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The Professor Nedley Series
Simple Courtroom Accounting In Family Law
By Edward B. Huntington
July 1, 2006
Basic accounting in the Family Law courtroom serves certain essential functions such as cash flow calculations for support purposes and business valuations. This short accounting guide offers a summary of accounting principals for those who don't understand accounting. The worst thing an attorney or litigant can do is bring in a stack of bank statements or bills or any clutch of financial receipts and expect that the judge can convert that to useable evidence. Always have an accountant put these "stacks" into intelligible reports.
The starting point is the double entry system of debits and credits. No matter how complex the accounting reports, they ultimately stem from double entry accounting, meaning that for every debit entry there must be a balancing credit entry or entries.
The reports with which we are concerned are the Profit-Loss Statement, the Balance Sheet, the Cash Flow analysis (if any) and the attendant supporting journals and input sources.
A closely related report which is an offshoot, but not an integral part of the financial reporting system, is the Tax Return and its supporting schedules.
The Judge’s concern stems from a need to understand when intentional manipulation or innocent distortion can and does take place and how it affects the overall reporting.
An example of innocent distortion is the deduction of the not-so-fictional expense of depreciation or the non-deduction of legitimate business loan payments (only the interest is allowed).
A not-so-innocent distortion would be the purchasing of inventory, a future source of cash, but, which presently increases costs and reduces net profit.
There is also the more rare occurrence of flat-out, false reporting and incorrect journal entries.
The sole purpose in this report is to show the interrelationship in the reports, explain the mechanics of double-entry bookkeeping, point out certain common areas of distortion and provide a road map for reading a tax return.
B. Basic Accounting Reports
There are two fundamental accounting reports, the Balance Sheet and The Income or Profit and Loss (P&L) Statement. Period. All other reports are derived from these two reports or are records or “journals” that make up these reports. Other important courtroom documents that are derivatives of these two reports are a Cash Flow Statement and the Tax Return.
The Balance Sheet is called a balance sheet because it must balance. The assets are on one side of the scale and the liabilities plus the owner’s equity (positive or negative) are on the other side of the scale. They must be equal. The balance sheet is in effect a “snapshot” of the enterprise’s financial standing at a specific point in time, most commonly either month’s end or year’s end.
The Income or Loss Statement is more in the nature of a “movie picture” of the enterprise giving a more dynamic view of the ongoing activity of the business. Generally, if there is mischief it will be found in the income statements. The connection between these two statements is that the so-called “bottom line” from the income statement whether it be profit or loss is carried over to the Balance Sheet at the conclusion of the accounting period as “Retained Earnings”. This is in the “Owner’s Equity” section of the balance sheet. Since the Balance Sheet must balance, if you put a negative number into the owner’s equity section, the assets also must be reduced.
The Cash Flow Statement is required for courtroom use because there are fictional expenses or quasi-fictional expenses included in an Income Statement and there are some very real expenses not included in the Income Statement. A fictional or quasi-fictional expense would be “depreciation”. It is a proper accounting deduction, but depending on the asset it may or may not result in an actual expenditure of cash. Depreciation is a method of spreading lump sum expenditure for a tangible asset over an appropriate number of accounting periods, i.e. 20 years for a building, 10 years for a machine or 3 years for a computer. “Amortization” is another method of spreading a lump-sum expenditure for an intangible asset, such as a license or a patent over an appropriate accounting period. On the other hand the payment of a loan payment comes from very real hard cash dollars but is not a proper accounting expense other than for the interest portion of the payment. These items are made as adjustments to the income statement to demonstrate the real cash that is available from the enterprise. The cash flow statement is critical to both business valuation issues and calculation of child and spousal support.
The Tax Return is derived primarily from the income statement. There are certain adjustments that are required by the Internal Revenue Code that will cause the business’s income statement to be slightly different than the tax return. Those are generally not significant differences.
C. The Accounting Process
All but the most rudimentary accounting systems are “double-entry” systems. Double-entry means that for every financial transaction there are two entries to be made. One is on the asset side and the other is on the liability/equity side. For example, in the simplest example possible, cash is expended for an asset. Cash going out the door reduces assets and correspondingly the Owner’s Equity is reduced on the other side of the balance sheet. These are “debit” and “credit” entries. In any single transaction or in the sum of all transactions, debits must equal credits. Then the asset that is purchased increases assets and owner’s equity in equal amounts.
These accounting entries or transactions are kept in the “General Ledger”. While the Income Statement and the Balance Sheet are reports, the general ledger is the ongoing repository of the transactions taking place on a daily business. “T-Accounts” represent the simplest form of ledger accounting. A debit or “asset” entry goes on the left side of the T, whereas a liability or equity entry goes on the right side of the T.
In a simple transaction, where the business buys a building for a combination of cash and a mortgage you would have the following T-account entries.
Land Cash
(Asset account) (Asset account)
_______________________ __________________________
$100,000 ]
] $25,000
]
Mortgage ]
(Equity/Liability account)
_______________________
Back to the Top ] $75,000
Debits equal credits. The asset side, the left side or the debit side has received an asset, such as land, valued at $100,000, while the right side or the credit side has incurred a liability of $75,000 and has depleted or reduced its cash account by 25,000. The credit entry on the cash account reduces the cash account, which is an asset account reduction. The net result is that the asset side has been increased by a net of $75,000 and the equity/liability side has been increased by $75,000.
If a patient pays a doctor’s fees in the amount of $20,000, the Doctor’s cash account would have a debit or left hand entry of $20,000 and at the same time the Owners Equity Account would receive a credit or right-hand entry of $20,000.
_______Cash_________ Doctor’s Net Worth $20,000 ] ] $20,000
This information comes to the company from “Source Documents”. These are many and varied. Internally, they may be purchase order forms, receipts issued, checks or deposits tickets. Externally, there may be invoices and receipts received. All of the transactions reflected by the source documents are recorded in various “Journals”. A checkbook in a small business functions as both a cash receipts and a cash disbursements journal As the business grows the journals become more specialized as in the case where there is a true “cash receipts” journal and “cash payments journal”.
Ultimately all of the journal entries are recorded in the “General Ledger”. A separate ledger page is kept for each account that the company has. “Cash” would be an account, “land” would be and account, “inventory” would be an account and there could be an infinite number of other accounts that can be named. All Journal entries when taken as a whole must balance and since all Journal entries ultimately go into the General Ledger it is axiomatic (no, that is not a food processor) that the General Ledger must balance. Prior to preparing the Income or Profit and Loss statement and the Balance Sheet the accountants must test the journal entries and the general ledger through the preparation of a “Trial Balance”. This is done by totaling all of the debit entries and all of the credit entries for a specific accounting period, such as a month. This includes both permanent accounts and the revenue and expense accounts. They must be equal.
After adjusting entries are made and accounts have been balanced, the ending entries are made and the accounts are closed out. The revenue and expense accounts are closed out to either the “Retained Earnings” account or a temporary “Revenue Summary Account”. As an example if there were a revenue or earnings account showing earnings of $100,000, that account would be closed out to the temporary income summary account. This means that the accountant would debit the revenue account thus reducing it to zero and credit the temporary revenue summary account. Then you would close out the various expense accounts. Assume the expenses total up to $75,000, the accountant would credit the expense accounts thus reducing the expense accounts to zero and debit the income summary account in the amount of $75,000. The income summary account now shows a credit balance of $25,000. This account is now receives a debit entry of $25,000 and the Retained Earnings account receives a credit entry of $25,000.
In a small business the shorter way of saying all of this is “after the accounts are balanced out, the earnings over and above the expenses on the Profit & Loss Statement that don’t get paid out in salary or bonuses go to the Retained Earnings Account on the Balance Sheet.”
Adjusting Entries
Note that all of the entries during the actual accounting period are the result of a transaction with an outside party. You bought an asset or paid an employee.
In closing out the accounting period, the accountant must also make internal transactions that involve no outside party. These are called “Adjustment Entries”. These adjustments are made to give a more accurate picture at period’s end.
Accrual accounting requires accounting period adjustments that are beyond the scope of this article. By and large family law courts deal with cash basis taxpayers. Income or an expense may be spread over a more relevant number of accounting periods, i.e., think of an NFL contract where the bonus is paid now, but only charged against the team over the entire five-year term of the player’s contract. Woe is the team that trades the player in mid-contract and must accept the acceleration of an amount previously accrued.
Prepaid expenses such as a three-year premium or a three-year lease paid in advance can be areas of mischief depending on what reports have provided to the non-business spouse.
For example, a substantial expense could significantly reduce this years earnings, but, actually, reflect a significant increase in Owner’s Equity. A prepaid expense is an asset after adjusting entries are made.
More simply stated, the reduction of cash flow this year will result in a lower income this year as well, but will result in significantly higher cash flow next year after the divorce is over and gone.
