Talking Points
- The process of identifying, measuring and communicating economic activities of both profit and non-profit organizations.
- The accounting equation: Assets (A) = Liabilities (L) + Stockholders’ Equity (SE) and Debits = Credits must always be true
- Generally Accepted Accounting Principles (GAAP) is used to prepare public accounting information.
- The main financial statements are: Income (or P&L), Retained Earnings, Cash Flows and Balance Sheet
- The Chart of Accounts is how financial transactions are categorized. All transactions have a double entry or two sided effect.
- Assets depreciate according to a schedule which decreases their value over time. That time is dependent on the asset
- Some important company metrics include: Net Sales, Cost of Good Sold (COGS), Gross Margin, Net Income and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
Discussion
Accounting is one of those disciplines that takes some getting used to. It just feels foreign. I blame the acronyms. GAAP, P&L, GM or EBITDA. It’s all alphabet soup to most of us. Well, grab a big spoon and dive in since it’s important to understand some of this stuff. We all deal with money and understand what we pay taxes, that we have stuff (assets) and our checking account is mostly balanced (wait, I should double check that). If you invest, then you have surely looked at a financial statement or two and probably wondered, what does it all mean? Well, it means a lot. In fact, accounting is the only consistent language that all businesses understand. You can go anywhere in the world and they will all have financial statements. It’s really the language of business.
Show Me The Money
Accounting is all about reporting how the money was spent and earned. The key here is past tense. Accounting tells you what happened. They have really complicated rules and procedures but it all boils down to show me where the money came from and what we spent it on. Simple. Well, maybe. You see, most companies kind of, sort of, well, make their own accounting rules that they refer to as pro forma. Pro forma accounting reports can be misleading since it’s really up to the company to define it (well, within reason). That’s why it’s critical to understand what a pro forma financial statement is really saying. Typically, pro forma earns are greater than GAAP, which makes some critics charge that you really can’t compare different companies based on pro forma earnings. For our discussions, we will deal with GAAP definitions since that is consistent across companies.
Debits and Credits
The equations of accounting are meant to always be in balance. This balance is the cross check that maintains the integrity of the accounting process (or your “books”, since that is how they kept records back in the day). The double entry method of accounting ensures that each transaction is recorded in two separate ledgers. This means that one ledger will have a debit for the transaction while the other will have a credit. The rules for what is a debit and credit are complex and vary depending on the ledger they go in. As with anything, there are some nuances that complicate matters. The general rules are summarized below (adopted from Double Entry Accounting Article below):
- Assets Increase Debit, Decrease Credit. Assets are anything your company owns of value (including cash)
- Expenses Increase Debit, Decrease Credit. Expenses are monies spent or costs incurred to generate revenue
- Liabilities Increase Credit, Decrease Debit. Liabilities are any monies owed to people or companies other than owners.
- Equity Increase Credit, Decrease Debit. Equity is any amount of money (debt) owed to the owners of the company
- Revenue Increase Credit, Decrease Debit. Revenue is the amount of money you receive from selling goods and services.
The thing to remember about double entry is that it strives for balance always. If you use accounting software (like Quickbooks), then you probably won’t even notice this since most of your transactions will be revenue and expense ones.
Keeping In Balance
The basic accounting equation, Assets (A) = Liability (L) + Stockholders’ Equity (SE) is meant to always keep your books in balance. Achieving balance requires that a change in one account must be matched with a change in another account. This is heart of the double entry method. Any deviation from balance, means that an accounting error has occurred. The theory behind the equation is that someone must provide assets or resources so that the company can operate. If that holds true, then the Assets of the company have to equal the equity provided. Liabilities comes in when non-company owners (say a vendor), supplies credit to the company. This is a liability since the company providing credit wants it’s money back.
Financial Statements
All of these transaction create a lot of data. Understanding what it all means requires summaries and reports. In accounting, there are four basic reports that allow management to determine the health of the company. All are linked together in some way to provide checks to ensure the books are in balance. The statements are:
- Income Statement: Often referred to as a Profit and Loss statement or P&L. This statement shows the profitability of the company over a specific period of time. It includes the Revenue (Top Line) and Expenses during the period of interest. The result is the Net Income (Bottom Line) for the period.
- Statement of Retained Earnings: Connects the Income Statement to the Balance Sheet by explaining the changes in retained earnings between two balance sheet dates. These changes are the increase (or decrease) in net income from the previous balance sheet date. Also, this is where any dividends are placed since dividends are not expenses so they will not show up on the Income Statement.
- Balance Sheet: It’s also called the Statement of Financial Position. This statement lists the Assets, Liabilities and Stockholders’ Equity for a specific moment in time. It’s a snapshot in time of the companies financial position. It ties the statements together to see if the books are in balance.
- Cash Flow Statement: Cash flow is an important metric. It is the real inflows and outflows of cash into the company. This statement shows where all those inflows and outflows went. It’s different than the other statements in that those statements take into account deprecated assets, credit and liabilities not yet paid. All of those don’t effect the cash in the bank. It’s important to monitor cash flows because that determines your ability to operate the company.
Why Free Cash Flow Is King
Out of all the financial statements, figuring out your cash position is the most important. Knowing this allows you to operate your company. Having a shortage of cash will hamper your operations. Having a handle on the cash flow and what your burn rate of cash is, allows you to plan for times when cash might be tight. We will discuss how to determine your burn rate and budgets in the next post on Budgets and Financial Models.
It’s Not Just Counting Paperclips
Accounting is vital to any business. Knowing a little bit about what your accountant does will allow you to ask the right questions and understand the answers. Accounting is the language of business. Any business, anywhere in the world, understands accounting. This post is just a brief glimpse into a field that makes it possible for business to exist.
Things To Ponder
- Look up the financial statements for your favorite public company. How do they report earnings? What does it say in the fine print?
- For that same company, what methods do they use to depreciate an asset(s)? What is the book value of their assets?
- Analyze your own finances. What are your assets? What about your Profit and Loss per month? Do you have liabilities?
- Ask your company accountant to show you the companies chart of accounts. What are the various types of accounts he deals with? Where does your groups expenses get entered?
- Pick a company and compare the pro forma earnings to GAAP earnings. Why are they different? Hunt down the footnotes that explain how the pro forma was calculated.
