By Richard Molina
In 2002, I first taught the course "Accounting in Law" while teaching as a law school adjunct professor. The enrollment for the course was pretty decent at first because much was going on outside the walls of academia. Enron and Worldcom had just imploded, and Congress was debating the Sarbanes Oxley Act, which significantly affected the business, legal and accounting worlds. Students knew these scandals included elements of accounting fraud and those students without a business background wanted to know more about accounting. In subsequent semesters, enrollment drifted after those events.
In most law schools today, a course such as Accounting in Law or Accounting for Lawyers is rarely offered. Even if it were offered, I would dare to say many students would avoid it. This is unfortunate, because in practice it is likely that at some point, lawyers in a corporate practice, small business or general practice may encounter financial statements. This article is designed to discuss some basics that lawyers should be aware of when using financial statements.
Four primary financial statements
The four primary financial statements and their functions are as follows:
1. Statement of financial position
Most commonly referred to as the "balance sheet," this statement commonly lists all the assets, liabilities and equity either contributed by owners or earnings retained in the business. The meanings of assets and liabilities are straight forward. Contributed equity is the amount of capital the owners have invested in the business. Retained equity or retained earnings are earnings generated by the entity that have been distributed to owners as dividends.
2. Statement of retained earnings
This statement provides additional detail with respect to the earnings retained by the business.
3. Income statement
As its name implies, this statement lists the revenues and expenses incurred by the firm in generating net income or net loss for a particular period of time—usually a calendar year, although it could be for a month or a quarter.
4. Statement of cash flows
For most users, this is the least familiar of the four statements, but its importance cannot be more emphasized. Essentially, this statement describes for its users how a business generates its cash flow and how it uses cash flow. The key to analyzing a successful business is to examine its cash flow. A good business generates healthy cash flow from its core business activities. The statement tells users how much cash is generated by and used in its operating activities, its investment decisions and its financing activities.
Three significant limitations of the balance sheet
- Assets are listed at historical costs and not fair values. For example, land, equipment and similar assets are listed at their original acquisition costs and not today's market values. Consequently, independent valuations should be done to ascertain the asset values.
- Important intangible assets are generally not reflected on the balance sheet. For some businesses, a patent and trademark are very important assets, but unless the intangibles were purchased from an unrelated company, they are not listed. In other words, self-created intangibles are not listed as assets.
- Never view the liabilities appearing on the balance as the only liabilities of the business. Certain contingent liabilities related to anticipated lawsuits or potential settlements are not listed if the accountants or managers of the business believe an adverse outcome is "remote" or less than likely.
Moreover, even if a contingent liability is recorded on a balance sheet, it is often a best judgment based on a range of potential outcomes. Judgments, of course, include some degree of subjectivity. In short, never defer to a balance sheet to determine the potential liabilities of a business. You must do your own due diligence of these matters.
Limitations of the income statement
You should note at the onset that the income statement does not tell you how much cash is being generated by a business. To understand how much cash a business is generating, go to the Statement of Cash Flows and examine the cash flows from the operating activities section. In many cases, a business wants to show the highest net income possible, like when its owners want to sell the business, or when the business is looking to obtain capital. Many accounting frauds related to the preparation of the income statement are fairly basic—they either overstate revenues or understate expenses.
The income statement is prepared using a blend of accounting principles commonly referred to by accountants as accruals and deferrals. For example, a company may accrue sales for goods or services not yet paid for by its customers. Many accounting frauds occur because companies overzealously accrue sales when customers have rights to return goods within a period of time. Sometimes fictitious revenues are accrued. Expenses are to be accrued when a benefit has been received by a firm even if not yet paid for. A simple accounting fraud may be to simplify not accrue expense, even though the business is obligated to pay for it, or to record expenses as assets so that net income is increased.
Pay particular attention to items included with the statements
There are two other important aspects to understanding financial statements. First, be sure to carefully read any disclosures or footnotes associated with the statements. Not only do these disclosures explain accounting policies used by the firm, but also, if properly prepared, they may make you aware of circumstances involving such things as terms of sales transactions, terms associated with debt obligation, and matters related to contingencies.
Second, if the statements have been prepared or reviewed by outside independent accountants (usually certified public accountants, CPAs), be sure you understand the extent of the services performed by those parties. For example, if the company has prepared its own financial statements and has had those statements reviewed by certified public accountants (auditors), be sure you understand the report provided by the auditors. Ideally, you will receive an unqualified opinion which means the statements have been substantially prepared in accordance with generally accepted accounting principles (GAAP). But even here the auditor is not "guaranteeing" the statements. In other situations, the outside accountants may only be performing a compilation or review of the financial data. In this case, you should review the statements more rigorously and with more skepticism because the outside accountant is providing you with a lower level of assurance that the statements are of the highest conformity with generally accepted accounting principles.
Financial statements are integral instruments used in the business world. A lawyer should understand the basics of what these statements are intended to do and what their significant limitations are. Accounting fraud happens, and in some cases it may be detected too late. A lawyer should consult with an accountant when doing a transaction where financial statements are important.