behind the numbers – what every lawyer should know … know about financial statements don...

Jeffrey Roberts, CPA, CFE, CFFSenior Managing Consultant

Behind the Numbers – What Every Lawyer Should Know About Financial Statements

Don Wengler, CPA, CFE, CFF, CVASenior Managing Consultant

BKD Forensics Institute

Agenda

• Financial statement overview

• Understanding the basis of presentation

• Manipulation of financial statements

• Reliability issues

• Landmines to avoid


Applicability

• General business litigation

• Business interruption

• Contract disputes

• Patent, trademark, trade name infringement

• Bankruptcy

• Divorce


• Where did the company’s money come from?

• Where did the company’s money go?

• Where is the money now?

You can easily begin to answer these questions with some basic tools

Follow the Money!

Accounting is complex, but the questions are simple:


Financial Statements: The Big 3 to Know

• Balance sheet

• Income statement

• Statement of cash flows


Balance Sheet

The balance sheet will tell you what a company owns (its assets)and what it owes (its liabilities) and what is left over for theowners (equity)

Key points• Not necessarily current market values • Current financial health of the company• Focus on the quality of the assets - e.g. is the company sitting

on a pile of cash – or is everything sitting in past due receivables?


Income Statement

Shows a company’s performance over a period of time - i.e. how did a company earn its money last year?

Key points• Also referred to as a “Profit and Loss” or “Statement of

Operations”• Useful for determining performance before or after an event

– e.g. after an acquisition, following a natural disaster, etc.• Revenues on income statement ≠ cash in the door. This is a

common misconception


Cash Flow Statement

Shows a company’s sources and uses of cash during a period of time

Key points

• Quickly tells you how a company is using its cash or funding its day-to-day operations

• Good information on cash flow statement. Earnings on the income statement you can fake, but cash is hard to change


Visual Summary - Financial Statements

Balance Sheet

Financial condition at a point in time

Balance Sheet


Balance Sheet


Balance Sheet


Beginning of YearJanuary 1, 2010

End of YearDecember 31, 2010

Income Statement

Summary of activity for a period of time

Income Statement


Statement of Cash Flows


Statement of Cash Flows


Reporting ofBusiness Activity


Financial Statement Examples


Basis of Preparing Financials

Be aware: Different accounting methods often produce radically different results – e.g. accrual basis revenue vs. cash basis revenue.

• Accrual basis

• Cash basis


Cash Basis Accounting• Recognizes income/expense

when cash changes hands• Advantage – easy to use,

almost like keeping a personal checkbook

• Downside – will not match up revenues with related expenses

• Common method in small businesses

• Accrual basis recognizes income/expense when event occurs

• Advantage - the accrual method matches revenues and the related costs

• Downside - more complicated and judgment required = numbers easier to fudge

• Common in larger companies

Accrual Basis Accounting


Balance Sheets IllustratedABC Co. 12/31/2009 Cash Accrual Common Fair

Basis Basis Size ValueCash 10,300$ 10,300$ 4% 10,300$ Accounts Receivable 54,500 34,500 13% 34,500 Loan to Shareholder 25,000 - 0% - Inventory 84,157 54,157 20% 54,157 Current Assets 173,957 98,957 37% 98,957

Fixed Assets, Net 140,000 140,000 53% 140,000 Investment in Collectibles 25,000 25,000 10% 125,000

Total Assets 338,957$ 263,957$ 100% 363,957$

Accounts Payable 35,400 35,400 13% 35,400 Accrued Payroll and Liabil ities - 35,000 13% 35,000 Current Portion Long-Term Debt 20,200 20,200 8% 20,200 Current Liabilities 55,600 90,600 34% 90,600

Long-term Debt 190,000 190,000 72% 190,000

Total Liabil ities 245,600 280,600 106% 280,600

Common Stock 1 1 0% 1 Paid-in capital 999 999 0% 999 Retained Earnings 92,357 (17,643) -7% 82,357 Total Equity 93,357 (16,643) -6% 83,357

Total Liabil ities and Equity 338,957$ 263,957$ 100% 363,957$


Income Statement IllustratedXYZ Co. Income Statements Period 1 Period 2 Period 3 Period 4

Sales 100,000$ 150,000$ 125,000$ 175,000$ Cost of Goods Sold: Materials and Production Labor 20,000 28,000 25,000 37,000 Variable Monthly Factory Rent 15,000 15,000 15,000 15,000 Fixed Depreciation-Factory 10,500 10,400 10,300 10,200 Fixed Total Cost of Goods Sold 45,500 53,400 50,300 62,200

Gross Profit 54,500 96,600 74,700 112,800

Sell ing General & Admin. Expense Salaries 50,000 50,000 50,000 50,000 Fixed Sales Commission 5,000 7,500 6,250 8,750 Variable Advertising 7,000 6,500 6,750 7,000 Fixed Depreciation-Office 5,250 5,200 5,150 5,100 Fixed All other operating expenses 1,000 1,050 1,150 1,150 Fixed

Operating Income (13,750) 26,350 5,400 40,800

Interest Expense 1,000 1,200 800 1,000 Income Tax Expense (5,015) 8,551 1,564 13,532

Net Income (9,735)$ 16,599$ 3,036$ 26,268$


Lost Profits Calculation

• Lost incremental income over 4 periods, assuming a 50% loss in sales:

XYZ Co. Common Size Inc. Stmt. Period 1 Period 2 Period 3 Period 4

Lost Future Sales (50%) 50,000$ 75,000$ 62,500$ 87,500$

Less:Materials and Production Labor (20%) 10,000 15,000 12,500 17,500 Sales Commission (6%) 2,500 3,750 3,125 4,375

Lost Profits by Period 37,500$ 56,250$ 46,875$ 65,625$

Total Lost Profits/Lost Incremental Income 206,250$


Statement of Cash Flows IllustratedBad Guys Corporation

Operating Activities: Period 1 Period 2Net income 120,000$ 50,000$ Add back noncash expense––depreciation 8,000 8,000 Less: Increase in accounts receivable (60,000) - Decrease in accounts payable (28,000) 10,000 Net cash provided by operating activities 40,000 68,000

Investing Activities:Purchase of property, plant and equipment (220,000) Net cash used by investing activities (220,000) -

Financing Activities:Loan From Shareholder (Repayment) 100,000 (10,000) Loan from Bank (Repayment) 100,000 (100,000) Net cash provided by investing activities 200,000 (110,000)

Net increase (decrease) in cash 20,000$ (42,000)$

Beginning cash balance 22,100$ 42,100$ Ending cash balance 42,100 100 Net increase (decrease) in cash 20,000$ (42,000)$


Other Helpful Information


Notes to Financial Statements

• Found in a set of audited financial statements• Provides more of the “story” behind the financial statements• Information may not be found elsewhere• Not exciting stuff - but do not ignore notes


Management Letters

• Normally a separate letter issued by the accounting firm performing the audit

• Tells you about many critical issues– Fraud and illegal acts within company

– Disagreements with auditors

– Problems with the company’s accounting

• Consider requesting


Pulling it All Together

• The financial statements, notes and management letter should be viewed as a package

• A company can have a horrible year of sales (income statement), but still be financially healthy (balance sheet)

• A company can show a profit (income statement) but have a decrease in cash (cash flow statement will tell you why)


Manipulation of Financial Statements


• Accounting more art than science….for some

• Several gray areas in accounting rules

• Not a simple bean counting game anymore

• Several numbers require a lot of judgment

• For those inclined, it can be very easy to “meet earnings expectations” with a few simple accounting tricks

Accounting Fraud


Areas Commonly Manipulated in Financial Statements • Overstating revenues – fictitious sales, recognizing revenues

prior to shipment• Manipulating reserves – may change estimate for

uncollectible accounts or self insurance reserves. Companies may use reserves like a cookie jar to boost profits in down years

• Recording expenses as assets - this artificially inflates earnings and misrepresents the balance sheet. This was a primary method used in the WorldCom fraud


Reliability Considerations


What is an “Audit”?

• The term “audit” is used loosely, but refers to a specific level of service

• Accounting firms provide varying levels of assurance on financial statements

• Key: Know the level of scrutiny – determine the level of assurance provided by the accounting firm

• Read the “Accountant’s Report” to find out


The Levels of Assurance –From Highest to Lowest

• Audit – must be independent; audits required for publicly traded companies, by some regulators and many banks

• Review – must be independent; required annually by some banks as condition of a loan

• Compilation – independence not required, but lack of independence must be disclosed; not necessarily more reliable than internal financials

• Internal financial reports – just that; may or may not be reliable; it depends on the circumstances


Sample Independent Auditor’s Report

To the Board of Directors and Shareholders ABC Company

We have audited the accompanying balance sheets of ABC Company as of December 31, 2010, 2009 and 2008, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company as of December 31, 2010, 2009 and 2008, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


INDEPENDENT ACCOUNTANT'S REPORT

Board of Directors Professional Office, Inc. Carlisle, Pennsylvania We have reviewed the accompanying statements of assets, liabilities and stockholders' equity - income tax basis of Professional Office, Inc., as of December 31, 1999 and 1998, and the related statements of revenue,expenses and retained earnings - income tax basis, and cash flows - income tax basis for the years then ended,in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. All of the information included in these financial statements is therepresentation of the management of Professional Office, Inc. A review consists principally of inquiries of Company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards,the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to theaccompanying financial statements in order for them to be in conformity with the income tax basis of accounting described in Note 1.

Carlisle, Pennsylvania January 13, 2000

Sample Accountant’s Review Report


INDEPENDENT ACCOUNTANT'S REPORT Mary Beth Addams Small Potatoes, Inc. Carlisle, Pennsylvania We have compiled the accompanying statement of assets and stockholders' equity - income tax basis of Small Potatoes, Inc., as of December 31, 1999, and the related statements of revenue, expensesand retained earnings - income tax basis, and cash flows - income tax basis for the year then ended,in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting information that is the representation of management in the form of financial statements. We have not audited or reviewed the accompanying financialstatements and, accordingly, do not express an opinion or any other form of assurance on them. Carlisle, Pennsylvania January 31, 2000

Sample Accountant’s Compilation Report


Landmines to Avoid

• Using accounting terminology and standards loosely – e.g. in asset purchase agreements

• Drafting agreements that fail to adequately define terminology like “revenues” or “expenses” or “assets”

• These terms mean different things to different people and can lead to disputes


Summary

• Financial statements have applicability in a wide variety of cases

• Know what you are getting – audit, review, etc.

• Know the basis of the preparation – cash or accrual

• Avoid using accounting terminology loosely in agreements, contracts, etc.


Contact Information

Jeffrey Roberts910 E. St. Louis Street, Suite 200Springfield, MO [email protected]

Don Wengler1201 Walnut Street, Suite 1700Kansas City, MO [email protected]

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