Accounting for Lawyers Outline
Brooklyn Law School
Brooklyn Law School
I. General Accounting Definitions
Bookkeeping: Recording of financial data
Accountant: Creates a system
Accountant creates a system, bookkeeper fills in information, and accountant creates financial statements using the information.
Our focus will be on the income statement and the balance sheet. Income statement measures efficiency (i.e., profitability) of a business. Balance sheet measures status of a business.
Period convention: Measure efficiency and status at any point in the operation of the business (i.e., an interruption in the continuing life of the business)
Period is usually a year. Can be shorter.
Who is interested? Management, creditors, etc.
Under securities act, there must be annual statements in substantial detail (the period convention is a year). Quarterly statements must also be provided under securities law in less detail.
Entity convention: In law, individual proprietorship and partnership fall under "aggregate" theory (i.e., an aggregate of individuals). Corporations are an entity. In accounting, everything is an entity.
Assets: Everything that entity owns that has a money value. Valued at cost to the entity. Shown in order of liquidity (first current assets, then fixed assets). Current assets include cash and cash equivalents, and those things that will be converted to cash in the accounting period (e.g., cash accounts receivable, notes receivable, inventory). Fixed assets are things that will not be converted to cash in the accounting period, I think. E.g., machinery, office equipment, trucks/cars, building, land.
Liability: Includes current liabilities and long-term liabilities. Current liabilities (e.g., accounts payable, notes payable, tax payable). Long-term liabilities (e.g., mortgages payable, bonds payable). E.g., an obligation to render service (e.g., legal service), or where there is a sale of goods but not yet delivered, but payment has been received, that is a liability.
Proprietorship: Also referred to as vested proprietorship. Reflects owner's equity in the entity (i.e., owner's interest in the business).
Every other account is a variation of an asset, liability, or vested proprietorship.
E.g., revenue expense.
Basic Accounting Formula
A(ssets) – L(iabilities) = P(roprietorship)
A = L + P <- BASIC FORMULA FOR THE BALANCE SHEET
Owner invests $100.
Assets go up $100. Proprietorship goes up $100.
Entity borrows $300.
Assets go up $300. Liability goes up $300.
II. Accounting Cycle, and Modification of Balance Sheets By Using Journals and Ledgers
Journal: Collects transactional information chronologically. Also referred to as "book of original entry." Periodically, journal entries are "posted." Posted means transferring information to ledger account or T account.
Ledgers: Also referred to as "T accounts." Collects information by subject or category. Eventually, information in T accounts is summarized and used to create financial statements (income statement and balance sheet).
III. Double-entry bookkeeping
Increased by debiting. Decreased by crediting.
Decreased by debiting. Increased by crediting.
Decreased by debiting. Increased by crediting.
E.g., Revenue and expense are forms of proprietorship accounts.
Expense account is debited when incurred. Revenue account is credited when earned.
HYPOS: Remember, always consider from the entity's perspective.
1. Purchase of office furniture for cash.
Debit the asset "furniture." Credit the asset "cash." Swapped the asset furniture for the asset cash.
2. Purchase of office furniture for credit.
Debit the asset "furniture." Credit liability (liability going up).
3. Paying off liability with cash.
Debit liability (liability going down). Credit the asset cash.
4. Discharged an account payable with a note payable (more formal, a piece of paper stating). Substitution of one liability for another liability.
Debit the liability "accounts payable" (liability going down). Credit the liability in the form of "note payable" (liability going up).
(Makes it easier to bring action, since there is a note now, i.e., a contract; don't have to show the steps of delivering good, etc.)
5. Creditor investing in business and becoming part of business
Debit liability. Credit proprietorship (somebody getting more equity in the proprietorship).
6. Owner pulling cash out of the business
Debit the proprietorship. Credit the asset cash.
IV. Real accounts (e.g., the cash asset account) and a nominal account
Revenue and expense accounts are closed to become profit-and-loss ("P&L") account (a single debit or credit). The single resulting number goes to the proprietorship. Happens at the end of the period.
Temporary proprietorship or nominal accounts (e.g., revenue and expense). When closed, go to income statement.
An entity has sales of 100. Rent of 10. Salary of 20.
1. Regular Journal Entries
First entry: Debit Cash (A <- the type of account, here, "asset") 100. Credit Sales (R) 100.
Second: Debit Rent Exp (i.e., rent expense account) (E) 10. Credit Cash (A) 10.
Third: Debit Salary Exp (E) 20. Credit Cash (A) 20.
2. Posting the Regular Journal Entries
100 10 100
Rent Exp(E) Salary Exp(E)
3. Making the Closing Journal Entries at the end of the period (i.e., giving a zero balance)
Now, only temporary or nominal accounts are closed.
Debit Sales(R) 100 Debit P&L 10 Debit P&L 20
Credit P&L 100 Credit Rent Exp(E) 10 Credit Salary Exp(E) 20
(zero balances sales, (zero balances rent exp) (zero balances salary exp)
Result is a credit of 70 for P&L.
5. Debit P&L 70, then credit vested proprietorship 70. That is the result.
Resulting Income Statement
Revenues – Sale 100
Net Income 70
Proprietorship is unencumbered, with exception of investments in the business, withdrawals from the business, and net results from operation of the business.
A L P
May 25, 2006
-Think of the entity, nothing else. (E.g., doesn't matter where a proprietor got money from in investing that money to the proprietorship)
-Proprietorship is also referred to as a "vested proprietorship." Revenue and expense accounts are forms of "nominal" or "temporary proprietorship" accounts.
-When to use miscellaneous expense? Answer: If expense is infrequent, and nominal in amount, then use miscellaneous expense.
-The balance sheet shows the status of the business at a given point in time. Therefore, in a balance sheet, must specify the point in time.
-The income statement shows the efficiency of the business for a given period of time. Therefore, in an income statement, must specify the period of time.
-Short-life things, such as books (e.g., magazines) are expenses as opposed to assets. Therefore, it is important to ask how long is something going to last.
-Current assets: Those assets that are cash or expected to be turned into cash (expected to be consumed within the accounting period). Fixed assets: Not going to be liquidated in the normal course of the business. These assets will stay with the business.
-Current liabilities: Everything business owes which will be liquidated in the accounting period. Long-term liabilities: E.g., bonds, mortgages.
-Proprietorship tells a story. What happened to the business during the period.
May 30, 2006
-"Mistake" in page 42 of textbook: Jan. 4 transaction should read "the entity" or "the business" instead of "her note payable." Idea: Entity is something separate.
-"Closing" means closing the nominal or temporary proprietorship accounts to Profit and Loss (P&L). P&L is then closed to the vested proprietorship. For numbers to jot down in closing step, look at T-account (since they have been generated from the journal entries).
-"Formula" for income statements: Revenue + Expense = Net income or loss
-Trial balance: Simply collects balance in all accounts before closing. Makes it easier, possibly, to put together financial statements. Also shows all the debits and credits (and that they are equal). Does not tell you that each debit and credit was made correctly (e.g., debit and credit could have been swapped). Trial balance has very little meaning otherwise.
I. Tax Accounting
A. Period of a calendar year or a fiscal year (full year ending on any month other than December).
B. Two methods: Cash receipts and disbursements method of accounting (i.e., "cash method"). Accrual method of accounting. Different methods of accounting differ in when one recognizes revenue, and when one recognizes expenses.
Cash method (aka, in and out of pocket method)
Income, whether in the form of cash, property, or services, will be recognized or recorded in the period that they were actually or constructively received. Expenses will be recorded when the expenditure was actually made.
-Results in overstating/understating expense and income.
Income recorded in the period when all events have occurred which fix the right to receive the income (and the amount can be determined with reasonable accuracy). Expenses recorded in the period when all events have occurred which establish the fact of liability.
-More legalistic (since looking at when right is fixed), and yet more complex.
-Matching concept: Stated otherwise (in a simpler way) take the revenue earned in the period (i.e., the period that the revenue is earned) and match with the expense for the period (in the earning of that revenue).
1. "Accrue" income when earned but not received.
2. "Defer" income when received but not earned.
(e.g., in the first period, where payment is received before service is rendered, debit cash, credit "prepaid" or "deferred income," which is a liability account; in period two, debit liability (the liability real account has been expunged), credit "professional income" (don't jump to crediting proprietorship account, since proprietorship collects income/expense at the end of the period))
3. "Accrue" expense when earned but not paid.
4. "Defer" expense when paid but not incurred.
Summing it up in chart that illustrates the four possibilities under the accrual method (accrual/deferral of income/expense):
Period I Period II
A/R (A) Cash(A)
Sale(R)(when income is earned) A/R (A)
PPInc(L) ProfInc(R)(when income is earned)
Tel Exp(E)(when expense is incurred/earned) TelExpPayable(L)
PPRentExp(A) Rent(E)(when expense is incurred)
June 1, 2006
No notes taken.
June 6, 2006
-First inventory is the "opening" or "beginning" inventory. Ending inventory of this period becomes the opening inventory of the next period.
-Inventory is only an opening or closing item!!
June 8, 2006
Article 5 of the New York Business Corporation Law ("BCL"). We will work with the old BCL.
These are all synonymous:
-Stated Capital. Sometimes referred to as "Legal Capital."
Addit (additional) Paid in Surplus
This is how the proprietorship (shareholder equity) is broken down.
Representation of ownership of stock: shares.
Section 402 of BCL
Section 402 of BCL says what must and what may be in the certificate of incorporation.
1. Must state number of authorized shares
Corp comes into existence when cert of incorporation is filed with the Dept of State in Albany. Cert is then duplicated to the various county offices.
Authorized versus issued versus outstanding shares – different states
What is the share at this point? Authority given by state to the corporation to create a share (i.e., share is only authorized). Share is created when it is issued, i.e., sold or exchanged for a legal consideration. An outstanding share means that it is in the hands of a shareholder.
Common versus preferred stock
Preferred stock: Either has 1) preference to dividends, or 2) preference to assets on liquidation.
Generally, what does a shareholder own?
An undivided interest in every asset of the corporation.
Board of directors (defined by Article 7 BCL)
Elected by shareholders in annual meeting. Board – Fiduciaries who manage the business of the corporation.
Section 402 BCL
Must state the par value per share. Par value is discretionary.
Assets recorded in journal at cost, stated capital (i.e., stock) is recorded at par.
Stated Capital (S) 100 (assuming sold 100 shares at $1 par value/share)
Section 504 BCL
What is proper form of consideration that can be received by corporation upon issuance of original issue stock?
Can issue shares for:
Tangible or Intangible Property.
-Property had to be actually received (therefore cannot be delivered next week, as stated in 504(a)).
-Cannot receive note payable (as it is an obligation of subscriber under 504(b)) as consideration for the issuance of shares.
-"Services to be rendered" is now sufficient.
-Obligations of the subscribers are sufficient to issue shares.
New York has become liberal in this respect.
II. A Focus on Stated Capital (stated capital is obtained by selling shares)
What about selling shares at above par value (i.e., at a premium)?
Credit "Paid In Surplus." Difference is called a premium.
e.g., Selling 100 shares at $10 par value for $14, I think.
Cash (A) 1400
Stated Capital (S) 1000
Paid In Surplus (S) 400
Selling shares below par? Can't do this in NY. Breach of Section 504(c). Also, director would breach their fiduciary duty, would be jointly and severally personally liable; in addition, it would be a criminal violation per the Model Penal Code. Even directors who abstained from the vote in a decision to make this sale would be liable. Director would have to voice negative opinion to absolve them from liability.
Cash (A) 70
Discount on Share (S) 30
Stated Cap (Par) 100
Takeaway: Par value of stock has to be respected.
Contract/agreement to purchase stock in the future at a set price (not under par, of course). Prevents under-subscription. (Section 503 BCL, which is covered in Corporations, covers subscriptions.)
Example: 100 shares at $10 par value. Can be pre- or post- incorporation.
Subscription Receivable (A) 1000 (Separate capital structure account from trade accounts, which would be Accounts Receivable.)
Capital Stock Sub (i.e., Subscribed) (S) 1000
The balance sheet of PARTS A and B will look like:
Sub Rec 1000
S | H | E (Shareholder Equity)
Stated Capital (Authorized 1000 shares, Issued and Outstanding 100 shares, Par $10)
Capital Stock Subscribed 1000
Paid in Surplus 400
When money is received (to receive receipt of cash and issuance of shares):
Cash (A) 1000
Sub Rec (A) 1000
Capital Stock Subscribed (S) 1000
Stated Capital (S) 1000
The new balance sheet will look like:
S | H | E (Shareholder Equity)
Stated Capital (Authorized 1000 shares, Issued and Outstanding 200 shares, Par $10)
Paid in Surplus 400
III. No Par Value Shares of Stock
Owners of a corporation must respect the corporate entity for courts to recognize no liability to company owners due to the entity theory of a corporation.
Creating "watered stock"
Property (A) 130
Stated Cap (S) 130
To resolve this, early 1900 legislatures created the no par value share. Section 504(d) BCL.
Without par values, there still may be capital surplus (i.e., "Paid in Surplus" (a form of capital surplus)). Section 504(b) BCL: Total consideration goes to stated capital. Within 60 days of the issuance of the shares, (board can determine and authorize treasurer) any but not all may be allocated to capital surplus. Only caveat: If shares are preferred shares with a preference to assets (not a dividend preference), an amount equal to the preference must remain.
(Great flexibility intended by legislatures.)