A fundamental understanding of accounting principles is critical to creating any meaningful financial analysis. Before diving into a complicated analysis of mergers and acquisitions, a strong foundation in accounting is essential. We build from the beginning and try to summarize and explain accounting principles in simple terms. Therefore, we begin with an explanation of the three accounting statements: balance sheet, income statement, and cash flow statement.
Accounting Principles – Balance sheet components
An asset is property that is presently in control of an enterprise. A firm owns this asset because it will confer some future benefit to its operation. Assets are typically items that are used to conduct business (factories, machines, company receivables, etc.) but can also include other products owned by the enterprise (bonds, stocks, other investments owned by the company, etc.)
A liability is a present obligation that a company owes. Liabilities are funded by assets and company operations. They may also be used to fund operations, such as when a company issues bonds to raise capital. In a sense, liabilities represent future outflows of company property to meet present obligations (deferred taxes, potential lawsuits, payables, etc.).
Equity is the residual interest of assets an enterprise holds in excess of liabilities (Equity = Assets – Liabilities) and can be thought of as ownership interest in a business. The two principal elements of equity are equity (or shares that have been issued by the business to investors) and retained earnings of the company (the aggregate year-to-year profit or loss that a company has accumulated since starting business)
Assets and liabilities are only recognized if:
- There is sufficient evidence of existence.
- The monetary amount can be measured with sufficient reliability.
If there is uncertainty by a business about obtaining a future asset or liability, it is not recognized in financial reporting.
Accounting Principles – Income statement components
Income is the benefit that a company earns as a vendor of its goods or services. An enterprise is compensated for its goods or services through income (sales revenue). Income also arises when there is an increase in future economic benefits related to an increase in an asset or a decrease of a liability (this can occur when an equity investment by a firm rises in value by $100, this $100 is recognized as income).
Expenses are costs that an enterprise incurs in the process of conducting business. Directly traceable costs during production (cost of goods sold) and those not directly traceable (Selling, General, and Administrative) are common expenses. Expenses also arise when there is a decrease in future economic benefits related to a decrease in an asset or an increase of a liability (this can occur when an equity investment by a firm falls in value by $100, this $100 is recognized as an expense).
Accounting Principles – Cash flow statement
The cash flow statement maintains a record of a company’s cash inflows and outflows in a given accounting period. This statement breaks up cash movement into operating, investing, and financing activities.
Balancing the balance sheet
The sum of liabilities and equity must always equal the assets as this is the fundamental accounting equation (Assets = Liabilities + Equity). The equality means that the assets a company uses in the process of operations are funded through obligations of liabilities (e.g., issuing bonds) and by the residual interest of equity (e.g., issuing stocks). Whatever happens to the company will create two equal and opposite effects on its financial statements, maintaining this equality.
The following are examples of this equality and maintenance of the fundamental accounting equation:
|Company borrows money from the bank|
Equal and opposite movements on the balance sheet
|Cash (asset) ↑||Loan (liability) ↑|
|Company buys a vehicle|
Equal and opposite movements on the balance sheet
|Cash (asset) ↓||Vehicle (asset) ↑|
|Company pays staff wages|
The expense will reduce retained earnings (equity) which will match the fall in assets
|Cash (asset) ↓||Wages (expense) ↑|
|Company sells goods for cash of $10||Cash (asset) ↑|
Inventory (asset) ↓6
|Sales (income) ↑10|
Cost of sales (expense) ↑6
Cost of sales (expense) ↑6. Balance sheet assets increase by 4, which matches the ↑4 in retained earnings.
Presentation of financial statements
The differences between the presentation of financial statements are considerable when switching between International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (US GAAP). Therefore, many of the differences in reporting will be highlighted throughout these articles.
Non-recurring items are business practices that are highly exceptional and are not expected to occur on a routine basis. Actions such as the sale of a company are considered non-recurring items. IFRS requires that non-recurring items should be presented separately in the income statement before operating profit (or EBIT). US GAAP requires that non-recurring items be presented net of taxes in a separate section of the income statement before operating profit (or EBIT).
Discontinued operations are business operations, segments, or product lines that are sold or abandoned. An example of discontinued operations would be an athletics apparel company discontinuing their line of children’s clothing. Accounting rules require that the results of these operations be presented separately on the face of the income statement. The balance sheet must also show separately the amounts relating to assets and associated liabilities held for sale at the balance sheet date.
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