Accounting 'Cheat Sheet'
Here are 10 tips to keep your company out of trouble

Stanley Siegel Corporate Counsel 10-08-2002

The mere mention of financial statements these days sends shivers down the spines of many corporate attorneys. Even before this year's debacles in accounting and financial disclosure, many lawyers doubted their ability to draw meaningful conclusions from these invariably complex and often ambiguous documents.

Today, with multiple revelations of accounting failures grabbing the headlines, forming these opinions has become even harder and more important. How should an in-house lawyer review the financial statements of his employer, and those of companies with whom his business is involved?

Here are 10 rules of the road.

1. Read the three principal financial statements closely.

The balance sheet discloses a company's financial position, usually at year's end. Assets, liabilities, and net worth are listed, according to established accounting principles. Note that items listed are at cost, not at their current values. To learn the real values of buildings, land, patents and other assets, look beyond the financial statements.

The statement of cash flows and statement of income reflect the company's financial performance. Cash flows are receipts and disbursements that track where the cash came from and went.

Net income is a complex accounting concept. Its components, income and expenses, are reflected only after all conditions for their realization have been met. A lawyer recognizes income, for example, when he performs the work and sends a bill.

Tip: Net income and positive cash flow are not the same. While "income" is an accounting concept, "cash flow" simply refers to how much cash came in and how much went out.

2. Pay attention to all the numbers, not just the bottom line.

Audited financial documents are prepared in accordance with Generally Accepted Accounting Principles (GAAP). These principles include year-to-year consistency of financial reports, full disclosure, and fairness of overall disclosure. But applying GAAP standards involves making choices among accounting principles, as well as judgments about their application.

Tip: The only way to draw reasonable conclusions from financial statements is to read them in detail and to understand what principles have been applied and what judgments have been made.

3. Study the notes to the statements.

Notes, an integral feature of the statements, contain detailed explanations of many of the items and specify the accounting principles that have been applied. Which inventory and depreciation methods did the company use? Is the company a party to material litigation? The answers are found only in the notes.

4. Compare the figures for prior years.

GAAP requires that financial statements cover at least the current and previous year; companies that file reports with the SEC generally provide summary data for the previous five years. Even a two-year comparison, however, can reveal salient facts about a corporation's status and direction. Have sales, expenses and net income increased or decreased? What's happened with cash, accounts receivable and inventories?

5. Understand the meaning of an audit report.

The audit report, prepared by an independent certified public accountant, uses standardized language to alert the reader to what the financials say, or don't.

Company management prepares the financial statements, chooses the accounting principles, and makes financial judgments. This means that management can, and usually does, prepare the statements to paint the most favorable picture of the corporation's financial position and results of operations -- meaning net income and cash flow.

Tip: Even though auditors provide reasonable assurance that financial statements contain no material misstatements and comply with GAAP, that's still no guarantee. Why? An audit is an examination based on tests and samples, not a full-scale investigation of every transaction. The reliability of audits has increased over the years, but no audit can provide absolute assurance.

6. Evaluate cash flow.

On the statement of cash flows, the cash flowing into and out of a company is divided into three areas: operations, investment, and financing. Cash from operations is a critical measure of a business's health: A company with a positive operating cash flow can usually stay afloat despite net losses. Conversely, negative cash flows from operations, despite profitable operations, may mean a critical cash shortage and possible insolvency.

Tip: Negative operating cash flow at an apparently profitable company calls for further investigation.

7. Calculate working capital.

No company can maintain its operations unless it can pay its debts. For a quick gauge of a company's health in this area, look at its working capital. To calculate this, subtract a company's current liabilities from its current assets. A company's current assets (including cash, accounts receivable and inventories) are assets that are expected to become cash within the year. A business's current liabilities are debts that must be paid in cash within the coming year.

Tip: A sharp decline in working capital indicates trouble.

8. Beware of unaudited, interim and pro forma statements.

It is not always practical to insist upon audited financial statements. Indeed, interim financial documents are routinely prepared with limited, nonaudit review, for the SEC or for other purposes. Similarly, so-called pro forma statements may be drawn up to reflect the position and results of a company division that is not separately audited. Pro formas also may be prepared to reflect the results of a transaction that will take place soon or that has just taken place.

Tip: These unaudited statements are inherently dangerous and should be handled by both the issuer and the user with great care.

9. Never rely on newspaper or analysts' reports; go to the source.

Understandably, corporate officers, financial analysts and others may wish to report on a company's financial position or performance in simple -- and often sharply defined (whether good or bad) -- terms. Often, these reports will restate earnings to eliminate certain selected expenses (so-called pro forma, or continuing, earnings), or will fail to disclose conditions affecting expected earnings or expected expenses.

Tip: It is dangerous to rely on such reports and to authorize or participate in their issuance. Any company counsel who does creates the risk of a claim of misdisclosure or fraud, even if the financial statements are in good order.

10. Conduct your own due diligence examination.

Readers of financial statements should develop a healthy sense of skepticism. Results that look too good or too bad, income or expenses that seem too high or low, or items that appear unusual by comparison with prior years or comparable companies all bear further investigation. A business that reports continued growth in net income, but a decline in operating cash flows, for example, should be viewed with skepticism.

Often, in-house counsel will be among the first to note questionable or even suspicious items. Direct inquiry can then be made of the company's own auditors. If appropriate, a partial or due diligence examination can be requested.

Considering the accounting scandals rippling through corporate America, company counsel are wise to take the initiative when reviewing questionable financial statements -- and make the effort to find out what the numbers really mean.

Stanley Siegel is a professor of law at New York University School of Law, where he teaches courses in business associations, accounting and finance. He is a certified public accountant and a member of the Committee on Law and Accounting of the ABA Section of Business Law. E-mail: ss3@nyu.edu.