WFU Law School
Law & Valuation
Chapter 2 - Risk and Return

Chapter 3 - Accounting Basics
(and Reading Financial Statements)

This chapter, a primer on financial accounting, is meant to acquaint you with the essential ways in which business information is prepared and presented, the important terms and vocabulary of financial accounting, and how accounting data is used in business valuation. You should get a sense for what accountants do and how they count the dots.

As Chapter 5 on business valuation reveals, many business valuation techniques turn on analyzing company financial statements prepared in accordance with generally accepted accounting principles. Although accountants and business valuators typically are the ones who provide expert advice on these issues, this chapter is meant to make you conversant with accounting terms and issues.


Count the dots?

Chapter Subsections
Problems

 

 

Professor Larry Cunningham identifies compelling reasons for this chapter:

A familiar pass-the-buck pas de deus in deal meetings occurs when the accountant says, after an impasse, "that's a legal problem" while the lawyer says "that's an accounting problem." The truth is, both are right; the trouble is, as Enron shows, prevailing professional cultures create a crack between law and accounting that resolute fraud artists exploit, not cultures that emphasize the intersection of law and accounting that should foil would-be fraudsters. As policymakers rush to respond to Enron, this perspective on law and accounting should be appreciated, as should Enron's place in soecity's parade of corporate debacles.

At Enron's core are accounting chicanery related to off-balance sheet financing and related party transactions, but in its penumbra are also colossal examples of governance, audit, and regulatory failure. Even in its accounting aspects, Enron is both an isolated example of fraud and epitome of systemic failure in the financial reporting and disclosure regime. It is another accounting scandal added to the sum of accounting scandals that evidences a broader dysfunction. While not in the league of the LBO, BCCI, or S&L debacles, Enron as an accounting scandal is the straw that broke the accounting camel's back.

Among possible regulatory responses are wresting the standard setting function from the profession of accounting and rendering accounting rules and standards matters of law, as is done in many countries. While such a bold move would surely constitute a huge power shift from accountants to lawyers, the effect on the competent business lawyer's practice would be more modest. Competent business lawyers already treat accounting principles as an important tool in their professional toolbox, even if by virtue of the manner and source of their present promulgation they are better understood as facts rather than law.

Despite the increasing role accounting plays in business law practice since the mid-1970s, accounting teaching in law schools has declined. First taught in 1950, professors at top schools rapidly published impressive books and the number teaching the subject gradually increased through 1975, its peak, and has decreased as steadily since. In 1975, 150 full-time law professors taught accounting while today only 96 do, a drop of 36% during a period when the number of law schools increased by 19% and the number of full-time law professors increased by 35%.

So beginning when accounting rose in practical importance to lawyers, the academy began to demote its significance in the law school curriculum. Reasons for the decline include the rising intellectual influence of modern finance theory. This theory's efficient market hypothesis discounts the relevance of accounting data in a world where financial analysts pierce the form of accounting reports to discover fundamental values wholly apart from accounting choices. In law schools, modern finance theory became the centerpiece of a rival course, corporate finance.

The string of accounting debacles culminating in Enron show the folly and fantasy of ECMH and modern finance theory. When coupled with the practice of business lawyers, questions beyond pedagogy arise, particularly the professional ethics of business lawyers. It suggests that the ethical duty of competence should require knowing some accounting. The professional literature concerning legal ethics offers a more equivocal answer. Yet all lawyers know that just because something is legal doesn't mean it is right. In the area of legal ethics, just because a duty can be technically discharged in a painless way, doesn't mean client interests are served.

LAWRENCE A. CUNNINGHAM, Sharing Accounting's Burden: Business Lawyers in Enron's Dark Shadows (2002) Boston College - LAC Working Paper No. 1 (reprinted in Business Lawyer).

Introductory web materials

There are additional introductory sources on the Internet

  • Accounting Over Easy - accounting terminology and financial statement presentation for small business owners, students, and board of directors
  • Motley Fool - how to read an annual report

ACKNOWLEDGMENT

The materials in this chapter have been adapted from Soderquist, Sommer, Chew & Smiddy, Corporations and Other Business Organizations (4th ed - 1997 / Appendix B, Reading Financial Statements).

The authors state --

Accounting is like parachute jumping. To be good enough to survive, you don't need much knowledge and skill, but what little you need is absolutely necessary . Here are the basics of jumping:

Stand up, hook up, shuffle to the door,
Jump right out and count to four.
If my chute don't open wide,
I got a reserve chute by my side.

Accounting can't be pared down this far, but this introduction to reading financial statements should be enough for a parachute jumper.

Chapter 2 - Risk and Return

©2003 Professor Alan R. Palmiter

This page was last updated on: March 25, 2005