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Accounting for Lawyers
Professor Bradford
Fall 2014
Exam Answer Outline
The following answer outlines are not intended to be model answers,
nor are they intended to include every issue students discussed. They
merely attempt to identify the major issues in each question and some
of the problems or questions arising under each issue. They should
provide a pretty good idea of the kinds of things I was looking for. In
some cases, the result is unclear; the position taken by the answer
outline is not necessarily the only justifiable conclusion.
I graded each question separately. Those grades appear on your
printed exam. To determine your overall average, each question was
then weighted in accordance with the time allocated to that question.
The following distribution will give you some idea how you did in
comparison to the rest of the class:
Part
Part
Part
Part
Part
I, Question 1: Range 5-9; Average =
I, Question 2: Range 3-9; Average =
I, Question 3: Range 2-8; Average =
I, Question 4: Range 4-8; Average =
I, Question 5: Range 4-9; Average =
Part II: Range 4-9; Average = 6.75
7.31
6.50
6.19
6.31
6.31
Total Exam Score (70% of grade): Range 5-9; Average = 6.63
Homework (30% of grade): Range 6-9; Average = 8.06
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
If you have any questions about the exam or your performance on the
exam, feel free to contact me to talk about it.
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Part I, Question 1
Present Value of the Settlement Offer
The Annuity Component
The first component of the settlement offer is an annuity. We can use
Table 10-3 (p. 255 of the book) to calculate the value of this annuity.
However, the table is based on annuities paid at the end of the year.
The first payment of the settlement is paid immediately, at the
beginning of the year, but this is equivalent to a payment now, which
already is a present value, and a nine-year annuity payable at the end
of each of the nine years.
The present value factor for the nine-year annuity (using 9 for n and
4% as the discount rate) is 7.435. Multiplying this by the amount of
the payment, we get a present value of $7,000 x 7.435 = $52,045. We
then add the initial payment of $7,000 to this, $52,045 + $7,000 +
$59,045. Thus the total present value of the ten payments is $62,045.
The Lump-Sum Payment
The second component of the settlement offer is a lump -sum payment
to be paid in 15 years.
The formula for its present value is
PV = FV/(1 + r) n , where r is the discount rate and n is the number of
years.
= $50,000/(1.04) 15
= $27,763.23
[Alternatively, you could use Table 10-2 (p. 254 of the book). The
present value factor for a payment in 15 years with a discount rate of
3
4% is 0.5553. Multiplying this by $50,000, we get $50,000 x .5553 =
$27.765.]
Adding the two components together, the total present value of the
settlement offer is $59,045 + $27,763.23 = $86,808.23.
Present Value of Taking the Case to Trial
To determine the present value of taking the case to trial, we must
calculate the present value of the judgment and subtract the present
value of the payments Susan must make for fees and expenses.
The judgment is a single, lump-sum payment to be made in three
years. The formula for its present value is
PV = FV/(1 + r) n , where r is the discount rate and n is the number of
years.
= $135,000/(1 + .04) 3
= $120,014.51
[Alternatively, you could use Table 10-2 (p. 254 of the book). The
present value factor for a payment in 3 years with a discount rate of
4% is 0.8890. Multiplying this by $135,000, we get $135,000 x .8890
= $120,015.]
The three payments for costs and attorneys’ fees are an annuity. We
can use Table 10-3 (p. 255 of the book) to calculate the value of this
annuity. The present value factor for the three-year annuity (using 3
for n and 4% as the discount rate) is 2.775. Multiplying this by the
amount of the annuity, the present value of the annuity is -$10,000 x
2.775 = -$27,750.
Adding the two annuities, the present value of taking the case to trial
is $120,015 - $27,750 = $92,265.
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Conclusion
Taking the case to trial has a higher present value ($92,265) than
accepting the settlement ($86,808).
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Part I, Question 2
The cost of an asset for depreciation purposes includes not only the
purchase price, but also the cost of moving it to the location and
condition of its intended use. The cost of the packaging machine
would therefore include the $17,500 price paid for the machine, the
$600 cost to ship it to the cannery, and the $400 cost to modify it for
use by Mountain. The regular oil and maintenance costs are repairs
that would not be capitalized into the cost of the machine. Thus the
total cost for depreciation purposes is $17,500 + $600 + $400 =
$18,500.
The useful life of the machine for depreciation purposes is its
expected life to Mountain, not how long the machine will last. That is
5 years. The salvage value is $4,500.
To apply the double-declining balance method, we use twice the
straight-line rate of 20% (1/5 a year over the 5-year life) and apply
that rate to the net book value of the machine each year. We don’t
subtract salvage value from the depreciable cost, but we never
depreciate below the salvage value.
The depreciation expense for each year would be:
Year 1
$18,500 x .4 = $7,400.
(Net book value = $18,500 -$7,400 = $11,100)
Year 2
$11,100 x .4 = $4,440.
(Net book value = $11,100 – 4,440 = $6,660)
Year 3
$6,660 x .4 = $2664.
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(Net book value = $3,996)
Since the salvage value is $4,500, we can only have a depreciation
expense of $2,160 in Year 3, leaving a net book value of $4,500.
We can’t depreciate below the salvage value, so the depreciation
expense for Years 4 and 5 would be $0.
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Part I, Question 3
Consent
The firm can respond to this audit inquiry only with the consent of
the client, Acme. ABA Statement of Policy Regarding Lawyers ’
Responses to Auditors’ Requests for Information, ¶ 1. The letter from
Paul Prez is sufficient consent, unless we are disclosing a client
confidence or evaluating a claim. Since, as discussed below, we will
be evaluating a claim, we need to get informed consent from Acme.
We must explain the consequences of our disclosure to Acme and
provide a response only after they agree to that disclosure. The ABA
Statement suggests that we share a draft of our response to the
auditor, although that isn’t required.
What We May Comment On
All three of the items you mentioned are loss contingencies. We can
discuss only those loss contingencies specified in ¶ 5 of the ABA
Statement. The Smith accident falls within ¶ 5(a)—overtly threatened
or pending litigation—since the plaintiff ’s lawyer is aware of the
claim and the likelihood of litigation or settlement is certainly more
than remote (meaning “slight” or “extremely doubtful.”)
The guaranty falls within ¶ 5(b). It is a contractually assumed
obligation that the client has specifically identified and requested
comment on.
The possible chemical spill liability falls within ¶ 5(c). It is an
unasserted claim. Since the client has not specifically identified it and
requested comment, ¶ 5 does not allow us to comment on it. ¶ 5 says
that we should not comment in response to a general request of the
sort in ¶ 3 of Prez’s letter. However, we should make clear in our
response that we are limiting our comments to those matters allowed
by the ABA Statement of Policy.
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General Information
We may always provide general information about the Smith and Big
Bank matters: “an identification of the proceedings or matter, the
stage of proceedings, the claim(s) asserted, and the position taken by
the client.” ABA Statement ¶ 5. Thus, as to the Smith claim, we may
say that Smith is asserting liability with respect to an auto accident
that occurred in March in Bellevue, Nebraska, that he has not yet
filed suit, that we deny liability, and that we are negotiating with
Smith’s attorney. As to the Big Bank guaranty, we may say that we
have entered into a guaranty of the loan to First State Bank and the
specifics of the loan and guaranty.
The question is whether we may, in either case, provide an opinion as
to the probable outcome or offer an estimate of the expected loss or
range of loss.
The Smith Accident
We may not express an opinion as to the probable outcome of the
Smith case. The ABA Statement allows us to express such an opinion
only when an unfavorable outcome is either probable or remote —in
essence, where either Acme’s chances of winning or Smith’s chances
of winning are “slight.” ABA Statement ¶ 5. Since it’s not clear who
was at fault, we can’t say that either side has only a slight chance of
winning.
We may offer an estimate of the amount or range of loss only if the
probability of an unfavorable outcome is not remote and we believe
that “the probability of inaccuracy of the estimate . . . is slight. ”
ABA Statement ¶ 5. As just discussed, the probability of an
unfavorable outcome is definitely not remote. Pain and suffering is so
uncertain that it’s unclear what Smith would get if he wins. However,
the amount of the medical bills seems certain, so it would probably
be acceptable to say that, if Acme loses, the loss could be at least
$130,000, as long as we make it clear that greater liability is possible.
The Guaranty
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It is probable that we will have to pay the on the guaranty. It is “fairly
certain” that Beta will be unable to repay any of the principal and, i f
it doesn’t, we are “clearly liable.” Therefore, Acme’s prospects of
success are slight and it is extremely doubtful that the Bank will lose.
We therefore can comment on the outcome, to say that it is probable
Acme will have to pay the claim.
We may also comment on the expected amount of the liability. Beta is
unlikely to be able to pay much, if any, of the loan’s principal, so it is
almost certain we will have to pay the full amount of the guaranty,
$150,000. We may say that in the letter.
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Part I, Question 4
The lender’s concern is whether the borrower will be able to repay the loan. A
number of the ratios we discussed might be relevant to that concern, although
some clearly are not. I graded your answer based on the relative importance
of the ratios you chose and your justification of those rati os. The answer
below represents one plausible set of choices.
Big Bank’s primary concern is whether Acme will have the cash flow
to be able to repay the principal and interest on the loan as it becomes
due. The three most important ratios for making this evaluation are
probably the interest coverage ratio, the cash inter est coverage ratio,
and free cash flow.
Interest Coverage Ratio
The interest coverage ratio is calculated by dividing EBIT (earnings
before interest and taxes) by the company’s interest expense. In effect,
this measures interest expense as a proportion of the company’s
earnings—how easily its pre-tax earnings can cover the interest it has
to pay. The higher the ratio, the better.
Cash Interest Coverage Ratio
A similar measure is the cash interest coverage ratio, whic h is
calculated by dividing cash flow from operating activities by interest
expense. This compares interest expense to the company’s cash flow
from operating activities. In essence, it’s a measure of how easily the
company’s regular operating cash flow can cover the interest
obligation. Again, the higher the ratio, the better. This is a better
measure than the interest coverage ratio because interest is paid in
cash; non-cash earnings don’t necessarily provide funds to repay Big
Bank.
Debt-Equity Ratio
The third measure I would suggest is the debt-equity ratio. This is
calculated by dividing the company’s total debt by its total equity.
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Since Equity = Assets –Liabilities, the amount of equity represents, at
least in theory, the net free assets after paying liabilities. (Of course,
this is true only in theory, since balance sheet values are not based on
actual fair value.) In this case, a lower number is better. The lower the
debt-equity ratio, the greater the proportion of net assets in excess of
over the company’s liabilities and, everything else being equal, the
more secure the loan.
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Part I, Question 5
Cash accounting is relatively simple. The business only has to keep
track of when cash comes in and goes out. The allocation of revenue
and expenses to particular periods is easy.
But accrual accounting provides a much more accurate picture of the
period-to-period progress of the business. Under the cash method, a
huge outlay that is going to benefit the company for a number of
periods, such as the purchase of a machine, is treated as an
immediate expense in the period of purchase, making the business ’s
earnings look incredibly bad for that period. Correspondingly,
earnings look better than they should in future periods because they
don’t take into account the cost of the machine tha t is being used to
generate those earnings. Similarly, if a customer prepays for work, the
cash method would recognize that revenue upon payment, even
though the company has not yet done anything to earn the money.
Accrual accounting more accurately allocates revenues and expenses
from period to period. But it achieves this accuracy at the expense of
complexity. Businesses must decide how to allocate costs over
multiple periods and when revenues and expenses should be
recognized. Those judgments are not always easy to make and are
subject to manipulation.
However, cash accounting is also subject to manipulation —timing
collection of accounts, for example, to increase revenues when times
are bad or delaying capital purchases to avoid the associated cash
expense. It’s not clear which is worse in this respect.
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Part II of the Exam
The answers to the question on Part II of the exam are contained in a
separate Excel file.