Accounting and finance for lawyers in a nutshell, 5 edition

WEST’S LAW SCHOOL ADVISORY BOARD JESSE H CHOPER Professor of Law and Dean Emeritus, University of California, Berkeley JOSHUA DRESSLER Professor of Law, Michael E Moritz College of Law, The Ohio State University YALE KAMISAR Professor of Law Emeritus, University of San Diego Professor of Law Emeritus, University of Michigan MARY KAY KANE Professor of Law, Chancellor and Dean Emeritus, University of California, Hastings College of the Law LARRY D KRAMER President, William and Flora Hewlett Foundation JONATHAN R MACEY Professor of Law, Yale Law School ARTHUR R MILLER University Professor, New York University Formerly Bruce Bromley Professor of Law, Harvard University GRANT S NELSON Professor of Law, Pepperdine University Professor of Law Emeritus, University of California, Los Angeles A BENJAMIN SPENCER Professor of Law, Washington & Lee University School of Law JAMES J WHITE Professor of Law, University of Michigan I ACCOUNTING AND FINANCE FOR LAWYERS IN A NUTSHELL FIFTH EDITION By CHARLES H MEYER Senior Vice President Taxes and Senior Tax Counsel GE Capital Aviation Services Mat #41337719 II Thomson Reuters created this publication to provide you with accurate and authoritative information concerning the subject matter covered However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdiction Thomson Reuters does not render legal or other professional advice, and this publication is not a substitute for the advice of an attorney If you require legal or other expert advice, you should seek the services of a competent attorney or other professional Nutshell Series, In a Nutshell and the Nutshell Logo are trademarks registered in the U.S Patent and Trademark Office COPYRIGHT © 1995 WEST PUBLISHING CO West, a Thomson business, 2002, 2006 © 2009 Thomson Reuters © 2013 Thomson Reuters 610 Opperman Drive St Paul, MN 55123 1-800-313-9378 Printed in the United States of America ISBN: 978–0–314–28564–5 III To Joseph and Lisa Meyer V FOREWORD TO THE FIFTH EDITION The accounting world and accounting rules continue to change reflecting both changes in the business environment and refined thinking about how transactions and events should be presented in financial statements The fifth edition reflects the key developments that have occurred since the fourth edition As in the case of both the third and fourth editions, the FASB adopted further changes to the rules regarding transfers of receivables and servicing rights and obligations, which continues to be a hot topic Chapter has been updated to reflect these further changes Changes to the rules for the consolidation of “variable interest entities” were duscussed in the fourth edition Since then, the FASB has continued to refine these rules Since the rules regarding goodwill created in connection with business acquisitions were amended to require an annual quantitiative impairment review for goodwill rather than an automatic amortization of goodwill, companies have been concerned about the time and cost involved in performing these impairment reviews As discussed in Chapter 8, the FASB has introduced a new concept for testing goodwill VI A company now first undertakes a “qualitative” assessment to determine if it is more likely than not that an impairment of goodwill has occurred If that is not the case, it is not necessary to undertake the quantitative testing of goodwill for impairment The requirement to present total “comprehensive income” in addition to the traditional net income continues to receive focus by the FASB The FASB adopted new standards allowing companies to elect between preparing one continuous statement that presents both net income and comrephensive income or preparing two statements, one for net income and one immediately following that presents other comprehensive income and comes to a total that includes all the components of comprehensive income Aside from these substantive changes, one of the biggest developments in accounting in the United States was the issuance by the FASB of a codification of accounting standards that came out while the fourth edition was in production The individual FASB statements and interpretations and other sources of official accounting guidance in the United States have been incorporated into a consolidated set of accounting rules The FASB now periodically issues accounting standards updates that amend the codification The fifth edition has been revised to reflect the new citations to the codification There is also a cross reference table in the appendix that cross references between the old FASB (and APB) pronouncement VII numbers that were covered prominently in prior editions and the new codification references As always, I trust that this fifth edition will continue to provide law students, lawyers, and other readers with a sufficient understanding of the basics of accounting and finance so that they can better appreciate the significance of accounting and its importance in the commercial and legal world CHM Norwalk, CT October 2012 XXIII ACCOUNTING AND FINANCE FOR LAWYERS FIFTH EDITION IX OUTLINE FOREWORD TO THE FIFTH EDITION Chapter The Basic Financial Statements A The Balance Sheet Assets Liabilities Owners’ Equity The Balance Sheet Equation Balance Sheet Format B The Income Statement Revenues and Gains Expenses and Losses Format of the Income Statement C The Statement of Owners’ Equity D Statement of Cash Flows E Additional Information Footnotes Supplemental Disclosures Management’s Discussion and Analysis Audit Report Chapter The Accounting Process A Source Documents B Journal Entries C Ledgers and Posting D Adjusting Entries Accrued Revenues and Expenses a Accrued Revenues b Accrued Expenses X c Accounting for Actual Receipt of Payment d Reversing Entries Deferred Revenues and Expenses a Deferred Revenues b Prepaid Expenses Depreciation Expense Recognizing Cost of Goods Sold E Revenue and Expense Accounts F Closing the Books G Preparation of Financial Statements Chapter Generally Accepted Accounting Principles A Sources of GAAP Pre-Codification Official Pronouncements of the FASB and Its Predecessors a FASB Statements and Interpretations b APB Opinions c Accounting Research Bulletins d Enforcement of Official Standards Other Sources of GAAP B Governmental Regulation of Accounting SEC Regulatory Agencies C Income Tax Accounting D Some Fundamental Accounting Concepts Historical Cost Measuring Fair Value The Going Concern Assumption Yearly Reporting Revenue Recognition and Matching Conservatism XI Materiality and Cost–Benefit Analysis Chapter Recognition of Revenues and Expenses A Revenue Recognition Sale of Goods or Services Revenue From Services a Specific Performance Method b Proportional Performance Method c Completed Performance Method Long Term Contracts Revenue Recognized With the Passage of Time Revenue Recognized Based on Receipt of Cash Completion of Production interest Thus, the interest for year would be 6% of $106, or $6.36 and 503 the total interest with annual compounding is $12.36 Future Value of $1 The future value of $1 is the future equivalent value of $1 today One dollar available today will increase to a greater amount in the future as a result of the ability to earn interest on the $1 by investing it until the future date Thus, future value is the sum of the original principal amount plus the interest that accrues on that original amount over a designated period of time To illustrate, assume that you have $100 today and you want to know the future equivalent value of that $100 at the end of three years To compute the future value, you need to know the relevant interest rate to use in the calculations In this illustration, it is assumed that you can earn 6% interest on investments over the three-year period At the end of the first year, the original $100 will have grown to $106 This amount is computed by multiplying the original $100 by the sum of plus the appropriate interest rate expressed as a decimal Thus the calculation is $100 × 1.06 = $106 For the next year, the amount available to invest is not only the original $100, but the additional six dollars of interest earned in the first year as well As discussed above, the ability to earn additional interest on interest from prior periods is referred to as compounding Accordingly, at the end of the 504 second year, the original $100 will have grown in value to $106 × 1.06, or $112.36 Similarly, at the end of the third year, the original $100 will have grown in value to $112.36 × 1.06, or $119.10 From these calculations, it can be seen that the appropriate factor to compute the future value of $1 at the end of three years assuming an annual interest rate of 6% is 1.191 ($119.10/$100) This factor can be computed directly by multiplying 1.06 × 1.06 × 1.06, which can also be expressed as 1.063 More generally, the formula used to compute future value factors is (1 + r)n where r is the appropriate interest rate per period and n is the number of periods for which the money will be invested The known present value (PV) multiplied by this factor equals the unknown future value (FV) Expressed as a formula, future value is computed as follows: FV = PV × (1 + r)n Aside from performing the mathematical calculation each time a future value factor is needed, there are two primary sources for future value factors Many books have future value tables that give the future value factors for a number of different interest rates and different time periods The interest rates are listed on the top or side margin and the time periods are listed on the other margin The appropriate factor for use in a calculation is taken from the intersection in the table of the interest rate and the number of time periods (called compounding periods) A future value factor table is included at 505 the end of this appendix (Table 1) As can be seen, the future value factor for 6% interest for three periods is 1.191 A principal limitation of the table approach is that the factors are only provided for certain discrete interest rates and numbers of compounding periods Other factors can be estimated by interpolation between the closest factors given in the table The other primary source for future value factors are calculators or computers Most calculators and many computer software packages include built-in formulas for calculating the appropriate future value factor for any interest rate and any number of periods In many cases, interest compounds or is payable on a basis other than annually When that is the case, the procedures described above are applied except that the interest rate used in the calculations is the annual interest rate divided by the number of compounding periods during the year and the number of periods used in the calculations is the number of years multiplied by the number of compounding periods during the year After making these adjustments, the calculations proceed in the same manner as set forth above To illustrate, if the 6% interest in the example above is compounded quarterly, the future value would be computed using an interest rate of 1.5% (6% divided by 4) for twelve periods (three years multiplied by 4) Mathematically, the future value factor would be 1.01512, or 506 1.1956 Note that the effect of compounding on a more frequent basis than annually is to increase the future value factor Present Value of $1 The present value of $1 is the present equivalent value of $1 that is not available until some time in the future It is the amount that would have to be invested now so that at the end of the time period at issue, the amount invested plus accrued interest would equal the known future value The $1 that is available in the future is not worth as much as $1 available today because if you had the $1 available today, you would be able to earn interest on the $1 by investing it until the future date To illustrate, assume that you are offered $100 at the end of three years and you want to know the present equivalent value of that $100 (that is, how much you would be willing to receive today in lieu of the $100 at the end of three years) To compute the present value, you need to know the relevant interest rate to use in your calculations In this illustration, assume that you can earn 6% interest on investments over the three year period To compute present value, it is helpful first to review the future value calculation From the analysis of future value in Section 1, we know that the future value of $1 after three years assuming a six per cent interest rate is $1 × 1.063 If FV equals the future value and PV equals the present value, then FV = PV × 1.063 If you rearrange this expression, then PV = 507 FV/1.063 Accordingly, if the future value (the amount available in three years) is $100, the present value equivalent is $100/1.063, or $83.96 Thus, if you had $83.96 available to invest today and you invest it for three years at 6% interest, the total investment at the end of three years would be $83.96 × 1.063, or $100 We therefore say that the present value equivalent of $100 available at the end of three years is $83.96 More generally, the formula used to compute present value factors is 1/(1 + r) n where r is the appropriate interest rate per period and n is the number of periods for which the money will be invested As noted above in connection with future value calculations, many books have present value factor tables that give the present value factors for a number of different interest rates and compounding periods The appropriate present value factor is taken from the intersection in the table of the interest rate and the number of compounding periods A present value factor table is included at the end of this appendix as Table The present value factor in Table for 6% interest and three periods is 8396 As in the case of future value factors, most calculators and many computer software packages include built-in formulas for calculating the appropriate present value factor for any interest rate and any number of periods Where interest compounds on a basis other than annually, the same procedures are applied except 508 that the interest rate is the annual rate divided by the number of compounding periods during the year and the number of periods to use is the number of years multiplied by the number of compounding periods per year After making these adjustments, the calculations proceed in the same manner as set forth above Thus, if the 6% interest in the example above is compounded quarterly, the present value would be computed using an interest rate of 1.5% (6% divided by 4) for twelve periods (three years multiplied by 4) Mathematically, the present value factor would be 1/(1.015) 12 or 8364 Note that the effect of compounding more frequently than annually has the effect of decreasing the present value factor Future Value of an Annuity of $1 In some cases, a future value analysis involves a stream of equal periodic payments rather than just a single cash flow A string of equal periodic payments is called an annuity An example of an annuity would be where a parent decides to make a contribution of $1,000 to a child’s college investment fund at the end of each of the next ten years This creates a ten year annuity of $1,000 In order to determine the amount that will be in the child’s college fund at the end of the ten year period, we need to compute the future value of a ten year annuity To calculate the future value of this annuity, assume that the relevant interest rate is six per cent The annuity can be analyzed as ten separate 509 amounts of $1,000 each The sum of the future values of these ten amounts will be the future value of the annuity The $1,000 invested at the end of the first year will earn interest for nine years Therefore, using the procedures for calculating future value as discussed in Section 1, the future value of the first $1,000 payment at the end of the tenyear period will be $1,000 × 1.069, or $1,689.48 The $1,000 contribution at the end of the second year will only be invested for eight years The future value of the second contribution at the end of ten years will therefore be $1,000 × 1.068, or $1,593.85 This process is repeated for each payment until the last payment at the end of the ten year period The last payment will not be invested at all so that the future value of the last payment will be $1,000 The total of the future values of each $1,000 payment would be $13,180.79 This is the future value of an annuity of $1,000 per year for ten years at an interest rate of 6% per year Note that in the problem in the preceding paragraph, each payment of $1,000 is being multiplied by a future value factor The separate future values are then added to give the future value of the entire annuity An alternative approach to making this calculation would be to add the appropriate future value factors for each period in the annuity and then multiply this sum of future value factors by $1,000 Mathematically, this will produce the same result as the calculation of the separate future values 510 for each $1,000 payment and adding those future values Future value tables for annuities are prepared just as in the case of future values and present values of $1 The factors in these tables represent the future value of an annuity of $1 for the number of periods indicated and at the interest rate indicated A sample table of future value factors for annuities is included at the end of this appendix as Table Calculators and computer software also have functions that calculate the future value of an annuity The annuity illustrated above called for payments to made at the end of each year during the annuity period This is called an ordinary annuity or an annuity in arrears If the payments in the annuity are to be made at the beginning of each of the years in the annuity period, this is referred to as an annuity due or an annuity in advance As compared to an annuity in arrears, an annuity in advance gets one additional year’s interest on each of the annuity payments For example, the first payment of a ten year annuity in arrears earns interest for nine years but the first payment in a ten-year annuity in advance earns interest for ten years The last payment in an annuity in arrears does not earn any interest but the last payment in an annuity in advance earns interest for one year Most tables for the future value of an annuity give the future value for an annuity in arrears When using such tables to determine the factor for an annuity in advance, the 511 procedure is to look up in the table the factor for the period one greater than the actual number of payments in the annuity and then subtract one from that factor This can be illustrated using the factors in Table Assume that you want to determine the future value of a ten year annuity in advance at an interest rate of 8% The future value factor for an eleven-year annuity in arrears at an interest rate of 8% is 16.64549 Subtracting one from that factor gives 15.64549, the appropriate factor for a 10–year annuity in advance at an interest rate of 8% Similar adjustments must be made when using a calculator or computer software function, unless the calculator or software has separate functions for annuities in advance Present Value of an Annuity of $1 In many situations, it is necessary to determine the present value of an annuity For example, a proposed investment may be projected to produce an annual cash flow for a number of years If the cash flow each year is projected to be equal in amount, the returns on this investment constitute an annuity To determine whether this investment should be made, the present value of the annuity would be computed The present value of the annuity is the sum of the present values of the separate payments making up the annuity As in the case of the future value of the annuity, you can alternatively add up the present value factors for each year in the annuity and multiply the constant annuity payment by the sum of these present value factors 512 Tables are available that give the factors for the present value of an annuity of $1 for selected interest rates and selected terms for the annuity Based on the term of the annuity and the applicable interest rate, you determine the appropriate factor from the table and multiply that factor by the amount of the annuity payment Table at the end of this appendix gives the present value factors for annuities at a variety of interest rates and for a variety of periods Alternatively, special functions in calculators or computer software can be used to calculate the present value of an annuity based on any interest rate and any number of periods for the annuity The factors in the present value tables discussed above are normally based on the present value of an annuity in arrears Adjustments must be made to calculate the present value of an annuity in advance As compared to an annuity in arrears, the payments on an annuity in advance are discounted for one less period (since each payment occurs one period earlier as compared to an annuity in arrears) The last payment of a ten-year annuity in arrears is discounted for ten periods while the last payment of a ten year annuity in advance is discounted for only nine years The first payment in an annuity in arrears is discounted for one year while the first payment of an annuity in advance is not discounted at all To determine the appropriate present value factor for an annuity in advance from the tables for the present value of an annuity in arrears, you select from the tables the appropriate factor for one period 513 less than the number of periods in the annuity and then add one to that factor This can be illustrated using the factors in Table The factor for the present value of a ten-year annuity in advance at an interest rate of 12% would be the present value factor for a nine-year annuity in arrears at a 12% interest rate (5.32825) plus one, or 6.32825 Similar adjustments must be made when using a calculator or a computer software application unless they provide separate functions specifically for annuities in advance The formula for computing the present value of an annuity can be rearranged to produce different results For example, assume that you have $100,000 to invest You want to know the amount that you would have to receive as an annuity for fifteen years to earn an interest rate of 14% In the illustrations above, the annuity factor is multiplied by the annuity amount to compute the present value of the annuity In this case, since the present value of the annuity is known, you can divide this amount by the annuity factor to compute the annuity that would have to be received to produce the desired 14% return The factor for the present value of a 15–year annuity at an interest rate of 14% from Table is 6.14217 Dividing this into the present value gives the necessary annuity amount of $16,280.89 ($100,000/6.14217) 514 Irregular Cash Flows The discussion above relates to determining present or future values for a single amount or for simple annuities with an equal payment in each of the annuity periods Most present value and future value problems not present such simple cash flow patterns This section will discuss how to compute present and future values for more complicated cash flow streams One type of problem that is encountered frequently is a computation of the present value of a cash flow stream that includes an annuity for the life a project and then a terminal cash flow at the end of the project For example, the market value of a bond is the present value of the stream of stated interest payments on the bond (an annuity) plus the present value of the principal amount of the bond at the date of maturity To compute the present value in this situation, you simply compute the present value of the stated interest payments using the procedures for the present value of an annuity and then add to that amount the present value of the principal amount determined using the procedures for computing the present value of a single cash flow To illustrate, assume that a ten-year, $1,000,000 bond is issued with a stated interest rate of 8% payable semi-annually The actual yield on the bond is 10% The market value of this bond is the sum of two components The present value of the semi-annual interest payment of $40,000 is determined 515 using the factor for the present value of an annuity for 20 periods at a rate of 5% From Table 4, this factor is determined to be 12.46221 and the present value of the interest payments is $498,488.40 The second component is the present value of a single amount at the end of 20 periods at an interest rate of 5% (using 20 periods reflects the semiannual compounding on the bond) The present value factor for $1 received at the end of 20 periods at a rate of 5% is 35894 and the present value of the $1,000,000 principal amount is $358,940 The total market value of the bond is thus $857,428.40 ($358,940 + $498,488.40) A second type of problem occurs where none of the cash flows are equal There are multiple cash flows presented in the problem and the amounts of cash flow to be received or paid during each period vary In this type of problem, the present or future value must be computed separately for each cash flow and the sum of these separate present or future value calculations would be the present or future value of the uneven stream The third type of frequently encountered problem in future value/present value problems arises when the relevant stream of cash flows involves an annuity but the initial period of the annuity is not the current period Computing a present or future value in this type of problem involves multiplying the annuity by both an annuity factor and a single sum factor For example, a business might be reviewing 516 a project that involves a stream of cash flows that is structured as an annuity but that does not begin until some time in the future Assume that such a project generates a cash flow of $100,000 per year for twelve years beginning at the end of year five The present value of this annuity (assuming a 10% discount rate) would be determined in two steps First, the $100,000 annuity is multiplied by the present value of an annuity factor for twelve periods at 10% From Table this factor is determined to be 6.81369 and the present value of the annuity is $681,369 This, however, is the present value at the end of year four To determine the present value as of the present date, you must multiply the present value of the annuity by the present value of $1 at the end of four years at a 10% discount rate This rate from Table is 68301 and the present value of the annuity at the current time would be $465,381.84 ($681,369 × 68301) 517 Table Future Value of $1 518 519 Table Present Value of $1 520 521 Table Future Value of Annuity of $1 522 523 Table Present Value of Annuity of $1 524 525 APPENDIX C CROSS REFERENCE TABLE SELECTED ACCOUNTING STANDARDS COMPILATION EQUIVALENTS OF PRONOUNCEMENTS REFERENCED IN PRIOR EDITIONS Pronouncement ASC Reference FASB Statement No ASC 730 FASB Statement No ASC 450 FASB Statement No 13 ASC 840 FASB Statement No 48 ASC 605 FASB Statement No 52 ASC 830 FASB Statement No 87 ASC 715 FASB Statement No 88 ASC 715 FASB Statement No 106 ASC 715 FASB Statement No 109 ASC 740 FASB Statement No 114 ASC 310 FASB Statement No 115 ASC 320 FASB Statement No 123(R) ASC 718 526 FASB Statement No 129 ASC 505 FASB Statement No 130 ASC 220 FASB Statement No 131 ASC 280 FASB Statement No 133 ASC 815 FASB Statement No 140 ASC 860 and 405 FASB Statement No 141(R) ASC 805 FASB Statement No 142 ASC 350 FASB Statement No 144 ASC 360 FASB Statement No 150 ASC 480 FASB Statement No 153 ASC 845 FASB Statement No 156 ASC 860 FASB Statement No 157 ASC 820 FASB Statement No 158 ASC 715 FASB Statement No 159 ASC 825 FASB Statement No 160 ASC 810 APB Opinion No 28 ASC 270 APB Opinion No 29 ASC 845 527 INDEX _ References are to Pages _ No index entries found ... students, lawyers, and other readers with a sufficient understanding of the basics of accounting and finance so that they can better appreciate the significance of accounting and its importance in the... the financial accounting process should assist in understanding the accounting process and the issues that arise in the preparation of the financial statements A THE BALANCE SHEET The balance... Terms of a Lease Originally Treated as a Capital Lease C Special Rules Leveraged Leases Leases Involving Real Estate Sale/Leasebacks D Disclosures Regarding Leases Chapter 12 Accounting for Other