Back to Accounting Basics

Why are you afraid of accounting?

Is it the numbers? Are they confusing? Are you confused by the terms? Do you think accounting means complicated concepts like tax accounting?

I am confused sometimes by tax accounting.

I want to demystify accounting for you.

US GAAP & IFRS

Because I live in the United States, we go by an accounting code called Generally Accepted Accounting Principles or GAAP. Pretty much the rest of the world follows International Financial Reporting Standards. While there are similarities, there are some things that are treated differently.

But for the normal non-accounting people, the differences won’t skew a general understanding of how accounting works.

Generally, all financial statements are inclusive or an income statement, balance sheet and a statement of cash flows.

The reason for this, is so that if someone is looking from the outside, they can get a quick comparison, and understanding if a company can continue in business, or accounting speak – a going concern.

These statements are required for publicly traded companies. Privately owned companies are not necessarily governed by these principles, but because they layout a standard method, and because most people within the accounting world understand this, even private companies follow these methods.

Why? Because lenders, private investors and others are used to this type of statement as well, and they will be able to use these statements to judge as well.

Income Statement

What truly is an income statement?

An income statement shows how much income your business has or will generate over a period based on its normal transactions.

Why is this important?

This is important for several reasons.

It allows a company to understand its profitability, or the amount of money it keeps.

They take Revenues, income they receive for providing goods or services. Notice I say income, because its not always understood that a company will receive cash. This means that they could sell their goods or services on credit.

Next, they deduct a cost of goods, or services sold and deduct that from the revenues.

Some companies will take all their costs and collect them as their cost of sales, while others will set up “Standard Costs” and then create what are called variations. This allows them to have an expected cost, and then manage the Contribution Margin and the Variations. The Variations are quick ways for them to see what is causing the difference from expectations.

The next bucket is either called Sales, General and Administration. These are kept separate, because the costs are usually fixed, and they determine that these costs will remain the same independent of the number of sales that they have.

You take your Contribution Margin deduct your Sales, General and Administrative costs, and it brings you to your Earnings before Interest and Taxes or EBIT.

Finally, we separate interest and taxes. Interest is either income or expense from investment or debt. The reason to separate this, is these are not activities that are making money from selling your goods or services. Taxes are separated as they are calculated on the amounts prior to. This allows interested parties to see how profitable the business activities are. There is so much treatment that can differ and give a clouded view to how well a company is doing with its actual business activity. But this is EBIT minus Interest and Taxes is your Net Earnings.

This is an easy overview of your income statement. Things get a lot more complicated as we dive into each component.

Balance Sheet

The balance sheet is comprised on a very easy calculation.

Assets = Liabilities + Equity

Assets are comprised of Long-Term Assets and Short-Term Assets and provide future value to the company.

Long-Term Assets are considered anything that is not easily changed into value in less than one year. Subsequently Short-Term Assets would be something that you would see value in in one year or less.

Long-Term Assets are things that hold value such as tangible assets, like buildings, property or equipment, and intangible assets such as patents, or royalties on intellectual property.

Short-Term Assets can be things like Accounts Receivable (money owed that was sold on credit that is due in less than one year), Inventory or cash. There is also something called pre-paid assets like paying a year’s premium on an insurance policy, but you have yet to see the full value. If you cancelled the policy, you would get the money back.

Liabilities are anything that holds future use of resources from a company and are also split up between Long-Term Liabilities, greater than one year, and Short-Term Liabilities, less than one year.

Examples or Long-Term Liabilities could be a mortgage on a property or a pension for employees. Examples of Short-Term Liabilities could be Accounts Payable (money owed to someone bought on credit for goods or services), or Payroll.

Equity is the value held in the company that is not currently owed to anyone and is the earnings that a company has retained for itself. Remember a company is like a person, as it is its own entity. Generally Net Earnings would be part of the Equity Calculation, so it is possible that this sits in a loss position.

Statement of Cash Flows

As important as the Income Statement and Balance Sheet, which shows the relative health of a businesses continuing operations is the Statement of Cash Flows.

There are several Cash Flow formulas: Cash Flow, Free Cash Flow and Operating Cash Flow.

Cash Flow captures everything.

This calculation is a little more complicated and we can address this in future articles.

Free Cash Flow tries to capture all money (cash) moving in and out of a company, where Operating Cash Flow determines the amount of cash generated by your revenues.

We will look at Free Cash Flow as this shows the health and the ability of your company to continue to operate. Operating Cash Flow can differ based on the definitions you are looking at.

There are three terms that I need to explain as we did not discuss them in detail yet. Depreciation/Amortization is the expense that is recognized on the Income Statement related to Fixed Assets. These are your long-term assets that you need to buy with cash up front (Capital Expenditures). Accounting rules do not allow you to expense spend up front if you expect to have a long-life use of the assets and you must slowly take the expense to match the useful life of the asset. Because you buy the asset up front, the cash is then spent, and the cash is an outflow. Because the depreciation is an expense, but it is recognized as a deduction to your net earnings, we would treat this as an inflow of cash.

Your change in working capital would be the following formula.

Within this formula, the changes in each represent either a cash inflow or outflow. This is also a little more complicated and we can discuss this further in future articles as well.

Summary

If you understand the concepts behind these three statements, you are well on your way to understand what drives the financial information behind all business. Everything rests on just these three statements.

In further articles I will break down these concepts into easy-to-understand concepts that should make accounting easy for you to understand. Proper Financial Planning & Analysis relies on these concepts, and if you are a good FP&A professional, then you have a solid foundation in accounting, as it is these same concepts, but instead of looking at the past, you are looking into the future.

Thanks for reading my newsletter, The Accounting Hero and your interest in Accounting Topics, where I share Accounting Tips and education. If you want more tips, please consider subscribing and also sharing this within your network if you know anyone that has any questions on Accounting and its methods.