March 27, 2020 Practice Points

The Basics of Accounting for Lawyers: Part 1—Understanding Financial Statements

Some simple concepts and tools that can be applied in your practice.

By Kevin Kwan

Welcome to the first of a three-part series created to help attorneys unlock what may be a black box called “accounting.” I’m sure each of you know your particular area of law really well but still sometimes find it difficult to answer what appears to be a simple question because of all the nuances behind the answer. Well, it’s similar with accounting. With that in mind, I’ve tried to identify a comprehendible framework for you to understand.

My goal is to provide you with the basics of accounting so that you have some fluency when making discovery requests and engaging opposing counsel on accounting and financial issues, while also understanding when you might need a little more help from accounting professionals.

What are the Accounting Issues for Lawyers?

First, it is important to understand how accounting can be applied in your practice. Some examples of practical applications for accounting are:  

Business Valuation

Exposure Damages

Solvency Analysis

Financial Reporting

Cost Allocations

Financial Due Diligence

Lost Profits and Lost Income

Fraud Investigations

Future Costs

Forensic Accounting

Representations and Warranties Claims

Reasonable Royalty Calculations

Viability of Proposed Reorganization Plans

Liquidated Damages

 

There are a number of approaches, all applying numbers and accounting, to establish an opinion for the court and trier of fact to rely upon, which will be covered in part 3 of our series.

Financial Reporting

Financial reporting is expected to provide information about an enterprise's financial performance with a focus on the financial position, earnings or income, and the cash flows or how cash is utilized during a period. Financial reports are useful for making business and economic decisions. To fully have a handle on financial reporting, you need to know about the accounting information used in financial reporting and the three most common types of financial reports.

Accounting Information Systems

Accounting data, the key to accurate financial reporting, is typically captured and accumulated in the ordinary course of business by recording transactions in accounting software. Every financial transaction results in an accounting entry that is captured in the company’s general ledger, which contains detailed data such as the date, amount, expense type, and a description of each transaction. Examples of transactions that trigger a general ledger entry include supplies purchases, shipments or receipt of goods, sales of goods or services, employee wages and salaries, and many, many more. Amongst smaller businesses, one of the most popular accounting platforms is QuickBooks. Larger businesses utilize enterprise software such as Oracle NetSuite, SAP, or Sage.

Accounting software contains reporting capabilities that utilize the general ledger data to generate financial reports and also includes capabilities to create subledgers (i.e., cash disbursement, cash receipts, payroll, account receivable, etc.). The most commonly referenced reports are the three key financial statements: income statement, balance sheet, and statement of cash flows.

The income statement, or profit and loss statement, represents the results of operations of a given entity over a period of time. What did we earn over the period and what are we on the hook to pay out?  The following is an example of an income statement:

An income statement provides the results for fixed period of time, which could be one month, quarter, or year. Note that the income statement title conveys the relevant period, one year in the example above.

The income statement reflects, in simple terms, what did we sell and how much did it cost to sell it?   Revenue represents the amount earned from selling goods and services. The cost of goods sold represents the direct cost of the goods and services—i.e. the labor, materials, and direct overhead, such as a manufacturing facility, freight, etc.

Other operating expenses represent general costs or overhead, which can’t be directly attributed to sales—for instance the “Selling, General and Administrative Expenses” line could include advertising costs, accounting department salaries, repairs and maintenance, and costs associated with the building that aren’t attributed to the manufacturing process, etc.

When you deduct these costs from the revenues, it results in operating income, which is a reasonable measure of the operations of the business. Net income takes into consideration other revenues and expenses that are unrelated to the operations of the entity (e.g., interest income or expense, taxes, etc.). 

In the second part of our series, we will discuss balance sheets, statements of cash flows, and financial analysis.

Kevin Kwan is a managing director in the Global Disputes and Economics practice at Ankura in their Tamps, Florida, office.


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