability is on the books% should be in the footnotes any$ay 6a$yers duty to auditor o Make a$are of ratio re,uirements (e': bank re,uires G:3 asset: liability ratio% etc) o *elation of compensation to bottom line /apitali>ing21'pensing inappropriately o 0f title passes to o$ners% then capitali>ed. 0f title ne&er passes% pure rental (e'pensed) asides currency trading is largest trading operations% not stocksA Most analysts think GBU return on your money ($hen buying a business) is fair. #his normally represents a O:3 P21. Al$ays $ant at least three years history to analy>e% look to MD@A for future possibilities /$R /'1AL 23A4 kno$ the difference bet$een accounting and auditing o accounting: preparation of the financial statements. Mgmt is responsible for these figures. :nder GAAP o auditing: does not create figures% but performs an independent e&aluation% e&aluates the procedures% tests measurements (&ia outside confirmations% such as attorney% etc% using mgmt as a conduit due to pri&ilege) under GAA! using the entities documents% he tests the books% uses representations of mgmt% but gets outside confirmation2&erification of that info determines if GAAP $as follo$ed and if info $as properly recorded did they capitali>e the repairs problem: sometimes these things should be e'pensed% but the big long term benefits should be capitali>edA !mall comps only ans$er to :ncle !am% not shareholders% so try to e'pense e&erythingA *enders a report on the accuracy and fairness of the statements (the auditors report)% (directed to the "oard of Directors saying statements are fair representations)

1'amines% on a test basis%

/ina% exa": H hours% GB Es% each $ith subCparts. !horter the ans$er the better (be on point) (usually G sentences% ma'). Most of the test material comes from the notesA