ACADEMY OF AMERICAN AND INTERNATIONAL LAW Accounting and Finance for Lawyers Stanley Siegel New York University Law School 2015, Stanley Siegel
Financial Accounting Part I: Overview and Basic Principles The Hewlett-Packard Company Form 10-K Part II: Selected Current Issues Leases and Off-Balance Sheet Financing Securitization, Asset Impairment, Investments Business Combinations and Intangible Assets Sarbanes-Oxley and Principle-Based Accounting
Accounting Principles and Auditing Standards I. The Importance of Understanding Financial Accounting II. The Legal Framework
Accounting Principles and Auditing Standards III. Generally Accepted Accounting Principles (GAAP) IV. Generally Accepted Auditing Standards (GAAS)
The Importance of Understanding Financial Accounting B. Financial accounting and auditing: 1. GAAP-based financial statements are the principal source of data. 2. GAAS is the fundamental method of assurance of reliability.
The Importance of Understanding Financial Accounting B. Financial accounting and auditing: 3. Most of what is relevant tax or otherwise can be found in the statements, notes or supplementary data. 4. Accounting culture and practice are the keys to understanding the content of the financial statements.
The Legal Framework A. State law: 1. Regulation of licensing of accountants 2. General absence of accounting and reporting requirements
The Legal Framework B. Federal law: 1. The regulatory power of the SEC: The core accounting regulations: S-K and S-X Regulatory power over auditing and accounting The history of SEC regulation: the SEC as gadfly Continued expansion of SEC regulation
The Legal Framework B. Federal law: 2. Expanded federal accounting regulation under Sarbanes-Oxley: Auditing standards by the PCAOB. Registration and independence requirements for auditors Certification requirements for company officers. New independence requirements for the FASB. 3. Potential political intervention into accounting standards setting.
The Legal Framework B. Federal law: 3. Accounting and the Internal Revenue Service: Absence of an IRS body of accounting principles. Why tax and financial accounting should be similar. Why tax and financial accounting must sometimes differ.
The Legal Framework C. The legal basis for accounting principles and auditing standards: 1. Accounting and auditing outside the United States: Treaty-based legal rules on accounting and auditing Statutory principles of accounting and auditing
The Legal Framework C. The legal basis for accounting principles and auditing standards: 2. The unique United States structure: Auditing standards until recently developed by the profession Accounting principles developed by the profession and an independent standardssetting body
Generally Accepted Accounting Principles (GAAP) A. The history of the development of definitive GAAP: 1. Accounting Research Bulletins (ARB s) 2. Opinions of the Accounting Principles Board (APB s) 3. Statements of the Financial Accounting Standards Board (FAS s)
Generally Accepted Accounting Principles (GAAP) B. Problems with the early standards: 1. Erratic, problem-based development. 2. Conflicting and overlapping standards: absence of a hierarchy. 3. The contrast with International Financial Reporting Standards (IFRS). 4. Movement toward international harmonization and principle-based standards.
The FASB Accounting Standards Codification A. The new hierarchy FASB ASC Topic 105: 1. All definitive GAAP included; all other sources are non-definitive. 2. In theory, at least, no substantive changes were created by the codification. 3. Inclusion of SEC definitive statements, with limitations.
The FASB Accounting Standards Codification B. The new structure FASB ASC, Notice to Constituents: 1. At core, an on-line based, near-real-time standards compilation. 2. Searchability by topic, by words, by aggregation of topics and sections. 3. The concept of codification: parallels to legal codes. 4. Citation form.
The FASB Accounting Standards Codification C. Implications of the Codification: 1. Simplification: avoidance of inconsistency and overlap. 2. Completing the body of standards: gaps in coverage revealed. 3. Movement toward principle-based standards. 4. Harmonization with IFRS: is this an attempt to maintain the primacy of US GAAP?
Generally Accepted Auditing Standards (GAAS) A. The nature of audit and audit regulation: 1. The profession: licensing, regulation, review 2. Definitive GAAS for SEC registered companies: the PCAOB. 3. Definitive GAAS for non-public companies: the AICPA Auditing Standards Board.
Generally Accepted Auditing Standards (GAAS) B. The standards of GAAS: 1. General standards, including competence, supervision and independence 2. Field work standards, including planning, internal control and evidentiary matter 3. Reporting standards
The Financial Statements: Balance Sheet, Statement of Income I. Introduction: A. The principal financial statements B. General observations on the statements C. Realization and recognition in accounting D. For whom are the statements prepared?
The Financial Statements A. The principal financial statements: 1. Balance sheet, or statement of financial position 2. Statement of income 3. Statement of cash flows 4. Statement of stockholders equity
The Financial Statements B. Some general observations: 1. Multiple years disclosed and audited: Two years of balance sheets Three years of income statements and cash flows Comparative data as an analytical tool
The Financial Statements B. Some general observations: 2. Consolidated financial statements 3. Notes are an integral part of the financial statements 4. Balance sheet and income statement are articulated
The Financial Statements C. Realization and recognition in financial accounting: 1. The realization concept Transaction-based recording and reporting
The Financial Statements C. Realization and recognition in financial accounting: 2. Items that do not appear on the statements: Non-purchased assets, e.g., self-generated inventions Gain contingencies Contract rights and obligations not yet realized
The Financial Statements C. Realization and recognition in financial accounting: 3. An alert to recent developments that alter these core concepts: Fair value in recent accounting principles The call for greater disclosure of self-generated assets
The Financial Statements D. For whom are the financial statements prepared: 1. The US view: investors and creditors 2. The IAS view: multiple users 3. Which view is more sound?
The Financial Statements II. The Balance Sheet: A. The left and right sides: Assets Liabilities Net Worth
The Balance Sheet B. Current assets: 1. Cash and cash equivalents 2. Short-term investments 3. Accounts receivable and uncollectibles 4. Inventories: cost, and lower-of-cost-or-market
The Balance Sheet C. Property, plant and equipment: 1. Cost basis 2. Depreciation and amortization 3. Impairment
The Balance Sheet D. Other assets: 1. Long-term investments 2. Intangibles 3. Goodwill
The Balance Sheet E. Liabilities: 1. Current liabilities and current portion of long-term debt 2. Analytical tools: the current ratio 3. Long-term debt 4. Deferred taxes
The Balance Sheet F. Stockholders equity: 1. Common and preferred stock 2. Additional paid-in capital 3. Retained earnings
The Statement of Income A. Gross profit or gross margin: 1. Revenues 2. Cost of sales 3. Analysis of gross profit
The Statement of Income B. Earnings from operations: 1. Operating expenses 2. Research and development expenses 3. Analysis of earnings from operations
The Statement of Income C. Net earnings: 1. Financial expenses and income: interest, investments, etc. 2. Provision for income taxes 3. Extraordinary items
The Statement of Income D. Some important differences between net income and taxable income: 1. Inventories: lower-of-cost-or-market, obsolescence 2. Depreciation: methods, asset impairment 3. Intangible assets and goodwill
The Statement of Income D. Some important differences between net income and taxable income: 4. Non-taxable items of income 5. Acquisition accounting: basis, carryover of tax attributes 6. Retained earnings compared with earnings & profits
The Statement of Income E. Earnings per share: 1. The complexity of calculation 2. Variations: dilution, extraordinary items
The Financial Statements: The Statement of Cash Flows I. Net Income vs. Cash Flow The Differences and Their Consequences II. The Statement of Cash Flows III. Other Cash Flow Concepts
Net Income vs. Cash Flow A. Net income: 1. Realization, recognition and periodic allocation 2. Matching of costs against related revenues 3. Timing of cash flows usually ignored
Net Income vs. Cash Flow A. Net income: 4. Effects of choice of different accounting principles 5. Effects of judgment differences in applying accounting principles 6. Current criticisms of variability in accounting principles and judgments
Net Income vs. Cash Flow B. Cash flow: 1. Apparently simple concept: cash in, cash out 2. Direct and indirect measurement of cash flows 3. Major difference between cash flow and net income: non-cash allocations and charges.
Net Income vs. Cash Flow B. Cash flow: 4. The operational relevance of cash flow 5. Does reporting of cash flow avoid the criticisms and defects of reporting net income?
The Statement of Cash Flows A. Direct and indirect cash flow calculation B. Categories of cash flow and their relevance: 1. From operating activities reconciliation with net earnings 2. From investing activities 3. From financing activities
The Statement of Cash Flows C. Cash flow as a test of real earnings and real earning power 1. Net loss companies with positive cash flows 2. Net losses combined with net negative cash flow: the e-commerce disaster
Other Cash Flow Concepts A. Cash flow as a test of asset impairment. B. Discounted cash flow as a valuation method for assets or for the enterprise.
Other Disclosures: The Audit Report; Notes to the Financial Statements; MD& A I. The Report of the Independent Auditors II. The Notes to the Financial Statements III. Managements Discussion and Analysis of Financial Condition and Results of Operations (the MD&A )
The Audit Report A. We have audited... 1. Audit report speaks as of date it is signed 2. Audit is of the listed financial statements 3. Management is responsible for statements 4. Auditors responsibility is to express an opinion
The Audit Report B. Generally Accepted Auditing Standards: 1. Reasonable assurance of absence of material misstatements 2. Examination of evidence on a test basis 3. The implications of sampling
The Audit Report C. The opinion of the auditors: 1. The financial statements present fairly 2. In all material respects 3. In conformity with generally accepted accounting principles
The Audit Report D. Qualification of opinion: 1. Scope limitations 2. Disclosure and GAAP questions 3. Going concern qualification 4. Negative opinion or denial of opinion
The Audit Report E. The internal control opinion: 1. Nature of the new opinion 2. Questions of cost effectiveness
Notes to the Financial Statements A. Notes are an integral part of the financial statements: 1. The notes are audited 2. Disclosures under GAAP may be in the statements or in the notes 3. Contrast notes with MD&A
Notes to the Financial Statements B. Note 1: summary of significant accounting policies: 1. Provides detail on which principles of GAAP were applied, and how 2. Some but not all judgments are explained
Notes to the Financial Statements C. Earnings per share calculation. D. Financial details on material transactions 1. Investment gains and losses 2. Discontinued operations 3. Acquisitions and divestitures
Notes to the Financial Statements E. Detailed disclosures on components of the financial statements: 1. Balance sheet: inventory, fixed assets, long-term investments 2. Financial instruments, including derivatives 3. Leases and financing receivables
Notes to the Financial Statements E. Detailed disclosures on components of the financial statements: 4. Borrowings 5. Income taxes and deferred taxes 6. Capital structure
Notes to the Financial Statements F. Supplementary financial disclosures: 1. Comprehensive income 2. Cash flow details 3. Retirement and post-retirement benefits
Notes to the Financial Statements F. Supplementary financial disclosures: 4. Litigation and contingencies 5. Material post financial statement events G. Segment information
The MD&A A. Introduction: 1. MD&A is not required by GAAP, but by SEC regulations 2. Therefore, MD&A is generally available only from companies registered with the SEC 3. MD&A is not audited, but reviewed
The MD&A B. Results of operations: 1. Detailed review by category of revenue and expense 2. Detailed segment information C. Risk disclosures: 1. Liquidity and capital resources 2. Factors that could affect future results; risk factors
Leases and Off-Balance-Sheet Financing I. Financial Objectives of Off-Balance-Sheet Financing II. GAAP Lease Rules Substance Governs Over Form III. Accounting for an Operating Lease IV. Accounting for a Capital Lease
Financial Objectives of Off-Balance-Sheet Financing A. Keep assets and related liabilities off the financial statements: 1. Avoid disclosure of significant liabilities 2. Favorable effect on financial statement ratios 3. Avoid potential violation of loan and other covenants
Financial Objectives of Off-Balance-Sheet Financing B. Obtain full use of the assets through effective financing: 1. Long-term use may be equivalent to ownership 2. Financing terms may be equal to or better than direct borrowing
Financial Objectives of Off-Balance-Sheet Financing C. From the lessor s viewpoint: 1. Spread out recognition of gain or loss on effective sale 2. Obtain desirable contract with possibly non credit-worthy buyer/lessee 3. Maintain legal title, with superior rights to secured creditor
GAAP Lease Rules Substance Governs Over Form A. Operating vs. capital leases distinctions for lessor and lessee B. When is a lease a capital lease the economics of leasing and ownership
GAAP Lease Rules Substance Governs Over Form C. When is a lease a capital lease the four criteria: 1. Transfer of title at end of lease term 2. Bargain purchase option at end of lease 3. Lease term equal to 75% or more of asset useful life at inception of lease 4. Discounted present value of minimum lease payments at least 90% of fair market value at inception
Accounting for an Operating Lease A. Accounting by the lessee: 1. Lease payments recorded as rental expense when accrued/paid 2. No other reporting on the financial statements