presents

Brendan McCorry, Justin Vogel, Sonal Shah,

Ernst & Young

Introduction to Accounting Foundations

► Welcome and Introductions

► Accounting Foundations

► Type of Entity – Tax considerations

Agenda

► Brendan McCorry

Audit Partner

brendan.mccorry@ey.com

(617) 585-3421

► Justin Vogel

Audit Senior Managerjustin.vogel@ey.com

(617) 585-0990

► Sonal ShahTax Senior Manager

sonal.shah@ey.com

(617) 585-6813

Welcome

► Objectives of financial reporting

► Governance

► Financial statement overview

► Income statement

► Balance sheet

► Statement of cash flows

Accounting Foundations

► To provide information that is useful to present and potential investors and creditors

► To help investors, creditors and other users assess the amounts, timing and uncertainty of prospective net cash inflows

► To provide information about the economic resources of an enterprise, the claims to those resources and the effects of transactions, events and circumstances that change resources, and claims to those resources.

Objectives of Financial Reporting

► Purpose of financial accounting system

► To provide information in a standardized format that allows financial stakeholders to understand a business from an economic standpoint

► Establish reporting requirements

► Companies with publicly traded securities are governed by Regulatory authorities, which ensure compliance with local jurisdiction reporting requirements

► Privately owned companies may not have any accounting requirements at all, depending on their financial stakeholders

Governance

► Established accounting standards

► Auditors examine the financial statements to ensure they are presented in accordance with generally accepted accounting principles (“GAAP”)

► Many countries have adopted the International Financial Reporting Standards (“IFRS”), which seek convergence in global financial reporting.

Governance

► U.S. GAAP

► Accounting rules and guidance are established through various publications issued by groups including the following:

► Financial Accounting Standards Board (“FASB”),

► American Institute of Certified Public Accountants (“AICPA”) and

► Public Company Accounting Oversight Board (“PCAOB”).

► GAAP is also influenced by the Securities and Exchange Commission (“SEC”).

► Governance of Accounting Rules

► State boards of accountancy

► Federal regulation (Securities and Exchange Commission)

► PCAOB

► Companies have audits performed to show compliance with GAAP

Governance

Financial statements generally include:

► Income statement

► Balance sheet

► Statement of cash flows

► Statement of changes in stockholders’ equity

Financial Statement Overview

► Income statements are generally presented top-down (i.e., revenues listed first followed by expenses)

► Key components:

► Revenue

► Cost of sales

► Gross profit

► Operating expenses

► Operating income

► Tax expense

► Net income

► Sample summary income statement

Gross revenue 100 Sales deductions (10)

Net revenue 90 Cost of sales 60 Gross profit 30 Operating expenses 20 Operating income 10 Tax expense 4 Net income 6

As a percentage of net sales:Gross margin 33.3 Operating income 11.1 Net income 6.7

Income Statement

Revenue

►Inflows of assets or settlements of liabilities from the sale of product, rendering of services, or other activities that constitute an entity’s ongoing major or central operations

Revenue is generally realizable and earned when the following criteria are met:

►Persuasive evidence of an arrangement exists

►Delivery has occurred or services have been rendered

►Seller’s price to the buyer is fixed or determinable

►Collectibility is reasonably assured

Revenue

Gross to net revenue:

► Consideration offered by a vendor on a either a limited or a continuous basis to a customer such as discounts, coupons, rebates and free products or services is generally required to be recorded as a reduction to gross revenue.

► The following is an example:

Gross to Net revenue

Expenses

► Represent decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities

Matching principle

► Indicates that when it is reasonable to do so and allowed under the accounting standards, expenses should be matched with revenues.

► Only if no connection with revenue can be established, costs are charged as expenses to the current period (e.g. office salaries and other administrative expenses)

Expenses

Cost of sales are:

►Direct expenses incurred in producing a particular good for sale, including the actual cost of materials that comprise the good, and direct labor expense in putting the good in saleable condition

Operating expenses are:

► Day-to-day expenses incurred in running a business, such as sales and administration, or research & development

► Operating expenses do not include direct production costs

► In short, operating expenses include amounts spent by companies on matters such as selling, advertising, accounting and other costs that are required to sell their products and services.

Cost of Sales and Operating Expenses

Other income and expense

► Generally includes items such as interest income, interest expense, and non-operating income/expense

► It is important to understand the composition of other income and expense because there are sometimes operating expense/income items inappropriately included in the detail.

Other Income and Expense

Objective:

Shows assets (what a company owns), liabilities (what a company owes) and stockholders’ equity (portion of assets owned by shareholders) at a particular date in time

General characteristics

► Assets = Liabilities plus stockholders’ equity

► Assets and liabilities are generally listed in order of liquidity

► In general, assets and liabilities are carried at cost (accounting convention of conservatism); however, there are certain exceptions (i.e., lower of cost or market, fixed asset impairments, investments, etc.)

► Net assets = Assets – Liabilities

Balance Sheet

Significant operating components generally include:

► Cash

► Accounts receivable

► Other current assets

► Fixed assets

► Accounts payable

► Accrued expenses

► Debt or shareholder’s equity

In addition, fixed assets are often significant due to the use of cash for capex requirements.

Balance Sheet

► Accounts receivable

► Amounts that customers owe to a business

► Since not all customer debts will be collected, businesses typically record an allowance for bad debts which is subtracted from gross accounts receivable

► Other considerations – Credit terms

► Collection periods often vary by company and industry

► Discounts offered are reserved at the time of sale

► Certain allowances may be recorded in accrued expenses

Accounts Receivable

► Prepaid expenses and other current assets

► Services/ benefits to be received in the future which were paid in advance (e.g. future months of insurance coverage when annual premium is paid at the beginning of the term)

► Refundable items (lease deposits)

► Inventory

► Goods and/or materials (to be converted into goods) held for sale to customers

► Inventory is usually classified into the following categories:

► Raw materials

► Work-in-process (WIP)

► Finished goods

► Generally reported net of reserves

Other Current Assets

► Fixed assets

► Includes long-lived tangible assets used in the production of other goods and services. Examples include land, buildings, machinery, furniture, and tools.

Capex

► Capex represents the amounts spent to acquire fixed assets and is generally broken up into the following components:

► Growth capex (e.g., building expansion)

► Recurring capex (e.g., periodic replacement of laptop computers)

Other considerations

► Repairs and maintenance expense

Fixed Assets

▶ Accounts payable

▶ Amounts that are owed to suppliers and other vendors

▶ Other considerations:

▶ Cut-off

▶ Stretching of payables

Accounts Payable

▶ Accrued liabilities

▶ Liabilities that have occurred (i.e., known obligation to pay for or provide services), but (i) have not been paid (e.g., invoice) or performed (e.g., warranty) and (ii) not recorded as an obligation in accounts payable during an accounting period;

▶ Examples include:

▶ Obligations for goods and services provided for which invoices have not yet been received.

▶ Accrued wages payable

▶ Accrued sales tax

▶ Accrued bonus

▶ Accrued vacation

▶ Accrued warranty

▶ Accrued customer allowance

▶ Deferred revenue

Accrued Liabilities

► Recording obligations

► Liabilities are required to be recorded once the obligation is known

► Liabilities should be accrued via a charge to income if the liability is probable and the loss can be reasonably estimated.

► Accrued liabilities are often subjective and require management estimates (e.g., accrued warranty, bonus, etc.)

Accrued Liabilities

▶ Objective:

▶ Provide financial users with cash receipt and payment information

Format:

▶ Most companies follow the indirect method – net income is the starting point and adjustments are made to remove non-cash components of net income.

▶ Three major sections:

▶ Cash flows from operating activities

▶ Cash flows from investing activities

▶ Cash flows from financing activities

Statement of Cash Flows

▶ Footnotes to Financial Statements

▶ Disclosure is required beyond the basic financial statements

▶ Provides an opportunity for management to explain items which are not obvious from the statements. May also provide additional detail on the components of accounts.

Other Considerations

Type of Entity - Tax Considerations

► The following are the three most common legal entities for conducting a business:

► “C” corporation

► A traditional statutory (state law) corporation where no election has been made to treat as an “S” corporation

► “S” corporation

► A traditional statutory (state law) corporation that, subject to certain requirements and restrictions, makes a special tax election or “S” election

► LLC/partnership

► A joint venture of two or more parties entered into for profit

Types of Taxable Entities

► The “C” corporation tax considerations:

► The C corporation is a separate taxpaying entity

► Corporate income is usually subject to two levels of income tax (i.e., “double taxation”)

► Entity level income tax

► Shareholder level tax (dividend distributions)

► Losses and other tax attributes are retained at the corporate level and do not flow through to shareholders

► The treatment of these attributes to the corporation may be subject to limitation upon a purchase or “change in ownership”

Type of Entity – Tax Considerations

The “S” corporation tax considerations:

► Generally, not subject to entity level income tax

► Entity level income, gain or loss flows through to the shareholders

► Shareholders report S corporation income, gain, or loss in their personal income tax returns and adjust their tax basis in their stock accordingly

► No second level of income tax on distributions of previously taxed earnings

Type of Entity – Tax Considerations

► The “S” corporation tax considerations (continued)

► Eligibility requirements

► Domestic corporation

► Maximum number of shareholders is 100

► Eligible shareholders are limited to US citizen or resident individuals, certain estates, certain trusts and ESOPs

► One class of stock

Type of Entity – Tax Considerations

The LLC or Partnership tax considerations:

► Generally, not subject to entity level income tax

► Entity level income, gain or loss flows through to the member/partner and is taxed on member/partner tax return

► Other considerations

► Significant flexibility on the rights of equity interests and the types of equity holders. However, LLCs may be complex when compared to C corporations

► Management incentive benefits and complexities in the use of profits interests vs. traditional corporate stock options

► Single-member LLCs are generally disregarded for US federal income tax purposes

Type of Entity – Tax Considerations

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