ACCOUNTING FOR LAWYERS  101UNDERSTANDING AND 

REVIEWINGFINANCIAL STATEMENTS 

DAVID L. EVANS JD, CPAALBANY, NY

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Introduction

• Compilation of an all day program on accounting for lawyers

• Thanks to Bill Chandler/Vincent Love prior panelists for concepts and ideas

• Accounting– The financial language of business

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Basic Purpose

– Common Size– Language of Communication 

• Financial activities• Overview of financial condition

– Understand the entity’s business• Operational model• It’s trends• It’s SWOT (Strengths, Weaknesses, Opportunities and Threats)

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Basis of Accounting

•U.S. GAAP•International Financial Reporting Standards (IFRS)•SEC•Other Comprehensive Basis of Accounting(Cash Basis,Tax Basis)

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Auditing

• Not Accounting• Separate component of what accountants do• In its most basic form auditing is:

• Examination and rendering an opinion on the Financial Statements, and

• What they present to the reader

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Basic Financial Statements

• Balance sheet• Income statement• Statement of cash flows• Statement of changes in equity• Notes to the financial statements

• Report of Internal Controls

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Cash Flow Reporting

Tranches of Statement:– Operating– Investing– Financing

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Accounting 101

• Cash or Accrual• Historical Costs• Matching• Materiality

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Business Judgment

What is not in the Financial StatementsExamples: – Capital expenditure requirements, plant expansion– Operating decisions, personnel– Financing

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Footnotes

Accounting Policies:– Revenue recognition– Consolidation or combination– Investments in unconsolidated subs– Inter-company transactions– Use of estimates– Credit risk and concentrations

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Obligations– B/S Footnotes

• Lease obligations (capital vs. operating)• Real Estate Leases (long term, percentage rent)• Purchase commitments (inventories or capital expenditures)

– Sale – Leaseback Transactions– Supply Contracts (take or pay)

• Loan Covenants• Obligations to reduce debt• Unused letters of credit• Workers Compensation (self funded)• Post Employment Benefits (health insurance)• Deferred Compensation

– Qualified (defined benefit), Non-Qualified (financial or equity)

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Reserves

– B/S Footnotes• Legal proceeding• Environmental issues• FIN 48 – Uncertain tax positions• Off-balance sheet assets and liabilities

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Related Party Transaction– B/S Footnotes

• Consolidated Entities• Non-consolidated Entites• Transactions

– Income impact– Asset/Liability impact

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Intangible Assets

• Capitalization policy– Costs

• Overhead on self developed projects

• Acquisitions– Goodwill…valuation/evaluation– Impairment Studies

• Non‐marketable Assets– Especially non‐financial assets

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Financial Ratios

• Ratios illustrate the relationships of reported financial accounts

Helps interpret financial performance and condition.

Facilitates comparisons Past performance Peers performance

Provides tools for: Planning and forecasting Evaluation of management

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Ratio Analysis

• Five key categories:– Activity Ratios– Liquidity Ratios– Solvency Ratios– Profitability Ratios– Valuation Ratios

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Activity Ratios

Ratio Numerator DenominatorInventory Turnover Cost of Goods Sold Average InventoryDays Inventory on Hand (DOH)

Number of Days in Period Inventory Turnover

Receivables Turnover Revenue  Average ReceivablesDays Sales Outstanding (DSO)

Number of Days in Period Receivables Turnover

Payables Turnover Purchases Average Trade PayablesDays Payables Number of Days in Period Payables TurnoverWorking Capital Turnover

Revenue Average Working Capital

Fixed Asset Turnover Revenue Average Net Fixed AssetsTotal Asset Turnover Revenue Average Total Assets

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Activity Ratios

Accounts Receivable Turnover =Net Sales

Average Accounts Receivable

Sales to Working Capital = Net SalesWorking Capital

Inventory Turnover = Cost of Goods SoldAverage Inventory

Sales to Fixed Assets = Net SalesAverage Fixed Assets

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Liquidity Ratios

Ratio Numerator DenominatorCurrent Ratio Current Assets Current LiabilitiesQuick Ratio Cash + Short term 

marketable investments + accounts receivable

Current Liabilities

Cash Ratio Cash + Short‐term marketable investments

Current Liabilities

Defensive Interval Cash + Short‐term marketable investments + accounts receivable

Daily Cash Expenditures

Cash Conversion Cycle (net operating cycle)

DOH + DSO – Days Payables

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Liquidity Ratios

Working Capital = Current Assets less Current Liabilities

Quick Ratio =Cash + Mark Securities + Accts. Receivable

Current Liabilities

Current Ratio = Current AssetsCurrent Liabilities

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Solvency Ratios

Ratio Numerator DenominatorDebt Ratios:Debt to Assets Total Debt Total AssetsDebt to Capital Total Debt Total Debt plus EquityDebt to Equity Total Debt Total EquityFinancial Leverage Average Total Assets Average Total Equity

Coverage Ratios:Interest Coverage EBIT Interest PaymentsFixed Charge Coverage

EBIT + Lease Payments

Interest + Lease Payments

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Profitability Ratios

Ratio Numerator DenominatorReturn on Sales:

Gross Profit Margin Gross Profit Revenue

Operating Profit Margin Operating Income Revenue

Pre‐tax Margin EBT (after interest) Revenue

Net Profit Margin Net Income Revenue

Return on Investment:Operating ROA Operating Income Avg. Total Assets

ROA Net Income Avg. Total Assets

Return On Total Capital EBIT Debt and Equity

ROE Net Income Avg. Total Equity

Return on Common Equity Net Income – Preferred Dividends

Avg. Common Equity

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Profitability Ratios

Return on Assets = Net IncomeAverage Total Assets

Return on Equity = Net IncomeAverage Equity

Return on Investment =Net Income

Average (Total Equity + Total Long-term Debt)28

Credit Analysis

Ratio Numerator DenominatorEBIT interest coverage EBIT Interest (including 

capitalized expense)Funds From Operations (“FFO”) to Total Debt

FFO (net income plus non‐cash items)

Total Debt

Total Debt to EBITDA Total Debt EBITDAReturn on Capital EBIT CapitalTotal Debt to Total Debt plus Equity

Total Debt Debt plus Equity

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Leverage RatiosWorking Capital to Assets = Working Capital

Total Assets

Total Debt to Assets = Total LiabilitiesTotal Assets

Debt to Equity = Total DebtTotal Equity

Interest Coverage Ratio = EBITInterest Expense

Long-term Debt to Working Capital = Long-term DebtWorking Capital

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Valuation

•EBIT/DA

• Capitalization Rate

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Limitation of Ratio Analysis

• Financial statement inputs• Comparisons• Ratio selection• Interpretation bias

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Basic F/S TypesFrom an Auditor’s Perspective

– Company-Prepared Financial Statements (No Accountants Report)

– Compiled Financial Statements– Reviewed Financial Statements– Audited Financial Statements

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Report Language– Unqualified report– Qualified report– Adverse report– Disclaimer of report– Unqualified report with additional explanatory language

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Compiled Financial Statements

•Presentation of management’s representations in the form of financial statements.

•No level of assurance.

•CPA’s have no obligation to make inquiries or perform procedures.

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Reviewed F/S

•CPA’s express limited assurance that there are no material modifications that should be made to the financial statements in order for the statements to be in conformity with GAAP.

•CPA does:–Conduct analytical procedures–Making inquiries of management–Relies on management representation letter

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Audited F/S

•CPA opinion on whether the financial statements fairly present financial position of the company in conformity with generally accepted accounting principles (GAAP)

•CPA has to conduct procedures to obtain reasonable assurance about whether the financial statements are free of material misstatement, resulting from error or fraud.

•Such procedures plans, conduct, and reports are subject to generally accepted auditing standards (GAAS) or other acceptable standards (i.e. SEC or PCAOB).

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