This document provides an overview and introduction to accounting foundations presented by Brendan McCorry, Justin Vogel, and Sonal Shah of Ernst & Young. The agenda includes introductions, accounting foundations, and a discussion of tax considerations for different types of entities. Under accounting foundations, the document defines the objectives of financial reporting, governance of accounting standards, an overview of key financial statements including the income statement, balance sheet, and statement of cash flows, and components of revenues, expenses, assets, liabilities, and equity. It concludes with a discussion of tax implications for C corporations, S corporations, and LLCs/partnerships.

1. presents
Brendan McCorry, Justin Vogel, Sonal Shah,
Ernst & Young
Introduction to
Accounting Foundations

2. ► Welcome and Introductions
► Accounting Foundations
► Type of Entity – Tax considerations
Agenda

3. ► Brendan McCorry
Audit Partner
brendan.mccorry@ey.com
(617) 585-3421
► Justin Vogel
Audit Senior Manager
justin.vogel@ey.com
(617) 585-0990
► Sonal Shah
Tax Senior Manager
sonal.shah@ey.com
(617) 585-6813
Welcome

4. ► Objectives of financial reporting
► Governance
► Financial statement overview
► Income statement
► Balance sheet
► Statement of cash flows
Accounting Foundations

5. ► To provide information that is useful to present
and potential investors and creditors
► To help investors, creditors and other users
assess the amounts, timing and uncertainty of
prospective net cash inflows
► To provide information about the economic
resources of an enterprise, the claims to those
resources and the effects of transactions,
events and circumstances that change
resources, and claims to those resources.
Objectives of Financial Reporting

6. ► Purpose of financial accounting system
► To provide information in a standardized format that
allows financial stakeholders to understand a business
from an economic standpoint
► Establish reporting requirements
► Companies with publicly traded securities are governed
by Regulatory authorities, which ensure compliance
with local jurisdiction reporting requirements
► Privately owned companies may not have any
accounting requirements at all, depending on their
financial stakeholders
Governance

7. ► Established accounting standards
► Auditors examine the financial statements to
ensure they are presented in accordance with
generally accepted accounting principles
(“GAAP”)
► Many countries have adopted the
International Financial Reporting Standards
(“IFRS”), which seek convergence in global
financial reporting.
Governance

8. ► U.S. GAAP
► Accounting rules and guidance are established through various publications issued by
groups including the following:
► Financial Accounting Standards Board (“FASB”),
► American Institute of Certified Public Accountants (“AICPA”) and
► Public Company Accounting Oversight Board (“PCAOB”).
► GAAP is also influenced by the Securities and Exchange Commission (“SEC”).
► Governance of Accounting Rules
► State boards of accountancy
► Federal regulation (Securities and Exchange Commission)
► PCAOB
► Companies have audits performed to show compliance with GAAP
Governance

9. Financial statements generally include:
► Income statement
► Balance sheet
► Statement of cash flows
► Statement of changes in stockholders’ equity
Financial Statement Overview

10. ► Income statements are generally
presented top-down (i.e., revenues
listed first followed by expenses)
► Key components:
► Revenue
► Cost of sales
► Gross profit
► Operating expenses
► Operating income
► Tax expense
► Net income
► Sample summary income statement
Gross revenue 100
Sales deductions (10)
Net revenue 90
Cost of sales 60
Gross profit 30
Operating expenses 20
Operating income 10
Tax expense 4
Net income 6
As a percentage of net sales:
Gross margin 33.3
Operating income 11.1
Net income 6.7
Income Statement

11. Revenue
►Inflows of assets or settlements of liabilities from the sale of product,
rendering of services, or other activities that constitute an entity’s ongoing
major or central operations
Revenue is generally realizable and earned when the following
criteria are met:
►Persuasive evidence of an arrangement exists
►Delivery has occurred or services have been rendered
►Seller’s price to the buyer is fixed or determinable
►Collectibility is reasonably assured
Revenue

12. Gross to net revenue:
► Consideration offered by a vendor on a either a limited or a continuous basis
to a customer such as discounts, coupons, rebates and free products or
services is generally required to be recorded as a reduction to gross revenue.
► The following is an example:
Gross to Net revenue

13. Expenses
► Represent decreases in economic benefits during the
accounting period in the form of outflows or depletions
of assets or incurrence of liabilities
Matching principle
► Indicates that when it is reasonable to do so and
allowed under the accounting standards, expenses
should be matched with revenues.
► Only if no connection with revenue can be established,
costs are charged as expenses to the current period
(e.g. office salaries and other administrative
expenses)
Expenses

14. Cost of sales are:
►Direct expenses incurred in producing a particular good for sale,
including the actual cost of materials that comprise the good,
and direct labor expense in putting the good in saleable condition
Operating expenses are:
► Day-to-day expenses incurred in running a business, such as
sales and administration, or research & development
► Operating expenses do not include direct production costs
► In short, operating expenses include amounts spent by
companies on matters such as selling, advertising, accounting
and other costs that are required to sell their products and
services.
Cost of Sales and Operating Expenses

15. Other income and expense
► Generally includes items such as interest
income, interest expense, and non-operating
income/expense
► It is important to understand the composition of
other income and expense because there are
sometimes operating expense/income items
inappropriately included in the detail.
Other Income and Expense

16. Objective:
Shows assets (what a company owns), liabilities (what a company
owes) and stockholders’ equity (portion of assets owned by
shareholders) at a particular date in time
General characteristics
► Assets = Liabilities plus stockholders’ equity
► Assets and liabilities are generally listed in order of liquidity
► In general, assets and liabilities are carried at cost
(accounting convention of conservatism); however, there are
certain exceptions (i.e., lower of cost or market, fixed asset
impairments, investments, etc.)
► Net assets = Assets – Liabilities
Balance Sheet

17. Significant operating components generally include:
► Cash
► Accounts receivable
► Other current assets
► Fixed assets
► Accounts payable
► Accrued expenses
► Debt or shareholder’s equity
In addition, fixed assets are often significant due to the
use of cash for capex requirements.
Balance Sheet

18. ► Accounts receivable
► Amounts that customers owe to a business
► Since not all customer debts will be collected,
businesses typically record an allowance for bad debts
which is subtracted from gross accounts receivable
► Other considerations – Credit terms
► Collection periods often vary by company and
industry
► Discounts offered are reserved at the time of sale
► Certain allowances may be recorded in accrued
expenses
Accounts Receivable

19. ► Prepaid expenses and other current assets
► Services/ benefits to be received in the future which were paid in advance
(e.g. future months of insurance coverage when annual premium is paid at
the beginning of the term)
► Refundable items (lease deposits)
► Inventory
► Goods and/or materials (to be converted into goods) held for sale to
customers
► Inventory is usually classified into the following categories:
► Raw materials
► Work-in-process (WIP)
► Finished goods
► Generally reported net of reserves
Other Current Assets

20. ► Fixed assets
► Includes long-lived tangible assets used in the production of other goods
and services. Examples include land, buildings, machinery, furniture, and
tools.
Capex
► Capex represents the amounts spent to acquire fixed assets and is
generally broken up into the following components:
► Growth capex (e.g., building expansion)
► Recurring capex (e.g., periodic replacement of laptop computers)
Other considerations
► Repairs and maintenance expense
Fixed Assets

21. ▶ Accounts payable
▶ Amounts that are owed to suppliers and other
vendors
▶ Other considerations:
▶ Cut-off
▶ Stretching of payables
Accounts Payable

22. ▶ Accrued liabilities
▶ Liabilities that have occurred (i.e., known obligation to pay for or provide services), but (i) have
not been paid (e.g., invoice) or performed (e.g., warranty) and (ii) not recorded as an obligation
in accounts payable during an accounting period;
▶ Examples include:
▶ Obligations for goods and services provided for which invoices have not yet been received.
▶ Accrued wages payable
▶ Accrued sales tax
▶ Accrued bonus
▶ Accrued vacation
▶ Accrued warranty
▶ Accrued customer allowance
▶ Deferred revenue
Accrued Liabilities

23. ► Recording obligations
► Liabilities are required to be recorded once the
obligation is known
► Liabilities should be accrued via a charge to
income if the liability is probable and the loss
can be reasonably estimated.
► Accrued liabilities are often subjective and
require management estimates (e.g., accrued
warranty, bonus, etc.)
Accrued Liabilities

24. ▶ Objective:
▶ Provide financial users with cash receipt and payment information
Format:
▶ Most companies follow the indirect method – net income is the starting
point and adjustments are made to remove non-cash components of net
income.
▶ Three major sections:
▶ Cash flows from operating activities
▶ Cash flows from investing activities
▶ Cash flows from financing activities
Statement of Cash Flows

25. ▶ Footnotes to Financial Statements
▶ Disclosure is required beyond the basic financial
statements
▶ Provides an opportunity for management to
explain items which are not obvious from the
statements. May also provide additional detail
on the components of accounts.
Other Considerations

26. Type of Entity - Tax Considerations

27. ► The following are the three most common legal entities for
conducting a business:
► “C” corporation
► A traditional statutory (state law) corporation where no
election has been made to treat as an “S” corporation
► “S” corporation
► A traditional statutory (state law) corporation that,
subject to certain requirements and restrictions, makes a
special tax election or “S” election
► LLC/partnership
► A joint venture of two or more parties entered into for profit
Types of Taxable Entities

28. ► The “C” corporation tax considerations:
► The C corporation is a separate taxpaying entity
► Corporate income is usually subject to two levels of income
tax (i.e., “double taxation”)
► Entity level income tax
► Shareholder level tax (dividend distributions)
► Losses and other tax attributes are retained at the
corporate level and do not flow through to shareholders
► The treatment of these attributes to the corporation may be
subject to limitation upon a purchase or “change in
ownership”
Type of Entity – Tax Considerations

29. The “S” corporation tax considerations:
► Generally, not subject to entity level income tax
► Entity level income, gain or loss flows through to
the shareholders
► Shareholders report S corporation income, gain,
or loss in their personal income tax returns and
adjust their tax basis in their stock accordingly
► No second level of income tax on distributions of
previously taxed earnings
Type of Entity – Tax Considerations

30. ► The “S” corporation tax considerations (continued)
► Eligibility requirements
► Domestic corporation
► Maximum number of shareholders is 100
► Eligible shareholders are limited to US citizen
or resident individuals, certain estates,
certain trusts and ESOPs
► One class of stock
Type of Entity – Tax Considerations

31. The LLC or Partnership tax considerations:
► Generally, not subject to entity level income tax
► Entity level income, gain or loss flows through to the member/
partner and is taxed on member/partner tax return
► Other considerations
► Significant flexibility on the rights of equity interests and the
types of equity holders. However, LLCs may be complex when
compared to C corporations
► Management incentive benefits and complexities in the use of
profits interests vs. traditional corporate stock options
► Single-member LLCs are generally disregarded for US federal
income tax purposes
Type of Entity – Tax Considerations

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