ALI-ABA Course of Study Accounting Concepts - A Primer for Lawyers May 17, 2012 Video Webcast Pre-Recorded February 6, 2012

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1 45 ALI-ABA Course of Study Accounting Concepts - A Primer for Lawyers May 17, 2012 Video Webcast Pre-Recorded February 6, 2012 Accounting Principles for Lawyers By Charles A. Borek The Borek Group, LLC Columbia, Maryland

Pre-Recorded February 6, 2012 Accounting Principles

2 46 ACCOUNTING PRINCIPLES FOR LAWYERS Charles A. Borek, Esq., MBA. CPA The Borek Group, LLC April 4, 2012

3 47 I. Accounting Concepts What is accounting? When does a person decide to become an accountant? When he realizes he doesn t have the charisma to be an actuary. Accountants and accounting have been the butt of jokes for a long time, and with good reason. The activity of accounting doesn t exactly inspire poetry or great drama, but it is an essential component of life in a commercial society, and lawyers of all stripes are well advised to have at least a passing acquaintance with the topic. Technically, accounting is defined as a systematic and rational method of recording and summarizing financial transactions, and analyzing, verifying, and reporting the results of those transactions. Although accounting uses numbers, it is not a science. Much like the law, there is nothing natural about accounting. It s rules and procedures are not natural, but were made-up by people just like you and me. That is not to say that accounting is random, but accounting is not math or engineering. The specific rules and methods that have been adopted are designed to achieve a specific purpose is a specific way. The point is that accounting is not discovered, it is made-up. Just as in the law, sometimes an accounting rule will outlive its usefulness or a better rule will be developed. As such, accounting, like law, is always changing. Because it is just an unnatural, made-up set of rules that does not constitute science or math or engineering, accounting is not precise. That s right accounting, contrary to popular belief, is not precise. The rules, in most cases, do not so much define a specific approach or application, but rather a range of possibilities. Within that range are subjective choices that accountants have to make. Consequently, two accountants could use the same set of financial data and produce two very different sets of financial statements, both of which are perfectly accurate in the accounting sense. Accounting is, in reality, nothing more than a communications art. It is a method of communicating information in a manner that makes it understandable and comparable. Accounting is a language and, like any other language, it has a number of different dialects. As one researcher put it: Financial accounting, as a language, imposes a structure on observed phenomena and reduces the uncertainty about the environment. Stanley C.W. Salvary, Accounting in the Context of Communication, Language, and Information Theories: a Partial Analysis, Washington University (paper on file at ideas.repec.org). Lawyers frequently draft documents or base agreements that hinge on accounting results, as if these results are somehow produced in a laboratory and can be objectively verified. Contrary to

The activity of accounting doesn t exactly inspire poetry or great drama, but it is an essential component of life in a commercial society, and lawyers of all stripes are well advised to have at

4 48 what most laypeople believe, financial auditors do not verify or certify financial statements as being accurate. Rather, what they do is verify that the financial statements appear to be consistent with the financial data accumulated by the enterprise. Business enterprises accumulate massive amounts of financial data in the form of invoices, receipts, bank statements, etc. Someone who is interested in the financial status of the business would find it inconvenient at best, and impossible at worst, to be saddled with the task of going through this amorphous mass of information to gain an understanding of what is going on. Instead, through the magic of accounting rules, we systematize and categorize this information, and then summarize it in the form of financial statements. Accounting is the funnel through which we interpret financial information. You can image a mass of data going into the top of the funnel. The systematic summarization of that information, the financial statements, come out of the bottom of the funnel. The rules and processes that we refer to as accounting is the funnel itself. So what sorts of information go into the top of the funnel? Financial information is generated in a variety of forms. There are invoices and receipts, statements with respect to various third party accounts, spreadsheets, checks, loan documents, etc. Each one of these things contains valuable financial information. The purpose of the accounting funnel is to channel all of those bits of data and summarize them into a set of financial statements. So what are the financial statements? They are simply a presentation of financial data, including accompanying notes, derived from the accounting records of the enterprise. It is important to note that the financial statements do not end with the numbers. The notes are not only an integral part of the statements, arguably they are the most important part. The financial statements are intended to communicate the entity s economic resources or obligations, as well as changes in the entity s economic resources or obligations, in conformity with some comprehensive basis of accounting. There are several sources for the comprehensive basis of accounting. The primary source used for financial accounting is what is referred to as generally accepted accounting principles or GAAP. While GAAP is perhaps the most widely used comprehensive basis for accounting, there are others. For example, international financial reporting standards, or IFRS, has become more prominent as the economy becomes more and more globalized. IFRS is the basis of accounting that is used almost everywhere in the world except in the U.S. Smaller companies in the U.S. frequently jettison the complexity of GAAP, particularly if they are not issuing audited financial statements. Oftentimes their financial statements are rendered on some other comprehensive basis of accounting ( OCBOA ), such as the cash or tax basis of accounting. The cash basis of accounting tends to be much simpler than GAAP because no

Business enterprises accumulate massive amounts of financial data in the form of invoices, receipts, bank statements, etc.

5 49 accruals are made and much of the judgment needed to apply the GAAP rules is done away with. Tax basis accounting is similar to the cash basis, with a few variations required by the tax code. Since a business tax return is likely necessary, many small businesses simply use the tax basis of accounting for all purposes, so that no special adjustments are necessary when preparing the tax return. Any departure from GAAP arguably results in less effective communication. The GAAP rules we are going to discuss in this course are designed to effectively communicate the true economic status of the enterprise. Tax accounting has a very different objective. The purpose of tax accounting is to report income consistent with the rules contained in the tax code, and the purpose of the tax code is primarily social engineering. As a result, the accounting rules designed to comply with the tax code really have nothing to do with communicating financial status, and thus are poor forms of communication. The problem is that GAAP is a one size fits all set of standards. As such, the rules necessarily have to be able to effectively address complex, multi-faceted problems. Many of the reporting issues of smaller companies, however, are not complex and multi-faceted. As a result, the small business community and the accountants who serve them often complain that GAAP is just too cumbersome for more modest, non-public enterprises. There have been some efforts to address this. The international accounting community developed what is known as IFRS for SMEs. SME stands for small and medium sized enterprises. This version of IFRS is greatly watered down and designed to be more approachable for non-public companies. Unfortunately, it has never really taken hold in the United States. More recently, the U.S. accounting profession has begun to explore the possibility of establishing a baby GAAP set of standards that, similar to IFRS for SMEs, would allow simplified accounting for non-public companies. Progress has been slow, but the project seems to have gained a lot of support from the accounting community. What is accounting information used for? Obviously, the owners of an enterprise have a vested stake in knowing what the financial condition of the enterprise is. From a business perspective, this information is needed for deciding what the capital needs are, analyzing the effectiveness and efficiency of expenditures. Owners also need information to comply with government regulations, such as tax return filing. Lenders and other creditors want to know what happening with a business so that they can make rational decisions about the extension of credit. Banks and businesses don t extend credit because they are kind and caring. Credit is extended for the purpose of increasing the income of the lender. It only works that way, of course, if the lender lends in an intelligent manner. The information communicated through accounting helps in this regard.

return. Any departure from GAAP arguably results in less effective communication.

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