I studied business in college, but I never intended to become a businessman. I wanted to be a lawyer. I saw business school as a forgettable prelude to my real education in law school. It never occurred to me then that the knowledge I was gaining in business school – especially in accounting – would be so critical to my future legal career. The following are basic accounting concepts I use on a regular basis in my business litigation practice:
1.The Profit/Loss Statement
A profit/loss statement (or income statement) shows a company’s revenues, expenses, and bottom line net income for a given period of time. While reading a profit/ loss statement, it is important to understand the difference between cash basis and accrual basis accounting. With cash basis accounting, a company recognizes revenue when it receives a payment and recognizes an expense when it makes a payment. With accrual basis accounting, a company recognizes revenues or expenses when the right to receive or obligation to make those payments accrues – even if the payments will not be made until a later date. Most companies use accrual basis accounting for their internal books, but they use cash basis accounting for their tax returns. As a result, a profit/loss statement and tax return for the same company during the same period may tell very different stories, depending on how many unpaid customer invoices and outstanding expenses a company has on its books that do not appear on its tax return.
2. The Balance Sheet
A balance sheet has two sides – one side lists assets and the other side lists liabilities and owners’ equity. Total assets must equal total liabilities plus owners’ equity. If the two sides do not “balance,” something is missing, and you will need to request more documents and information in discovery or from your client to get a complete picture.
Another thing to keep in mind, especially in cases involving valuation disputes, is that a balance sheet does not necessarily reflect the value of a company or its assets for the purposes of a lawsuit or potential sale. The balance sheet represents the “book value” of a company’s assets. The book value of an asset is the amount of money the company originally paid for the asset less accumulated depreciation. The Generally Accepted Accounting Principles (GAAP) include formulas for calculating depreciation. The depreciation of an asset calculated according to GAAP may not be the same as the actual value the asset has gained or lost in the real world. A company’s assets could be worth a lot more or less on the open market (fair market value) than the balance sheet shows (book value).
Likewise, the owners’ equity shown on a company’s balance sheet is rarely an accurate measure of the fair market value of the company as a whole or any shareholder’s interest. For example, valuation experts often use the discounted cash flow method as one way to appraise a business or its stock. An expert applying that method will project a company’s future earnings and determine the present value of those earnings. The owners’ equity section of the balance sheet, however, does not reflect the companies’ future cash flows. The owners’ equity section merely shows the excess amount of the company’s assets, measured by their book value, over and above the company’s liabilities on a specific date. That number has limited utility in a lawsuit where the factfinder needs to determine the fair market value or fair value of the company’s stock.
3. The General Ledger
The general ledger is where a company records each of its individual transactions. Financial statements like the profit/loss statement and balance sheet are just summaries of the transaction-by-transaction detail included in the general ledger.
Each transaction in the general ledger has a debit and a corresponding credit. An increase to the asset side of the balance sheet is recorded as a debit, and a decrease is recorded as a credit. Conversely, an increase on the liabilities and owners’ equity side of the balance sheet is recorded as a credit, and a decrease is recorded as a debit. Note that revenues, expenses and income fall into the owners’ equity section of the balance sheet, so a sale will be a credit (increase to the owners’ equity section) and an expense will be a debit (decrease to the owners’ equity section). When you understand a general ledger and its relationship to the financial statements, you are in a better position to explain, use and challenge a company’s numbers from both a big and little picture perspective.
As an undergraduate, I wanted to go to sleep during every accounting class. As a business litigator looking back, I am glad I didn’t. Phil Kaplan