by Ivy N. Cadle
Accounting principles form the basic building blocks to create the language of business. Understanding how these principles affect a client’s case, and how a CPA can add value to the case, are both critical skills for an attorney who relies on accurate valuations. To work effectively with a CPA, one must understand accounting principles. To understand accounting principles, one must first understand accounting terms. Much like the law is full of legalese, accounting has its very own jargon where certain terms have very specific meanings.
Accountants use certain rules that govern the accumulation and compilation of financial information. In order to understand the relationship between accounting principles and value, it is critically important to understand certain basic accounting assumptions and principles. Those assumptions and principles include the following:
1. Separate Entity Assumption – An entity’s financial records should show only the subject entity’s position, as distinct from its owners or any other entities. Assets, liabilities, revenue, and expenses shown on an entity’s financials should follow corporate form. The entity should be governed in a manner that aligns entity activity with the entity’s legitimate interests.
2. Going Concern Assumption – It is assumed that the entity will continue its operations for the foreseeable future and that there are no new threats to its ability to meet its obligations in the near term. Such obligations or events that threaten the entity’s ability to meet its obligations may include lawsuit contingencies that create liquidity issues, internal governance conflicts, mismanagement of liquidity, or external issues, i.e. regulatory concerns.
3. Time Period Assumption – It must be possible to divide the activities conducted by the entity into discrete time periods. These periods may consist of weeks, months, or years.
4. Monetary Transaction Assumption – It must be possible to measure the activities of the entity in terms of observable monetary transactions.
5. The Principle of Conservatism – No one likes bad surprises and accounts are no different. Accountants seek to frame accounting information in a manner that avoids negative surprises. This results in an inherent bias that leads to understated earnings, cash flows, and asset values. It also leads to a bias that can result in the overstatement of expenses and liabilities. While conservatism is a legitimate consideration for accountants, conservatism can also be misused by management to justify the creation of reserves that serve only to smooth earnings and make an organization’s results appear falsely consistent.
6. The Principle of Matching – Items of expense should be allocated to the period where they were expected to create a related benefit. Depreciation is good example of the application of the matching principle, as depreciation is simply a systematic way to allocate the cost of a fixed asset over the period of time the fixed asset will benefit the organization.
7. The Principle of Consistency – Within a set of financial statements, one must apply accounting principles and judgments in a consistent manner. It is inappropriate to apply different conventions and judgments to similar transactions being reported in a single period or set of financial statements. If the applicable principles or judgments are changed, the entity should disclose the change and the reasons for the change.
8. The Principle of Cost versus Benefit – There is a great deal of information that can be gathered. It may not be cost effective to track it all. Information should not be tracked if the costs of compiling the information outweigh the benefits of using that information. This principle is especially relevant to small businesses. Compared to GAAP standards, financial statements of small businesses are often incomplete or unaudited because of the associated costs. These costs can be a legitimate concern for a small businesses.
9. The Principle of Materiality – While it may make sense for an organization to track information, the information in financial statements should be meaningful to users and not trivial.
10. Realization – Revenue should be recognized only when the entity has sufficiently completed a bona fide exchange. Furthermore, there must be some reasonable assurance that the resulting account receivable can be collected.
11. Cost Principle – Assets are to be reported on the financial statements at their historical cost. Unless otherwise specified, assets are not reported at fair market value.
Understanding the “set” of financial statements that should be included in any reporting package and the importance of each individual statement also is critically important. Any missing financial statement may signify a problem. The financial statements that should be included in any reporting package include the following:
1. Balance Sheet a/k/a Statement of Financial Position – The balance sheet simply lists the assets of a business and the claims against those assets. The statement is relatively simple in its appearance and it is a complete description of the entity as of a specific date. The balance sheet is often called a “snapshot” because it only provides the status of an entity as of a specific point in time. There are three broad classifications of the accounts that appear on the balance sheet. Those classifications are assets, liabilities, and equity.
2. Income Statement a/k/a Profit & Loss Statement a/k/a P&L – The income statement is like a motion picture of the enterprise over a defined period and it shows how the entity performed over that period. It can be compared to a rain gauge. Each period, the income statement starts with zero balances in each account. Over a period of time, the performance of the organization, in the form of revenues and expenses, accumulates on the income statement much like rain would accumulate in a gauge over a period of time. At the end of the period, the results are measured and the income statement accounts are closed back to zero. The closing process results in a change in the equity account balance shown on the balance sheet.
3. Statement of Owner’s Equity – Most entities should include a document entitled “Statement of Stockholder’s Equity” with the financial statements. This statement should be reviewed to discover any equity interests that were added or diminished during the period. It can also reveal dividends, distributions, and adjustments to retained earnings. For any client where a valuation will be performed, a statement of equity that shows accumulated deficits in retained earnings will present a special challenge because the deficit in retained earnings indicates the entity has been operating at a loss, possibly for a prolonged period of time.
4. Statement of Cash Flows – Neither the balance sheet, nor the income statement seek to show the flow of cash through an organization during any accounting period. Rather, those statements track a range of overall operations by reporting many transactions that do not involve the inflow or outflow of cash. For an organization to continue as a going concern, it must have enough cash on hand to meet its obligations and avoid default. Therefore, the statement of cash flows focuses on the financial viability of an organization and it provides insight on how the organization met its obligations during the period under consideration.
5. Notes to the Financial Statements – The Notes to Financial Statements are required supplementary disclosures that discuss the numbers provided by the financial statements. The notes present the financials with disclosures that can be fundamental to assess the financial statements and they often provide commentary concerning changes from previous periods. Other items discussed in the notes often include business activities, significant accounting policies, changes in significant accounting policies, descriptions of significant relationships, asset sales, discussion of significant liabilities, disclosure of parent and subsidiary relationships, subsequent events, and other items important to understanding the financial statements.
Any lawyer with a valuation oriented practice depends on quality valuation opinions. Because valuations are dependent on reliable and accurate accounting information, the appropriate understanding of accounting vocabulary and principles is critical. Knowing the basic principles used by accountants can help uncover instances where an accounting principle is distorting an economic reality. Knowing the basic form of financial statements can help determine when a client is providing incomplete or misleading information. For an attorney with a practice that depends on quality valuation information, a strong understanding of accounting is especially important.