Accounting and Finance for Lawyers

Class Info

Law School: Liberty University School of Law

Course ID: LAW 630

Term: Spring 2020

Instructor: Dean Todd

Books Used
  • Introductory Accounting, Finance and Auditing for Lawyers by Lawrence A. Cunningham
Journal

A journal is a chronological record of changes in a company's assets, liabilities, shareholders' equities, revenues, and expenses. These can then be added up to make a balance sheet.

To make a double-entries in a general journal, the three questions are:

  1. What has happened?
  2. Which accounts are affected?
  3. In which direction are the affected accounts?
Example

E.g., if someone contributes $5,000 in exchange for stock, and $2,000 is used to buy supplies, half on credit:

Account Debit Credit
Cash 5000
O/E 5000
     
Supplies 2000
Cash 1000
A/P 1000

O/E means owner's equity.

A/R means accounts receivable.

N/R means notes receivable.

A journal will include the entries for both the balance sheet and the income statement.

Balance Sheet

A balance sheet is an overview of assets, liabilities, and equities at a point in time.

Assets are increased by numbers in the left column and decreased by numbers in the right.

Liabilities and equities are decreased by numbers in the left column and increased by numbers in the right.

Before creating a balance sheet, an income statement must be closed so that the profit and loss can be assessed.

Income Statement

An income statement is a summary of revenues and expenses.

Revenue

Revenue is a generation of equity from selling goods or rendering services in one's line of business.

Expense

Expenses are costs incurred by a business without receiving an equivalent asset in order to generate its revenue.

Revenues are decreased by numbers in the left column and increased by numbers in the right.

Expenses are increased by numbers in the left column and decreased by numbers in the right.

P&L Account

To close out an income statement, a nominal account called a profit and loss account is created.

When a period is closed out, this P&L account is closed out by decreasing/increasing the income statement entries to 0 with a new entry on the opposite side and a P&L entry on the first side.

The P&L account will then be closed out and added to equity.

Example
Account Debit Credit
Cash 5000
Fee Revenue 5000
     
Fee Revenue 5000
P&L 5000
     
P&L 5000
Owner's Equity 5000

After calculating the income statement and P&L account, the balance sheet can then be made.

Deferred Revenue

Revenue for services not yet rendered cannot be entered be entered as Revenue when it is paid. Instead, a Deferred Revenue liability account must be increased. When the service is rendered, this account is then decreased and the Revenue account is increased.

Example
Account Debit Credit
Cash 1000
Deferred Revenue 1000
     
Deferred Revenue 1000
Revenue 1000
COGS

"COGS" is an abbreviation of "cost of goods sold."

Perpetual Inventory System

A perpetual inventory system just adds journal entries as soon as goods are purchased and sold.

A purchase decreases Cash and increases Inventory by the purchase price.

A sale increases Cash and Sales (Revenue) by the sale price and decreases Inventory and increases COGS by the purchase price of the goods.

Periodic Inventory System

A periodic inventory system only logs COGS entries on fixed dates.

A purchase still immediately decreases Cash and increases a Purchases account by the purchase price.

A sale increases Cash and Sales (Revenue) by the sale price.

Then, on a fixed date, the Inventory is reassessed, and the cost of goods sold during the period is calculated by adding the beginning Inventory and the Purchases and subtracting the ending Inventory. (It's the consumed inventory.)

The purchase price for COGS has various ways of determination:

Specific Identification Method

The specific identification method looks at the actual cost of purchasing/producing the exact good sold.

Cost Flow Assumption Method

There are three ways of assuming cost flows:

FIFO

FIFO stands for "first in, first out." The goods purchased the longest ago are assumed to be sold first.

FIFO is more accurate for balance sheets as the assets left at the end of the month are closest to the current price of purchasing them.

LIFO

LIFO stands for "last in, first out." The last goods purchased are assumed to be sold first.

LIFO most accurately reflects the costs at the time of sale and is thus most accurate for the income statement. However, this messes up balance sheets.

Average

The third possible assumption averages the costs.

Gross Profit

Gross Profit is equal to Sales minus COGS.

Fixed Asset

Fixed assets are assets that will be used for more than one year.

Such assets should be depreciated to better reflect their expense.

Depreciation

Depreciation is allocating the upfront cost of an asset over multiple years to better match its cost of the asset against when its benefit is acquired. This is basically consuming the asset through wear and tear.

Depreciation goes from the historical cost to the scrap value over the asset's expected useful life.

Delivery, installation, and improvement costs are included in an asset's historical cost amount.

Scrap value is what the asset can be sold for at the end of its useful life.

Depreciation must be accounted in contra accounts to avoid messing up the historical costs of assets on the balance sheet.

Contra Account

A contra account is an account that keeps track of the depreciation or bad debt expense that accumulates for an asset.

A credit to a contra account essentially decreases the value of the opposed asset while keeping the original value.

Example
Account Debit Credit
Equipment 10000
Cash 10000
     
Depreciation Expense 2000
Accumulated Depreciation 2000
     
Cash 9000
Accumulated Depreciation 2000
Equipment 10000
Gain on Sale 1000

On the balance sheet, the accumulated depreciation will be listed below the fixed assets, and the resultant book value under that.

Account Amount
Equipment 9000
Accumulated Depreciation 1000
Book Value 9000
Straight Line Method Depreciation Expense = Cost − Scrap Value Useful Life
Sum of the Years' Digits Method

SYD depreciation multiplies the cost minus the scrap value by a fraction based on the years.

Example Fractions Over Five Years 5 + 4 + 3 + 2 + 1 = 15
  • Year 1: 5 15
  • Year 2: 4 15
  • Year 3: 3 15
  • Year 4: 2 15
  • Year 5: 1 15
Double Declining Method

The double declining method depreciates by taking the percent of the useful life the year is, doubling it, and multiplying it by the opening balance.

  • Note that unlike the others, scrap value does not change this depreciation every year. It just cannot depreciate it below such value.
Example
Year Historical Cost Opening Balance Depreciation Expense (20%) Accumulated Depreciation Book Value
1 $100,000 $100,000$20,000$20,000$80,000
2 $100,000 $80,000$16,000$36,000$64,000
3 $100,000 $64,000$12,800$48,800$51,200
4 $100,000 $51,200$10,240$59,040$40,960
5 $100,000 $40,960$8,192$67,232$32,768
6 $100,000 $32,768$6,554$73,786$26,214
7 $100,000 $26,214$5,243$79,028$20,972
8 $100,000 $20,972$972$80,000$20,000
9 $100,000 $20,000$0$80,000$20,000
10 $100,000 $20,000$0$80,000$20,000
Receivable

To match the expected bad debt of accounts receivable, a contra account for such allowance should be created.

When debts actually become bad, the contra account is closed and removed from the Accounts Receivable account.

Example
Account Debit Credit
Accounts Receivable 100000
Fee Revenue 100000
     
Uncollectible Accounts Expense 4000
Allowance for Doubtful Accounts 4000
     
Allowance for Doubtful Accounts 4000
Accounts Receivable 4000
Intercompany Ownership
Debt
Held-to-Maturity Debt

Held-to-maturity debt is debt expected to be held until the debt is paid off.

Held-to-maturity debt is reported at cost.

Trading securities and other forms of debt are measured at fair value on the balance sheet.

Equity Security

For equity securities of less than 20% ownership, cost or fair value methods are used.

For equity securities of between 20% and 50% ownership, equity method accounting is used.

Equity Method

The equity method of account reports investments at cost and then adjusts according to the the investor's proportionate share of the investee's earnings and losses.

For equity securities of greater than 50% ownership, the books are merged. All the assets and liabilities of the subsidiary are reported on the books of the parent company.

Lease
Operating Lease

An operating lease gives the lessee the right to use some property for a period of time, but he has no ownership in or obligation for the property.

Capital Lease

A capital lease reports leased property as an asset and the payment obligations as a liability on its balance sheet.

This is not ideal as it makes one's debt ratio bigger.

Under GAAP, a lease must be reported as a capital lease if one of the following conditions is met:

  • The lessee gets ownership at the end of the lease term.
  • The lessee has the right to purchase the property for a "bargain price"—one dramatically below any possible sense of the asset's market value.
  • The lease covers at least 75% of the property's useful life.
  • The lease payments amount to at least 90% of the fair market value of the property.

To close out a P&L account to a capital account, debit the P&L account and credit the Retained Earnings. (No longer called Owner's Equity.)

Dividend

To pay out a dividend, debit the Retained Earnings account and credit the Cash Dividend Payable account. When it is actually paid, debit that and credit Cash.

Large Stock Dividend

If a corporation pays out a dividend in stock of at least 20% of the recipients', dividends are recorded according to the par value.

Small Stock Dividend

If a corporation pays out a dividend in stock of less than 20% of the recipients', dividends are recorded according to the market value (divided into the stock according to the par value and the Additional Paid-in-Capital).

Gross Profit Margin

A company's profit margin is its gross profit on sales divided by its net sales.

Gross Profit on Sales

Gross profit on sales is a company's net sales minus its cost of goods sold.

Profit Margin

A company's profit margin is its income divided by its net sales.

Cash Flow

Cash flows show a business's increase or decreases in cash.

Cash flows are divided into three categories based on their origins:

  1. Operating activities
    • The normal ways you get money
    • Includes the receipt of interest and dividends
  2. Investing activities
    • Purchases and sales of securities, investments, loans to others, and the purchase and sale of fixed assets
  3. Financing activities
    • Borrowings, issuance of stock, and repayments and dividends related to such

It can either be done by the direct method, where all journal entries are just classified when entered, or it can be done by the indirect method, where all non-cash income is taken away from net income.

To find the indirect income, take the net income and add back:

and subtract out:

  • Increases in assets
  • Decreases in liabilities