I studied business in college, but I never intended to become a businessman.
I wanted to be a lawyer. I saw business school as a forgettable prelude to my real education in law school. It never occurred to me then that the knowledge I was gaining in business school – especially in accounting – would be so critical to my future legal career. The following are basic accounting concepts I use on a regular basis in my business litigation practice:
1. The Profit/Loss Statement
A profit/loss statement (or income statement) shows a company’s revenues, expenses, and bottom line net income for a given period of time. While reading a profit/ loss statement, it is important to understand the difference between cash basis and accrual basis accounting. With cash basis accounting, a company recognizes revenue when it receives a payment and recognizes an expense when it makes a payment. With accrual basis accounting, a company recognizes revenues or expenses when the right to receive or obligation to make those payments accrues – even if the payments will not be made until a later date. Most companies use accrual basis accounting for their internal books, but they use cash basis accounting for their tax returns. As a result, a profit/loss statement and tax return for the same company during the same period may tell very different stories, depending on how many unpaid customer invoices and outstanding expenses a company has on its books that do not appear on its tax return.
2. The Balance Sheet
A balance sheet has two sides – one side lists assets and the other side lists liabilities and owners’ equity. Total assets must equal total liabilities plus owners’ equity. If the two sides do not “balance,” something is missing, and you will need to request more documents and information in discovery or from your client to get a complete picture.
Another thing to keep in mind, especially in cases involving valuation disputes, is that a balance sheet does not necessarily reflect the value of a company or its assets for the purposes of a lawsuit or potential sale. The balance sheet represents the “book value” of a company’s assets. The book value of an asset is the amount of money the company originally paid for the asset less accumulated depreciation. The Generally Accepted Accounting Principles (GAAP) include formulas for calculating depreciation. The depreciation of an asset calculated according to GAAP may not be the same as the actual value the asset has gained or lost in the real world. A company’s assets could be worth a lot more or less on the open market (fair market value) than the balance sheet shows (book value).