Attorneys in all practice fields need to know the basics of reading financial statements. Attorneys practicing Business or Bankruptcy law need to know how to read financial statements in order to properly value a business and business assets. Criminal law attorneys need to read financial statements in order to recognize and understand fraud and embezzlement. Family law attorneys will use financial statements for valuing assets. The following is a brief refresher on financial records and statements.
The Language: Financial Data
In accounting, like most fields of law, everything has to do with the language. Key terms or words give us the ability to understand what we’re looking at, almost immediately. Accrual or GAAP (Generally Accepted Accounting Principals), cash accounting as opposed to accrual accounting, and general versus subsidiary ledgers are all key terms I will expand on below.
The Accounting Basis
You must always start by asking, “With what accounting basis was this financial statement prepared?”
Accrual Basis Accounting: All companies on GAAP basis are required to be on accrual basis accounting. The Accrual or GAAP basis requires that public company financial statements apply the accrual method by matching expenses to revenue.
With accrual basis accounting, revenue is recognized when it is earned and expenses are recognized when they are incurred. Revenue is matched to expenses incurred to generate the revenue and there are no timing differences. All liabilities and related expenses are recognized when incurred and all receivables and related earnings are recognized when earned on an accrual basis.
Cash Basis: Smaller companies that do not have to provide financial information to third parties often use cash basis accounting. With cash basis accounting, revenue is recognized when it is received and expenses are recognized when they are paid. This requires only simple bookkeeping and is most common to small businesses. Unlike accrual basis, there is no matching of revenue to expenses which can result in time differences or delays and in some cases can be extreme and significantly affect the accuracy of any future financial analysis. Therefore, it does not provide a true picture of a company’s financial status.
Modified Cash Basis: Typically a tax basis accounting where a hybrid cash and accrual basis are usually used for tax returns.
The Literature: Financial Statements
There are various purposes of financial statements, including for reporting, monitoring, measuring performance, planning / projecting / modeling, and problem correction. Published financial statements have distinctive traits. They are internally generated, independently tested, and are for both public and private use.
Generally, these statements are not subject to independent scrutiny or auditing but, they are susceptible to bias. In litigation, you should always ask for loan applications and if you are on the defense, always protect your client from giving up loan applications. People are naturally biased, so stay high on revenue and low on expenses.
The types of information presented is defined by the user and the purpose. This information can be found in loan applications, tax returns and project financials. Quantum information discloses what one owns, owes and did during a specified period. Quantum information can be found on a balance sheet or an income statement, statements of retained earnings and statements of cash flows.
Balance sheets, or Statements of Financial Position at Particular Time, are the most comprehensive financial statements providing the most information. A balance sheet shows (1) what a company owns or the assets; (2) what the company owes or liabilities against the assets; (3) remainders including owners equity or retained earnings (equity goes up depending on how much is earned); (4) at a specific point in time. You must always ask, “Do assets equal liability plus equity?” If they don’t, there is a major red flag!
Non-Quantum information is useful financial information provided through accounting notes or management discussions and is user defined. Accounting notes may provide information about who is relied upon for funding.
Income statements show revenues and expenses during a specific period of time. An income statement will always have a beginning and an ending point. Typically produced at least once a year, income statements may be created monthly or quarterly and will reflect any business income losses over that period.
The Statement of Shareholder’s Equity explains the composition of the ownership and any changes since the last statement. The statement will begin with a balance at the beginning of the time period which adds net income or subtracts losses, deducts dividends, includes issuance of stock and other transactions that affect the shareholder’s equity and ends with a new balance.
Statements of cash flows explain where the money comes from by providing information on the sources and uses of cash that have come into and have left the entity. Cash flow is generated from operations, investing and financing or borrowed money. Other sources for income statements include tax returns for a proprietorship, partnership or corporation which show profits and losses from the business or profession and includes an income statement and a balance sheet.
Now that you understand the language of financial statements and the valuable information such statements provide, what do you do with all of this newfound knowledge and vast information? That depends on your clients needs or the details of each specific case. Always start by looking for red flags and make sure all statements are accurate.
How To Earn CLE Credit on this Topic
For additional information on this topic, Attorney Credits offers a course titled “A Lawyer’s Refresher: Financial Records & Financial Statements.”
The course is available for CLE credit in the following states: Alaska (AK) | Arizona (AZ) | California (CA) | Connecticut (CT) | District of Columbia (DC) | Illinois (IL) | Maryland (MD) | Massachusetts (MA) | Michigan (MI) | New Jersey (NJ) | Pennsylvania (PA) | South Dakota (SD)