THE STATE BAR OF CALIFORNIA 84th Annual Meeting Program 17 How to Read between the Lines of a Financial Statement Thursday, September 15, 2011 2:15 p.m.-3:45 p.m. Sponsored by the Litigation Section The State Bar of California and the Office of Section Education and Meeting Services are approved State Bar of California MCLE providers. Points of view or opinions expressed in these pages are those of the speaker(s) and/or author(s). They have not been adopted or endorsed by the State Bar of California’s Board of Governors and do not constitute the official position or policy of the State Bar of California. Nothing contained herein is intended to address any specific legal inquiry, nor is it a substitute for independent legal research to original sources or obtaining separate legal advice regarding specific legal situations. ©2011 State Bar of California All Rights Reserved READING AND UNDERSTANDING FINANCIAL STATEMENTS An Attorney’s Guide to Accounting Documents Needed in Litigation ANNUAL MEETING of the CALIFORNIA STATE BAR ASSOCIATION 2011 Presented by: Hank Kahrs, CPA/ABV/CFF, CMA, CFE, MBA Partner – Orange County, Los Angeles Offices 1 Course Contents •Financial Statements – Balance Sheet, Income Statement, Equity, Cash Flow •Flow of Accounting Records •Sources of Operating Information •Internal vs. External Financial Statements •Basis of Presentation – Cash vs. Accrual •Accounting Professional Standards – GAAP & GAAS •Internal vs. External Sources of Information •Ratio Analysis •Fair Value •Glossary of Terms •Closing 2 READING AND UNDERSTANDING FINANCIAL STATEMENTS An Attorney’s Guide to Accounting Documents Needed in Litigation • SOURCES OF • FINANCIAL • INFORMATION 3 1 FINANCIAL STATEMENTS • • • • Balance Sheet Income Statements Statement of Retained Earnings Statement of Cash Flows 4 BALANCE SHEET • The Balance Sheet shows: • What a company owns - Assets • What it owes - Liabilities • Remainder - Owners equity • Balance Sheets are at a point in time. • • Balance Sheet is also known as: Statement of Financial Position 5 BALANCE SHEET • • • • • • • • Balance Sheet Assets – Current & Long Term Liabilities - Current & Long term Owner’s Equity Stock Retained Earnings Beginning Balance Current Net income 6 2 Apple Computer 7 INCOME STATEMENTS • • Income Statements Summary of revenue and expenses. • • • • Also known as: Profit & Loss Statement Statement of Operations Statement of Earnings 8 INCOME STATEMENTS • The Income Statement shows the revenues and expenses during a period of time. • Typically produced at least once a year but can be more frequently – monthly or quarterly 9 3 The Income Statement Gross Sales 10 The Income Statement Expenses Operating Profit 11 The Income Statement Manufacturing/ Retail Returns & Allowances Cost of Sales Freight Out Commissions Payroll Rent Other Operating Profit 12 4 The Income Statement Service/ Bad Debts Rentals Billing Adjustments Expenses Payroll Other Expenses Operating Profit 13 Apple Computer 14 STATEMENT OF SHAREHOLDER’S EQUITY • The Statement of retained earnings explains the composition of ownership. 15 5 STATEMENT OF SHAREHOLDER’S EQUITY • The Statement of Shareholder’s Equity explains ownership composition and changes since the last statement. • Summary of changes during a specific period of time. • • • • • • • • Begins with balance at beginning of period Add net income or subtract loss Deduct dividends Issuance of Stock Other transactions that affect equity Deferred Stock Compensation Stock Options Ends with new balance 16 Apple Computer 17 STATEMENT OF CASH FLOWS • The Statement of Cash Flows provided information on the sources and uses of cash that have come into and have left the entity. • From Operations • From Investments • From Financing 18 6 Apple Computer 19 FINANCIAL STATEMENTS • The Balance Sheet is the most comprehensive financial Statement. – Net Income for the most previous period found in the owner’s equity section. – Shareholder's Equity Balances – Cash Flow statement is from Balance Sheet accounts. 20 Records in the Flow of Accounting Information Source Document Journalizing Journal Posting Ledger Summarizing Worksheet/ Trial Balance Financial Statements Tax Returns 21 7 Sources of Operating Information Information going into an accounting system, called source information, is generated by the individual transactions entered into each day by a business. They consist of sales/revenue, cash receipts, expenses/accruals and disbursements. Each transaction is recorded into the accounting system. A transaction that affects the current period is a revenue or expense and appears in the statement of operations or similarly named document. In an accrual-basis system, which will be discussed later, entries that affect other periods are assets and liabilities. What kind of information is generated by the accounting system? It depends on the sophistication of the system. 22 Sources of Operating Information •Source documents (invoices, bank statements) •Trial balance (hand-prepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040)) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (hand-prepared, QuickBooks, MAS90, Peach Tree) •External financial statements: •Compiled •Reviewed •Audited 23 Sources of Operating Information Acme Appliances Trial Balance 12/31/03 •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited Acct. No. 401 402 425 510 515 550 560 561 564 … Description Taxable sales Nontaxable sales Sales returns Materials Supplies Labor FICA SUI Workers' Comp 24 … Dr. Cr. 25,847.00 4,652.46 1,292.35 7,754.10 1,550.82 11,631.15 872.34 348.93 1,163.12 … 8 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 25 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 26 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 27 9 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 28 Internal vs. External Financial Statements • Internal financial statements are prepared by the entity in question and are primarily used by that entity. • External financial statements are audited by outside accountants and are prepared for users outside of the entity. 29 Financial Statements • It is important to know what kind of financial statement has been prepared – Internal vs. External • There are different levels of assurance for external financial statements 30 10 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 31 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited To The Board of Directors ABC Company We have compiled the accompanying balance sheet of ABC Company as of December 31, 200x, and the related statements of income, retained earnings, and cash flows 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 in the form of financial statements information that is the representation of management. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them. 32 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited To The Board of Directors ABC Company We have reviewed the accompanying balance sheet of ABC Company as of December 31, 200x, and the related statements of income, retained earnings, and cash flows 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. All information included in these financial statements is the representation of the management of ABC Company. 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 review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles. 33 11 Sources of Operating Information •Trial balance (handprepared or computer) •Tax returns: •Proprietorship (Schedule C (Form 1040) •Partnership (Form 1065) •Corporation (1120 or 1120S) •Internal financial statements (handprepared, QuickBooks) •External financial statements: •Compiled •Reviewed •Audited 34 Bases of Presentation • Major Bases: • • Cash Basis—Most common in small business. Accrual Basis—Most “accurate” method of measurement (“GAAP”). • Modified Cash Basis—A hybrid reporting method (usually for tax • “Other Comprehensive Basis of Accounting” (Usually on returns). compliance returns, very unusual). 35 Bases of Presentation • Cash Basis—Most common in small business • Accrual Basis—Most accurate method of reporting • Modified Cash Basis—A hybrid reporting method Revenue is recognized when it is received and expenses are recognized when they are paid. This can prevent the matching of revenue to related expenses and results in timing differences (delays) that, in some cases, can be extreme and significantly affect the accuracy of a business income loss claim. 36 12 Bases of Presentation • Cash Basis—Most common in small business • Accrual Basis—Most accurate method of reporting • Modified Cash Basis—A hybrid reporting method Revenue is recognized when it is earned (i.e., the sale is made) and expenses are recognized when they are incurred. Revenue is matched to expenses and there are no timing differences. Accrual basis accounting is more difficult to maintain. 37 Bases of Presentation • Cash Basis—Most common in small business • Accrual Basis—Most accurate method of reporting • Modified Cash Basis—A hybrid reporting method Modified cash basis accounting incorporates features of cash basis and accrual basis. It is most often used in accounting for income taxes. The income statement is prepared on the cash basis. This approach has all the issues that cash-basis reporting has. 38 Bases of Presentation Here is a comparison of cash basis and accrual basis accounting. •Revenue is collected 30 days after it is earned. ABC CONTRACTOR - CASH BASIS ACCOUNTING INCOME STATEMENT Description January March Total $ - $ 25,000.00 - $ 15,000.00 $ 25,000.00 15,000.00 Net Income $ - $ 25,000.00 $ (15,000.00) $ 10,000.00 ABC CONTRACTOR - ACCRUAL BASIS ACCOUNTING INCOME STATEMENT •Expenses are paid 60 days after they are incurred. Description See other examples in binder. February Revenues Less Expenses January February March Total Revenues Less Expenses $ 25,000.00 15,000.00 $ - $ - $ 25,000.00 15,000.00 Net Income $ 10,000.00 $ - $ - $ 10,000.00 NOTE: 39 Example adapted from Kieso and Weygandt, Intermediate Accounting, Pages. 84-85. 13 Bases of Presentation •Check the tax return to determine the basis of presentation. 40 Generally Accepted Accounting Principles GAAP • GAAP is the abbreviation for Generally Accepted Accounting Principles. It refers to a set of widely accepted accounting standards, set by the Financial Accounting Standards Board (FASB) and used to standardize financial accounting of public companies. 41 Generally Accepted Auditing Standards • GAAS is the abbreviation for Generally Accepted Auditing Standards. It refers to a set of systematic guidelines used by auditors when conducting audits on companies' finances, ensuring the accuracy, consistency and verifiability of auditors' actions and reports. By relying on GAAS, auditors can minimize the probability of missing material information. 42 14 Generally Accepted Auditing Standards • General standards: • 1. The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor. • 2. In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors. • 3. Due professional care is to be exercised in the planning and performance of the audit and the preparation of the report. 43 Generally Accepted Auditing Standards • • • • Standards of fieldwork: 1. The work is to be adequately planned and assistants, if any, are to be properly supervised 2. A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed. 3. Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. 44 Generally Accepted Auditing Standards • • • • • Standards of reporting 1. The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles (GAAP) 2. The report shell identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. 3. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report. 4. The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reason therefore should be stated. In all cases where an auditor’s name is associated with financial statement, the report should contain a clear-cut indication of the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking. 45 15 Audit Report REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Apple Computer, Inc.: We have audited the accompanying consolidated balance sheets of Apple Computer, Inc. and subsidiaries (the Company) as of September 25, 2004 and September 27, 2003, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended September 25, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 consolidated 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 consolidated financial statements referred to above present fairly, in all materia1 respects, the financial position of Apple Computer, Inc. and subsidiaries as of September 25, 2004 and September 27, 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended September 25, 2004, in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations and for financial instruments with characteristics of both liabilities and equity in 2003 and changed its method of accounting for goodwill in 2002. 46 Inside Sources of Information (Source Documents) • • • • • • • • • • Financial Statements Forms 1099’s Forms W-2 Paycheck Stubs/Payroll Records Check Registers Ledgers Journals Bank Statements Brokerage Statements Mortgage & Other Loan Applications 47 Outside Sources of Information • • • • • • • • • • Litigant’s Accountant IRS Litigant’s Suppliers Litigant’s Customers Litigant’s Employees Litigant’s Competitors Industry Data Economic Data Bank Statements Personal Banker 48 16 Tax Returns as Sources of Information • Sometimes Tax Returns are the Only Source of Data • • • Corporate Tax Return (Form 1120 or 1120S) Partnership Tax Return (Form 1065) Sole Proprietorship (Form 1040, Schedule C) 49 XYZ COMPANY INC. 50 XYZ COMPANY INC. 51 17 XYZ COMPANY INC. 52 ABC INC. 53 ABC INC. 54 18 ABC INC. 55 RGL PRACTICE AREAS 1. 2. 3. 4. LITIGATION SUPPORT BUSINESS VALUATION FRAUD INSURANCE SUPPORT 56 Types of Cases • • • • • • • Business damages Business interruption Personal injury Asset & income searches Shareholder/Partner disputes Officers’ and directors’ litigation Partnership dissolution 57 19 Types of Cases – Economic Loss Calculation • • • • • • • • • Business interruption Wrongful termination/death Personal injury Breach of contract Loss of goodwill Price erosion Unjust enrichment Prejudgment interest Opportunity costs 58 Types of Cases – Economic Loss Calculation • • • • Intellectual property infringment Construction defect & delays Anti-trust Lender Liability 59 Accountant’s Role in Litigation Support • • • • • • • Expert Witness Consulting Document Requests Assist in Preparation of Interrogatories Questions for Deposition Evaluate/Critique Opposing Experts’ Reports Brainstorming 60 20 RGL Statistics • Over 125 Professional Accountants Dedicated Entirely to the Field of Forensic Accounting 61 15 US Office Locations and 6 International Locations Atlanta Orange County Charlotte Portland Chicago Sacramento Dallas St. Louis Denver San Diego Indianapolis San Francisco Los Angeles Seattle New York International: Cologne London Perth Sydney Tokyo Singapore 62 21 Speakers Biography Name : Henry J. Kahrs Title : Partner Firm : RGL, Inc. Address : 625 The City Drive, Suite 290 Orange, California 92868 Telephone : 714-740-210 Fax : 714-740-2020 E-Mail : [email protected] Mr. Kahrs has been involved in forensic accounting since 1985. He received his BS in accounting from the Rochester Institute of Technology and immediately began his career at Campos & Stratis. The first case Mr. Kahrs worked on was, at the time, the largest fire ever investigated by the FBI. Mr. Kahrs spent over two years on the file and based on the firm’s work the client received a full defense verdict. In 1987, Mr. Kahrs moved to Orange County, California. He went onto to receive an MBA from California State University – Fullerton. He also obtained many credentials. Mr. Kahrs is a Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Fraud Examiner (CFE) and Accredited In Business Valuation (ABV). During his time at Campos & Stratis, which became RGL, Inc. Mr. Kahrs has worked on hundreds of cases involving lost profits and measuring damages in employee dishonesty cases. He has been retained as an expert on over three hundred cases involving issues such as fraud, lost profits, intellectual property damages, business valuation, employee dishonesty, vendor schemes, partner and shareholder disputes and other forensic accounting issues. Mr. Kahrs currently manages the Los Angeles and Orange County offices of RGL.