Accounting: The Language of Business - Vol. 2 (Intermediate: Part 77)

People are arguing whether Mel Gibson's "Passion of the Christ" is anti-semitic. Well, whether it is or it isn't, it doesn't matter, because I've been in touch with his accounting firm, Rosencrantz, Levy and Stern, and they're screwing him out of his profits.

Joan Rivers

 Statements of Financial Position and Cash Flows and the Annual Report (Part O) 

by

Charles Lamson

Interview

 MICHAEL COHEN

CONSULTANT (RETIRED PARTNER) 2014 - 2015

COHNREZNICK

Michael Cohen
 

Retired in 2015, Michael Cohen oversaw all accounting and tax operations for CohnReznick's New Jersey offices. In this capacity he directed over 400 people, including over 70 partners, and was a member of the firm's management committee. Mr. Cohen provided accounting and advisory services to middle market companies in diverse industries that range in size from $1 million to $3 billion.

Assets and liabilities aren't nearly as eye-catching to financial statement users as revenue and earnings. While earnings are important, they don't tell the whole story. The balance sheet reflects the financial condition of a company and offers a snapshot of a company's health.

Business owners create shareholder wealth by keeping the cost of capital below the rate of return on investment. By reviewing the balance sheet, a reader should be able to determine the various drivers of shareholders' wealth, including invested capital, cost of capital (including cost of debt), and incremental capital expenditures.

Investors use ratio analysis to measure a company's liquidity, solvency, and financial stability. Typically, they use the current ratio, quick ratio, networking capital, and debt to equity ratio, among others, to evaluate whether a company has sufficient resources to satisfy existing obligations in a timely manner. They can also determine whether a company's financial condition allows it to take advantage of potential opportunities and withstand unexpected crises.

Typically, critical estimates include allowance for bad debts, allowance for inventory obsolescence and slow moving items, fair value of financial instruments, impairment of long lived assets and intangible assets, warranty liabilities, contingent liabilities, stock-based compensation, valuation of deferred tax assets, uncertain tax positions, and valuations in business combinations. These are high risk audit areas because significant judgment is involved in determining estimates. Sometimes management's estimates are not reasonable and require revision. Such estimates must be challenged by auditors, who spend considerable time reviewing critical estimates to ensure that our client's accountants used proper methods and procedures, reasonable inputs, and consistent methods from year to year.

The balance sheet does not portray the fair value of the entity as a going concern or its liquidation value. Despite this limitation, the balance sheet provides information useful for assessing future cash flows and near- and long-term liquidity. Using 100% fair value accounting does not currently seem practical for various reasons including the increased cost involved in determining fair value estimates, the difference is in values based upon the methods used to determine fair value, and a lack of expertise in the marketplace to value all balance sheet items at fair value.

The Enron fraud and bankruptcy revealed how certain companies used off-balance sheet entities to offload debt from their books. The FASB tightened requirements by adopting rules for special purpose entities (SPEs) and variable interest entities (VIEs). If consolidation of SPEs and VIEs is not required under U.S. GAAP, the auditors must review whether the company has contractual obligations to fund the operations of the off-balance sheet entities. The contractual obligations should be disclosed in the notes to the financial statements. 

No financial statement, standing by itself, can give a user a clear picture of a company's financial position and/or performance. Users should interrelate the income statement, cash flows statement, and balance sheet in their financial analysis to determine a company's overall financial health. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., P. 261*

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