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Basics of Accounting in Divorce

BASICS OF ACCOUNTING IN DIVORCE

Before reading this article be advised that I, Eric Roy, am not a certified public accountant. I am an attorney. I write this material for my own benefit, take from this article what you like, but understand that you will achieve a more thorough and accurate understanding of accounting by reading books or attending lectures taught by actual certified public accountants.

As a basic principle we must understand that most businesses use ledgers which record financial transactions within the company. These specific ledgers then are generally posted onto a general ledger. This general ledger contains the necessary financial information for the ultimate production of financial statements. The overall complexity and thoroughness of these record keeping systems will vary depending on the size of the business. Smaller businesses will generally have much less sophisticated accounting systems than larger organizations. Financial statements are prepared for both internal users as well as external users. This is important to remember. The statements prepared for internal users are often different than those prepared for external users. External users include creditors, investors, financial analysts, taxation authorities, and other federal and state regulatory authorities.

Certified Public Accountants are guided by Generally Accepted Accounting Principles (GAAP). GAAP are the principles in which CPA's must follow to ensure that financial statements are in fact reliable and standardized. Thanks to GAAP, external users generally have confidence in the reports that are prepared or audited by CPAs. Keep in mind that reports prepared for internal users need not confirm with GAAP. This is why it is important to distinguish who the report was prepared for, internal or external users. The divorce lawyer should be skeptical of reports prepared for internal users.

Companies often prepare multiple sets of books. A company may have a set for tax purposes, a set of books for the public and lenders, another set of books for management, and another set of books for an alternative cost accounting method. Divorce practitioners should be aware of what purpose a set of books was prepared for. A practitioner should be wary of a special set of books prepared in anticipation of divorce.

As a family lawyer or forensic accountant you will be looking over financial statements. These financial statements include balance statements, income statements, cash flow statements, statements of retained earnings, amongst others. The balance sheet is a fundament financial statement. This statement indicates a business's total assets, liabilities, and owner equity. This statement can describe the financials picture of a business at any given date and a statement will generally be prepared to reflect that picture as of December 31st of a given year. The income statement will report revenues, gains, expenses, losses, and net income. The statement of cash flow describes changes in cash flow over a given period of time.

Fortunately, most companies will have prepared reports in the most favorable light possible for the company for the purpose of satisfying an external user. For instance, if a business seeks to obtain financing then that business will generally want to produce reports showing the most favorable financial position possible. This includes showing high profits, strong assets, and good cash flow. If a business seeks to induce investors it will also have an interest in producing similarly favorable financial reports. As the divorce practitioner or forensic accountant in a divorce, these are the financials you want to get your hands on. These are especially useful if they were prepared recently. If the employer spouse produces different reports prepared for purposes of litigation and you possess these other reports prepared for creditors or investors then you may have excellent fodder for cross examination.

Larger companies also must produce reports which are audited for GAAP and additionally produced for the benefit of potential investors. These are businesses who wish to issue or sell securities across state lines. These companies must prepare a prospectus. These companies must produce 10-K reports which are audited financial statements as well as 10-Q reports which are unaudited quarterly statements. These reports can largely be relied on and become a significant benefit for the divorce lawyer in litigation.

It is important for the family law practitioner to understand the difference in accounting methods. The difference between accrual basis and cash basis is a significant one. Under the accrual basis transactions are recorded so as to match revenue and expenses to a given date when an event occurred. For instance, revenue is recorded when the completion of the earnings process and collection are reasonably certain. Likewise, under the accrual basis, expenses are recorded when the business receives the benefit it pays. Under the cash basis revenue and expenses are recorded according to when the cash is actually received or paid out. Know that it is not unusual for a business to have more than one set of books. One set of books may be prepared under the accrual basis while another is prepared using the cash basis.

GAAP requires accountants to be conservative when there is doubt as to how to record a transaction. Being conservative means recording the expenses in the present and deferring the recording of revenue. Be advised that this is a tactic that can be used to the businesses benefit while divorce is pending. If the business records all expenses presently and defers revenue this will ultimately show depressed net income. The business owner lawyer can argue that under GAAP this conservative treatment is recommended, while at the same time realizing the benefit of depressed earnings within the divorce arena. Analogously, when businesses prepare their federal income tax returns they will act similarly. Business, want to expense as much as possible in the given tax year while at the same time deferring revenue to the following year. In this way they can limit their tax exposure for this given tax year. When attacking the financials of a business keep in mind that this is the prerogative of the business when it prepares such returns. This is strong ammunition for cross examination. For a business owner or CPA to deny this fact on the witness stand will illuminate a lack of credibility.

It is important to understand the distinction between temporary accounts and permanent accounts. Permanent accounts appear on the balance sheet as assets, liabilities, and owner's equity. Permanent accounts remain consistent despite the end of one year and the beginning of the next. There is no zeroing out of the account as there is for temporary accounts. Temporary accounts appear on the income statement as revenue, expenses, and gains and losses. At the end of a reporting period the temporary account is closed out so that the balance of such account will be zero at the beginning of the next accounting period.

Accountants used the debit/credit system to maintain the journals which ultimately post to the general ledger. This debit and credit system can be difficult to conceptualize. At a basic level, an increase in one requires a simultaneous increase in the other. Thus there are two sized of the ledger (debit/credit) which ultimately must zero out. In this sense the accountant can confirm that all entries were made correctly. For instance, if a business buys an asset for $10,000 then it must increase the asset account by $10,000 while at the same time crediting the cash account as the business now has $10,000 less cash in reserve.

Some terms that are important to understand include "extraordinary items". Extraordinary items include those events which are both unusual and infrequent. An extraordinary event is one which is rare in that you can't anticipate its occurrence and you should not expect it to happen again. Extraordinary events are backed out by CPAs. These expenses are backed out because these events complicate and confuse multi period analysis of financials. Keep in mind that extraordinary items must be material. This means that they must be significant in amount. This of course is subjective in interpretation.

When analyzing financials know that some assets may not be recorded at all. For instance GAAP dictates that these intangible assets not be recorded. Yet these intangible assets might be very large. Intangible assets include such things as the goodwill of the business. Intangible assets also include such things as intellectual property. To measure these assets you will likely need the assistance of an evaluation expert. See more on business valuation in my other articles.

Other terms you should be familiar with are amortization and capitalization of assets. Amortization is similar to depreciation but is a concept used to describe the reduction in value of intangible assets such as goodwill. Amortization also describes the reduction of debt by way of principle and interest pay down over time. Capitalizing refers to recording something purchased with cash as an asset rather than showing the cash paid out as an expense. The asset is then depreciated over a number of years following its acquisition.

This blog just outlines some of the basic accounting principles a divorce attorney should understand. Please see my other articles or speak to a CPA for a more involved conversation on the subject.

Categories: Family Law