Finance for Lawyers
© Joseph Novello 2016
1
Joseph Novello, CPA, MBA Finance4Lawyers.com 732-737-7310
[email protected]
Disclaimer This document is protected by copyright and any reproduction or distribution of any kind is strictly prohibited. The information in this presentation is of an instructional nature and while it is believed to be correct, errors may occur. This presentation is not intended to give legal, financial, or tax advice. Please consult with your legal, financial, or tax professional for advice. © Joseph Novello 2016
3
Table of Contents • • • • • • • • • • • • •
Foundations of Modern Accounting Basic Equation of Finance Financial Statements Accounting Methodologies and Principles Who Is Who in Financial Reporting Private Company Accounting and Auditing Key Numbers and Ratios Present Value Concepts Business Valuations Lawyer’s Role in Financial Audits Basic Concepts of Financial Investment Financial Fraud Schemes Appendices
© Joseph Novello 2016
4
Foundations of Modern Accounting
© Joseph Novello 2016
5
Foundations of Modern Accounting • Modern accounting is called the double-entry system. • Originated in 12th-century Islamic world–from algebra. • Refinement of accounting practices in Florence and Medici in the 13th and 14th century. • Luca Pacioli, called the Father of Accounting, codified double-entry accounting in 1494 in Summa de Arithmetica, Geometria, Proportioni et Proportionalità. © Joseph Novello 2016
6
Early Form of Accounting
Source: Metropolitan Museum of Art http://www.metmuseum.org/Works_of_Art/collectio n_database/ancient_near_eastern_art/cuneiform_ tablet_caravan_account_of_the_payment_of//obje ctview.aspx?OID=30004518&collID=3&dd1=3 Retrieved 12 24 2010 © Joseph Novello 2016
• Earliest accounting records found in Mesopotamia • Middle Bronze Age Assyrian trading colony 20th–19th century B.C. • Cuneiform tablet: caravan account of the payment of silver for donkeys and harness, textiles, tin, lapis lazuli, a guide, and export duty • Ceramic 85 x 65 x 24 mm 7
Accounting Artifact from Italy •
•
•
•
Source: Metropolitan Museum of Art Department of European Paintings © Joseph Novello 2016
This painted wood panel once covered an account book compiled by the biccherna, a committee who served as administrators and treasurers of the commune, of Siena, Italy. The scene at the top shows three of the five committee members, all of whose names are listed in the inscription below The carmarlingo, or secretary, wearing the white robes of a Cistercian monk, counts a bag of money before two officers with record books. From the 13th to the 18th century, the commune hired local painters to decorate the covers of the financial books at the end of each fiscal term.
8
Basic Equation of Finance
© Joseph Novello 2016
9
Basic Equation of Finance • Assets = Liabilities + Equity • Economists show it as: Assets – Liabilities = Net Worth Net worth is a synonym for equity.
© Joseph Novello 2016
10
Assets are economic resources owned or controlled by an entity Assets can be: • Long Term or Short Term – Example : Building = long term Accounts receivable = short term • Tangible or Intangible – Example: Building = tangible Patent = intangible • Legally Owned or Controlled – Can be controlled, but not owned, and still be considered an asset. – Example: Jets leased by an airline © Joseph Novello 2016
11
Examples of Assets • • • • •
Cash Inventory Equipment Real estate Patents
© Joseph Novello 2016
12
Intangible Assets • • • • • •
Patents Software Customer lists Intellectual property FCC frequency licenses Goodwill
© Joseph Novello 2016
13
Goodwill • Arises when a company purchases another company. • Results when the purchase price exceeds the fair value of assets less liabilities of the company acquired. • Subject to continuing review of value to see if it is impaired. © Joseph Novello 2016
14
Goodwill Example • The law firm Small Time leases everything: office space, computers, equipment, etc., and the leases all expire on December 31, 2012. • The law firm Big Guy & Company buys Small Time on January 1, 2013, for $1 million. • As part of the purchase agreement, Small Time pays off all of its liabilities on December 31, 2012. • On January 1, 2013, the $1 million purchase price is recorded as goodwill (or other intangibles) by Big Guy & Company because Small Time had no other assets. © Joseph Novello 2016
15
Liabilities are economic claims owed by an entity They can be: • long term or short term. • owed to individuals, companies, or government entities. • evidenced by written documents or arising through the normal course of business. • liabilities may arise for claims other than cash, for example, an unexpired magazine subscription. © Joseph Novello 2016
16
Examples of Liabilities • • • • •
Accounts payable (amounts owed to suppliers) Taxes payable Bonds and notes payable Customer deposits Interest payable
© Joseph Novello 2016
17
Equity is the remainder of assets less liabilities Equity can • be evidenced by formal documents such as stock certificates. • vary by legal entity – corporation, partnership, sole proprietorship. • have different classes of owners with different risks and rewards of ownership. © Joseph Novello 2016
18
Examples of Equity • • • • •
Common stock Retained earnings Preferred stock Partnership interest Home equity
© Joseph Novello 2016
19
Financial Statements
© Joseph Novello 2016
20
Basic Financial Statements • Balance sheet • Income statement • Cash flow statement
© Joseph Novello 2016
21
Balance Sheet • Shows Assets = Liabilities + Equity. • As of a certain date: – Example December 31, 2012.
• Should be “consolidated”
© Joseph Novello 2016
22
Balance Sheet Components: Assets • Current Assets = cash or turned into cash in a year • Property, Plant, and Equipment = land, factories, and machinery • Intangible Assets = patents, goodwill, and customer lists • Investments = ownership of other companies • “Accounting” Assets
© Joseph Novello 2016
23
Balance Sheet Components: Liabilities • Current Liabilities = to be paid within a year • Long-Term Debt = maturity in excess of a year • Other Non-Current Liabilities • Usually accounting liabilities, such as deferred taxes, deferred revenue, or retirement obligations
© Joseph Novello 2016
24
Balance Sheet Components: Equity • Stock = listed at a par or “face” value, often $1 • Capital in Excess of Par = Excess of stock price issued over the $1 par • Retained Earnings = accumulated profits kept in the business • Treasury Stock = company stock bought back • Other accounting items
© Joseph Novello 2016
25
Common Stock • • • •
Also called capital stock Evidences the ownership of a company Usually has voting rights Shares in the company’s earnings and dividends • Last in line in bankruptcy and liquidation • Usually has a “par value,” which is meaningless
© Joseph Novello 2016
26
Preferred Stock • • • • • • • • • •
Also called Preference Stock Has a meaningful par value Usually has a stated dividend rate, for example 6% Dividends are subject to Board of Director declaration Usually dividends must be paid on preferred stock before dividends can be paid on common stock No participation in earnings of the corporation beyond stated dividends In line before common stock in bankruptcy and liquidation, but after liability holders Sometimes offers rights to convert into common stock; this is called Convertible Preferred stock Dividends can offer tax benefits to holders of preferred stock, but dividends are not deductible by the issuer Often issued by utilities © Joseph Novello 2016
27
Treasury Stock • Treasury Stock arises when a company buys its own stock. • It is not shown as an asset, but rather as a deduction of stockholder's equity. • Treasury Stock is primarily bought for two reasons: – To have stock available to issue compensation awards, such as stock options. – If a company thinks its stock is undervalued in the stock market, buying treasury stock decreases the shares outstanding and thereby increases earnings per share. © Joseph Novello 2016
28
Dividends Dividends are paid via a reduction of retained earnings. • Declaration Date – This is the date that dividends are declared by the Board of Directors (BoD); it is also when the payment becomes a liability of the corporation. • Record Date – This date, announced by the BoD on the declaration date, is when someone must own the stock to receive the dividend. • Ex (Dividend) Date – This date is set by the stock exchange, two days before the record date, for publicly traded companies. Holder on the day before this date gets the dividend. Allows time for a stock trade to “settle”. • Payment Date – This date, announced by the BoD on the declaration date, is when dividends are paid. © Joseph Novello 2016
29
Joe’s Limousine, Inc., Day 1
Joe founds a corporation with 1,000 shares of stock with a $1 par value and an issue price of $25
© Joseph Novello 2016
30
Joe’s Limousine, Inc., Day 2
Joe’s Limousine, Inc., borrows $5,000 © Joseph Novello 2016
31
Joe’s Limousine, Inc., Day 3
Joe’s Limousine, Inc., buys a limo for $27,000 © Joseph Novello 2016
32
Joe’s Limousine, Inc., Day 31
Joe’s Limousine, Inc., had a net profit of $6,000 in January © Joseph Novello 2016
33
Joe’s Limousine, Inc., Day 32
Joe’s Limousine, Inc., puts a $2,000 sound system in the limousine. © Joseph Novello 2016
34
Joe’s Limousine, Inc., Day 32
Joe’s Limousine, Inc. declares a $4,000 dividend © Joseph Novello 2016
35
Joe’s Limousine, Inc., Day 51
Joe’s Limousine, Inc. pays a $4,000 dividend © Joseph Novello 2016
36
Balance Sheet
© Joseph Novello 2016
37
Consolidated Balance Sheet
© Joseph Novello 2016
38
Balance Sheet Example
Source: Verizon 2011 Annual Report. Some items reclassified for seminar purposes. © Joseph Novello 2016
39
Balance Sheet Components: Noncontrolling (Minority) Interest The noncontrolling (minority) interest is the equity of outside shareholders in subsidiaries that are included in the financial statements. Subsidiary Shareholders
Parent Company Shareholders
Parent Company
Subsidiary
© Joseph Novello 2016
40
Balance Sheet Components: Noncontrolling (Minority) Interest • The noncontrolling (minority) interest is the equity of outside shareholders in subsidiaries that are included in the financial statements. • In our example, Verizon Communications, Inc., owns 55% of Verizon Wireless. Vodafone owns owns the remaining 45%.
© Joseph Novello 2016
41
Income Statement • Shows Revenue - Expenses = Net Income. • Measurement covers a period of time – Example: the year ended December 31, 2012
• Should be “consolidated” – similar to the balance sheet consolidation.
© Joseph Novello 2016
42
Income Statement Components: Revenue • Derived from products or services sold to customers. • Consolidation eliminates revenue from sales to consolidated affiliates. • Accounting rules govern when revenue is recognized, generally a performance obligation is completed and collection is reasonably assured. • Does not have to be received in cash to be recognized under accrual accounting. © Joseph Novello 2016
43
Income Statement Components: Cost of Goods Sold and Gross Profit • Cost of Goods Sold = the cost of inventory sold • Gross Profit = revenue less cost of goods sold
© Joseph Novello 2016
44
Income Statement Components: Operating Expenses Operating Expenses (called above the line expenses) – Selling, General, and Administrative – Depreciation and Amortization
© Joseph Novello 2016
45
Income Statement Components: Depreciation and Amortization • The write-off of tangible assets (via depreciation) and intangible assets (via amortization) over their useful lives. • Is a non-cash expense. • Can be done over a straight-line basis or with an accelerated method where larger depreciation charges are recognized in earlier years. • Can have two different methodologies: one for financial statement purposes and one for income tax purposes.
© Joseph Novello 2016
46
Income Statement Components: Depreciation Example Cash Outlay Annual Expense on Income Statement
© Joseph Novello 2016
47
Income Statement Components: Accelerated Depreciation
Accelerated Method
Annual Expense is Greater in Earlier Years
© Joseph Novello 2016
48
Other Depreciation Methodologies • Accelerated Depreciation – Records more depreciation in the early years of the asset’s useful life – Two most common methods are double declining balance and sum of year’s digits
• Tax Methods – Prescribed by the tax code – Provisions for “bonus” depreciation in early years – “The Modified Accelerated Cost Recovery System (MACRS) is used [for] property placed in service after 1986.”1 1 IRS Publication 946, October 25, 2010, Page 34 © Joseph Novello 2016
49
Land • Land is not subject to depreciation. • “You cannot depreciate the cost of land because land does not wear out, become obsolete, or get used up”.1 • If the land is used to extract natural resources, such as oil or ore, the cost of the land is subject to depletion, not depreciation. 1 IRS Publication 946, October 25, 2010, Page 6 © Joseph Novello 2016
50
Income Statement Components: Operating Income
Operating Income = Gross profit less operating expenses
© Joseph Novello 2016
51
Income Statement Components: Other Income and Expenses • Other Income and Expenses = expenses not part of the normal course of the business. – Interest Income and Expense = These are items related to financing the business, not operating the business (except for financial services companies). – Gains and losses from investments – Other items, such as loss from the sale of equipment used in the business © Joseph Novello 2016
52
Income Statement Components: Other Income and Expenses Question: Where does the sale of a couch go on the Income Statement? Answer: It depends! • For Raymour & Flanigan Furniture Store – They are in the business of selling furniture, so it’s recorded as revenue. • For psychiatrist selling an old couch – Since the psychiatrist is not in business of selling furniture, this is other income. © Joseph Novello 2016
53
Income Statement Components: Pre-Tax Income, Income Taxes, Net Income • Operating Income - Other Expense + Other Income = Pretax Income • Income Taxes include federal, state, and foreign income taxes. Property, excise, sales, and other taxes are not included. • Net Income = Pretax Income - Income Taxes. Often referred to as “the bottom line”.
© Joseph Novello 2016
54
Income Statement Example
Source: Verizon 2011 Annual Report. Some items reclassified for seminar purposes. © Joseph Novello 2016
55
Law Firm Income Statement Example Notes • Can be cash basis or accrual basis • Keep contingency fees separate • Percent of revenue for management accounting • Occupancy and compensation are main expense drivers
© Joseph Novello 2016 56
Cash Flow Statement • Shows cash flow from three areas: – Operating activities – Investing activities – Financing activities
• Measurement covers a period of time: – Example: the year ended December 31, 2009
• Consolidated – similar to the balance sheet consolidation © Joseph Novello 2016
57
Cash Flow Statement vs. Income Statement • The income statement measures transactions on an accrual basis. The cash flow statement measures events when they are completed in cash. • The income statement only measures income. The cash flow statement also includes measurement of cash flow from operating activities, but also from financing and investing activities. • The cash flow statement is more objective in that it is less subject to accounting estimates. © Joseph Novello 2016
58
Cash Flow Statement: Operating Activities Shows cash flow from the normal operation of the business. – Often shown “Indirect”. – Highlights the differences between accrual and cash accounting. – For example, revenue is recorded when a title passes from the seller to the buyer, cash is recorded when received. – Also shows the impact of non-cash expenses such as depreciation. © Joseph Novello 2016
59
Cash Flow Statement: Investing Activities Shows cash flow from the investments of the business. – Capital expenditures – Acquisition of companies – Sale or disposition of investments or assets
© Joseph Novello 2016
60
Cash Flow Statement: Financing Activities Shows cash flow from the financing activities of the business. – Issuance and repayment of debt – Issuance of stock – Purchase of treasury stock – Dividends paid (but not interest)
© Joseph Novello 2016
61
Cash Flow Statement Example
Source: Verizon 2011 Annual Report. Some items reclassified for seminar purposes. © Joseph10ovello 2010
62
Cash Flow Statement Presentation Two methods are used to develop the statement of cash flow: • Direct method – Shows the actual cash flow from each category – Examples: Cash received from customers, cash paid to suppliers – Difficult to develop for companies that use the accrual basis of accounting
• Indirect method – Adjusts accrual basis numbers to derive cash flow – Adds or deducts cash items from accrual amounts – Examples: Net income plus depreciation to derive operating cash flow – Most common method for companies that use the accrual basis of accounting
© Joseph Novello 2016
63
Other Financial Statement Components • Notes to Financial Statements • Statement of Equity and Other Comprehensive Income • Auditor’s Report • Management Discussion and Analysis • SOX Certifications
© Joseph Novello 2016
64
Notes to Financial Statements • Includes important information not included in the financial statements. This section is extensive, NOT short as the name implies. • The first note is typically a summary of significant accounting policies. • Other notes provide detailed information on items such as taxes, debt, property plant and equipment, pensions, and contingent liabilities. • Contingent liabilities include lawsuits, regulatory proceedings, and other matters. Statement of Financial Standards No. 5 “Accounting for Contingencies” governs the accounting rules for this. © Joseph Novello 2016
65
Notes to Financial Statements Case Study: Verizon Notes to Financial Statements 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.
Description of Business and Summary of Significant Accounting Policies Acquisitions and Divestitures Wireless Licenses, Goodwill, and Other Intangible Assets Property Plant and Equipment Investments in Unconsolidated Businesses Noncontrolling Interest Leasing Arrangements Debt Fair Value Measurements and Financial Instruments Stock Based Compensation Employee Benefits Taxes Segment Information Comprehensive Income Additional Financial Information Commitments and Contingencies Quarterly Financial Information
© Joseph Novello 2016
66
Segment Information
Versus $12,880 on slide 55 From Verizon Annual Report, Note 13, Page 77 © Joseph Novello 2016
67
Commitments and Contingencies
From Verizon Annual Report, Note 16, Page 82 © Joseph Novello 2016
68
Commitments and Contingencies
From Verizon Annual Report, Note 16, Page 82 © Joseph Novello 2016
69
Commitments and Contingencies
From Verizon Annual Report, Note 16, Page 82 © Joseph Novello 2016
70
Commitments and Contingencies
From Verizon Annual Report, Note 16, Page 82 © Joseph Novello 2016
71
Statement of Equity and Other Comprehensive Income • Statement of Equity shows changes in capital such as issuance of stock, payment of dividends, and changes in treasury shares. • Other comprehensive income includes gains and losses that GAAP prescribes to be accounted for apart from the income statement. These are technical items related to things like taxes, pensions, and foreign currency translations. © Joseph Novello 2016
72
Management Discussion and Analysis • Report issued by the company’s management included in the 10K report and Annual Report. • Required by Item 301 of regulation S-K. • Not a formal part of the financial statements. • Includes a comparison of one period versus the previous one and reasons for changes. • Will also cover significant business and accounting issues. © Joseph Novello 2016
73
Auditor’s Report • Report issued by the company’s external CPA firm auditors. • Four types of engagements can be preformed by a CPA firm: – A full-scope audit – A limited “review” – A “compilation”, with no audit or review procedures – A “preparation”, similar to compilation but with no report © Joseph Novello 2016
74
Auditor’s Report • Public companies require a full-scope audit. • A “clean” audit report opinion is called an unqualified opinion and will state: – that financial statements were audited. – that the audits were performed under professional standards. – In the auditor’s opinion, the financial statements “present fairly” the information presented in accordance with Generally Accepted Accounting Principles (GAAP). – Implies that the accounting principles are consistently applied and disclosures are reasonably adequate, unless stated otherwise. © Joseph Novello 2016
75
Auditor’s Report
© Joseph Novello 2016
From Verizon Annual Report, Page 51 Resized to fit this page
76
SOX Certifications • The Sarbanes--Oxley Act of 2002 is named after its sponsors: Senator Paul Sarbanes (D-MD) and Representative Michael Oxley (R-OH). • Referred to as SOX, it was enacted in reaction to the accounting scandals of Enron, Tyco, et al. • Requires specified certifications from the company CEO and CFO (section 302) and its auditors (section 404), which appear in the annual report. • SOX created the Public Company Oversight Board (PCAOB) to regulate the auditing of public companies. • Restricts services that auditors may offer their clients. © Joseph Novello 2016
77
Financial Statement Recap
© Joseph Novello 2010
78
Financial Statements Recap • Balance Sheet – Displays Assets = Liabilities + Equity – As of a certain date
• Income Statement – Displays Revenue – Expense = Net Income – Covers a period of time
• Cash Flow Statement – Displays operating, investing, and financing activities – Covers a period of time © Joseph Novello 2010
79
Financial Statements Recap • Notes to Financial Statements – Not short as the name implies – Gives detailed quantitative and qualitative information in support of the Financial Statements
• Auditor’s Report – Not long as the name implies – Gives the auditor’s opinion about the fairness of the financial statements © Joseph Novello 2010
80
Financial Statement Exercise
© Joseph Novello 2010
81
Prepare a Balance Sheet and Income Statement Using Info Below
© Joseph Novello 2010
82
Balance Sheet
© Joseph Novello 2010
83
Income Statement
© Joseph Novello 2010
84
Accounting Methodologies & Principles
© Joseph Novello 2016
85
Accounting Methodologies There are four major types of accounting methodologies: • The Accrual Method recognizes revenue when earned and expenses when incurred. Its major goal is to properly match revenue and expense. GAAP requires accrual accounting. • The Cash Method recognizes revenue when received and expenses when paid. Professional corporations generally use this method. • The Statutory Method of accounting is defined by law for certain industries like insurance or local government. • Tax Accounting rules are defined by law, which states when revenue is recognized and when expenses may be deducted for income tax purposes. • Public companies use both accrual accounting for financial reporting purposes and tax accounting for the income tax return. A reconciliation of between the two is required on Schedule M of the companies income tax return (Form 1120). © Joseph Novello 2016
86
Accounting Principles • Matching – Periodic net income should be determined by matching revenue and expense. • Materiality – Application of accounting rules is not required for items of minor significance. • Consistency – Required to provide comparability. • Going Concern – Financial reporting under U.S. GAAP assumes that a company will continue to operate as a going concern until its liquidation becomes imminent1. A new standard has requirements for disclosures when substantial doubt about the ability to continue as a going concern arises. • Conservatism – Anticipated losses are recorded and gains are postponed until realized. • Substance Over Form – Economic substance takes precedence over legal form. 1
Per PWC In Depth September 23, 2014
© Joseph Novello 2016
87
Management Accounting • Management Accounting is the area of accounting for a company’s internal use and does not have to conform with GAAP. • Focus is on reporting information that a business can use to analyze and improve its performance. • Includes the use of a budget and forecasts. • Also includes the measures of key nonfinancial data, such as billable hours in a law firm. © Joseph Novello 2016
88
EBITDA: A Non-GAAP Measure • Earnings Before Interest, Taxes, Depreciation, and Amortization EBITDA Benefits Eliminates the impact of debt on operating results Eliminates the impact of taxes on operating results Yields a result that is closer to cash flow than net income © Joseph Novello 2016
89
EBITDA • Critics don’t like EBITDA because “References to EBITDA make us shudder…. That makes sense, … only if you think capital expenditures are funded by the tooth fairy” --Warren Buffet.1 If used as a substitute for cash from operations, it does not include working capital requirements. It can mask problems of high debt levels. 1 Per Forbes.com http://www.forbes.com/global/2003/0317/024.html Retrieved 1 13 2012 © Joseph Novello 2016
90
EBITDA vs. Operating Cash Flow
Source: Verizon 2011 Annual Report. Some items reclassified for seminar purposes. © Joseph Novello 2016
91
Who Is Who in Financial Reporting
© Joseph Novello 2016
92
Who is Who in Financial Reporting • • • • • • •
Securities and Exchange Commission (SEC) Financial Accounting Standards Board (FASB) International Accounting Standards Board (IASB) Internal Revenue Service (IRS) Big Four American Institute of CPAs (AICPA) Private Company Financial Reporting Committee (PCFRC) © Joseph Novello 2016
93
Securities and Exchange Commission (SEC) • Created by the Securities Act of 1934. • Responsible for setting accounting standards for publicly traded companies. • Has allowed the FASB to set these standards. • Requires annual (Form 10-K) and quarterly (Form 10-Q) reports to be filed under prescribed timeframes. • Requires that disclosures of significant financial events be filed on Form 8-K. © Joseph Novello 2016
94
Financial Accounting Standards Board (FASB) • Private sector non-profit organization that sets standards of GAAP. • Recognized by the SEC and AICPA in that role. • Has issued over 150 Statements of Financial Accounting Standards (SFAS) since its inception in 1973. • Recently codified the SFAS into subject areas. © Joseph Novello 2016
95
International Accounting Standards Board (IASB) • Responsible for setting International Financial Reporting Standards (IFRS). • Movement to unify US GAAP and IFRS called “convergence”. • IFRS questions appeared on the CPA exam for the first time in 2011.
© Joseph Novello 2016
96
Internal Revenue Service (IRS) • US government agency responsible for administering US federal taxes. • Part of the Department of Treasury. • Does not make tax law, but interprets and enforces laws passed by Congress.
© Joseph Novello 2016
97
Big Four • Four accounting firms responsible for the audits of most publicly traded companies. • These firms are: – Deloitte Touche Tohmatsu – Ernst & Young – KPMG – Pricewaterhouse Coopers
© Joseph Novello 2016
98
American Institute of Certified Public Accountants (AICPA) • Professional institute of CPAs in the US • Issued pronouncements on GAAP before FASB was created. • These pronouncements are GAAP unless overridden by subsequent FASB pronouncements.
© Joseph Novello 2016
99
Private Company Accounting and Auditing
© Joseph Novello 2016
100
Big Company vs. Small Company GAAP Pros • Implementing GAAP is expensive and time consuming. • Impact of implementing IFRS of totally domestic companies. Cons • Confusion due to different accounting standards. • What to do when a small company becomes a big company.
© Joseph Novello 2016
101
Private Company Financial Reporting Committee (PCFRC) • The FASB embarked on an initiative to further improve their standard-setting process. Under the initiative, the PCFRC was formed in June, 2006, and held its first meeting in April, 2007.1 • The PCFRC led to the creation of the “Blue Ribbon Panel.” • PCFRC’s primary objective is to provide recommendations to the FASB, as the FASB sets accounting standards for privately held enterprises.2 • Also considers the needs of private companies and their constituents of financial reporting.2 • A major concern is the impact of convergence of US GAAP and IFRS on private companies.3 1http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1218220151736 2www.pcrf.org 3
retrieved 10-1-2013
retrieved 12-4-2010
Journal of Accountancy, December 2010, pages 22-24 © Joseph Novello 2016
102
PCFRC Blue Ribbon Panel Report • The Blue Ribbon Panel issued recommendations in January 2011. • Concluded there “are urgent and growing systemic issues that need to be addressed.”1 • Panel believes “that the system has not done a sufficient job of”:1 – “understanding the information that users of private company financial statements consider...useful”1 – “weighing the costs and benefits of GAAP for use in private company financial reporting”1 1http://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2 FDocument_C%2FFAFDocumentPage&cid=1176158181336 retrieved 1-31-2011
© Joseph Novello 2016
103
PCFRC Blue Ribbon Panel Recommendations • “recommends a U.S. GAAP model with exceptions and modifications for private companies”1 • “recommend[s] that a separate private company standard-setting board under the FAF be established”1 • “the new board would consist of members that are representative of the private company sector and would work closely with the FASB”1 • “A cost-benefit analysis would be performed to take into account the costs to prepare, report on, and use the financial statements”.1 • 7,700 letters were sent to the FAF with the vast majority supporting the Blue Ribbon Panel recommendations.2 1http://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2F
Document_C%2FFAFDocumentPage&cid=1176158181336 retrieved 1-31-2011 2 Georgia
31-2011
Society of CPAs http://gscpa.wordpress.com/2012/01/31/january-2012-aicpa-board-meeting/ retrieved 1© Joseph Novello 2016
104
Private Company Council (PCC) On Wednesday, May 23, 2012, the Financial Accounting Foundation’s Board of Trustees approved the establishment of the Private Company Council (PCC), a new body to improve the process of setting accounting standards for private companies 1 1www.fasb.org/cs/ContentServer?c=Page&pagename=FASB%2FPa
ge%2FSectionPage&cid=1351027243391 Retrieved 10/1/2013 © Joseph Novello 2016
105
PCC’s Responsibilities The Private Company Council has two principal responsibilities: • The PCC and the FASB will agree on a set of criteria to decide whether and when exceptions or modifications to US GAAP are warranted for private companies. Based on those criteria, the PCC will review and propose exceptions or modifications to U.S. GAAP to address the needs of users of private company financial statements. • The PCC also serves as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda.1
1 www.fasb.org/pcc/aboutus © Joseph Novello 2016
Retrieved 10/1/2013 106
PCC Completed Project List1 • PCC Issue No. 13-01A, "Accounting for Identifiable Intangible Assets in a Business Combination“ • PCC Issue No. 13-01B, “Accounting for Goodwill Subsequent to a Business Combination” • PCC Issue No. 13-02, "Applying Variable Interest Entity Guidance to Common Control Leasing Arrangements“ • PCC Issue No. 13-03, "Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps" 1 http://www.fasb.org/pcc/projects
Retrieved 1/21/2015 © Joseph Novello 2016
107
PCC Current Project List1 • PCC Issue No. 14-01, Definition of a Public Business Entity (phase 2)
1 http://www.fasb.org/pcc/projects
Retrieved 1/21/2015 © Joseph Novello 2016
108
Private Companies and the CPA
© Joseph Novello 2016
109
CPA’s Types of Service • • • •
Audit Review Compilation Preparation
© Joseph Novello 2016
110
Review Engagement • The CPA can assist in preparation of financial statements. • The CPA performs review procedures that are lower in scope than a full audit. • The review procedures include inquiries, analytical analysis, and review of the financial statements’ conformance with GAAP. • CPA should obtain representation letter from the company's management to confirm the oral representations made during the course of the review. • The CPA opinion is form of a negative assurance. © Joseph Novello 2016
111
Accountant’s Report on a Review Engagement March 10, 20XX To the Board of Directors and Shareholders Easy Example Company We have reviewed the accompanying balance sheet of Easy Example as of December 31, 20X0, 20X1 and 20X2, and the related statements of operations, retained earnings, and cash flows 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 information included in these financial statements is the representation of the management. 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. Steady & Co. CPAs 1313 Mockingbird Lane Beverly Hills, CA 90210
© Joseph Novello 2016
112
Compilation Engagement • CPA firm assists in preparation of financial statements so they are associated with the financial statements. • The financial statements present management’s representations without review by the CPA as to their accuracy. • Therefore the CPA disclaims an opinion as to the fairness of the financial statements. © Joseph Novello 2016
113
Accountant’s Report on a Compilation Engagement March 10, 20X3 To the Board of Directors and Shareholders XYZ Company Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheets as of December 31, 20X2 and 20X1 and the related statements of income, changes in stockholders' equity, and cash flows for the years then ended, and the related notes to the financial statements in accordance with accounting principles generally accepted in the United States of America. We have performed a compilation engagement in accordance with the Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. We did not audit or review the financial statements nor were we required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, we do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements Steady & Co. CPAs 1313 Mockingbird Lane Beverly Hills, CA 90210 2015 © Joseph Novello 2016
114
Preparation Engagement Differences between a financial statement preparation engagement and a compilation engagement: •
•
Independence. If a CPA is not independent, it must be disclosed in the compilation report. No such disclosure is required for a preparation engagement. Report. A preparation engagement does not require a report. It requires either indication on each page of the financial statements indicating no assurance is provided or a disclaimer for the financial statements.
© Joseph Novello 2016
115
Accountant’s Legend on Prepared Statements Each page of the financial statement must include language stating no assurance is being provided. Examples • "No assurance is provided on these financial statements,“ • "These financial statements have not been subjected to an audit or review or compilation engagement, and no assurance is provided on them." If an accountant cannot include a statement on each page of the financial statements as described above, then a disclaimer must be issued clarifying that no assurance is being provided. Examples "The accompanying financial statements of XYZ Company as of and for the year ended December 31, 20XX, were not subjected to an audit, review, or compilation engagement by me and, accordingly, I do not express an opinion, a conclusion, nor provide any assurance on them." A signature line including the city, state and date would follow the disclaimer. Per Minnesota Society of CPAs Downloaded 10-19-2015 http://www.mncpa.org/publications/footnote/2015-06/SSARS-21-clarified-revised.aspx © Joseph Novello 2016
116
Key Numbers and Ratios
© Joseph Novello 2016
117
Key Numbers and Ratios • Various measures are used to evaluate a company’s financial performance: – Earnings per share (EPS) – Revenue and earnings growth – Financial ratios: liquidity, solvency, profitability
• It’s like using baseball stats to compare players. © Joseph Novello 2016
118
Compare These Players:
Who is the better hitter? © Joseph Novello 2016
119
Earnings per Share (EPS) • EPS = Net Income / Shares Outstanding • EPS growth is a key driver in stock price. • Compare these two stocks:
Source: Company annual reports, Yahoo Finance and Morningstar
© Joseph Novello 2016
120
Diluted Earnings Per Share Companies can have various securities outstanding that can potentially raise the number of shares outstanding. These issues include: • Employee Stock Options •Example: stock options exercisable at $10/share when the stock price is $15/share. • Stock Warrants – Similar to stock options, issued to investors rather than employees • Convertible securities •Example: convertible preferred stock or convertible bonds • These securities, if converted into common stock, would increase the number of shares outstanding and reduce EPS. • Diluted EPS accounts for these “dilutive” securities to show the impact on EPS. • Example : EPS = $1.05, Diluted EPS = $1.00
© Joseph Novello 2016
121
PE Ratio (Price/Earnings Ratio) • Compares the price of a stock to its earnings. • Shows how “expensive” a stock is. • Compare these two stocks:
Source: Company annual reports, Yahoo Finance and Morningstar
© Joseph Novello 2016
122
Revenue Growth • Revenue growth = Change in revenue over previous year revenue. • Key driver in stock price of “growth” companies. • Compare these two stocks:
Source: Company annual reports, Yahoo Finance and Morningstar © Joseph Novello 2016
123
Financial Ratios Helps to answer questions: – Liquidity - Does the company have the ability to meet its bills? Will there be a problem collecting receivables? Is the inventory obsolete? – Solvency - Does the company have the ability to pay its long-term debt obligations? – Profitability - How profitable is this company compared to others?
© Joseph Novello 2016
124
Liquidity Ratios Liquidity ratios measure a company’s ability to meet its short-term cash requirements. • This is done by looking at current assets and current liabilities. • Working Capital = Current Assets – Current Liabilities • Current Ratio – The ratio of current assets to current liabilities • Quick or Acid Test Ratio – The ratio of current assets less inventory divided by current liabilities © Joseph Novello 2016
125
Liquidity Ratios continued • Accounts Receivable Turnover – Measures how many times per year receivables turns over. • Accounts Receivable Days Outstanding – Measures the average number of days it takes to collect accounts receivable. • Inventory Turnover – Measures how many times per year inventory turns over. • Days Sales in Inventory – Measures the average number of days it takes to sell inventory. © Joseph Novello 2016
126
Liquidity Ratio Examples
Source: Company Annual Report. Assumes 10% of Costs of Sales and Services are for sale of inventory © Joseph Novello 2016
127
Solvency Ratios Solvency ratios measure a company’s ability to pay its long-term debt obligations. • Debt-to-Equity Ratio – Measures the amount of debt vs. equity used to finance a business. It is calculated by dividing long-term debt by long-term debt plus equity. An alternate calculation is long-term debt divided by stockholders’ equity. • Interest Coverage – Measures a company's ability to pay interest on its long-term debt by comparing interest expense to earnings. It is calculated by dividing operating income (earnings before interest and taxes) by interest expense. © Joseph Novello 2016
128
Solvency Ratio Examples
Source: Company Annual Report. © Joseph Novello 2016
129
Profitability Ratios • Profitability Ratios – Measure a company’s profits in relation to its sales and level of investment. • Gross Profit Ratio – Measures the amount of gross profit to revenue. • Operating Margin Ratio – Measures the amount of operating income to revenue. • Return on Sales – Measures the amount of net income to revenue. • Return on Equity – Measures a company's profit compared to its level of investment. It is computed by dividing net Income by average stockholder’s equity. © Joseph Novello 2016
130
Profitability Ratio Examples
Source: Company annual report. © Joseph Novello 2016
131
Yield • In this low-interest environment, yield is becoming a more important factor in determining a stock’s value • Yield = dividend/share divided by its stock price • Dividends are dependent on a company’s ability to generate earnings in order to fund its dividends • The Payout Ratio is a way to compare a company’s earning to its dividends • Payout ratio = dividend/share divided by earnings/share © Joseph Novello 2016
132
Yield Examples
Source: Company annual report. © Joseph Novello 2016
133
How Ratios Work Together
© Joseph Novello 2016
134
Industry Financial Ratios • Print – Almanac of Business and Industrial Financial Ratios – Industry Norms and Key Ratios – RMA Annual Statement Studies
• Electronic – – – – –
Research Insight Mergent Online Market Insight Hoover’s On-line Yahoo Industry Center
Source: The Biz Wiki http://www.library.ohiou.edu/subjects/bizwiki/index.php/Industry_Financi al_Ratios
© Joseph Novello 2016
135
Key Numbers and Ratios Exercise
© Joseph Novello 2010
136
Calculate the Key Ratios Below
© Joseph Novello 2010
137
Liquidity Ratio Examples
© Joseph Novello 2010
138
Solvency Ratio Examples
© Joseph Novello 2010
139
Profitability Ratio Examples
© Joseph Novello 2010
140
Present Value Concepts
© Joseph Novello 2016
141
Present Value Concepts • A dollar today is worth more than a dollar in the future. • Example: $10,000 in 10 years from now can be obtained with a $5,496 deposit in an account earning 6% per year. • “The Present value of $10,000 at 6% in 10 years is $5,496”. • “The Future Value of $5,496 at 6% in 10 years is $10,000”.
© Joseph Novello 2016
142
Business Valuations
© Joseph Novello 2016
143
Why Value a Business? • • • • •
Estate tax purposes Divorce To obtain credit To purchase or sell a business Expansion with new investors © Joseph Novello 2016
144
Business Valuation Methodologies • Industry “rules of thumb” – example X percent of revenue (See the Business Reference Guide, http://www.bvresources.com/bvstore/book.asp?pid=PUB01) • Stock price on organized exchange. Controlling interests demand a premium. Restricted stocks require a discount. • Financial modeling – Present value of projected cash flows • Excess earnings method • Comparison to similar business sales • Evaluation of assets and liabilities • Book value © Joseph Novello 2016
145
Business Valuation Tips • Often a business is worth more to a new owner than the current owner. • A new owner may bring things to the table that increases the value of a business, such as: – – – –
Economies of scale and reduction of expenses New sources of labor and material Lower financing costs Enhanced marketing opportunities
• The sum of the parts of a business may be greater than the whole. • Sellers should consider all of the above in negotiations. © Joseph Novello 2016
146
Capital Stock vs. Asset Purchase Capital Stock Purchase • Buying the capital stock of a company only buys the equity. • Liabilities still exist. • Possible contingent liabilities exist. Asset Purchase • Buyer does not assume the liabilities. © Joseph Novello 2016
147
Asset vs Stock Purchase
Buy the assets - Pay $500,000 for the assets, own it free and clear. This is called the “Enterprise Value”.
Buy the Equity – pay $200,000 and assume the debt. This is called the “Market Cap”.
Buying a company’s assets leaves the liabilities with the seller Buying the stock of a company just buys the equity, the liabilities still exist © Joseph Novello 2016
148
What to watch out for • Type of CPA service – Audit, Review or Compilation • Bias to increase or decrease income? • Independence of ownership vs management • Related party transactions • What direction is the business headed? • Problems © Joseph Novello 2016
149
Security Services Company Valuation Example Industry Rule of Thumb
• “Easy” method • Projections are not required • Accepted within a given industry • Ignores future prospects, can be good or bad Rule of Thumb per Business Reference Guide 2006 © Joseph Novello 2016
150
Security Services Company Example Income Statement Projection
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition © Joseph Novello 2016
151
Security Services Company Example Balance Sheet Projection
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition © Joseph Novello 2016
152
Security Services Company Example Cash Flow Statement Projection
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition © Joseph Novello 2016
153
Security Services Company Valuation Example – DCF (Discounted Cash Flow)
• Best theoretical method • Projections are key in determining value • High residual value can sway results • Longer projections have more uncertainty • Calculation of appropriate interest rates are important and can be complex © Joseph Novello 2016
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition 154
Security Services Company Valuation Example – DCF with Synergies
• This illustration assumes that the buyer could reduce cost of goods sold 20% • This increases the value of the company from $4.6M to $6.0M •This illustrates how a company could be worth more to a buyer than a seller
© Joseph Novello 2016
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition 155
Security Services Company Valuation Example – DCF 10 yr projection
• Lower value assigned to residual • More value assigned to cash flow • Longer projections have more uncertainty
© Joseph Novello 2016
Illustration developed by Joe Novello based on industry averages per Industry Norms & Key Business Ratios 2003-2004 Desk Top Edition 156
Security Services Company Excess Earnings Example
• Often used for professional practices • Projections are not required • Used in divorce cases. Since it ignores future prospects, the implication is that future earnings are not part of the divorce settlement • Interest rates are subjective, one of main criticisms of this method. Suggested rates are found in Revenue Ruling 68-609 © Joseph Novello 2016
157
Security Services Company Evaluation of Assets and Liabilities Example
• Method useful for an acquisition that will no longer continue as a going concern • Good when the alternative use of assets yields greater value that the existing business • Good for possible break up and liquidation • Can be used to supplement other methods to find value not inherent in other methodologies © Joseph Novello 2016
158
Security Services Company Comparable Companies Example
• Method establishes a market value of private, non-publicly traded companies • Use of the revenue to value ratio helps equate different size companies • Further refinement is possible to develop pro forma ratios, adjusting for positive and negative factors
© Joseph Novello 2016
159
Verizon Valuation Example
Source: Verizon 2011 annual report. Some items reclassified for course purposes. © Joseph Novello 2016
160
Verizon Valuation Example X
Note: This is an illustration only, NOT to be used as a valuation of Verizon © Joseph Novello 2016
161
Business Valuation References • Easy reading: Business Valuation for Dummies by Jim Bates • Good read, more thorough: The Small Business Valuation Book, 2nd Edition by Lawrence W. Tuller • Good reference of industry rules of thumb and other industry information: Business Reference Guide • Movie: Other People’s Money (1991). Danny DeVito and Gregory Peck debate break up value versus going concern value of a company during a takeover battle • Good online reference for lawyers: Law & Valuation. Financial Valuation in Legal Contexts, Wake Forest University School of Law, http://www.wfu.edu/~palmitar/Law&Valuation/toc.htm
© Joseph Novello 2016
162
The Lawyer’s Role in Financial Audits
© Joseph Novello 2016
163
Types of Auditor’s Report • Unqualified Opinion – as we have seen • Adverse Opinion – Report says the financial statements do not present fairly the company's financial performance. • Qualified Opinion – Includes an exception (“except for”) in the report as to the fairness of the financial statements or restriction of the auditor’s scope. • Disclaimer of Opinion – The auditor states that he or she cannot issue an opinion on the fairness of the financial statements. © Joseph Novello 2016
164
Sample Adverse Opinion
In our opinion, because of the effects of the matters discussed in the preceding paragraphs, the financial statements referred to above do not present fairly, in conformity with accounting principles generally accepted in the United States of America, the financial position of X Company as of December 31, 20X2 and 20X1, or the results of its operations or its cash flows for the years then ended.
Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf
© Joseph Novello 2016
165
Sample Adverse Opinion
Per Atlantic City Website 2013 annual Report retrieved 2/2/2016 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf
© Joseph Novello 2016
166
Sample Qualified Opinion GAAP Issue In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the preceding paragraph, the financial statements referred to above, present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, 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.
Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf
© Joseph Novello 2016
167
Sample Qualified Opinion Not Presenting Statement of Cash Flow The Company declined to present a statement of cash flows for the years ended December 31, 20X2 and 20X1. Presentation of such statement summarizing the Company's operating, investing, and financing activities is required by accounting principles generally accepted in the United States of America. In our opinion, except that the omission of a statement of cash flows results in an incomplete presentation as explained in the preceding paragraph, the financial statements referred to above, present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations for the years then ended in conformity with accounting principles generally accepted in the United States of America.
Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf © Joseph Novello 2016
168
Sample Qualified Opinion – Scope Limitation We were unable to obtain audited financial statements supporting the Company‘s investment in a foreign affiliate stated at $_______and $_______at December 31, 20X2 and 20X1, respectively, or its equity in earnings of that affiliate of $_______ and $_______, which is included in net income for the years then ended as described in Note X to the financial statements; nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in its earnings by other auditing procedures. In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to examine evidence regarding the foreign affiliate investment and earnings, the financial statements referred to in the first paragraph above, present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, 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. Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf © Joseph Novello 2016
169
Sample Disclaimer of Opinion The Company did not make a count of its physical inventory in 20X2 or 20X1, stated in the accompanying financial statements at $_______ as of December 31, 20X2, and at $________ as of December 31, 20X1. Further, evidence supporting the cost of property and equipment acquired prior to December 31, 20X1, is no longer available. The Company's records do not permit the application of other auditing procedures to inventories or property and equipment. Since the Company did not take physical inventories and we were not able to apply other auditing procedures to satisfy ourselves as to inventory quantities and the cost of property and equipment, the scope of our work was not sufficient to enable us to express, and we do not express an opinion on these financial statements. Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf
© Joseph Novello 2016
170
Piecemeal Opinions Piecemeal opinions (expressions of opinion as to certain identified items in financial statements) should not be expressed when the auditor has disclaimed an opinion or has expressed an adverse opinion on the financial statements taken as a whole, because piecemeal opinions tend to overshadow or contradict a disclaimer of opinion or an adverse opinion.
Per AICPA AU508 Retrieved 1/18/2012 http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00508.pdf
© Joseph Novello 2016
171
Generally Accepted Auditing Standards • General Standards – Training and proficiency – Independence – Due care
• Fieldwork Standards – Planning and supervision – Understanding the entity and its environment, including its internal control – Obtaining appropriate evidential matter © Joseph Novello 2016
172
Generally Accepted Auditing Standards continued • Reporting Standards – State whether financial statements are in accordance with GAAP. – Identify where principles are not consistent. – Disclosures are reasonably adequate unless stated in the auditor’s report. – Obligated to express an opinion on the financial statements or give reason why opinion can’t be given. © Joseph Novello 2016
173
Lawyers and Audited Financial Statements • Cooperative effort of the legal and accounting professions • ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information – December 1975 • Statement of Auditing Standards Number 12 – (Codification Section 337) - Inquiry of a Client’s Lawyer Concerning Litigation, Claims and Assessments- January 1976 © Joseph Novello 2016
174
Lawyers and Audited Financial Statements • “Section 337 and the ABA Statement of Policy provide for an exchange of information that should be understandable and acceptable to lawyers and auditors.”1 • Client consent is required. • Auditor’s goal is assessment of contingencies. • Auditors makes inquires to both inside and outside counsel. 1 Practitioners Guide to GAAS 2012, Steven M. Bragg © Joseph Novello 2016 175
Accounting for Contingencies (FASB ASC 450) • A loss must be recorded if – The amount can be reasonably estimated. – The loss is probable.
• Disclosure (in Notes) only is required if – Loss can’t be estimated or – Loss is not probable.
• Disclosure of an unasserted claim is required if – It is probable that the claim will be asserted. – There is a reasonable probability that the outcome will be unfavorable. © Joseph Novello 2016
176
Role of Finance in an Organization
© Joseph Novello 2016
177
Role of Finance in an Organization • Protector of Assets – responsible for a system of internal controls to protect a company’s assets. • Compliance with Laws and Regulations – Especially in the areas of taxation, securities law, licenses, and employment. • Relationship Management – plays a role in the management of relationships with suppliers, customers, and sources of finance. • Business Management – shapes business decisions and strategies, assessment of risk, and opportunity of business ventures. © Joseph Novello 2016
178
How Lawyers Add Value to the Financial Function of a Company • Protector of Assets – legal protection of company’s assets • Compliance with Laws and Regulations – add expertise • Relationship Management – relations governed by enforceable contracts • Business Management – Assess legal risks of business ventures © Joseph Novello 2016
179
Basic Concepts of Financial Investment
© Joseph Novello 2016
180
Basic Concepts of Financial Investment • Expected return increases with risk. • Diversification -- Don’t put all your eggs in one basket. • A dollar today is worth more than a dollar in the future.
© Joseph Novello 2016
181
Risk and Return
© Joseph Novello 2016
182
What Is Risk? • Risk is the probability that the expected return will not occur. – Example: A lottery ticket has a high risk in that the probability of winning is extremely low. – Example: A US treasury obligation has virtually no risk in that the probability of repayment is virtually certain.
© Joseph Novello 2016
183
Risk Versus Return High Return
Good Investment
Lottery Ticket
Bad Investment Low Return
US Treasury Obligation Low Risk
Risk
High Risk
Risk must be in proper proportion to potential return. © Joseph Novello 2016
184
Risk Versus Return High Return
Low Return Low Risk
High Risk
Example of use of risk vs. return graph From The Forbes ETF Advisor, March 2013, Page 4 www.fidelityinvestor.com Reproduced with permission © Joseph Novello 2016
185
Types of Risk • Market Risk – Decline in the value of the investment due to decline of the market. • Interest Rate Risk – Decline in the value of the investment due to an increase in interest rates. • Company Risk – The risk that the issuer of the investment fails. • Foreign Exchange Risk – The risk that an investment in a foreign denomination will decline due to changes in exchange rates. • Inflation Risk – Decline of the purchase power of the investment due to inflation. • Timing – Risk that the investment will be in decline when you need to cash it in. © Joseph Novello 2016
186
Modern Portfolio Theory: Diversification • Nobel Prize in Economics in 1990 awarded to William Sharpe, Harry Markowitz, and Merton Miller “for their pioneering work in the theory of financial economics” • Vary investments so that if one type does poorly, other types can compensate.
© Joseph Novello 2016
187
Illustration of Diversification • In the first graph we put all of our money in Investment 1. • In the second graph we put all of our money in Investment 2. • In the third graph half of our money is in Investment 1 and half in Investment 2. • By combining Investment 1 and Investment 2 into a portfolio, we diversify the portfolio and reduce risk. © Joseph Novello 2016
188
All money is put in Investment 1 R e t u r n
Kids start college, oh no!!!
Time © Joseph Novello 2016
189
All money is put in Investment 2 R e t u r n
Daughter is getting married, bad timing!!
Time © Joseph Novello 2016
190
Diversification: Money is split between Investments 1 and 2 R e t u r n
R e t u r n Time Note: This is a theoretical “perfect” example for illustration only! © Joseph Novello 2016
Time
R e t u r n Time
191
Compounding
© Joseph Novello 2016
192
The Power of Compounding In 1626, Native Americans sold Manhattan to Peter Minuit for $24. If the Native Americans invested the $24 at 6% compounded monthly, the $24 would have grown to $230 billion today. According to Answerbag.com, the value of Manhattan was $169 billion in 2004. © Joseph Novello 2016
193
Compounding for the Average Investor Example - You invest $2,000 per year in equal monthly installments over a 30-year period in a tax-sheltered IRA for your retirement. Assuming a 6% compound rate of return, in 30 years it will grow to $167,419. Example – If you waited 10 years and only invested for 20 years, your invest grows to only $77,007. Time is on your side in investing. By starting 10 years earlier, you invested $20,000 more, but gained $90,000 more © Joseph Novello 2016
194
Investment Features
© Joseph Novello 2016
195
Favorable Investment Features What investment has all of these favorable features? • Income – has periodic monthly income • Capital Gain – demonstrated history of steady gains • Risk – demonstrated history of very low risk • Liquidity – easy to dispose of • Tax Treatment – favorable capital gains rates • Management – no management for you, all the work done for you • Costs – very low, especially in relation to high returns © Joseph Novello 2016
196
Investment Features What investment has all of these features?
© Joseph Novello 2016
197
Assessing Investments • If it sounds too good to be true, it is!!! • You can’t maximize each feature of an investment. • You must look at your individual situation to see what is most important to you. – For example, people in retirement generally need income and prefer to avoid risk.
© Joseph Novello 2016
198
Financial Fraud Schemes
© Joseph Novello 2016
199
Figures don’t lie, but…..
© Joseph Novello 2016
200
Which company is doing better?
© Joseph Novello 2016
201
It’s the same company!!
The trick is cutting off the bottom of the graph!
© Joseph Novello 2016
202
Gains and Losses My friend told me, “I lost 40% in the market last year, but I gained 50% this year, so I’m happy”.
© Joseph Novello 2016
203
Gains and Losses Don’t be so happy, you’re still behind. You needed to gain 66% to recover from your 40% loss!!
© Joseph Novello 2016
204
Gains and Losses
© Joseph Novello 2016
205
Success rates The bus company says “We have a 95% on-time rate, use us and get there on time!!”
© Joseph Novello 2016
206
Success rates They could also say, “We have a 95% ontime rate; that means that we are late 5% of the time.” If you work 20 days a month, you will be late one day. A 99% on-time rate is the same as a 1% failure rate. That makes a 99% on-time rate 5 times better than a 95% on-time rate. © Joseph Novello 2016
207
Sound Familiar? This image cannot currently be display ed.
© Joseph Novello 2016
Reproduced with permission
208
Fun To Watch and Learn • Enron: The Smartest Guys in the Room – 2005 documentary about the Enron scandal – Well done, moves quickly, and explains the various business and accounting practices at Enron
• American Greed – CNBC series on financial crimes – Many episodes involve crimes such as art theft, counterfeiting, etc., but several episodes gave an excellent report in regard to WorldCom, Madoff, Tyco, etc. © Joseph Novello 2016
209
Financial Statement Fraud Schemes • • • •
Use “mark to market” to record phantom profits. Record expenses as assets. Recognize revenue prematurely. Swap sales of excess capacity, and each company records revenue. • Keep problems off the balance sheet. • Fake inventory: – Fool the auditors to show more inventory than actually exists. – “Sometimes auditors do not take the extra step of examining packed boxes. To inflate inventory, management stacks empty boxes in the warehouse”1 – Examples: Oil on top of water, move inventory between warehouses before the auditors arrive. Journal of Accountancy June 2001. http://www.journalofaccountancy.com/Issues/2001/Jun/GhostGoodsHowToSpot PhantomInventory.htm © Joseph Novello 2016
210
Companies with Stories • • • • • •
Enron WorldCom Qwest Sunbeam Global Crossing Allied Crude Vegetable Oil – “Salad Oil Scandal” • MF Global © Joseph Novello 2016
211
Appendices
© Joseph Novello 2016
212
IFRS
© Joseph Novello 2016
213
International Financial Reporting Standards (IFRS) • Comparing US GAAP to IFRS: “results between them are often the same or similar”1 (Ernst & Young) • GAAP has more “bright lines” rules while IFRS has more broad guidance, in particular, for revenue recognition. • Convergence of the two is a goal; the SEC has eliminated the requirement to reconcile IFRS results to GAAP. • “The movement towards IFRS [convergence] is still going forward, but the pace seems to be slower and less certain than it was before”2 (Robert Herz, Former FASB Chairman) 1 US
GAAP vs. IFRS The Basics - Ernst & Young January 2009, http://www.ey.com/Publication/vwLUAssets/IFRS_v_GAAP_basics_Jan09/$File/IFRS_v_GAAP_basics_Jan09.pdf retrieved 11/30/2010 2 The CPA Journal ,]February, 2011, page22
© Joseph Novello 2016
214
Current Topics
© Joseph Novello 2016
215
Impact on Debt Equity Ratio
© Joseph Novello 2016
216
Leasing - Old Rules • Criteria for capital leases called Bright Line Tests. • If a lease meets one of the criteria below it is recorded as a capital lease: • Ownership transfer to lessee at the end of the lease • A bargain purchase option exists • The lease term is 75% or more of the useful life • The present value of the lease payments is >90% of the fair value of the leased property © Joseph Novello 2016
217
What Is the FASB/IASB Proposal to End Avoidance of Capital Leases?
Virtually all leases are on the balance sheet.
© Joseph Novello 2016
218
Compounding
© Joseph Novello 2016
219
Consolidation
© Joseph Novello 2016
220
Consolidation • The old rule was that subsidiaries that were 50% or more owned were consolidated. • The new rule is that subsidiaries that are “controlled” are consolidated. • Many complex rules are used to determine “control”
© Joseph Novello 2016
221
Consolidation Why would a company want to avoid consolidating a subsidiary? • A subsidiary could have a large amount of debt that would hurt the debt/equity ratio.
© Joseph Novello 2016
222
Unconsolidated Example
Parent owns 49.9% ($3.75M) of subsidiary plus $3M loan © Joseph Novello 2016
223
Consolidation Example
Assumes Parent owns 50% of Subsidiary © Joseph Novello 2016
224
Fixed Income Investments
© Joseph Novello 2016
225
Fixed Income Investments • Fixed income investments are a loan that an investor makes to an issuer of that security. In return, the investor receives interest payments and the principal at maturity. • Government entities and corporations issue these securities in the form of bonds and notes, and banks issue them as Certificates of Deposits (CDs). • Mutual funds can also invest in fixed income investments. • Fixed income investments are generally less risky than stocks, but have lower potential returns. © Joseph Novello 2016
226
Fixed Income Risks • Interest Rate Risk – Decline in the value of an investment due to increase in interest rates. • Company Risk – The risk that the issuer of an investment fails and can’t pay you back. • Inflation Risk – Decline of the purchase power of the investment due to inflation.
© Joseph Novello 2016
227
Interest Rate Risk • Yield Curve – Generally, the longer the maturity, the higher the interest rate. •Example •10-year bond pays 4% interest •30-year bond pays 5% interest •This is because longer terms carry more risk •Keep in mind, however, there are times when this is not the case!
• Five years later, interest rates rise 3% for each bond. • The 10-year bond has 5 years to maturity and is now worth $9,168, an 8.3% decline • The 30-year bond has 25 years to maturity and is now worth $6,778, a 32.2% decline
© Joseph Novello 2016
228
Value of $10,000 Bond with 5% Yield, 25 Years to Maturity
B o n d V a l u e
If there is no change in market interest rate, the bond holds its value
If the market interest rate drop, the bond gains value
© Joseph Novello 2016
If the market interest rate climbs, the bond loses value $6,778
Market Interest Rate 229
Value of $10,000 Bond with 5% Yield at 8% Market Interest Rate
B o n d V a l u e
$9,717
The longer the time to maturity, the more a bond can lose value The shorter the time to maturity, the less a bond can lose value $6,778 Years to Maturity © Joseph Novello 2016
230
Interest Rate Risk Recap • Bond values move in the opposite direction of interest rates. • The longer the maturity, the higher the interest rate risk.
© Joseph Novello 2016
231
How to Reduce Interest Rate Risk • Hold bonds until maturity, then you get back 100% of the principal. • Avoid longer maturities. • Ladders - Have a portfolio of bonds of varying maturities that come due as you need the money. Also, you can roll over bonds in different years, sort of “dollar cost averaging” of interest rates. © Joseph Novello 2016
232
Laddering Example Two investors in 2005 have $100,000 to invest in fixed income investments. Investor 1 invests in 10 different bonds maturing from 2006 to 2015. Investor 2 invests in one bond maturing in 2010.
© Joseph Novello 2016
233
Laddering Example Example 1: Laddered maturities make money available to the investor every year, and allows maturities to be rolled over to new bonds over a period of time. This reduces the risk of rolling over when rates are low.
© Joseph Novello 2016
Example 2: The investor chose to select a 5-year maturity. This was an “average” maturity, but the money was subject to interest rate risk for 5 years and roll over opportunities are at historically low interest rates. 234