C. Accounting Scandals 4 1. Waste Management, Inc Enron Corp WorldCom, Lehman Brothers, and More 7

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1 Preface xxiii 1 OVERVIEW OVERVIEW OF ACCOUNTING 1 A. Introduction 1 B. Brief History of Accounting 1 C. Accounting Scandals 4 1. Waste Management, Inc Enron Corp WorldCom, Lehman Brothers, and More 7 D. Importance of Accounting and Finance Literacy for Lawyers 9 2 UNDERSTANDING THE BASICS OF FINANCIAL STATEMENTS 11 A. Introduction 11 B. Primary Financial Statements Balance Sheet 12 a. Components of the Balance Sheet 14 i. Assets 14 (a) Current Assets 15 (b) Long-Term Assets 15 ii. Liabilities 16 (a) Current Liabilities 17 (b) Long-Term Liabilities 18 iii. Equity 18 (a) Sole Proprietorship 19 (b) Partnership 19 (c) Limited Liability Company 19 (d) Corporation 20 b. Application to Practice 21

2 xii 2. Income Statement 23 a. Revenues 23 b. Expenses 24 i. Cost of Goods Sold 24 ii. Operating Expenses 25 c. Other Income or Gains and Other Expenses or Losses 26 d. Income Tax Expense 27 e. Application to Practice Statement of Cash Flows 29 a. Operating Activities 30 i. Direct Method 30 ii. Indirect Method 31 b. Investing Activities 33 c. Financing Activities 34 d. Net Increase or Decrease in Cash 35 e. Application to Practice Statement of Changes in Stockholders Equity Interconnections Between the Financial Statements 38 a. Balance Sheet and Income Statement 38 b. Balance Sheet and Statement of Changes in Stockholders Equity 39 c. Balance Sheet and Statement of Cash Flows 39 OVERVIEW OF ACCOUNTING AND AUDITING 3 PRINCIPLES 41 A. Introduction 41 B. Accounting Bodies Generally Accepted Accounting Principles 42 a. FASB Accounting Standards Codification 43 C. Accounting Assumptions, Principles, and Constraints General Assumptions 44 a. Business Entity Assumption 44 b. Going Concern Assumption 44 c. Monetary Unit Assumption 45 d. Time Period Assumption General Principles 45 a. Historical Cost Principle 45 b. Revenue Recognition Principle 46 c. Matching Principle 46 d. Full Disclosure Principle General Constraints 46 a. Materiality Constraint 47 b. Conservatism Constraint 47

3 xiii c. Industry Practices Constraint 47 d. Consistency Constraint 47 e. Cost Constraint 48 f. Objectivity Constraint 48 D. American Institute of Certified Public Accountants Generally Accepted Auditing Standards 49 E. Public Company Accounting Oversight Board PCAOB Auditing Standards 50 F. Auditing Process Planning the Audit Audit Risk 51 a. Risk of a Material Misstatement 51 b. Detection Risk 52 G. Audit Procedures Test of Controls Substantive Procedures 53 a. Audit Evidence Management s Representations Audit Inquiry Letters 56 a. Attorney Responses to Audit Inquiry Letters Audit Documentation Audit Report and Opinion 59 a. Audit Report 59 i. Unqualified Opinion 60 ii. Unqualified Opinion with Explanatory Language 60 iii. Qualified Opinion 61 iv. Adverse Opinion 61 v. Disclaimer of Opinion 62 H. Auditor s Liability Liability to Clients Liability to Third Parties Statutory Liability Criminal Liability 66 I. Audit Alternatives Compilation Engagement Review Engagement 67 J. Cost of an Audit 68 K. International Accounting Standards Board International Financial Reporting Standards 69

4 xiv 4 FINANCIAL STATEMENT PREPARATION 73 A. Introduction 73 B. Bookkeeping Double-Entry Bookkeeping Debits and Credits Accounts 75 C. Balance Sheet Entries and Preparation Preparing Journal Entries Posting Journal Entries to T-Accounts 79 D. Income Statement Entries and Preparation Cash Versus Accrual Accounting Methodology 90 a. Cash Basis Accounting 90 b. Accrual Basis Accounting 91 i. Revenue and Gain Recognition 92 ii. Expense and Loss Allocation 93 c. Basic Accrual Concepts at Work 94 d. Basic Deferral Concepts at Work 95 e. Accrual and Deferral in More Detail 96 i. Prepaid Expenses 96 ii. Deferred or Unearned Revenue 97 iii. Advanced Accrual and Deferral Concepts at Work 98 f. Bad Debt Expense 102 i. Estimating Bad Debt Expense 102 (a) Percentage of Credit Sales Method 102 (b) Aging of Accounts Receivable Method 103 ii. Accounts Receivable Write-Offs 104 g. Posting Adjusting Entries 105 h. Closing the Income Statement Accounts 105 i. Income Tax Calculations and Entries 106 ii. Closing Profit and Loss Account 108 E. Accounting for Inventory A Merchandise Business A Manufacturing Business Ownership of Inventory 121 a. Items in Transit 122 b. Items Governed by a Consignment Arrangement 122 c. Items Subject to a Financing Arrangement 122 d. Items Eligible for Return Inventory Accounting Methods 123 a. Perpetual Inventory Method 124 b. Periodic Inventory Method 125

5 xv 5. Valuation of Inventory 129 a. Specific Identification 129 b. Cost Flow Assumptions 130 i. First-In, First-Out (FIFO) 130 ii. Last-In, First-Out (LIFO) 131 iii. Weighted Average 133 iv. Comparison of Cost Flow Assumption Methods Lower of Cost or Market for Inventory Estimating the Value of Inventory 140 a. Gross Profit Method 140 b. Retail Method 141 F. Fixed Assets and Depreciation Accounting for the Initial Acquisition of the Asset Depreciation Accounting 143 a. Determining Depreciation Expense 145 i. Useful Life 145 ii. Salvage Value 146 iii. Method of Depreciation 146 (a) Straight-Line Method 147 (b) Declining Balance Method 147 (c) Sum-of-the-Years Digits Method 148 (1) Prorating Depreciation 150 (d) Units of Production Method Post-Acquisition Costs Sale or Disposal of a Fixed Asset Impairment of a Fixed Asset Other Long-Lived Assets 156 a. Intangible Assets and Amortization 156 i. Goodwill 157 b. Natural Resources and Depletion DIVIDEND DISTRIBUTIONS 163 A. Introduction 163 B. Dividend Distribution Overview 163 C. Understanding the Components of the Balance Sheet s Equity Section 164 D. Types of Dividend Distributions Cash Dividends Property Dividends Stock Dividends Stock Splits 171

6 xvi E. Legal Restrictions on Distributions Statutory Restrictions 173 a. Traditional Legal Capital Tests 173 b. Modern Legal Capital Tests 175 i. Balance Sheet Insolvency 176 (a) Valuation of Assets: Randall v. Bailey and Introduction of Fair Market Value 177 (b) Modern Statutes and Fair Market Value 178 ii. Equity Insolvency 179 iii. Combination of Equity and Balance Sheet Insolvency 180 iv. Earned Surplus Test 180 c. Other Dividend Distribution Tests Other Restrictions 181 a. Shareholders Agreement Restrictions 181 b. Loan Agreement Covenants F. Creditors Rights Fraudulent Conveyance Laws Federal Bankruptcy Code 185 ANALYSIS OF FINANCIAL STATEMENTS 189 A. Introduction 189 B. Annual Report on Form 10-K Risk Factors Selected Financial Data Management s Discussion and Analysis Financial Statements and Supplementary Data Audit Report 192 C. Horizontal Trend Analysis 193 D. Common-Sized Analysis 195 E. Ratio Analysis Liquidity Ratios 197 a. Current Ratio 197 b. Quick Ratio or Acid Test Profitability Ratios 199 a. Gross Profit Margin 199 b. Net Profit Margin 200 c. Return on Assets 201 d. Return on Equity 201 e. Earnings per Share 202 f. Price-to-Earnings Ratio 203

7 xvii 3. Leverage Ratios 204 a. Debt-to-Equity Ratio 204 b. Debt-to-Assets Ratio Coverage Ratios 205 a. Interest Coverage Ratio 205 b. Other Coverage Ratios Efficiency or Activity Ratios 206 a. Asset Turnover 207 b. Accounts Receivable Turnover 207 c. Inventory Turnover 208 F. Overview of Analyst s Reports COMMITMENTS AND CONTINGENCIES 213 A. Introduction 213 B. Commitments 213 C. Contingencies Loss Contingencies 216 a. Probability Determination 216 b. Timing Determination 217 c. Reasonably Estimable Determination Type of Disclosures 221 a. Loss Contingency Is Probable and Timing Is Met 221 b. Loss Contingency Is Reasonably Possible and Timing Is Met 221 c. Loss Contingency Is Remote and Timing Is Met 222 d. Loss Contingency Is Unasserted 222 i. Disclosure Generally Types of Potential Loss Contingencies 222 a. Litigation 223 i. Probability Assessment in Litigation Context 223 b. Guarantees 226 c. Product Warranties 227 d. Environmental Liabilities INTEREST AND TIME VALUE OF MONEY PRINCIPLES 233 A. Introduction 233 B. Overview of the U.S. Federal Reserve System and Interest Rates The Federal Reserve 234

8 xviii 2. Prime Rate and LIBOR Interest 235 C. Calculating Interest Simple Interest Compound Interest 237 D. Overview of the Time Value of Money Future Value of a Lump Sum Present Value of a Lump Sum Annuities 245 a. Future Value of an Annuity 246 i. Future Value of an Ordinary Annuity 247 ii. Future Value of an Annuity Due 248 b. Present Value of an Annuity 250 i. Present Value of an Ordinary Annuity 250 ii. Present Value of an Annuity Due 251 c. Amount of an Annuity Payment 253 d. Perpetual Annuity Rules of 72 and Time Value of Money Limitations 256 E. Bonds and Bond Valuation Increased Market Interest Rates Decreased Market Interest Rates Other Bond Features Bond Ratings 260 FINANCIAL TERMS AND COVENANTS IN 9 CONTRACTS 263 A. Introduction 263 B. Commercial Loan Agreement Financial Covenants 264 a. Incurrence Covenants 264 b. Maintenance Covenants 265 i. Balance Sheet Covenants 265 (a) Minimum Net Worth 265 (b) Debt-to-Equity or Debt-to-Total-Capital 266 ii. Cash Flow Covenants 266 (a) Minimum EBITDA 267 (b) Debt-to-EBITDA 267 (c) Interest Coverage 267 (d) Fixed Charge Coverage 268

9 xix C. Indentures, Bonds, and Notes Financial Covenants 269 a. Limitation on Incurrence of Indebtedness 269 b. Limitation on Restricted Payments 270 c. Limitation on Liens 270 d. Limitation on the Sale of Assets 271 e. Limitation on Transactions with Affiliates 271 f. Limitation on Sale and Leaseback Transactions 272 g. Limitation on Dividends 272 D. Merger and Acquisition Agreement Purchase Price Adjustments Earn-Outs BUSINESS VALUATION 279 A. Introduction 279 B. Business Valuation Methods Income Approach 280 a. Determining Cash Flows 280 i. Capitalized Cash Flow Method 281 ii. Discounted Cash Flow Method Market Approach 283 a. Guideline Method 284 b. Transaction Method Asset Approach 286 a. Book Value Method 286 b. Adjusted Book Value Method 287 c. Liquidation Value Method 288 d. Cost to Create Method 289 C. Valuation Report 289 D. Valuation in Practice OTHER ACCOUNTING AND CORPORATE FINANCE CONCEPTS 293 A. Introduction 293 B. Leases Capital Leases from the Lessee s Perspective 294 a. Transfer of Ownership 294 b. Bargain Purchase Option 295

10 xx c. Lease Term 295 d. Present Value of Minimum Lease Payments Accounting for Capital Leases by the Lessee Operating Leases from the Lessee s Perspective Leases from the Lessor s Perspective 299 a. Operating Lease 300 b. Sales-Type Lease 300 c. Direct Financing Lease 300 d. Leveraged Lease 301 C. Financial Markets Capital Markets Money Market 303 D. Methods of Raising Capital Equity Debt 304 E. Types of Equity Financing Common Stock Preferred Stock Convertible Securities 307 F. Types of Debt Financing Commercial Loans 308 a. Term Loan Facility 308 b. Revolving Credit Facility 309 c. Swingline Loan Facility 310 d. Letter of Credit Facility Debt Securities 310 a. Bonds and Debentures 311 b. Notes and Commercial Paper 311 G. Cost of Capital 312 H. Derivative Instruments Options Forward Contract Futures Contract Swaps 318 Exhibit A Retailers, Inc. Sample Financial Statements 319 Exhibit B Sample Audit Inquiry Letter for Fictitious Company 323 Exhibit C Audit Response Letter for Fictitious Company 325 Exhibit D Unqualified Audit Opinion for Fictitious Company 327 Exhibit E Unqualified Audit Opinion with Explanatory Language for Fictitious Company (Elective Change in Accounting Principle) 329

11 xxi Exhibit F Qualified Audit Opinion for Fictitious Company 331 Exhibit G Adverse Audit Opinion for Fictitious Company 333 Exhibit H Disclaimer of Opinion for Fictitious Company 335 Exhibit I Future Value of a Lump Sum Table 337 Exhibit J Present Value of a Lump Sum Table 343 Exhibit K Future Value of an Ordinary Annuity Table 347 Exhibit L Present Value of an Ordinary Annuity Table 351 Exhibit M Net Working Capital Adjustment Example 355 Exhibit N Earn-Out Example 357 Glossary 359 Index 377