While financial statements comprise balance sheets along with statements of income, cash flow and retained earnings, the balance sheet and the income statement are the most frequently available. Discovering what the balance sheet and income statement intend to present leads to more accurate discovery.
To prove economic damages, attorneys likely should analyze the defendant’s financial statements. While financial statements comprise balance sheets along with statements of income, cash flow and retained earnings, the balance sheet and the income statement are the most frequently available. Discovering what the balance sheet and income statement intend to present leads to more accurate discovery.
Before reading an income statement or balance sheet, one must understand the method of accounting used to prepare it to know what is included: the cash method will record items only if cash has been received or disbursed, and the accrual method will recognize items for which rights and obligations have arisen. But hybrid methods also exist. Under the cash method, no accounts receivable or payable appear because they have not been respectively received or paid.
The elements of a balance sheet are assets, liabilities and equities while the income statement reflects revenues less expenses resulting in net income. Definitions of these terms (except for net income) can be found at www.fasb.org under Statement of Financial Accounting Concepts No. 6. According the glossary to the Accounting Standards Codification, which provides generally accepted accounting principles, net income represents a measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses.
While printed summary financial statements are helpful to understand broadly the financial condition of the defendant, the most valuable discovery occurs, when appropriate, from the electronic detail beneath the financial statements. This valuable detail usually resides in the electronic general ledger and, if maintained, the related journals for cash, accounts receivable, payable and sales. Retrieving this electronic detail to enable discovery likely requires the services of a financial expert.
Of course the attorney wants to know the general ledger and financial statements derived from it represent what they purport to represent. Three common ways to assess the faithfulness of the financial statements and the general ledger are to 1. determine whether a CPA has prepared the financial statements; 2. determine if the general ledger agrees to the signed tax return; and 3. whether the bank accounts have been reconciled to the general ledger.
With regard to the financial statement preparation by a CPA, there will be a report from the CPA representing the level of assurance provided, from simple compliance with GAAP for a compilation at the minimum, through testing to assure overall fair presentation with an audit at the maximum. Usually the CPA provides footnotes to the financial statements to further explain the elements of the financial statements. These footnotes may be especially helpful to identify related party transactions which may not occur at arms-length values. The CPA-prepared financial statements can be tested against those produced from the general ledger provided.
With regard to the signed tax return (See “Discovering the Tax Return,” Texas Lawyer, March 9), the certification on the tax return as to it being true and correct forms the basis to compare it with the financial statements produced from the general ledger. On business tax returns, a reconciliation to the book income appears within the return within the “M” schedules.
With regard to the bank accounts, the financial expert will likely ensure, if feasible, that the general ledger has been reconciled to the bank accounts and especially that the payees on the checks are accurately reflected in the general ledger. Reconciling the general ledger assures the transactions in the bank account appear completely on the general ledger.
The revenue detail from the general ledger provides the details of the sales made and serves to corroborate productions of invoices and other sales records while allowing discovery of additional relevant sales.
Expense detail from the general ledger tells the attorney where money has gone and allows evaluation of whether it should have gone where it did.
Comparison between the recorded payees and categorization versus those reflected on the checks themselves provides additional verification when appropriate.
Net income from the general ledger goes directly to profits and the evaluation of lost profits. Lost profits calculations sometimes use the percentage profit of the defendant in lieu of the plaintiff, either at the net income level or at the gross profit level as appropriate. Additionally, unjust enrichment damages require the profits, either net or gross as appropriate, of the defendant.
The general ledger representation of assets and liabilities reveals amounts due to and from the defendant and the net assets available to satisfy the plaintiffs’ claims. Land and equipment are likely carried at historical cost, requiring evaluation of market prices. If assets have become impaired in value, such impairment should be recognized in accordance with GAAP.
Equity, or the difference between assets and liabilities, equals net worth. When net worth is required to assess economic damages, remember the value of assets in the financial statements will represent either historical cost or the estimated market value depending upon the account. For example land is typically stated at historical cost while inventory typically should be stated at the lower of historical cost or market. Financial statement adjustments would need to be made by a financial expert to determine net worth using fair value or market value.
Understanding what the financial statements intend to tell a reader helps the attorney develop more effective financial discovery and aids the determination of accurate economic damages.