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. 5 2. Enron Corp. 6 3. 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 11 1. 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
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 28 3. 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 36 4. Statement of Changes in Stockholders Equity 37 5. 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 41 1. Generally Accepted Accounting Principles 42 a. FASB Accounting Standards Codification 43 C. Accounting Assumptions, Principles, and Constraints 43 1. General Assumptions 44 a. Business Entity Assumption 44 b. Going Concern Assumption 44 c. Monetary Unit Assumption 45 d. Time Period Assumption 45 2. General Principles 45 a. Historical Cost Principle 45 b. Revenue Recognition Principle 46 c. Matching Principle 46 d. Full Disclosure Principle 46 3. General Constraints 46 a. Materiality Constraint 47 b. Conservatism Constraint 47
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 48 1. Generally Accepted Auditing Standards 49 E. Public Company Accounting Oversight Board 49 1. PCAOB Auditing Standards 50 F. Auditing Process 50 1. Planning the Audit 51 2. Audit Risk 51 a. Risk of a Material Misstatement 51 b. Detection Risk 52 G. Audit Procedures 52 1. Test of Controls 53 2. Substantive Procedures 53 a. Audit Evidence 54 3. Management s Representations 55 4. Audit Inquiry Letters 56 a. Attorney Responses to Audit Inquiry Letters 57 5. Audit Documentation 59 6. 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 62 1. Liability to Clients 63 2. Liability to Third Parties 64 3. Statutory Liability 65 4. Criminal Liability 66 I. Audit Alternatives 66 1. Compilation Engagement 67 2. Review Engagement 67 J. Cost of an Audit 68 K. International Accounting Standards Board 69 1. International Financial Reporting Standards 69
xiv 4 FINANCIAL STATEMENT PREPARATION 73 A. Introduction 73 B. Bookkeeping 73 1. Double-Entry Bookkeeping 74 2. Debits and Credits 75 3. Accounts 75 C. Balance Sheet Entries and Preparation 76 1. Preparing Journal Entries 78 2. Posting Journal Entries to T-Accounts 79 D. Income Statement Entries and Preparation 89 1. 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 120 1. A Merchandise Business 120 2. A Manufacturing Business 121 3. 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 123 4. Inventory Accounting Methods 123 a. Perpetual Inventory Method 124 b. Periodic Inventory Method 125
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 134 6. Lower of Cost or Market for Inventory 138 7. Estimating the Value of Inventory 140 a. Gross Profit Method 140 b. Retail Method 141 F. Fixed Assets and Depreciation 141 1. Accounting for the Initial Acquisition of the Asset 141 2. 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 151 3. Post-Acquisition Costs 152 4. Sale or Disposal of a Fixed Asset 153 5. Impairment of a Fixed Asset 155 6. Other Long-Lived Assets 156 a. Intangible Assets and Amortization 156 i. Goodwill 157 b. Natural Resources and Depletion 157 5 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 167 1. Cash Dividends 167 2. Property Dividends 168 3. Stock Dividends 169 4. Stock Splits 171
xvi E. Legal Restrictions on Distributions 172 1. 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 181 2. Other Restrictions 181 a. Shareholders Agreement Restrictions 181 b. Loan Agreement Covenants 183 6 F. Creditors Rights 183 1. Fraudulent Conveyance Laws 184 2. Federal Bankruptcy Code 185 ANALYSIS OF FINANCIAL STATEMENTS 189 A. Introduction 189 B. Annual Report on Form 10-K 190 1. Risk Factors 190 2. Selected Financial Data 191 3. Management s Discussion and Analysis 191 4. Financial Statements and Supplementary Data 192 5. Audit Report 192 C. Horizontal Trend Analysis 193 D. Common-Sized Analysis 195 E. Ratio Analysis 197 1. Liquidity Ratios 197 a. Current Ratio 197 b. Quick Ratio or Acid Test 198 2. 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
xvii 3. Leverage Ratios 204 a. Debt-to-Equity Ratio 204 b. Debt-to-Assets Ratio 205 4. Coverage Ratios 205 a. Interest Coverage Ratio 205 b. Other Coverage Ratios 206 5. Efficiency or Activity Ratios 206 a. Asset Turnover 207 b. Accounts Receivable Turnover 207 c. Inventory Turnover 208 F. Overview of Analyst s Reports 209 7 COMMITMENTS AND CONTINGENCIES 213 A. Introduction 213 B. Commitments 213 C. Contingencies 215 1. Loss Contingencies 216 a. Probability Determination 216 b. Timing Determination 217 c. Reasonably Estimable Determination 220 2. 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 222 3. 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 229 8 INTEREST AND TIME VALUE OF MONEY PRINCIPLES 233 A. Introduction 233 B. Overview of the U.S. Federal Reserve System and Interest Rates 233 1. The Federal Reserve 234
xviii 2. Prime Rate and LIBOR 234 3. Interest 235 C. Calculating Interest 236 1. Simple Interest 236 2. Compound Interest 237 D. Overview of the Time Value of Money 241 1. Future Value of a Lump Sum 241 2. Present Value of a Lump Sum 244 3. 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 254 4. Rules of 72 and 110 255 5. Time Value of Money Limitations 256 E. Bonds and Bond Valuation 256 1. Increased Market Interest Rates 258 2. Decreased Market Interest Rates 258 3. Other Bond Features 259 4. Bond Ratings 260 FINANCIAL TERMS AND COVENANTS IN 9 CONTRACTS 263 A. Introduction 263 B. Commercial Loan Agreement 263 1. 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
xix C. Indentures, Bonds, and Notes 268 1. 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 272 1. Purchase Price Adjustments 273 2. Earn-Outs 274 10 BUSINESS VALUATION 279 A. Introduction 279 B. Business Valuation Methods 279 1. Income Approach 280 a. Determining Cash Flows 280 i. Capitalized Cash Flow Method 281 ii. Discounted Cash Flow Method 282 2. Market Approach 283 a. Guideline Method 284 b. Transaction Method 285 3. 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 290 11 OTHER ACCOUNTING AND CORPORATE FINANCE CONCEPTS 293 A. Introduction 293 B. Leases 293 1. Capital Leases from the Lessee s Perspective 294 a. Transfer of Ownership 294 b. Bargain Purchase Option 295
xx c. Lease Term 295 d. Present Value of Minimum Lease Payments 296 2. Accounting for Capital Leases by the Lessee 297 3. Operating Leases from the Lessee s Perspective 298 4. 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 302 1. Capital Markets 302 2. Money Market 303 D. Methods of Raising Capital 303 1. Equity 304 2. Debt 304 E. Types of Equity Financing 305 1. Common Stock 305 2. Preferred Stock 306 3. Convertible Securities 307 F. Types of Debt Financing 308 1. Commercial Loans 308 a. Term Loan Facility 308 b. Revolving Credit Facility 309 c. Swingline Loan Facility 310 d. Letter of Credit Facility 310 2. Debt Securities 310 a. Bonds and Debentures 311 b. Notes and Commercial Paper 311 G. Cost of Capital 312 H. Derivative Instruments 313 1. Options 314 2. Forward Contract 316 3. Futures Contract 317 4. 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
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