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 standards-setting 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