Recently, Berkshire Hathaway earned $81.4 billion in 2019, a 1,900% increase from the year before! How was this possible, by an accounting rule instituted in 2018 that requires companies to include in their bottom line gains from their stock portfolio, even if they don’t sell the stock. Buffett vehemently disagrees with this accounting rule but follows the letter of the law.
The above example illustrates the importance of financial accounting and understanding how accounting works; it can have a huge impact on your investments if you don’t understand how to read financial statements and the ramifications of new rule changes such as the one above.
To be a great investor doesn’t require you to become a CPA; rather, it requires understanding financial accounting for beginners. Have a basic idea of how to read financial reports and understand the correlation between the documents.
In this post, we will cover many of the basics of accounting and provide an overview of how accounting works and some important features to understand. Like learning any language, business speaks in accounting, and a basic understanding will help you speak in business.
Knowledge compounds, and you will find that the more you learn, the easier it becomes to learn more and continually compound. First, we need to cover the basics and grow from there.
In today’s post, we will learn:
- What is Financial Accounting?
- What are the Basics of Financial Accounting?
- Components of the Basic Accounting Equation
- Financial Statements – An Overview
Ok, let’s dive in a learn more about financial accounting.
What is Financial Accounting?
In a nutshell, financial accounting is the process of preparing financial statements for any business, whether they are public or private.
The three main financial statements are:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
The three statements serve two purposes for financial analysis of the financial condition of any company.
- The first purpose is to report on the financial condition of our company.
- The second purpose is to illustrate how a company performs over time.
Any vested interest in the company will peruse these documents looking for clues pertaining to the company’s financial condition.
Everyone is trying to determine whether or not the company is making or losing money; remember, that boils down to the company’s profitability and the likelihood that it will continue.
Financial accounting is the gathering and organizing of financial information in such a way that outside observers can understand the information in a presentable way.
The analysis of that information is related to the following:
- Creditors or lenders
The list can go on and on.
To start with, we have two basic types of accounting:
- Accrual accounting
- Cash accounting
The accrual method of accounting is the posting of revenue and costs as they occur. The accrual method applies the matching principle, which matches the revenues and the costs associated with creating those revenues. Accrual accounting ignores the timing of any cash flows associated with calculating the business’s profits.
An example of accrual accounting:
- Your local breakfast restaurant paid $1,000 for meat, fresh produce, and dairy on May 30.
- The restaurant paid $600 in cash for labor costs on June 15.
- The restaurant served guests on June 20 and brought in revenues of $2,300 for breakfast that day.
Using the accrual method of accounting, our restaurant posted revenues of $2,300 on June 20, along with food expenses and labor costs. The revenues match the costs incurred to generate revenue. All of which created a $700 profit.
Think of cash accounting like your checkbook for those who remember what that means.
When a customer pays you cash, you increase your revenue. And you post expenses when you pay for those expenses with cash.
That, in a nutshell, is cash accounting.
Using cash accounting in the above example would require us to post expenses such as food purchases and labor when they occur. Because the cash accounting method wouldn’t match our revenues, we wouldn’t be able to determine the profitability of our restaurant.
Let’s move on to the basics of financial accounting.
What are the Basics of Financial Accounting?
At the heart of financial accounting is the double-entry accounting method. The double-entry accounting method means entering each financial transaction in at least two different accounts; for example, assets and liabilities are accounts.
Next, we will introduce debits and credits, of which assets and liabilities are examples of these line items.
Debit means to enter a transaction on the left side of the account or ledger. Debits can increase some accounts and decrease others.
Entered on the right side of the ledger or account are credits. And likewise, credits can increase some accounts and decrease others.
How to Visualize Debits & Credits
Imagine that our restaurant takes out a loan. Under the double-entry system, the transaction must enter as a credit in one account and as a debit in another.
The loan bolsters the restaurant’s accounts as the cash/assets increase, and this transaction, a debit, is where the assets increase, which leads to entering the debit as a transaction under the asset account.
On the other side, the loan increases the restaurant’s liabilities, and this transaction, where the liabilities increase, is the credit transaction—the transaction listed under the liability account.
The above example is the flow of the double-entry accounting system.
We can easily find information concerning which accounts to credit or debit accounts online concerning accounting. Understanding the double-entry system is key to understanding how assets and liability are connected. You often need both to create more revenue for the company.
For example, an increase in an expense and a decrease in income are always debit entries. Likewise, a decrease in assets and an increase in liabilities are always credit entries.
Something important to keep in mind, debiting an account doesn’t always mean it will decrease, and the other side of the transaction, crediting an account, doesn’t always mean it will increase.
Another important idea to keep in mind, a debit needs to be balanced by a credit on the opposite of the journal entry. But that doesn’t mean that each debit and credit balance is on a dollar basis. A debit doesn’t always mean diminishing the account; likewise, crediting an account doesn’t mean its value will increase.
A major advantage of the double-entry system is that it always helps balance the accounting equation. The accounting equation is:
Assets = Liabilities + Shareholders’ equity
If our restaurant records its accounts accurately, the left side will match the right side of the equation.
The double-entry matches well with the accrual accounting method we mentioned earlier, as revenues and expenses are recorded in the financial statements as they occur. Not when the cash comes in and out of the accounts like it would with cash accounting.
The accrual system allows for the accuracy of the financial statements to reflect the financial condition of our restaurant and that revenues or profits are not overestimated or underestimated.
An example I came across about the importance of understanding accounting from a recent article:
“For example, in its most recent quarterly results, released on April 14, healthcare company Johnson & Johnson (NYSE:JNJ) reported net income of $5.796 billion, but its adjusted net earnings came in at $6.154 billion — this is the number that analysts focus on. One of the items that J&J excluded from its adjusted earnings included intangible asset amortization, which doesn’t involve cash. This isn’t a terribly big concern, since amortization just involves spreading the cost of capital expenses over a period of useful life. However, J&J also had other adjustments to its earnings that might be a bit more debatable.
For instance, it added back $120 million in litigation expenses during the quarter and $118 million for restructuring-related expenses. For a company with as many legal problems as J&J has related to baby powder and opioid lawsuits, these expenses are relevant, and I would say they shouldn’t be adjusted out. And “restructuring costs” can be vague. The danger of adjusted earnings calculations is that they can incentivize a company to find as many things as possible to book to these types of expenses, knowing that they’ll get added back to adjusted earnings anyway.”
Components of the Basic Accounting Equation
The basic accounting equation illustrates the two particulars of every company, what it owns and owes.
The basic accounting equation is the base of the above-mentioned double-entry system; the equation follows:
Assets = Liabilties + Shareholders’ Equity
The above equation tells us that a company can get assets by adding liabilities and shareholders’ equity, which is great because companies acquire assets using cash and liabilities. Shareholders’ equity equals the sources of this funding.
In the equation, liabilities appear before the shareholders’ equity. The reason for that location is that the company must pay creditors before company goes bankrupt, in the worst-case scenario. In the same scenario, the financial statements list current assets and liabilities before long-term assets and liabilities.
The accounting equation requires that all assets equal the liabilities and shareholders’ equity; both sides must balance.
Let’s break down the equation by the parts by listing some common components of each side of the equation.
We can refer to any resource controlled or owned by the business for use or benefit as an asset. Assets can be tangible such as machinery, and intangibles, such as goodwill.
Below is a list of some common assets:
- Accounts receivable
- Prepaid Expenses
- Machines or vehicles
- Land or buildings
Liabilities refer to money owed to another entity, such as a person, company, or organization. Accounts payable is an account that comes to mind when thinking about liabilities. An account payable is a promise to pay for a good or service purchased by the company; another way to think of it is credit extended for the goods or services with the promise to pay in the future.
Some common liabilities are listed below:
- Accounts payable
- Bank Loans
- Unearned Income
- Short-term borrowings
- Dividends payable
- Accrued Income Taxes
- Long-term Operating Lease Obligations
Also known as shareholders’ equity, the part of the company that shareholders, owners, or partners own. An owner can expand their shares by investing more in the company or reduce their share by selling company shares. Likewise, revenues expand the equity and expenses to reduce shareholders’ equity.
Common examples of items listed as shareholder equity:
- Common stock
- Retained Earnings
- Paid-In Capital
- Unearned Income
- Preferred Stock
- Purchase of company stock
Now that we understand accounting terms, the accounting equation, and double-entry accounting, let’s examine the financial statements, the final stomping ground for accounting.
Financial Statements – An Overview
As we mentioned above, the three main financial statements we concern ourselves with as investors consist of the following:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
All three statements flow from one to the other and record the daily accounting transactions as they occur in a business, but each presents the facts differently.
Let’s examine these statements from 30,000 feet look; we will dive into each in future posts.
The income statement summarizes the company’s revenues and expenses, usually quarterly or annually, over a certain period. We can break up the income statement into four parts or measures of profitability:
For our purposes as investors, the income statement summarizes Walmart’s sales (revenues) and expenses, either quarterly or annually, for each fiscal year. The final or net numbers are extremely important to investors and analysts.
Line items you will see in most income statements include:
- Net sales
- Cost of Sales
- Selling, General & Administrative Expenses (SG&A)
- Operating Income
- Pretax Income
- Net Income
For example, Walmart’s income statement will reveal four critical junctions of the company’s operations, all of which we measure by ratios to help analyze the results.
Those junctions are gross profits, operating profits, pretax profits, and net income. Comparison of these junctions is important to deciphering the profitability of Walmart, for example, not only to past operations but also to competitors.
An important note about income statements, investors must remember that the income statement realizes revenues when they occur. Or in other words, when goods are shipped, services performed, or expenses incurred.
Another item to keep in mind, with accrual accounting, the flow of the income statement does not coincide with the inflows and outflows of cash; rather, it is a measure of the company’s profitability, not cash flow.
The balance sheet is the financial statement that reports a company’s assets, liabilities, and shareholders’ equity, all at a specific time. Think of it this way; it is a snapshot in time of the financial condition of Walmart.
Common tools to assess the financial health and efficiency of the company come from the balance sheet in the form of ratios such as return on equity, return on assets, or return on invested capital. All of which measure a company’s profitability or its capital structure.
There is a very familiar formula used when assessing Walmart’s balance sheet:
Assets = Liabilities + Shareholders’ Equity
A better way of understanding the balance sheet, a company has to pay for all the things it owns (assets) by either borrowing money (liabilities) or reducing owner’s equity (shareholders’ equity).
The accounts for assets, liabilities, and shareholders’ equity break into smaller components that help break down the company’s finances. Unfortunately, the terms used on balance sheets can vary by company and are not standardized, but you will encounter some general terms.
Under the asset side of the equation, you will see:
- Cash and Cash Equivalents
- Marketable Securities
- Accounts Receivable
- Fixed Assets
- Intangible Assets
Under the liability side of the equation, you will see:
- Current portion of long-term debt
- Interest Payable
- Dividends Payable
- Accounts Payable
- Long-term Debt
- Deferred Tax Liability
Under the shareholders’ equity side of the equation, you will see:
- Retained earnings
- Treasury Stock
- Common Stock
- Preferred Stock
An important item to remember regarding the balance sheet is that it is just a snapshot in time and only refers to the past or future balance sheet.
Statement of Cash Flows
The cash flow statement is the final financial statement that companies file. The cash flow statement combines all the cash inflows a company receives from its operations and external investments. It also includes the cash outflows that pay for the company’s operations and investments during the period.
The cash flow statement is the most intuitive of the financial statements as it follows the cash flow through the operations of Walmart, for example. The cash flow statement follows the path through the cash flow from operations, investment, and financing, ending with the net cash flow of Walmart.
Please think of the cash flow statement as the checking account of a business like ourselves; it receives income, then pays out any bills we have to pay for our standard of living. The same rules apply to any business.
Following the cash flow statement flows from the net income from the income statement, through the cash flow from operations, to the cash flow from investments, and finally arriving at the cash flow from financing.
Common line items found in the cash flow statement include:
- Depreciation and Amortization
- Accounts Payable
- Changes in Capital Expenditures
- Share Buybacks
Financial accounting is another language; to learn to become a better investor, we need to understand that language, at least on a beginner level.
By studying financial accounting for beginners, we can begin to understand the terminology and how all the numbers interact with each other. Remember that knowledge compounds itself; as you learn more about the balance sheet, you will start to understand the relevance of the return on equity ratio and its relevance.
Buffett and Munger both repeatedly speak about the importance of understanding accounting and the importance of knowledge. The good news is the language is fairly static, so once you learn what depreciation is and how it functions, it won’t change much over your investing lifetime.
That is going to wrap up our discussion of financial accounting for beginners.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can further assist, please don’t hesitate to reach out.
Until next time, take care and be safe out there,