By Ilona Korzha, counsel at Sprint Corporation and co-chair of the ACC Career Development Committee.
Recently, I spoke with Michele Cross, Deloitte Advisory principal, and Caroline Lee, Deloitte Advisory senior manager, who are both part of Deloitte Financial Advisory Services LLP, about why it is paramount for in-house counsel to understand the key drivers of their companies’ overall financial performance in order to avoid being “commercially naïve.”
Why is it important and useful for in-house lawyers to understand some of the basic concepts of accounting?
Cross: Understanding some of the basic concepts of accounting and finance will enable in-house counsel to better advise their clients on legal considerations in a variety of contexts, such as disclosure obligations, mergers, acquisitions, joint ventures, capital markets transactions, and other business arrangements (e.g. customer, vendor, distributor relationships). In addition, it will also enable in-house counsel to engage more fully with business partners in the development and execution of overall business strategy.
So what are some of these basic accounting or financial concepts that an in-house counsel need to understand in order to avoid being “commercially naïve”?
Cross: In general, in-house counsel should develop an understanding of the drivers of their companies’ overall financial performance, such as the composition of revenue, key areas of cost and expenses, drivers of profitability, as well as sources and uses of cash.
Consider how these metrics or financial performance indicators have changed over time. What are the trends? What do they suggest about the company’s performance? Has the company grown revenue rapidly through acquisition? Does the company manage costs more or less effectively than its competitors? How is the company investing its resources to support future growth and operations?
Much of this information can be obtained from a company’s financial statements and from market and industry research reports.
What is the difference, if there is any, between a public and a non-public company?
Lee: Public companies are those which have stock or bonds traded on a stock exchange, such as the New York Stock Exchange, that is open to the public. Those publicly traded companies are subject to regulatory requirements within the markets in which they trade (e.g. the U.S. Securities and Exchange Commission (“SEC”)) — meaning they’re required to file financial statements and other information with relevant regulatory authorities, such as the SEC and the US Internal Revenue Service. Those public company financial statements are required to be audited by an independent external audit firm.
Non-public or private companies are held by private investors and do not sell stock or bonds on public exchanges.
What are the key financial statement filings of a public company?
Lee: There are five primary elements of financial statements: the income statement, the balance sheet, the statement of cash flow, the statement of owners’ equity, and the notes to the financial statements. The financial statements provide useful information to stakeholders in investment and credit decisions, as well as assessing cash flow and overall financial performance.
The income statement is sometimes referred to as a profit & loss statement (P&L). The income statement shows the results of operations for the period: how much revenue was earned; expenses associated with earning that revenue; and, the resulting profit or loss.
The balance sheet shows the company’s financial position at the end of the period, including cash and other assets, debt and liabilities, and equity. For example, the balance sheet can provide insight into the liquidity of the company’s assets (ability to convert quickly to cash) and the company’s leverage or the extent to which the company finances its operations with debt versus equity.
The statement of cash flow provides details about the sources and uses of cash (cash inflow and outflow) during the period. Cash inflows and outflows come from three general activities: operating (e.g., collections from customers or payments to suppliers); investing (e.g., sale of assets or purchase of equipment); and financing (e.g., issuance of debt and equity or payment of loans).
The statement of owners’ equity explains investments and distributions to owners during the period (e.g., issuance of dividends).
When looking at financial statements, remember the tables and numbers only tell part of the story. Equally important, the notes to the financial statements provide further explanations and disclosures. This may include an overview of the business, significant accounting policies, information related to business combinations, income taxes, and other commitments and contingencies.
Financial statements are included in certain regulatory filings, such as those filed with the SEC. There are a number of SEC filing types. Two commonly referenced filings are the 10-K and 10-Q. The 10-K is the set of annual audited financial statements and also contains additional detailed discussions about the business and its operations. The 10-Q is a quarterly filing and contains unaudited financial statements covering the quarterly period.
What are “pro-forma” financial statements?
Cross: Pro-forma financial statements can be helpful to inform a reader about how a transaction, such as an acquisition or disposition of an entity, might have impacted the historical financial statements if the transaction occurred at an earlier time.
For further reading, download the course material “Financial Decision Making for In-house Counsel, Part I and II” by Professor Michael Smith Boston University