ACCOUNTING FOR LAWYERS

A complete set of financial statements includes:

1. Balance Sheet 2. Income Statement
3. Statement of Cash Flows 4. Statement of Changes in Owner’s Equity
5. Accompanying Notes

BALANCE SHEET
Definition:
Static picture of a company’s financial position – a snapshot.
A continuing ledger of everything that has happened in a company from the beginning until present.
Issued by a set date.
Statement of Net Worth: Assets – Liabilities = Net Worth/Equity

Three sections to a balance sheet:

1. Assets (Right Side)
2. Liabilities (Left Side)
3. Equity or Net Worth (Left Side)
* Assets = Liabilities + Equity (Right and left sides must be equal/balanced)

ASSETS
Definition:
Anything a company owns that has economic value.
a. Tangible assets  land, equipment, cash
b. Intangible assets  patents, trademarks, goodwill (sometimes GW is seen as its own category)

Determining factors of an asset:

1. Control resource
2. Reasonably expect resource to produce a future benefit
3. Obtained resource in a transaction such that the resource is measurable

How are assets valued on the balance sheet?

At historical cost  Price paid to acquire the asset
a. Easier to ascertain
b. Less subjective than current FMV
c. This is beginning to change

Ordering:
Listed on the balance sheet in order of decreasing liquidity, from current assets to long-lived assets.
Liquidity  Refers to a company’s ability to convert an asset into cash, with assets more quickly
convertible into cash being viewed as more liquid than others.

1. Current Assets  Expect to convert into cash or use within one year (short-term)
a. Cash
b. Marketable securities  Stocks and bonds used as short-term investments
c. Notes receivable Amounts due to the entity, within the year, under promissory notes
d. Accounts receivable  Amounts due the entity, within the year, from customers
e. Inventories  Goods held for sale or resale
f. Prepaid expenses  Things paid for in advance for the year. Listed in declining liquidity
ẍ: insurance, rent, retainers, advertising

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 2. Long-Term Investments/Noncurrent Assets  Not expected to convert into cash or use w/in year
a. Stock and bonds, which entity expects to hold
b. Notes receivable, which are not due within the year
c. Accounts receivable, which are not due within the year
d. Prepaid expenses, which cover more than just one year

3. Fixed Assets (Also Noncurrent Assets) Tangible property other than inventory that is used in
the operations of the business and expected to be used for more than one year (permanent part of
business)
ẍ: Land, buildings, plant, equipment, machinery, furniture, fixtures

4. Intangible Assets
ẍ: Patents, copyrights, trademarks, goodwill

LIABILITIES
Definition:
Debts that a company owes or expects to owe
Arise from borrowing, purchases on credit, breaches of contract, torts
Current liabilities are due with one year
Long term liabilities are due in more than one year

Determining factors of a liability:

1. Must involve present duty or responsibility
2. Must obligate entity to provide future benefit
3. Must have arisen from a transaction that has already occurred so that obligation can be measured

Ordering:
1. Current Liabilities
a. Notes payable  Money borrowed under promissory notes
b. Accounts payable  Amounts owed for purchases on credit
c. Accrued liabilities or wages  Money owed for services already performed
d. Portions of long-term debt due within the year
e. Taxes payable
f. Unearned revenues  Amounts the entity will have to refund if it does not perform the
required services (ẍ: retainers)

2. Long Term Liabilities

a. Secured claims  Liabilities for which the borrower has pledged assets as collateral
b. Long term notes payable
c. Bonds payable
d. Lease and mortgage obligations
e. Pension plan obligations

Current Assets – Current Liabilities = Working Capital

EQUITY
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Definition:
Residual claim of the owners on the assets of the business after recognition of the business’s liabilities
Net worth / Equity = Assets – Liabilities
Assets > liabilities = positive equity
Liabilities > assets = negative equity
Net income increases equity
Net losses reduce equity

Powerpoint slides regarding equity of sole proprietorships, partnerships, and corporations, ltd p/s, llc, llp/s

Three Shareholder Equity Accounts [Legal Equivalent in Brackets]:

1. Capital Stock / Common Stock [Stated Capital / Legal Capital]
2. Additional Paid-in Capital or Paid-in Capital in Excess of Par Value [Capital Surplus]
3. Retained Earnings [Earned Surplus]

What is par value?

Arbitrary number at which a corporation decides not to sell its stock below that number.
If stock is sold at par value  money goes into capital stock account
If stock is sold above par value  the amount in excess of par value goes into additional paid-in capital

ẍ: Investor pays $100 for one share of stock with a par value of $10. Balance sheet:

Assets Liabilities / Equity

Cash + $100 Capital Stock + $10
Add Pd in Capital + $90

What if no par value is assigned?

Corporation can allocate b/w the Capital Stock Acct and the Additional Paid-in Capital Account.
Amount allocated to Capital Stock Acct  Stated Value
Amount of purchase price above state value  Additional Paid-in Capital
If no allocation is made, the entire price goes into the Capital Stock account.

Restriction of distributions:
Corporations cannot distribute earnings (dividends) below capital stock account.
Distributions can also be restricted by restrictive covenants.

What are retained earnings?

Net income / net loss
Can be a negative number  Accumulated Deficit
Account reduced upon payment of dividend.

Insolvency:
Most corporate statutes prohibit distributions of assets to shareholders if business is insolvent
1. Balance sheet insolvency
a. Debts are greater than assets
b. Results in a negative equity
2. Cash flow insolvency 
a. Assets aren’t easily liquidated
b. Current liabilities are greater than current assets

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INCOME STATEMENT
Definition:
Shows the extent to which equity has increased or decreased over a period of time.
Revenues – Expenses = Net Income (or Loss)
AKA  Statement of Earnings or Statement of Operations

Publicly traded companies must report their annual income stmt on form 10K and
must issue updates quarterly on form 10Q

After the period of time is over, income statements are added into the balance sheet (as retained
earnings), then set back to zero, and started over

Three parts to income statements:

1. List of revenues
2. List of expenses
3. Difference is Net Income or Net Loss

What are revenues?

Assets received from essential transactions of selling goods or performing services
Cash or non-cash
Increase assets and decrease liabilities

What are gains?

Results of transactions that occur other than in the ordinary course of business/non-essential transactions
Increase assets and decrease liabilities

What are expenses?

Costs incurred and consumed by the business in generating revenues.
Assets used in producing revenues.
Decreases assets and increases liabilities.

What are losses?

Decreases in assets or increases in liabilities from non-essential activities, those outside the ordinary
course of business.

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CASH BASIS / ACCRUAL METHOD / DEFERRAL
Cash Basis:
* Focus on movement of cash / based on when cash changes hands
* Allocates revenues/expenses to period when received/paid
* Actual delivery of goods or services irrelevant / receipt of benefit of payment irrelevant

Accrual Method:
* Reports revenues when they are earned, even though no cash has been received for the good/service
* Reports expenses when they are incurred / benefit received, even though payment for the good/service
has not been made
* Allocating revenue/expenses to the income statement in the period before cash changes hands

Accrued Income  Business earned by substantially completing the work, but has not yet been paid

Accrued Expense  Business received economic benefit from expense, but expense not yet paid

Deferral:
* Waiting to report revenue/expense until it is earned/incurred even though cash already changed hands
* Allocating revenues or expenses to the income statement in period after cash changes hands

Deferred Income  Business received cash, but not recognized as revenue until later accounting period
when the business actually earns the cash

Deferred Expense  Business paid cash, but payment will not be recognized as expense until some
future period when business obtains benefit from expense

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STATEMENT OF CASH FLOWS
Provides detail about the changes in the business’s cash balance for the period covered by the income statement
Net difference b/w cash in and cash out  Can have positive or negative cash flow
Reports changes in cash and cash equivalents
Replaced Statement of Changes in Financial Position

Divided into three parts:

(1) Operating Activities
(a) Transactions associated with sales of goods and services
i) Cash from sales, less
ii) Cash for expense to produce sales
iii) Interest and tax payments
(b) Interest and dividends received on miscellaneous investments (cash inflow)
(c) Interest payments to lenders and other creditors (cash outflow)
(d) Catch all category
(2) Investing Activities
(a) Purchase and sale of operating assets / long-lived, capital assets  buildings, machinery, patents
(b) Purchase / sale / returns received on investments  stocks, bonds, loans
(3) Financing Activities
(a) Issuing debt instruments or selling stock and amounts paid out to repay loans or repurchase stock
(b) Amounts paid out as dividends on corporation’s stock (not amounts paid as interest on loans)
(c) Cash from borrowing money; (d) Cash from investors; (e) Cash paid to investors

Cash Equivalents:
1) Enterprise able to convert equivalents to cash readily
2) Equivalents’ maturity dates do not exceed three months (measured from when investment acquired)
ẍ: Cd’s, T-bills, commercial paper, money market accounts;
6 month cd with 3 months left to maturity works – as long as it matures w/in 3 months

Four steps:
1) Cash at start of period, plus
2) Cash received during period, less
3) Cash paid during period, equals
4) Cash at end of period (Ending cash is beginning cash for next period)

Two Methods:
(1) Direct Method
(2) Indirect Method
Difference is how cash flows from operations is determined;
Cash flows from investing & financing activities is determined in the same way under both methods

Direct Method:
1) Determines how much cash was paid or received in connection with each account during period
2) Easiest method  take cash from Balance Sheet, go thru T-accts to determine what you did with the
cash, and take from the T-accts and put into the Cash Flow Stmt

Indirect Method:
1) Uses Net Income for the period as the starting point
2) Makes adjustments to Net Income to reflect cash transactions (Operating, Investing, Financing)
a) Not all revenues and expenses represent cash flow
b) Changes appear on Balance Sheet result in cash flow that is not reflected on the Income Stmt
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DEPRECIATION
Non cash item
Capitalization 
Payment by a business, whether on a purchase or an extraordinary repair, will not be recorded immediately as
an expense but will initially be recorded as an asset (capital asset) and will eventually be recognized as an
expense thru depreciation/amortization

Capital Expenditure  Expenditures that increase the life of the asset beyond the original estimated life
or expenditures that otherwise improve the quality or the productivity of the asset
ẍ: extraordinary or unusual repair costs, legal advice, investment banking, M&A fees

Tangible Assets  Depreciate

Intangible Assets  Amortize
Natural Resources  Deplete

* Land cannot be depreciated, amortized, or depleted

Three things you need to know in order to depreciate:

1. Cost  including freight costs, installation costs, real estate commissions, title insurance, legal fees
2. Useful Life  Period of time over which the asset is expected to be used; could be measured in time,
hours of operation, etc
3. Salvage/Residual Value  Amount expected to be realized at sale once useful life is over; scrap value

Methods of depreciation:
1. Straight Line Method
2. Accelerated Methods
a. Declining Balance Method
i. Double declining balance
ii. 150% declining balance
b. Sum of the Years’ Digits

Straight Line Method:

(Total Depreciation)
Original Cost - Salvage Value
-------------------------------------- = Depreciation Expense Per Year
Estimated Useful Life in Years

ẍ: 100,000 cost, 10,000 salvage value, 6 years useful life

100,000 – 10,000
----------------------- = 15,000 15,000 x 6 = 90,000 total depreciation
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ẍ: Same as above but after 2 yrs, you discover useful life is going to be 8 yrs not 6 yrs
Original depreciation was 15,000/yr, so after 2 years you will have depreciated 30,000.
90,000 – 30,000 = 60,000

60,000
--------- = 10,000 10,000 x 6 = 60,000 60,000 + 30,000 =
90,000
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 ẍ: Same but after 2 years, you decide useful life is 4 years
Already depreciated 30,000. 90,000 – 30,000 = 60,000
60,000
--------- = 30,000 depreciation for years 3 and 4 each
2

ẍ: Same but after 2 years you upgrade & spend 20,000 on the asset, which increases useful life to 8 yrs
60,000 left to depreciate: 60,000 + 20,000 = 80,000

80,000
---------- = 13,333 depreciable cost for each of the remaining 6 years
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ẍ 100,000 cost, 10,000 salvage value, 225,000 miles

100,000 – 10,000
---------------------- = 0.4 = 40 cents per mile depreciation
225,000

Drive 40,000 mi/yr x 40 cents = 16,000 depreciation per year

Accelerated depreciation methods:

This results in the recognition of greater depreciation expense in the early years and less depreciation expense in
the later years. Often deemed to be appropriate when the earnings potential of an asset is consumed more
rapidly in the early years of the asset’s use.
If you have greater depreciation expense in the first years, assuming other factors stagnant, your tax
liability would be less in the first years. Though this would eventually catch up to you, considering the
time value of money, putting off costs so that you can invest money today is usually preferred.
Additionally, companies can maintain, legally, two separate books: taxable books and accounting
books.

Double Declining Balance:

Double amount of depreciation upfront based on a declining depreciable base
1
---------------- x Depreciable Base x 2 = Yearly Depreciation
Useful Life

Continue this formula for each year of useful life.

ẍ: 100,000 cost, 10,000 residual value, 6 years useful life

Year 1: 1/6 x 100,000 x 2 = 33,333 100,000 – 33,333 = 66,667
Year 2: 1/6 x 66,667 x 2 = 22,222 66,667 – 22,222 = 44,445
Year 3 1/6 x 44,445 x 2 = 14,815 44,445 – 14,815 = 29,630
Year 4 1/6 x 29,630 x 2 = 9877 29,630 – 9877 = 19,753
Year 5 1/6 x 19,753 x 2 = 6584 19,753 – 6584 = 13,169
Year 6 13169 – 10,000 = 3169 13,169 – 3169 = 10,000
* Y6: Can’t depreciate so much as to leave base at less than residual value.

150% Declining Balance:

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Take formula for double declining method and multiply by 1.5 instead of 2.

Sum of the Years’ Digits:

ẍ: 100,000 cost, 10,000 residual value, 6 years useful life

6 + 5 + 4 + 3 + 2 + 1 = 21 100,000 – 10,000 = 90,000 base

Y1: 6/21 x 90,000 = 25714 (Depreciation amount for Year 1)

Y2: 5/21 x 90,000 = 21429
Y3: 4/21 x 90,000 = 17,143
Y4: 3/21 x 90,000 = 12,857
Y5: 2/21 x 90,000 = 8571
Y6: 1/21 x 90,000 = 4286
-----------
90,000

How do you account for depreciation on journal entries and balance sheet?
Year 1 Jan 1 Equipment 100,000
Note Payable 100,000
Dec 31 Depreciation Expense 25,714
Accumulated Dep Equip 25,714

Balance Sheet : Cash 80,000

Equipment 100,000
Less Accumulated Dep <25,714> 74,286

Only time you will see a liability listed on the asset side

Unit of Production Method (chapt IX?) – do you include installation costs in depreciation totals? Yes.
Note problem 9.3A, pg 551

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INVENTORY
Goods business holds for sale to customers in regular course of business (including what’s in warehouse, etc)

Four types of inventory methods:

1. Specific Identification Method
2. Average Cost
3. FIFO
4. LIFO

Two different types of companies:

1. Merchandising  Sales goods manufactured by others (retail)
2. Manufacturing  Produces goods to sale (usually to retail)
They have three types of inventory: (1) raw materials, (2) works in progress, (3) finished goods

Beginning Inventory  Inventory on hand for sale at beginning of accounting period

Ending Inventory  Inventory on hand at end of accounting period
Beginning Inventory + Inv Purchased/Manufactured - Cost of Inv/Goods Sold = Ending Inventory

Formula to determine what you sold:

COGS = Beginning Inventory + Inventory Purchased/Manufactured - Ending Inventory

* Revenue - COGS = Net Income or Loss Arising from Sales (Doesn’t account for overhead)

Methods for Tracking Inventory:

1. Periodic Method  Physical count of inventory done periodically; helps account for theft
Retail Method
2. Perpetual Method  Electronic running total of inventory; doesn’t acct for breakage/theft

Inventory on Balance Sheet:

- Assets are valued at their cost to the business
- Product cost is the sum of all expenditures and charges directly or indirectly incurred in bringing
inventory to its present condition and location
- Inventory is expensed in the accounting period in which it is sold
- Period costs include some overhead costs and are expensed in the current accounting period

Lower of Cost or Market:

Typically inventory is listed at its cost to the business, but if it is valued at a lower amount than it actually cost,
the balance sheet can show FMV instead of actual cost. Therefore, inventory can be valued at less than its cost.
Things causing FMV to be less than cost: physical damage, deterioration, obsolescence, decline in prices
Market Value = Replacement Value
The cost at which the inventory would be replaced by the business under current conditions.
Just b/c FMV is lower than original cost doesn’t always mean the inventory will be
valued at FMV.
If inventory that originally cost $100 can now be purchased for $85, the lower
market value of $85 would be used to determine the book value of the inventory.
However, if the replacement value were $105, no adjustment would be
made and the inventory would remain at its original valuation of $100.
**Cannot increase
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 value of inventory above original cost.

If book value is reduced due to above, the amount of the reduction is treated as either:
1. An addition to COGS for that period or
2. A loss shown on the Income Statement

Cost of Goods Sold:

- An expense
- Cost of manufacturing or purchasing inventory often varies over time

Specific Identification:
- Keeps track of each individual item and its exact cost
- Applies to unique and highly valuable goods
- Not for interchangeable inventory or high volume inventory
ẍ: Automobiles

FIFO  First In, First Out:

- Assumes goods are sold in the order in which they were purchased; oldest sold first
- Advantages: Income is higher b/c you are selling goods that are older and therefore cost less.
Balance sheet looks more like its value b/c your current inventory is on your Balance sheet
- Disadvantages: Artificially inflates Net Income. Selling goods at today’s prices but COGS is from a
previous period – doesn’t match.

LIFO  Last In, First Out:

- Assumes goods most recently purchased are sold before those previously purchased
- Advantages: Income Stmt accurately portrayed  matching revenues and expenses
Deflates Net Income b/c COGS is rising and by “selling” new inventory first, you are selling
higher priced inventory.
- Disadvantages: Balance sheet is off b/c you are tracking inventory using obsolete costs. Balance
sheet is carrying older inventory at older prices whereas should be at cost.

Average Cost (Hybrid Method):

- Assumes you don’t sell any inventory at what it actually cost you
- Averages costs of all units in inventoryTotal cost basis of inventory divided by total number of units
- COGS = Average Cost x Number of Units Sold

Why should we be concerned with which inventory method we use?

- Affects Net Income
- Affects valuation of inventory on Balance Sheet

Economics of Inventory Methodology:

Inflationary Economy  Inventory purchased more recently cost more than older inventory
LIFO Method:
- Higher COGS
- Lower income (Closely hold businesses)
- Lower inventory value on balance sheet
FIFO Method:
- Lower COGS
- Higher income (Publicly traded companies)
- Higher inventory value on balance sheet
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 Deflationary Economy  Inventory purchased more recently cost less than older inventory
LIFO Method:
- Lower COGS
- Higher income (Publicly traded companies)
- Higher inventory value on balance sheet
FIFO Method:
- Higher COGS
- Lower income (Closely held businesses)
- Lower inventory value on balance sheet

STATEMENT OF CHANGES IN SHAREHOLDER’S EQUITY

 Fully reconciles the changes in net worth between balance sheet dates.
 Summarizes the changes in the owners’ equity accounts for the period covered by the income statement
o Beginning balance of owner’s equity is set forth followed by any additional amounts invested by
the owners, the net income/loss of the business for the period, and any distributions to the owners
that reduce the owners’ equity (dividends).
o Amounts are then totaled to produce the ending balance of owners’ equity.
 Text 43 - 50

CONTINGENCIES
Recognized as possible future obligations of a business even though there is no current obligation and it is not
clear that there ever will be an actual obligation.

- The main arena where accountants and lawyers interact

o Accountants (auditors) want financial statements to present fairly
o Lawyers don’t want to admit liability (or their fees)
o Management negotiates between lawyers and auditors

- Three things auditors want to know:

1. How to accrue the contingency (ẍ: lawsuit – litigation expense)
2. Don’t accrue but disclose in footnote
* Doesn’t affect actual numbers but puts people on notice that there is something that could
materially affect financial statement
3. Don’t accrue, don’t disclose. Do nothing.

- Two possibilities for outcome (win or lose), but only the losses matter for contingency
purpose
- Definition: things that may or may not happen that affect financial statements
o Largely based on litigation – contingent gains or losses, based on outcome
o Potential liability: two ways to show it
 Accrue and reflect in the accounting statements
 Wait until the case is decided
o Matching principle mandates accrual and reflection
 Can increase revenues if do not accrue
 Can decrease revenues if accrue too much
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- Accounting rules: FASB 5
o Contingency – existing condition, situation, or set of circumstances involving
uncertainty as to possible gain or loss to an enterprise when one or more future
events occur or fail to occur.
o Covers four categories:
 Collectibility of receivables
 When there’s a question about your ability to collect on your receivables,
that’s a contingency
 Run your estimate through an Allowance for Doubtful Accounts
o Bad Debt Expense is debited and closed
o Allowance for Doubtful Accounts is credited and shown as a “liability”
reflected on the asset side of the balance sheet

 How to treat this, assuming a 5% failure of receivables

Accounts Receivable $500,000
Sales $500,000
Bad Debt Expense $25,000
Allowance for Doubtful Accounts $25,000

 Product warranties or defects

 Pending or threatened litigation
 Guarantees on debts of another (disclose in footnote)

- Accrual of contingencies
o Contingent gains: almost never accrued
o Loss contingencies accrued if two conditions met:
 It is probable that a loss will occur in the future, AND
 The amount of loss can be reasonably estimated
o The lack of insurance alone isn’t enough to trigger accrual

o How to accrue contingencies:

 If you lose the amount you think you’re going to lose:
Litigation Expense $5,000 Before it happens
Contingent Liability $5,000
Contingent Liability $5,000 When it happens
Cash $5,000

 If you lose LESS than you think:

Litigation Expense $5,000 Before it happens
Contingent Liability $5,000
Contingent Liability $5,000 When it happens
Cash $4,000
Litigation Expense $1,000

 If you lose MORE than you think:

Litigation Expense $50,000 Before it happens
Contingent Liability $50,000
Litigation Expense $25,000 When exposure goes up
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 Contingent Liability $25,000
Litigation Expense $5,000 When it happens
Contingent Liability $75,000
Cash $80,000

- Recognition:
o In order to recognize, the contingency must be probable, which means that the
future event or events likely
o It’s counted as a current expense

- Disclosure of loss contingency

o You have to disclose a contingent if the loss is not probable or the amount of loss
cannot be estimated
 No accrual, so no journal entries or anything like that
 Disclose in footnotes if reasonable possibility that material loss may occur
o Disclosure must indicate the nature of contingency and one of the following:
 Estimate of possible loss
 Range of possible losses
 State that estimate cannot be made

- Materiality: something the reader would like to know (defined by SCOTUS); all
disclosures in the aggregate must be material; generally thought of as 10% of assets
(?)

- Reasonably possible: the chance of future event occurring is more than remote, but
less than likely

- Contingency groupings:
o Don’t know of individual claims, but can estimate certain percentage
o Based on past experience
o If no experience, use experience of other enterprises in same business

- Individual contingency v. grouping:

o If consider individual claim alone – don’t meet test
o If consider all claims as a group – meet test
o Estimate overall percentage of claims that will succeed
o Accrue expected amount of the loss on group basis

- No accrual/disclosure if loss is remote (chance of future event occurring is slight)

- Voluntary disclosure: If not required to accrue

o May reflect contingency on balance sheet
o Create reserve account in the equity section
o Reserve for Contingencies
o Signals if contingency occurs, equity reduced by amount of reserve

- Contingency occurrences: two options

o Contingency materializes and business suffers loss
o Contingency does not materialize
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- Miscellaneous contingency items:
o Absence of insurance: no accrual until loss as no loss in value
o No accrual for present period for:
 Risk of loss from future injuries to others
 Damage to property of others
 Business interruption (ex: hurricane causes temporary closure)
o Threat of expropriation: accrual only if expropriation is imminent and
compensation less than book value

- Litigation claims and assessments: two categories

o Pending claims: factors to consider
 Period in which underlying cause of pending or threatened litigation occurred
 Degree of probability of unfavorable outcome
 Ability to make reasonable estimate of amount of loss
 Materiality – No accrual or disclosure for immaterial items
 Progress of case
 Opinions or views of legal counsel
 Experience in similar cases
 Experiences of other enterprises
 Decisions by mgmt re: intended response (contest v. settlement)

o Unasserted claims:
 Assess probability of claim
 If probable, use pending claims factors, treat as pending based on that

- Accounting rules v. SEC rules: they conflict

o No offset of gain contingencies against loss contingencies
o If jointly and severally liable w/ another party, only accrue or disclose own potential
liability unless probable that other party will not pay share
o Cannot delay accrual until amount can be reasonably estimated
 Must accrue, even if significant uncertainties
 If range, accrue at minimum of the range

- Auditor v. lawyer
o Mgmt’s discretion to accrue or disclose; usually based on subjective standards
o Auditors get information from mgmt; seek corroboration from lawyers
o “Audit inquiry letter”: permits lawyer to provide information about
contingent liabilities to auditor
o Goals of auditor and lawyer are often different; creates client dilemma

- A special word of caution for lawyers:

o NEVER, EVER, EVER disclose without client’s consent!
o Disclosure to a third party leads to waiver of att’y-client privilege
o Fiduciary duty to client before duty to auditors

- ABA statement of policy: two categories

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 o Pending litigation
o Third party indicates present intention to commence litigation

- FASB standards require WAY more disclosure than ABA standards; when there’s an
argument here, lawyers usually win

FASB Probable Reasonably possible Remote

ABA Probable Reasonably Remote
possible
*The conflicts come in the gray areas between FASB “reasonably possible” and ABA “reasonably possible”

- Anything you don’t want to be turned over to your opponent in litigation should be
carefully considered before going in an audit inquiry letter

- Limitation language: minimum response to audit inquiry letters:

o Scope of engagement
o Date when information furnished
o Disclaim undertaking to advise auditor of changes in future
o Responses are limited to material amounts
o Indicate if incomplete response; avoid implying response to all inquiries
o Include limitation on use of response: only to be used in connection w/audit

- ABA standards (Loss Contingencies): when to respond

o Overtly threatened/pending litigation: respond no matter what
o Contractually assumed obligation: respond if client specifically identified and which
client specifically requests comment
o Unasserted possible claim or assessment: respond if client specifically identified
and which client specifically requests comment

- Ordinarily, lawyers should avoid expressing opinions as to the outcome of litigation

unless an unfavorable outcome is either probable or remote
o Probable:
 Prospects of claimant not succeeding are extremely doubtful
 Prospects for success by client in defense are slight
 Contrast w/FASB – Future events likely to occur

o Remote:
 Prospects for client not succeeding are extremely doubtful
 Prospect of success of claimant are slight
 Contrast w/FASB – Chance of future events confirming loss slight

- Ranges
o Provide range of potential loss only if you believe there’s only a slight chance your
estimate is wrong
o Contrast w/SEC – management cannot delay accrual until single amount can be
reasonably estimated, even if significant uncertainties; if your estimate falls w/in
range, must accrue at the minimum of the range
16
 o FASB requires accrual only if amount of loss can be reasonably estimated

- Accountant-client privilege
o 30 states have accountant client privilege
o No privilege under federal law except §7225 of IRC.
o In cases involving federal claims, state law privilege does not apply
o Provides discovery opportunities: Pitfall v. Bonanza

- Discovery responses in litigation:

o Tronitech v. NCR
 Att’y opinion re: liability or settlement value not admissible at trial; not relevant
and not within scope of discovery
 Protected by work product doctrine – FRCP 26(b)(3)
 Materials prepared in anticipation of litigation or trial
 Does not apply to materials prepared in ordinary course of business
o US v. Gulf Oil Corp.: documents prepared to allow auditor to do job not prepared in
anticipation of litigation or trial
o Trend towards non-recognition of att’y-client privilege here
 No confidential communication between attorney and client
 Disclosure to 3rd party (auditor) normally waives privilege

- Dangers of a qualified opinion

o Every company wants an unqualified opinion from auditors
o If lawyers don’t provide information to auditors, the result could be a qualified
opinion
o Sample language:
 We are unable to obtain a response from legal counsel representing the
Company in lawsuit described in xxx regarding current status of suit or
pending/threatened litigation or unasserted claims and assessments.
 Therefore, we are unable to obtain sufficient competent evidential matter
supporting the Company’s representations regarding the contingent liability
discussed in xxx.
 In our opinion, except for the effects of such adjustments, if any, as might have
been determined to be necessary had a response from legal counsel been
obtained, the financial statements referred to above present fairly, in all
material respects, etc.

- Kovel privilege: if a lawyer hires an accountant for a client (and bills client) and filters
all communication from accountant to client (they can never speak alone), att’y-client
privilege applies. Accountant is agent of the attorney.

- Waiver of right to deny liability: four options

o Explicitly reject argument that defendant waives right to deny liability by accruing
expense or loss on claim (Continental Ins. Co. v. Beecham, Inc.)
o Refuse to permit party to discover information pertaining to reserves that
companies (esp. insurance) have set aside to satisfy future claims
o Communications concerning individual case reserves qualify for work product
protection while ordering defendants to provide aggregate reserve figures
o Information about litigation reserves might qualify as admissible evidence
17
- Final considerations:
o GAAS – generally accepted auditing standards
o GAAP – generally accepted accounting principles
o SEC governs both GAAP and GAAS but sometimes says its own thing
o There aren’t any international accounting standards; other countries use radically
different systems than ours (generally FMV, whereas we use historical cost)

o All audit workpapers MUST be kept for seven years (punishment is up to 10 years)
o DO NOT tamper with your records in any way once you’ve been told that you’re
being investigated (up to 20 year sanction)
o Internal controls  the stronger, the less money paid to auditors b/c they can rely
on them
o Rule #1: Never Deal in Cash

The amount you accrue will probably not be the exact amount for which you end up being liable.
Make the adjustment in the year it happens – don’t make a prior year adjustment.

Good to include an allowance for doubtful accounts b/c you probably want collect 10% of what you are owed.

Three types of opinions:

1. Unqualified  Financial statements present a fair picture of financial condition
2. Qualified  Fair except for _______
3. Adverse  Financial statements are not an accurate portrayal of financial condition

Auditors are responsible to the public.

Attorneys are responsible to their clients.
Auditors can’t issue an unqualified opinion without attorney’s cooperation.
Examples:

Y1 Litigation Expense 50,000

Contingent Liability 50,000
Y2 Contingent Liability 50,000
Cash 50,000

But what if we only had to pay 30,000 in Y2?

Y2 Contingent Liability 50,000

Cash 30,000
Litigation Expense 20,000 This essentially increases revenue

What if we had to pay 80,000 in Y2?

Y2 Contingent Liability 50,000

Liability Expense 30,000
Cash 80,000
18
TIME VALUE OF MONEY
- Interest
o The rate lenders charge for the use of money (lenders and investors)
o Factors that determine interest rates:
 Pure rate of interest:
 The rate that would be charged if there were no risks
 Generally accepted to be between 2%-3% per year
 NEVER charged, though, because there are always risks
 Premiums: amounts added to interest rates to account for risks
 Inflation premium: the amount added to account for inflation occurring over
the life of the loan
 Maturity premium:
o Offsets risks associated with lending $ for long periods
o Long-term rates are almost always higher than short-term rates for
investments with the same risk
 Default premium: reflects the risk that the borrower will default on the loan
and the lender will lose the principal
 Illiquidity premium: pays the lender for circumstances that come about if
he’s forced to sell the debt, especially if he needs cash quickly:
o Lack of marketability
o Price concessions
19
 o Calculating interest
 Actual $ amount of interest = principal x rate x time
 Simple interest:
 Each year’s interest on principle is calculated alone, with no impact on the
next year’s calculation
 Ex: $10,000 at 8% simple interest = $800 in interest per year; if it’s a 10-
year loan, that’s $8,000 total interest
 Compound interest
 The first period’s interest is added to the principal, which then becomes the
principal used to calculate the next period’s interest
 Example:
o Year 1 = $10,000 x .08 x 1 = $800 interest
o Year 2 = $10,800 x .08 x 1 = $864 interest
o Year 3 = $11,664 x .08 x 1… and so on
 Table I in Appendix B in the book has ratios for calculating compound interest
o Principal and interest at the end of the term = Principal x Ratio
o Interest = $10,000 x 2.15892 (10 periods @ 8%) = $21,589.20
o $11,589.20 in interest earned in the 10-periods term
 “Period” can be annually, semi-annually or quarterly, depending on the
terms of the transaction

- Future value
o The sum to which $ will grow at the end of a certain time period
o This can apply to a single sum or a series of payments (called an “annuity”)
 Future value of a lump sum
 Compound interest (annually)
o $10,000 deposit, earning 12% interest; how much $ in 10 years?
o Table 1: 3.10585 (the factor for 12% and 10 periods)
o $10,000 x 3.10585 = $31,058.50 future value
 Compound interest (semi-annually)
o $10,000 deposit, 12% interest; how much $ in 10 years?
o Table 1: 3.20714 (the factor for 6% and 20 periods, which is 10 years’
semi-annual compounding)
o $10,000 x 3.20714 = $32,071.40 future value
 Compound interest (quarterly)
o $10,000 deposit, 12% interest; how much in 10 years?
o Table 1: 3.26204 (the factor for 3% and 40 periods, which is 10 years’
quarterly compounding)
o $10,000 x 3.26204 = $32,620.04
o Obviously, if a bank gives you quarterly compounding interest, it will most
likely be at a low % rate
 What do you do if the # of periods you need isn’t in the table?
o Make intermediate calculations
20
 o Example: $40,000 at 5% interest (CA) for 98 years
 Factor for 50 periods = 11.46740
 Factor for 40 periods = 7.03999
 Factor for 8 periods = 1.47746
 Do the math:
 $40,000 x 11.46740 = $458,696.00
 $458,696 x 7.03999 = $3,229,215.25
 $3,229,215.25 x 1.47746 = $4,771,036.36
 $40,000 becomes $4,771,036.36 over 98 years
 If no chart available (?)  FV = Amount x (1 + interest rate)
 More than one year: FV = A x (1 + Rate) x (1 + R)…etc for how every many
years

 Future value of an annuity

 Ordinary annuity, also called annuity in arrears
o Payments are issued at the END of each period
o Example: $1,000 paid at the end of each year for 4 years; 5% CA
 Method 1:
 Add the Table 1 factors for each year together:
o First payment will compound for 3 periods = 1.15763
o Second payment will compound for 2 periods = 1.10250
o Third payment will compound for 1 period = 1.05000
o Fourth payment won’t compound at all = 1.00000
o Total of factors = 4.31013
 $1,000 x 4.31013 = $4,310.13
 Method 2:
 Use Table 2 factor (5% interest, 4 payments) = 4.31013
 $1,000 x 4.31013 = $4,310.13
o The Table 1 method can be adjusted to account for semiannual or
quarterly compounding, but the Table 2 method CAN’T

 Annuity due
o Payments are issued at the BEGINNING of each period
o $1,000 paid at the beginning of each year for 4 years; 5% CA
 Add the Table 1 factors together:
 First payment compounds 4 times = 1.21551
 Second payment compounds 3 times = 1.15763
 Third payment compounds 2 times = 1.10250
 Fourth payment compounds 1 time = 1.05000
 Total of factors = 4.52564
 $1,000 x 4.52563 = $4,525.64
o There is no Table 2 method for an annuity due

- Present value
o Tells you how much a given future sum or annuity is worth today
o Present value for a lump sum

21
  Use Table 3 to find out the present value of $1 at the end of however many
periods in question discounted by the interest rate you’ll get (it’s a discount
because we’re lowering the amount to get present value)
 Compound interest (annually)
 $10,000, payable in 10 years, discounted by 8%
 Table 3 factor = 0.46319
 $10,000 x 0.46319 = $4,631.90 needed to get $10,000 in 10 years at 8%
 Compound interest (semiannually)
 $10,000 in 10 years, discounted by 8%
 Table 3 factor = 0.45639 (4%, 20 periods)
 $10,000 x 0.45639 = $4563.90
 Compound interest (quarterly)
 $10,000 in 10 years, discounted by 8%
 Table 3 factor = 0.45289 (2%, 40 periods)
 $10,000 x 0.045289 = 4528.90
 PV = A / (1 + Rate)
ẍ: 108,000 / (1 + .08) = 100,000
ẍ: 5 years, 100,000, 7%  100,000 / (1+.07) x (1+.07) x(1+.07) x(1+.07) x(1+.07)
100,000 / 1.40255 = $71,298
ẍ: invest 50K, 6%, 40 years  10.28572 x 50000 = 514,286
ẍ: 5K a year for 40 years at 6%  154.7620 x 5000 = 773,810
ẍ: Invest 100,000, 62 years, at 12%? 112 million
first step – 50 year factor; second step – 12 year factor
100,000 x 289.0022 = 28,900,220
28,900,220 x 3.89598 = 112,594,679

o Present value for an annuity

 Ordinary annuity
 Promise to pay $1,000 at the end of each year for 4 years; how much
principal do we need at 8% interest?
 Method 1
o Add up your Table 3 factors:
 First payment will be discounted for one period = 0.92593
 Second will be discounted for two periods = 0.85734
 Third will be discounted for three periods = 0.79383
 Fourth will be discounted for four periods = 0.73503
 Sum of periods = 3.31213
o $1,000 x 3.31213 = $3,312.13 in principal to produce 4 payments of
$1,000 each at the end of each year
 Method 2
o Use Table 4 factor to calculate present value
o Factor for 4 payments, 8% interest = 3.31213
o $1,000 x 3.31213 = $3,312.13 principal needed
 You can adjust Method 1 for semiannual and quarterly compounding, but
NOT Method 2
22
  Calculating an annuity payment
 $100,000 borrowed for 5 years at 10% interest
 We already know the present value, so we alter the formula like so: $100,000
(present value) = payment x 3.79079 (Table 4 factor for 5 periods at 10%
interest)
 Solving for the payment = $26,379.73 per payment

- Perpetual annuities
o An annuity that the investor intends to continue forever
o In order to continue like this, only the interest can be withdrawn; the original
principal can never be touched
o Example:
 Investor wants $60,000 per year; with 5% interest, how much principal?
 Formula: 0.05(principal) = $60,000
 Investor needs $1,200,000 in principal to produce $60,000 interest/year

- How all these calculations work together for attorneys – settlements

o Choosing present amount, future sum or annuity
 Your client has 3 offers:
 Cash payment right now of $200,000
 $400,000 payable in 10 years (7% CA interest)
 Five-year ordinary annuity, paying $50,000 annually (7% CA)
 How can you tell which one is best? Bring them all to present value
 $200,000 cash payment has a PV of $200,000 (obviously)
 $400,000, payable 10 years from now
o Table 3 factor, 10 years @ 7% discount = 0.50835
o $400,000 x 0.50835 = $203,340
 $50,000 at the end of each year for 5 years
o Table 4 factor, 5 years @ 7% discount = 4.10020
o $50,000 x 4.10020 = $205,010
o Based on these calculations, choose Option 3; it’s worth more now
- Be careful here; these calculations, while accurate, can often mislead, since they
don’t factor in taxes and life-changing circumstances that could affect decisions

EXAMPLE
Representing Sheen and suing Warner Bros. 8 episodes per year. 5 years. 2 mill per show. 7% discount rate.
how much is sheen owed under contract?
16 mill for 5 years, per year
16 mill x 4.10020 = 65,603,200

What’s the difference in paying in the beginning v. the end of the year? The 16 million was paid at the end of
the year (figuratively). If we pay at the beginning of the year, we essentially subtract one payment. Is this
right? Check.

Sensitivity Analysis: provides ranges of what discount rate is likely

Terms of K can’t change – 5 years. Discount rate could change.

23
ẍ: Deck of cards. I’ll pay you $75 for every ace. You pay me $5 for anything else.
(57 x 4/52) - (5 x 48/52)
5.77 – 4.62 = 1.15 1.15 x 52 = 59.80

The point of all this is to compare settlements against _____. to decide if it’s worth it.

ẍ: 200K to settle (pay atty); 5 years to try at a cost of 1 mill (pay upfront); we think there is a 30% chance
that Sheen wins at trial. Sheen offers to settle for 7 mill. We represent other person (not sheen). 7%
30% chance we win and get 5 mill
30% chance we win and get 10 mill
10% chance we win and get 30 mill
30% chance we lose and get zero

What do we want to do? Take 7 mill settlement? Go to trial?

Use PV.
If we settle at 7 mill, we pay 200K in costs and take home 6,800,000 (this is the # we compare against)
Always use pv and fv first and expected value later.

ANSWERS ON HANDWRITTEN PAGE

FINANCIAL STATEMENT ANALYSIS

Financial Statements look backwards. They don’t predict the future.

A. Reading financial statements

- Three groups read financial statements, with separate concerns
o Creditors: can the company pay us? are their claims subrogated to other
creditors?
o Investors: what return on the investment vs. the risk in investing?
How much money will they make?
o Managers: how can we be more efficient as a company? (fyi: inventory)
Cash flow – for next project, do we use debt or equity?

- Three ways to read financial statements:

o Compare the company to itself with prior year statements
At least three years, but preferably five
o Compare company to similar companies in the industry with current year info

24
 o Compare one set of financial information to another (ex: to see if assets went
up in the current year) Isn’t this the same as #1?

- Two types of analysis (Note Exhibit Handout)

o Horizontal analysis:
 Compares company against itself over at least two years
 Prior periods to current periods
 Compares same budget items (inventory against inventory)
 Actual dollar change in a category (though inflation can skew this)
 Percentage change in a category (MUCH more meaningful)
o Vertical analysis
 Compares company against itself in one year
 Looks at % breakdown for each category on a financial statement (assets
on a balance sheet, for example)
 Each asset as compared to total assets
 Each liability/equity as compared to total liabilities & equity

B. Financial ratios
- The most important tool in analyzing financial statements
- Four Standard Ratios
1. Liquidity Ratios
2. Long Term Solvency & Capital Structure Ratios
3. Efficiency Ratios
4. Profitability Ratios

-- Two types of insolvency

o Cash flow insolvency – no money to pay debts (liquidity ratios show this)
o Balance sheet insolvency – you can pay, but you have LOTS of long-term
debt
o Long Term Financial Stability Issue

LIQUIDITY RATIOS
Measure whether you can meet current obligations as they become due
Considered in conjunction with the Statement of Cash Flows
These are short-term ratios

1. Current Ratio
o Current Assets : Current Liabilities
o Formula
Current Assets
------------------------ = Working Capital
Current Liabilities
o Wal-Mart, pg 29ish
4831 / 55,561 = .87
This tells us WM doesn’t have enough assets to cover its liabilities.
Potential
25
 cash flow problem. WM is getting charged a premium on their
borrowing b/ c this number
S & P average is 1:4 Industry standard is 1.1

2. Acid Text Ratio / Quick Ratio

o Measures ability to convert assets into cash quickly
 Inventory and prepaid expenses are difficult to convert quickly
o Formulas
Cash + Accounts Receivable + Marketable Securities
---------------------------------------------------------------------------
Current Liabilities

Current Assets – Inventory – Prepaid Expenses

o 1:1 is the bare minimum

 Too high  Inefficient, bad for investors and managers
 Less than  Not enough cash on hand to pay liabilities, unlikely to get
a loan

o Wal-Mart  7907 + 4144 + 0

------------------------- = .22
55,561

S & P Average is .9 Industry Standard is .5 Small Business is 1:1

LONG-TERM SOLVENCY & CAPITAL STRUCTURE RATIOS / LEVERAGE RATIOS

 Measure leverage or the overall use of debt in a corporation’s capital structure and
the ability of the corporation to service that debt over the long term (this long term
focus distinguishes these ratios from the liquidity ratios).
 Utilizing leverage by borrowing increases the potential returns of the stockholders
but also increases the risk for the stockholders b/c of the increased exposure to
fixed debt service payments.
 A word about leverage
o Two ways to finance business activities (capitalized)
 Debt financing – get loans to pay for it
 Equity financing – sell stock and set a low par value to get paid-in
capital to finance activity
o The higher your debt is, the more leveraged you are

26
 o Leverage is good, especially if you make more money on the activity than
it cost you to borrow
o You have to find the right balance between good leverage and excessive
debt
 If you’re overleveraged, you do worse at the beginning of recessions,
since you’re trying to pay obligations in a flat or declining market
 If you’re underleveraged, there’s no margin between the cost of $ you
spend and your earnings

1. Debt : Equity Ratio [Look at Balance Sheet]

 Measures relative use of debt and equity in a company’s capital structure
o How much of your business is financed with debt and how much is
financed with equity
 Helps banks decide if they want to lend to you and, if so, at what rate
o Higher ratio, the greater the risk [The more debt you have compared to
your equity, the more risky it is for a lender to lend you additional
money]
o Credit is upgraded or downgraded based on this
o Low debt : equity = upgrade = lower interest rate
o High debt : equity = downgrade = higher interest rate
 Debt analysis includes
o Short Term Borrowings
o Long Term Debt Due w/in One Year
o Obligations Due w/in One Year
o Long Term Debt
o Long Term Obligations
 Equity analysis does not include Noncontrolling interest
 Wal-Mart
41,320 / 70,749 = .584 More financed with equity
S&P is 1.04 Industry Standard is .666
Most small businesses need 2:1 in favor of equity

 Debt to Total Capitalization (subset of debt : equity)

o Another way to look at debt as compared to equity
o Formula Wal-Mart: 41,320
Debt ---------------------------- = 37% capitalized
------------------------- 112,069 with debt
Total Capitalization (41,320 + 70,749)
2. Times Interest Earned Ratio / Interest Coverage Ratio [Look at Income Statement]
o Compares income for the year to the amount of the interest expense for the
year
 Gives a rough estimate of how much the company’s income could
deteriorate w/out jeopardizing the ability to cover interest expense
o Portrays coverage debt holders have from earnings to ensure payment of
interest on debt
 Is company making enough money to service debt they borrowed to
fund business?
o Shows how many times a year they earn their interest expense
o Banks get more comfortable as this ratio gets higher
27
 o Formula
Interest Expense + Earnings Before Taxes
------------------------------------------------------------
Interest Expense

o Wal-Mart
1884 + 14,927 WM can service 9x the
amount
-------------------- = 8.92 of debt they owe
1884

S&P is 52.7% Industry Standard is 21.1%

Profitable Borrowing: Borrowing money at a certain interest rate and using that money to produce higher
revenues.
Try to find the equilibrium where amount you are borrowing is going to make enough to
pay for itself and have a left over profit.

Bond Ratings: How banks measure whether they should extend additional credit
AAA  Junk Bonds Wal-Mart is AA

3. Book Value Per Share

 Measures the net assets that back each share of common stock
o Theoretically, what the common shareholders would receive if the
company liquidated
 Market Fluctuations / Market Value Per Share
 In a bull market, stock price should be greater than book value
 In a down market, stock price will be equal to book value per share
 If stock price goes below book value, company is in trouble. you wold
be selling stock at less than worth (?)
 Looking at this to determine if we want to invest in business via buying stock
 Formula [This is what investors own in the business]

Net Assets/Equity (– Preferred Stock)

--------------------------------------------------- = How much assets are backing up
each stock
Number of Shares Outstanding

Net Assets: Assets minus liabilities which equals equity

 Wal-Mart
(72,929 – 2180)
70,749
---------------------- = 18.69 per share
3786

Every share of stock is worth $18.69 (though currently trading at

$52/share)
28
 S&P is 24.64 Industry Standard is 19.54

4. Debt Coverage Ratio [Look at Income Statement]

o Measures how well cash flow covers debt regarding capacity of business to
take on more debt
 Very much like Times Interest Earned Ratio
 One of the most widely used by lenders
 What capacity does WM have to take on more debt?
o Lower the number, the better you are
o Formula
(Net Profit + Non-Cash Expenses)
Net Operating Income
----------------------------------------------------
Debt
(Total Annual Debt)
o Wal-Mart
22,066
---------- = 3.24 WM is doing well.
6803 No problem extending additional credit.

6803 = interest paid 1884 + short term borrowing + long term yr + cap leases

Anything over 1 means you are generating enough income to pay debt (enough
cash flow).
Had the number been .8, they would have only been able to pay 80% of their debt.

S&P is 1.35 Industry Standard is 2.8

EFFICIENCY RATIOS
Measure of efficiency in the utilization of a company’s assets or in selected categories of
assets.
Primarily of interest to management  How efficient are they in conducting
operations?

1. Accounts Receivable Turnover

29
 o Efficiency at turning receivables into cash, quality of receivables, and how
quickly you collect receivables
 How long customers are taking to pay bills  how long are you giving
them an interest free loan?
o Two ways to compute: Using either sales or credit sales
 Our assumption: All sales are credit sales
o Formula
Sales
----------------------------
Average Account Receivables

o Wal-Mart
Net sales from income statement: 405,046
Average account receivables for 2010 & 2009: (4144 + 3905) / 2 =
4024

405,046 / 4024 = 100.64

365 / 100.64 = 3.6 days to collect receivables

S&P is 25 days Industry Standard is 1.5 (not valid comparison for WM)

2. Accounts Payable Turnover

o How quickly you pay off debts
 Number of times you pay your payables per year
o If your collection period is over 1/3 your normal selling terms, you have a
problem
o This is how we figure out cash flow. Very important
o If in service business (attorney / cpa), this is very important
 How can you shorten or lengthen this? Adjust how often you send bills
to your clients. Probably will want to send bills to them quicker.
o Formula
COGS (Purchases)
---------------------------
Average Accounts Payable

o Wal-Mart
304,657 / 29,650 = 10.276
365 / 10.276 = 35.5 days on average to pay your payables

This gives them 32 days of an interest free “loans” / cash flow.

[ 29,650 comes from: (30,451 + 28,849) / 2 ]

Industry Standard is 36 days

 Management wants to see collecting receivables faster than paying payables.

This is increasing cash flow.
If you pay payables faster than you collect receivables, you have negative cash
flow.
30
3. Inventory Turnover
o Compares amount of inventory to the volume of goods produced and sold
measured by their cost
 Ratio of how quickly inventory is sold
 The higher the ratio, the greater the volume
 The lower the ratio, the lower the volume
 Neither high nor low is good  Need a mix
o Managing inventory efficiently is the greatest way you can increase
profitability
 Goal: Get inventory as close to zero as possible before buying new
stock, but leave enough cushion to avoid running out
o Ratios change depending on type of business
o Formula
Cost of Goods Sold
--------------------------- = Inventory Turnover
Average Inventory

o Wal-Mart
304,657 / 33,835 = 9.004 how many times inventory turns over
per year
365 / 9.004 = 40.5 days is how often inventory turns over

[ 33,835 = (33,160 + 34,511) / 2 ]

S&P is 11.26 Industry Standard is 8.7

Higher the number, the faster they turn it over.

4. Asset Turnover Ratio

o Measures how efficiently a company uses its assets
 For every dollar of assets, how much sales is generated?
o Higher asset turnover indicates the ability to generate a relatively high
volume of sales using a given amount of assets
o You want to be as close to the industry standard as possible
o Formula
Sales
---------------------------
Average Total Assets

o Wal-Mart So for every dollar WM

invests,
405,046 / 167,067 = 2.4 it generates $2.40 in
sales.

31
PROFITABILITY RATIOS
Measures the degree of profitability of a business.

1. Earning Per Share

o The amount of earnings for a particular year allocable to one share of the
corporation’s residual security interest, normally the common stock of the
corporation.
o Often companies compute with diluted earnings per share – the number of
shares that would be outstanding if options were converted into common
stock.
o Used as a comparison against yourself and other companies
o Formula
Net Income (If preferred shares, subtract dividends)
-------------------------------------------------------------------------
Average Number of Shares Outstanding (Common stock)

o Wal-Mart
14,335
----------------------------- = $3.71 For every share of
stock,
3855.50 WM made $3.71
(3786 + 3925) / 2

2. Price Earnings Ratio

o Relates the current market price of common stock to the earnings per share
on that stock
 Number of times by which the per share earnings is multiplied to get to
the market price of a stock
o Higher P/E ratios anticipate higher projected future earnings
 A high P/E ratio is generally associated with a growth stock, since the
relatively high value of the stock in relation to current earnings
indicates that the market is anticipating substantial growth in the
earnings over time.
o You want to be above the standard.
o Formula
Market Value Per Share (Stock Price)
------------------------------------------------------
Earnings Per Share (Generally, use diluted earnings per share)
o Wal-Mart
Current stock price is $52.19.
Diluted earnings per share was 3.70 for the end of the year.
Must compute diluted earnings per share for today: 4.18.

52.19 / 4.18 = 12.5

32
3. Return on Assets
o Measures the return generated per dollar of assets invested in the business.
o It is a measure of managerial efficiency and profitability.
o Formula
Net Income (From continuing operations  take out nonrecurring
items)
---------------------------------------------------------
Average Total Assets

o Wal-Mart
14,927 (Includes Taxes)
---------------------------------- = .089 = 8.9%
167,067.50
[ (170,706 + 163,429) / 2 ]

Industry Average: 8.6 S&P: 8.0

o Light-asset companies should fall around 20%; heavy-asset companies

should be around 5%

4. Return on Equity
o Measures rate of return being earned by the common stockholders and
therefore includes the effects, positive or negative, of employing leverage
(debt) in the capital structure.
 What you get for every dollar you invest.
o Most important formula. Holy Grail.
1. If your return on investment is equal to industry average or better,
probably decent investment.
2. What about risk? If you’re making 12% and industry average is 10%,
you are probably taking more risk. Then consult other ratios to help
determine risk. If you were getting the same return with more risk,
bad investment. So you can’t just look at this one formula. Must
compare to others.
Investors look at same things banks look at to determine risk.
Generally, standard deviations.
An index is a series of stocks you can invest in. They follow the
market. It’s a group of stocks.
o Formula
Net Profits/Income
--------5. --------------------
Equity
o Walmart Industry Average: 20.5%
14,927
-------------------------- = 21.9% WM’s return on equity
is better than
68,017 Ind Avg but you are taking more
risk.
33
 (70,749 + 65,285) / 2 (Not enough cash flow to pay off
current liabilities.)

5. Leverage
o Return on borrowed money  the gap between rate of return and cost of
borrowing
o If leverage ratio is greater than cost of borrowing, profitable borrowing
o Compare this to return on assets. If it’s less than ROA, the company is doing
well with borrowed money
o Formula
Interest Cost for the Year
-------------------------------------
Debt
o Walmart
1884 / 41,320 = 4.55% Cost of borrowing money

1884  Income statement

41,320  Balance Sheet:
523 (short term), 4050 (long term/yr), 346 (obl cap lease),
33231 (long term debt), 3170 (long term cap leases)

Compare this cost of borrowing money to return on assets (8.9%).

8.9 - 4.5 = 4.4%

More money you borrow, the lower this money will be.

If you invest 250,000 in an asset (equipment),

and as a result you’re expecting to make a 75,000 profit.

75000 / 250000 = 30%

Instead of buying asset with cash, we buy half with cash and borrow half.

125K + 125K

125K x 12% interest = 15,000 worth of interest this year.

This comes from our profit. 75K – 15K = 60K

60K / 125K = 48% this is profitable borrowing.

48% - 30% = 18% profit.

34
6. Profit Margins
o Reflects the portion of each sales dollar that is realized as profit of the
business
o Management tool.
o Net Margin
 aka Net Operating Margin, Ratio of Income to Sales
 The lower the ratio, the more rapid the inventory turnover has to be.
 The higher the ratio, the more slowly their turnover can be.
 Compare to previous years to look for trends

Net Income (Net Operating Income)

---------------------------------------------------
Total Sales
For everything WM sales, they sale it
Wal-Mart 14,927 / 405,046 = 3.7% for 3.7% above what they paid for it
(including overhead costs).
Industry Average: 3.7%
S & P: 12.4% WM is at the industry average – this
is awesome.

o Gross Margin
 aka Inventory Markup
 Comparing profit against sales

Gross Profit [Gross Profit = Sales minus COGS]

-------------------
Total Sales

Wal-Mart (405,046 – 304,657) Industry: 25.1

100,389 S&P: 38.3
---------------------------- = 24.8%
405,046
WM’s gross profit margin is less
than Industry Avg but
their net margin equals
Industry, so they are running
more efficiently.

 COGS Margin
 Inverse of Gross Margin
 COGS Margin + Gross Margin = 100

COGS Wal-Mart = 75.2

----------------------------
Sales
35
 Gross Margin only takes into account markup on goods themselves.
Net Margin takes into account everything (salaries, etc).
7. Sales Growth
o Portrays whether the business has increased or decreased sales.
o Formula
Current Year’s Sales --- Last Year’s Sales
-------------------------------------------------------------
Last Year’s Sales

o Wal-Mart
405,046 – 401,087
-------------------------- = .9% increase from 2009 to 2010
401,087 Not a big change. They
explain.

8. SG&A
o Selling, general, and administrative costs  overhead
 Includes payroll, distribution, home office costs, etc.
o If a company is restructuring, it’s almost a given they don’t like the way this
ratio looks.
o Formula
SGA Expenses
----------------------
Sales

o Wal-Mart
79,607
--------------------------- = 19.7%
405,046

[Info from income statement, 2nd category]

Caveat  Don’t just look at one ratio.

Compare them all. Compare to others. Compare to yourself.

Profit Margin Issue I Never Worked Out:

If your COGS is 10,000 and you sell it for 12, 500, your profit is 2500.
If you bought your inventory on 1/1 and you sold it by the end of the year, you have turned your inventory
over once for the year and made a 2500 profit. The amount you invested was 10K, which means gross
profit percentage was 25% (2500/10000).
Instead, you invest 5K and make 6250 then buy 5K worth again and make 6250. This time we
only
invested 5K of our original money. Which makes profit margin 50% (2500/10000)
36
What if we invest only 2500? 2500, 2500, 2500, 2500: 2500/2500 = 100%
 ACCOUNTING FOR LAWYERS
PIETRUSZKIEWICZ, SPRING 2011

STUDY GUIDE

BALANCE SHEET  PROBLEM 1:

100 shares of stock, $2 par value, $30,000

Assets Liabilities
Cash 30,000

Equity
Capital Stock 200
Add pd in 29,800

Borrow 12K, buys bldg 35K, equip 3K

Assets Liabilities
Cash 4,000 Notes Payable 12,000
Bldg 35,000
Equip 3,000
Equity
Capital Stock 200
Add pd in 29,800

Earns 28K, pays off debt (income is treated as a cash asset)

Assets Liabilities
Cash 20,000
Bldg 35,000
Equip 3,000
Equity
Capital Stock 200
Add pd in 29,800
Ret Earnings 28,000

Loses 34K, borrows as necessary

Assets Liabilities
Cash 0 Note Payable 14,000
Bldg 35,000
Equip 3,000
Equity
Capital Stock 200
37
 Add pd in 29,800
Ret Earnings (6,000)
Total: Total:
38,000 38,000

GENERAL JOURNAL:
A chronological record of the business transactions
Keeps track of all transactions unlike the balance sheet

DOUBLE ENTRY BOOKKEEPING:

Every transaction in the journal receives one or more debit and credit entries, which are always equal to
one another [debits on left; credits on right]

Asset Increase  Debit

Asset Decrease  Credit

Liability Increase  Credit Equity Increase  Credit

Liability Decrease  Debit Equity Decrease  Debit

GENERAL JOURNAL  PROBLEM 2:

Jan 1, 60,000 invested, 6000 shares sold at $1 par value

Date Account Reference Debit Credit

1/1 Cash 60,000
Equity Capital Stock 6000
Equity Add pd in Cap 54,000

Make this into a balance sheet:

Assets Liabilities
Cash 60,000
Equity
Capital Stock 6000
Add pd in 54,000
Total: Total:
60,000 60,000

GENERAL JOURNAL  PROBLEM 3:

Invests 100,000 for 10,000 shares at $2 par value.

Date Account Reference Debit Credit
2/1 Cash 100,000
Equity Capital Stock 20,000
Equity Add Pd in Cap 80,000
Company bought building for 35,000 on Feb 5 with 5000 downpayment.
2/5 Building 35,000
Cash 5000
Note Payable Building 30,000
Sell building for 42,000 and pay off note on June 1.
38
6/1 Cash 42,000
Note Payable 30,000
Building 35,000
Equity 7000
Cash 30,000
GENERAL LEDGER
The collection of all the accounts that a business maintains
Consolidates all entries to each specific account
T-charts

CONTINUE PROBLEM 3:

(+) Cash (-) (-) Note Payable (+)

2/1 100,000 2/5 5000 6/1 30,000 2/5 30,000
6/1 42,000 6/1 30,000 Total: 0
Total: 107,000

Building
2/5 35,000 6/1 35,000
Total: 0

Capital Stock
2/1 20,000

Additional Paid in Capital

2/1 80,000

Equity
6/1 7000

Then make this into a balance sheet:

Assets Liabilities
Cash 107,000
Equity
Capital Stock 20,000
Add pd in 80,000
Ret Earnings 7,000
Total: Total:
107,000 107,000

39
INCOME STATEMENT  PROBLEM 4

Professional Fees 50,000/month

Rent 3000
Utilities 500
Insurance 400
Office Supplies 200
Salaries 20,000
Couriers 1,000

Income Statement:
Revenue
Prof. Fees 50,000
Expenses
Rent 3000
Utilities 500
Insurance 400
Office Supplies 200
Salaries 20,000
Couriers 1,000
Total Expenses (25,100)

Net Income (before taxes) 24,900

Taxes (35%) (8715)

Net Income (after taxes) 16,185

Close out t-accounts to profit & loss acct then transfer balance to retained earnings (B1 & B2)

Add into balance sheet:

Assets Liabilities
Cash 16,185
Equity
Retained Earnings 16,185
Total: Total:
16,185 16,185

Order of Process:
1. Journal
2. T-charts
3. Profit & Loss Account
4. Income Statement
40
5. Balance Sheet

CASH BASIS / ACCRUAL / DEFERRAL  PROBLEM 5

Go to the doctor in Dec for $600. Patient pays the $600 in Jan. When does the doctor record this revenue?

Cash Method:
12/10 Nothing b/c he hasn’t yet received cash
1/11 Cash 600
Revenue 600

Accrual Basis:
12/10 Acct Receivable 600
Revenue 600
1/11 Cash 600
Acct Receivable 600
---------------------------------------------------------------------------------
Lawyer rents office building for $800/month. He is billed at the end of the month and pays the next month.
When does he account for this expense?

Cash Method:
12/10 Nothing
1/11 Rent Expense 800
Cash 800

Accrual Method:
12/10 Rent Expense 800
Rent Expense Payable 800
1/11 Rent Expense Payable 800
Cash 800
---------------------------------------------------------------------------------
Client gives you $2000 in Dec as a retainer. You take depos in Jan and actually earn the money.

Cash Method:
12/10 Cash 2000
Prof Services 2000

Accrual Method:
12/10 Cash 2000
Deferral prof services 2000
1/11 Deferral 2000
Prof Services 2000
---------------------------------------------------------------------------------
Prepay Jan’s rent of $800 in Dec.
Cash Method:
12/10 Rent Exp 800
Cash 800

41
Accrual Method:
12/10 Prepaid Rent 800
Cash 800
1/11 Rent Expense 800
Prepaid Rent 800
INVENTORY PROBLEM  FIFO  PROBLEM 6a

Inventory acquired on the 1st of the month:

* 200 in Dec at $30 each
* 50 in Jan at $40
* 20 in Feb at $50
* 60 in March at $60
* 10 in April at $70

Inventory sold on the 20th of the month at $80 each:

* 120 in Jan
* 100 in Feb
* 40 in March
* 15 in April

2011 Beginning Jan Feb March April Total

Number Acq 200 50 20 60 10 340
Cost 30 40 50 60 70
Total Cost 6000 2000 1000 3600 700 13,300

Total Sales: 120 + 100 + 40 + 15 = 275 x 80 = 22,000

Month # Sold Of Original COGS Sold for Profit

Cost
Jan 120 Of 30 3600 9600 6000
Feb 80 Of 30 2400 6400 4000
20 Of 40 800 1600 800
March 30 Of 40 1200 2400 1200
10 Of 50 500 800 300
April 10 Of 50 500 800 300
5 Of 60 300 400 100
Totals 9300 22,000 12,700

Ending Inventory: 55 x 60 = 3300

10 x 70 = 700
----------
$4000 Worth of Ending Inventory

Total Inventory at Cost 13,300

COGS - 9300
-------------
$4000 Worth of Ending Inventory

Continued below
42
 INCOME STATEMENT

Gross Profit
Sales 22,000

Expenses
Less COGS
Opening Inventory 6000
Purchases + 7300
Goods Available for Sale 13,300

Less Closing Inventory 3300

+ 700
- 4000
COGS - 9300

Gross Profit 12,700

BEGINNING BALANCE SHEET * Eliminate Beginning Inventory (3)

Cash 54,000 * Eliminate Purchases (4)
Inventory 6000 Equity 60,000 * Add back into Inventory your Ending
------------------------------------------------------------- Inventory (5)
60,000 60,000 (A) and (B) are the closing of Income
Stmt accounts
JOURNAL ENTRIES
1. Purchases 7300 T - ACCOUNTS
Cash 7300 Cash COGS
2. Cash 22,000 54,000 7300 (1) (3) 6000 4000 (5)
Sales 22,000 (2) 22,000 (4) 7300
3. COGS 6000 68,700 9300 9300
Inventory 6000
4. COGS 7300 Inventory Sales
Purchases 7300 6000 6000 (3) (A) 22,000 22,000 (2)
5. Inventory 4000 (5) 4000
COGS 4000 4000

Closing Entries Purchases

A. Sales 22,000 (1) 7300 7300 (4)
P&L 22,000
B. P&L 9300 Profit & Loss Equity
COGS 9300 (B) 9300 22,000 (A) 60,000
C. P&L 12,700 (C) 12,700 12,700 (C) 12,700
Equity 12,700
72,700

43
ENDING BALANCE SHEET
Cash 68,700
Inventory 4000 Equity 72,700
72,700 72,700
INVENTORY PROBLEM  LIFO  PROBLEM 6b

2011 Beginning Jan Feb March April Total

Number Acq 200 50 20 60 10 340
Cost 30 40 50 60 70
Total Cost 6000 2000 1000 3600 700 13,300

Month # Sold Of Original COGS Sold for Profit

Cost
Jan 50 Of 40 2000 4000 2000
70 Of 30 2100 5600 3500
Feb 20 Of 50 1000 1600 600
80 Of 30 2400 6400 4000
March 40 Of 60 2400 3200 800
April 10 Of 70 700 800 100
5 Of 60 300 400 100
Totals 275 10,900 22,000 11,100

Ending Inventory: 50 @ 30 = 1500 Total Inv Balance 13,300

15 @ 60 = 900 COGS - 10,900
2400 2,400

BEGINNING BALANCE SHEET

Cash 54,000
Inventory 6000 Equity 60,000
-------------------------------------------------------------
60,000 60,000

JOURNAL ENTRIES (Equals the same as FIFO but done month-by-month rather than in lump)
1/1 Purchases 2000 Adjusting Entries
Cash 2000 A COGS 6000
1/20 Cash 9600 (Beg) Inv 6000
Sales 9600 B COGS 7300
2/1 Purchases 1000 Purchases 7300
Cash 1000 C (End) Inv 2400
2/20 Cash 8000 COGS 2400
Sales 8000 D Sales 22,000
3/1 Purchases 3600 P&L 22,000
Cash 3600 E P&L 10,900
3/20 Cash 3200 COGS 10,900
Sales 3200 F P&L 11,100
4/1 Purchases 700 Equity 11,100
Cash 700
44
4/20 Cash 1200
Sales 1200

T – ACCOUNTS
Cash Purchases
54,000 2000 1/1 1/1 2000 7300 B
1/20 9600 1000 2/1 2/1 1000
2/20 8000 3600 3/1 3/1 3600
3/20 3200 700 4/1 4/1 700
4/20 1200 0
68,700

Inventory Sales
6000 6000 A 9600 1/20
C 2400 8000 2/20
2400 3200 3/20
1200 4/20
D 22,000 22,000
0

COGS Equity
A 6000 2400 C 60,000
B 7300 11,100
10,900 10,900 E 71,100
0

Profit & Loss Sales & Revenue always have a credit balance and are
E 10,900 22,000 D closed with a debit.
F 11,100 0
COGS always has a debit balance and is closed with a
credit.
ENDING BALANCE SHEET
Cash 68,700
Inventory 2,400 Equity 71,100
----------------------------------------------------------
71,100 71,100

INCOME STATEMENT
Sales 80 x 275 = 22,000

Less COGS
Opening Inv 6000
Purchases + 7300
Goods Available for Sale 13,300

Less Closing Inv (LIFO)

50 x 30 1500
15 x 60 + 900
45
 Total Closing Inv 2400

COGS 13,300 – 2400 - 10,900

Gross Profit 11,100

INVENTORY PROBLEM  AVERAGE LIFE  PROBLEM 6c

$13,300 total cost Check:

--------------------- = $39.12 per unit
340 total units $2542 Ending Inventory
+ $10,758 COGS
Sold 275 @ $39.12 = $10,758 COGS $13,300 Total Beginning
340tot inv – 275 sold = 65 Units Ending Inventory

65 end inv @ $39.12 = $2542 Ending Inventory

ADJUSTING JOURNAL ENTRIES

Same journal entries as LIFO thru #8. Cash Purchases
Adjusting and closing entries change. 68,700 7300 7300 B
0
A COGS 6000 Inventory Sales
Inventory 6000 6000 6000 A D 22,000 22,000
B COGS 7300 C 2542 0
Purchases 7300
2542
C (Ending) Inventory 2542
COGS Equity
COGS 2542
A 6000 2542 C 60,000
B 7300 11,242 F
Closing Entries
D Sales 22,000 10,758 10,758 E 71,242
P&L 22,000 0
E P&L 10,758 Profit and Loss
COGS 10,758 E 10,758 22,000 D
F P&L 11,242 F 11,242
Equity 11,242 0

INCOME STATEMENT ENDING BALANCE SHEET

Sales 80 x 275 = 22,000 Cash 68,700
Inventory 2542 Equity 71,242
Less COGS 71,242 71,242
Opening Inv 6000
Purchases + 7300
Goods Available for Sale 13,300

Less Closing Inv (Average Cost)

65 x $39.12 2542
Total Closing Inv 2542

COGS 13,300 – 2542 - 10,758

46
Gross Profit 11,242

EXPENSE V. CAPITAL EXPENDITURE  PROBLEM 7

As the new millennium approached, UPS spent $700 million large amounts to address the so-called “Year 2000
Problem” by modifying hundreds of thousands of lines of computer code. Should those expenditures be treated
as expenses or capital expenditures? Why.

Originally questionable but recently deemed repair (expense): no addition, no improvement, no

replacement. Everyone expensed Y2K in 1999.

PROBLEM 1.6B, PG 103  PROBLEM 8

General Journal
4/1 Purchases 1000 Adjusting Entries
A/P (Kodak) 1000 A Insurance Expense 25
4/2 A/P (Kodak) 100 Prepaid Insurance 25
Purchase Returns Allowances 100 B Interest Expense 75
4/4 Cash 1325 Accrued Interest Payable 75
Sales Revenue 1325 C Depreciation Expense 100
4/7 Cash 75 A/D: Buildings 100
N/R (Observer) 600 D Depreciation Expense 30
Sales Revenue 675 A/D: F&F 30
4/9 Cash 600 E Accrued Interest Receivable 4
A/R 1700 Interest Revenue 4
Sales Revenue 2300
4/11 A/R (Bird) 175
600 x 10% x 24 = 4
Sales Revenue 175
12 30
4/14 Sales Returns 175
A/R (Bird) 175
Note entry on 4/7
4/15 Salary Expense 500
Cash 500
4/18 Purchases 1500 A/D = Accumulated Depreciation
A/P (Nikon) 1500
4/21 Prepaid Salary 600
Cash 600
4/23 Wage Expense 100
Cash 100
4/25 Telephone Expense 24
Cash 24
4/27 Cash 100
Unearned Revenue 100
(Un Rev is a liability account)
4/30 Salary Expense 500
Salaries Payable 500

47
Balance Sheet T-Charts
Cash Notes Receivable Accounts Payable
14,800 500 4/15 4/7 600 7900
4/4 1325 600 4/21 4/2 100 1000 4/1
4/7 75 100 4/23 Prepaid Salaries 1500 4/18
4/9 600 24 4/25 4/21 600 10,300
4/27 100
15,676 Accrued Interest Receivable Accrued Interest Payable
E 4 225
Accounts Receivable 75 B
2700 175 4/14 300
4/9 1700
4/11 175 Note Payable
4400 10,000
Salaries Payable
Inventories 500 4/30
2100 300 4/30
4/30 2000 2100 4/30 Unearned Revenue
1700 100 4/27

Prepaid Insurance
225 25 A
200

Land
10,000
Income Tax Payable
Buildings 45 4/30
40,000

A/D: Buildings
11,700
100 C
11,800

Furniture & Fixtures

3600

A/D: F&F
480
30 D
510
Common Stock
10,000
48
 Retained Earnings
33,120
105
33,225
Closing T-Charts

Purchases Sales Returns Profit & Loss

4/1 1000 4/14 175 175 175 4475
4/18 1500 1000 4
2500 2500 4/30 Salary Expense 100
4/15 500 24
Purchase Returns Allowances 4/30 500 25
4/30 100 100 4/2 1000 1000 75
130
Sales Revenue Wage Expense 45
1325 4/4 4/23 100 100 2800
675 4/7 105 105
2300 4/9 Telephone Expense
175 4/11 4/25 24 24 Closing Journal Entries, 4/30
4475 4475 Sales Revenue 4475
Insurance Expense P&L 4475
Interest Revenue A 25 25 Interest Revenue 4
4 4 E P&L 4
Interest Expense P&L 175
B 75 75 Sales Returns 175
P&L 1000
Depreciation Expense Salary Expense 1000
C 100 P&L 100
D 30 Wage Expense 100
130 130 P&L 24
Telephone Expense 24
P&L 25
Cost of Goods Sold Income Tax Expense Insurance Expense 25
4/30 2100 2000 4/30 4/30 45 45 P&L 75
4/30 2500 100 4/30 Interest Expense 75
4/30 300 Inventory Adjustment P&L 130
2800 2800 4/30 4/30 300 300 4/30 Depreciation Expense 130

P&L 45
4/30 Income Tax Expense 45 Income Tax Expense 45
Income Tax Payable 45
4/30 Inventory Adjustment 300
Inventory 300 P&L 2800
4/30 COGS 2100 COGS 2800
(Beginning Inventory) 2100
4/30 COGS 2500
Purchases 2500 P&L 105
4/30 (Ending) Inventory 2000 Retained Earnings 105
COGS 2000
49
4/30 Purchase Returns Allowances 100
COGS 100
4/30 COGS 300
Inventory Adjustment 300

Income Statement
Sales 4475
Less: Customer Returns (175)
Total Sales Revenue 4300
Cost of Goods Sold
Beginning Inventory (21 x 100) 2100
Purchases 2500
Less: Purchase Returns (100)
Goods Available for Sale 4500
Less: Ending Inventory (17 x 100) (1700)
COGS 2800

Gross Profit 1500

Operating Expenses
Salary Expense (1000)
Wage Expense (100)
Telephone Expense (24)
Insurance Expense (25)
Depreciation Expense (130)
Total Operating Expenses (1279)

Non Operating Revenues & Expenses

Interest Revenue 4
Interest Expense (75)
Total Non-Operating (71)

Income Before Taxes 150

Income Taxes at 30% (45)

Net Income 105

50
Balance Sheet

ASSETS LIABILITIES & EQUITY

Cash 15,676 Accounts Payable 10,300
A/R 4400 Accrued Interest Payable 300
N/R 600 Salaries Payable 500
Inventory 1700 Unearned Revenue 100
Prepaid Insurance 200 Income Tax Payable 45
Prepaid Salaries 600 Total Current Liabilities 11,245
Accrued Int Rec 4 Note Payable 10,000
Total Current Assets 23,180 Total Long-Term Liabilities 10,000
Total Liabilities 21,245
Land 10,000
Buildings 40,000 Common Stock 10,000
Less A/D (11,800) Retained Earnings 33,225
28,200 Total Equity 43,225
F&F 3600
Less A/D (510)
3090
Total Fixed Assets 41,290

Total Assets 64,470 Total Liabilities & Equity 64,470

51