Math for Lawyers: Accounting and Finance Fundamentals
Transcript of Math for Lawyers: Accounting and Finance Fundamentals
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Math for Lawyers:
Accounting and
Finance Fundamentals
February 24, 2010
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Introduction
Presentation
Jeff Litvak, FTI Forensic and Litigation Consulting
Kenneth Mathieu, FTI Forensic and Litigation Consulting
Questions and Answers ― (anonymous)
Slides ― now available on front page of Securities Docket
> www.securitiesdocket.com
Wrap-up
Agenda
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Series of webcasts ― every other week
www.securitiesdocket.com/webcasts
Next: March 9―Math for Lawyers: Valuation Theory
and Practice 101
Webcast Series
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Panel
Bruce Carton
Jeff Litvak
Ken Mathieu
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Jeff Litvak, CPA/ABV/CFF, ASA
Senior Managing Director, Forensic and Litigation Consulting
Ken Mathieu, CPA/ABV/CFF, MBA
Managing Director, Forensic and Litigation Consulting
Math For Lawyers:
Accounting and Finance Fundamentals: Accounting 101
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Agenda
• The Analysis of Financial Statements
• Management Discussion and Analysis
• Ratio Analysis
• Accounting Literature/GAAP/IFRS
• Other Matters
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Financial Statements
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Management Discussion & Analysis
• Notes to Financial Statements
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Generally Accepted Accounting Principles (GAAP)
• To facilitate the comparability of financial statements among
business entities and with respect to a particular business entity
over time
• Defines standards of practice and professional conduct for
accountants
• May influence the definition of negligence for accountants
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Balance Sheet
• A static picture of the financial position of an individual or
business at a particular point in time
• A financial photograph
• Displays the financial status of the organization from inception
to the specified date
• Consists of three different sections:
– Assets
– Liabilities
– Equity
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Sample Balance Sheet
XYZ Corporation Balance Sheet
As of January 31, 20XX
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Income Statement
• Displays the financial condition of a business or individual
over a limited period of time
• Comparable to a movie versus a snapshot
• Primary components of income statement
• Revenues
• Expenses
• Gain/(Losses)
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Sample Income Statement
XYZ Corporation Income Statement
For the Year Ending December 31, 200X
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Statement of Cash Flows
• Measures the financial viability of an entity
– An entity’s ability to meet its debts as they come due
– Depends on the way in which cash in the business is managed
and the way in which it flows through the business
• Accrual method of accounting obscures the actual inflow and
outflow of cash
• GAAP requires an entity to prepare a statement of cash flows
as part of its financial statements
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Categories of Statement
• Cash Flows from operations
– Transactions associated with sales of goods and services
• Cash flows from investing activities
– Cash an organization pays to acquire investments or long-lived, capital assets
– Cash received as a return on those investments
• Cash flows from financing activities
– Relates to liabilities and equity accounts – cash received by borrowing money, cash received from investors (stock sale), and cash paid out to investors (dividends)
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Direct Method
XYZ Corporation Statement of Cash Flows
For the period ending May 31, 200X
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Management’s Discussion and Analysis (MD&A)
• Ratio analysis raises as many questions as answers
• SEC requires public companies to provide a narrative discussion of the trends and analysis that management sees the financial statements to reveal, as well as those that management believes the financial statements may not reveal
• To fill in between the lines
• Often written by lawyers – always reviewed by them
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Management’s Discussion and Analysis (MD&A)
• Designed to provide investors with an insider’s view of an
entity’s financial condition, performance, and prospects
• Requires discussion of an entity’s liquidity, capital resources,
results of operations, and information relating to trends in and
uncertainties about aspects of the business
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Ratio Analysis
• Conventions used to analyze the financial condition and
performance of an entity
• Series of comparisons of bits of information on financial
statements designed to investigate trends in aspects of a
business and the entity’s capacity to operate the business
over time
• Ratios are working tools for analysis, not absolutes
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Ratio Analysis
When reviewing ratios, you must:
• Consider unique characteristics of the business being analyzed
• Compare the same ratios for the same entity at different periods in time
• Compare the ratios to other entities in the same industry
• Compare the ratios to other entities possessing similar economic characteristics
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Liquidity and Activity Ratios
• Assess the ability of the entity to pay its short term debts
when they come due
• Assess efficiency of asset management
– Current Ratio
– Inventory Turnover Ratio
– Accounts Receivable Turnover Ratio
– Debt-to-Equity Ratio
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Current Ratio
• Rule of thumb for most entities, the current ratio should
be around 2.0
• Too High – inefficiency problem
• Too Low – liquidity problem
Current Assets
Current Liabilities
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Current Ratio
Consolidate Balance Sheet
Kraft Foods Inc. and Subsidiaries
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Inventory Turnover Ratio
• The speed at which inventory is sold over time
Current Year's Cost of Goods Sold
[Beginning Inventory + Ending Inventory]/2
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Consolidate Balance Sheet
Inventory Turnover Ratio
Kraft Foods Inc. and Subsidiaries
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Inventory Turnover
• Inventories turned 6.49 times this year
• 365 / 6.49 = 56.28 days to turn inventory
• Ratio is used to asses how well the inventory levels are
being managed
• Slow inventory
– Diverts available cash
– Open for obsolescence/spoilage
– Increases financing needs
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Accounts Receivable Turnover
• Determines the speed of collection of A/R
Credit Sales
[Beginning A/R + Ending A/R] /2
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Accounts Receivable Turnover
Consolidate Balance Sheet
Kraft Foods Inc. and Subsidiaries
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Receivables Turnover
• Average number of days the receivables are outstanding
– 365/8.22 = 44.43 days
• If payments are due in 60 days – fine
• If payments are due in 30 days - trouble
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Accounting Humor
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Debt-to-Equity Ratio
• Measures the borrowing capacity of the entity
• Level of comfort a lender can have in the entity’s ability to
repay indebtedness
• Entities with high ratios are called “Highly-leveraged”
Total Debt
Owners’ Equity
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Profit Margin
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Gross Margin
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Variation Analysis
Kraft Foods Inc. and Subsidiaries
Consolidate Balance Sheet
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Measuring Profit
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Accounting Rules/Conventions
Financial Statements
GAAP (Generally Accepted Accounting Principles)
• The “rules” of accounting
• Comprised of standards and procedures for reporting financial
information accepted as appropriate because of their universal
application
• “Gray areas”
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Accounting Rules/Conventions
Financial Statements
Hierarchy of GAAP
Level One FASB Statements and Interpretations, APB Opinions,
AICPA Accounting Research Bulletins
Level Two FASB Technical Bulletins, AICPA Industry and
Accounting Guides, AICPA Statements of Position
Level Three FASB EITF, AICPA Practice Bulletins
Level Four AICPA accounting interpretations, FASB “Q and As,”
widely recognized industry practices
Level Five FASB Concept Statements
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Selected Accounting Concepts – US
GAAP
Financial Statements
• Matching Principle
• Historical Cost Principle
• Conservatism
• Full Disclosure
• Materiality
• Going Concern Assumption
• Accounting Estimates
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Matching Principle
Financial Statements
Efforts (expenses) matched in the same period as accomplishments
(revenues)
“Let the expense follow the revenue”
The expense should be recognized when that expense makes its
contribution to revenue
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Historical Cost Principle
Financial Statements
Price paid/value surrendered for an asset
Generally the value most often used as a basis for accounting records
Cost is definitive, objective and fixed
Cost has disadvantages
• May not reflect “value” of asset
• May distort comparisons between periods
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Conservatism
Financial Statements
When in doubt, choose the solution that will be least likely to overstate
assets and income
Merely guides the accountant in difficult situation
Does not suggest the accountant should understate assets or income
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Full Disclosure
Financial Statements
• Necessary because of numerous alternative accounting treatments
• Reveal any facts of sufficient importance to influence the judgment of an
informed reader
• Common disclosures
• Presenting account balance (e.g., Debt)
• Parenthetical disclosure
• Note disclosure
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Materiality
Financial Statements
Difficult concept:
“Is this item large enough for users of the information to be
influenced by it?”
- FASB Statement of Financial Concepts No. 2
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Going Concern
Financial Statements
Assumption that the business enterprise will continue
Credibility to historical cost
• “Liquidation” assumes business will not continue
• Liquidation affects asset values
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Accounting Estimates
Financial Statements
Expectations of future performance requires the use of accounting
estimates in financial statements
Utilized in a variety of areas
• Bad debt provisions
• Warranty expense provisions
• Inventory Obsolescence
• Etc.
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Contingent Liability Reserves
Accrue Liability Footnote Disclosure
Reasonably Possibly Remote
Amount Reasonably Estimable
Probable
SFAS 5
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International Financial Reporting Standards (IFRS)
History
• Previously known as International Accounting Standards (IAS).
• IAS were issued by the International Accounting Standards Committee (IASC)
between 1973 and 2001
• Adopted by the International Accounting Standards Board (IASB) in April 2001.
• IASB continued to develop the standards under the new name of International
Financial Reporting Standards (IFRS).
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International Financial Reporting Standards (IFRS)
International Financial Reporting Standards comprise of:
• International Financial Reporting Standards (IFRS) – standards issued after
2001;
• International Accounting Standards (IAS) – standards issued before 2001;
• Interpretations originated from the International Financial Reporting
Interpretations Committee (IFRIC) – issued after 2001; and
• Standing Interpretation Committee (SIC) – issued before 2001.
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International Financial Reporting Standards (IFRS)
Impact on US Companies
• In 2002, US Financial Accounting Standards Board and the IFRS agreed to
work towards reducing differences between US GAAP and IFRS (the Norwalk
Agreement).
• In August 2008, SEC Announced a decision to publish a proposed Roadmap
that would outline to steps for US issuers to adopt IFRS
• Largest 20 companies in their industries would be allowed to report under IFRS as
soon as 2010.
• All companies filing with the SEC would be required to follow IFRS by 2014.
• A Roadmap is published on the SEC website and open comments will be
accepted for until February 19, 2009.
• http://www.sec.gov/rules/proposed/2008/33-8982.pdf
• IFRS.com has resources for understanding the transition to IFRS.
• http://www.ifrs.com/pdf/IFRSUpdate_V8.pdf
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International Financial Reporting Standards (IFRS)
Reasons for adoption of IFRS:
• Greater Comparability for Investors – 2/3 of US investors own securities in
foreign companies reporting in IFRS, which makes the need for common
accounting language increasingly important.
• Lower Costs – Currently, foreign private issuers are required to file financial
statements either US GAAP or provide a reconciliation from local accounting
principles (often IFRS) to U.S. GAAP. This would reduce costs associated
with this requirement
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International Financial Reporting Standards (IFRS)
Main Differences between US GAAP and IFRS as cited in the Wall Street
Journal:
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IFRS Timeline
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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20122014-
2016
2001IASB established.
2002The IASB and FASB issued the
Norwalk Agreement.
The EU announces member
states must use IFRS
beginning 2005 financial
statements.
2005SEC releases a
roadmap for allowing
IFRS filings without
GAAP reconciliation for
foreign firms by 2009.
2006The IASB and the FASB agree to
work on major projects jointly.
2007The SEC announces foreign
filers in the U.S. can file IFRS
without reconciliation to U.S.
GAAP.
SEC issues a Concept
Release about U.S. public
company option to follow IFRS
instead of U.S. GAAP.
2009The IASB will end
moratorium on required
application of new
accounting standards and
amendments to existing
standards.
2008The SEC issues proposed
roadmap toward acceptance
of IFRS. The FASB and the
IASB issue an MoU focusing
on convergence of
accounting standards by
2011.
The AICPA’s governing
Council votes to recognize
IASB as an international
accounting standard setter
2011Canadian, Indian, and
Japanese companies
are slated to begin
using IFRS.
2012Companies in Mexico
schedules to begin
using IFRS.
2014-2016Earliest the SEC would
require U.S. public
companies to convert
their financials to IFRS.
Source: http://www.ifrs.com/pdf/IFRSUpdate_V8.pdf
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Concluding Remarks
• It is important to consider the financial statements taken as a whole to
evaluate a firm’s position
• Liquidity
• Leverage
• Profitability
• Asset Management
• IFRS is the new standard public companies will likely be reporting under
in the near future
• The SEC expects non-GAAP financial measures to be calculated on a
consistent basis from period to periodhttp://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm
http://www.sec.gov/rules/final/33-8176.htm
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Questions?
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Thank You
Thank you for attending this webcast.