Introduction and Basic Accounting Overview

NOTE TO READERS:

In this article series, I will attempt to provide investors with an understanding of corporate accounting and financial statement analysis.  Although I provide here a very brief overview of corporate accounting, I presume the reader has a basic understanding of the subject.

My intended audience is sophisticated individual investors who are either seeking to analyze companies themselves or who wish to further understand the work performed by professional securities analysts.  In other words, I have written these articles for individuals who seek to be informed and engaged on financial matters (at Tortuga Capital, we refer to such individuals as “enterprising investors”).  However, undergraduate and graduate-level finance students may also find these articles helpful supplements to their current coursework.  As a portfolio manager at a boutique investment firm, I am writing from the standpoint of a financial statement analysis practitioner rather than from the viewpoint of an academic.  As such, this article series may provide useful context to standard academic texts (many of which I have used as sources).

Financial accounting standards change frequently, and thus some topics in the article series are likely to become outdated rather quickly.  I will make every attempt to periodically update these articles to reflect substantial accounting rule changes.

  1. INTRODUCTION

Accounting is considered the “language” of business.  A company uses its financial reports to communicate its business performance and financial condition to all the company’s stakeholders.

When an investor purchases a share of common stock in a publicly-traded company, she is purchasing a minority ownership in the company.  The common stock investor would (hopefully) thus be interested in the same financial considerations as they would of an ownership interest in a small, private business – the long-term earnings potential of the company and its ability to grow (by reinvesting earnings) or payout those earnings in the form of dividends.  A company’s financial reports can help the common stock investor make intelligent decisions regarding share ownership.  Likewise, a creditor to the company is interested in the company’s ability to service fixed obligations through operating cash flows and quickly-saleable assets.  Financial reports greatly aid lenders as well.  For enterprising investors (both common stock and credit investors), an understanding of corporate accounting and an ability to analyze financial reports are necessary skills.

The task of interpreting financial statements is made difficult by an inherent conflict between the interests of corporate shareholders and the interests of corporate managers.  These corporate managers, many of whom have little ownership in the company, have been given a mandate to increase the wealth of the company’s shareholders.  Given that shareholders generally view the “worth” of their shares as the present value of future earnings, management has a clear incentive to utilize financial statements to minimize the company’s cost of capital (the rate used to discount future earnings).  Corporate managements which prepare financial statements with this end in mind are likely to provide an inaccurate (although not necessary fraudulent) picture of the company’s profits and financial condition.  Some analysists have referred to this conflict as the “adversarial nature of financial reporting.”i  For financial statement users, education is the first line of defense against these conflicts.

  1. RULES OF ACCOUNTING

In the U.S., the Financial Accounting Standards Board (FASB), a private organization operating under the oversight of the Securities and Exchange Commission (SEC), is responsible for establishing the accounting rules which must be followed by all companies with securities listed on U.S. exchanges.  The accounting standards as established by the FASB are referred to as U.S. Generally Accepted Accounting Principles (GAAP) and are recognized as authoritative by the SEC.  Public companies must file annual reports (Form 10-K) prepared in accordance with GAAP and which are audited by an independent accounting firm.  Public companies must also file unaudited quarterly reports (Form 10-Q).  These reports, along with other material, provide investors with the information to conduct proper company analysis.

Given the ease of purchasing securities of companies on non-U.S. exchanges, investors should also become familiar with accounting rules established by foreign standard-setting bodies.  The most notable of these organizations is the International Accounting Standards Board (IASB).  The IASB establishes International Financial Reporting Standards (IFRS).

There is currently an ongoing attempt by the FASB and the IASB to converge U.S. GAAP and IFRS.  However, despite this effort, many differences still exist among the two accounting systems, and I will highlight some of these differences in this article series.

  1. BRIEF ACCOUNTING OVERVIEW

Companies initially record business activity in a transactions book known as a journal.  The journal has two columns for numerical values – the column on the left is the debit column, and the column on the right is the credit columnii.  A bookkeeper will record each transaction so every debit entry will have a corresponding credit entry, and two or more accounts will be affected for every business transaction.  Throughout the journal, the total in the debit column must equal the total in the credit column.  This system of debit and credit entries is known as the “double-entry” system.  For an example of a business transaction recorded in a journal, consider an apparel retailer which purchases 100 t-shirts at $10 each, for a total of $1,000, for which the merchant pays cash.  The journal entry would be:

The company would record every transaction in the journal over a period.  These transactions are then posted to a ledger, in which transactions are grouped by accountiii.  The company uses the account balances in the ledgers to prepare the financial statements.

Companies prepare four basic financial statements:  the balance sheet, the income statement (profit-and-loss statement), the cash flow statement, and the statement of shareholder’s equity.

A company’s balance sheet shows, at a point in time, what a company owns (assets), what it owes (liabilities), and the difference as the residual claim from owner’s (shareholder’s equity).  The balance sheet must always “balance” in accordance with the basic accounting equation:  Assets = Liabilities + Owner’s Equity.  The balance sheet shows the resources of the company and the claims against those resources.

A company’s income statement recognizes the company’s sales, expenses, and profit (the difference between sales and expenses) over a period (quarter or year).  Companies use accrual accounting, meaning they recognize revenue when earned (and not necessarily when cash was received) and expenses when incurred (and not necessarily when cash has been paid).

Because of the use of accruals, a company’s net income will not equal its actual cash flow.  A company’s cash flow statement provides information on a company’s actual cash receipts and disbursements and shows the change in the cash balance on the balance sheet over the period.  The cash flow statement categorizes cash flow into: cash flow from operations, cash flow from investing activities, and cash flow from financing activities.

A company’s statement of shareholder’s equity is a statement which shows the changes in the individual components of shareholder’s equity (the residual between assets and liabilities).

These financial statements along with footnote disclosures and management commentary provide investors with the tools to make intelligent decisions regarding a company’s stock or debt.  I will discuss these financial statements and how to interpret them in greater detail in the proceeding articles.

i Martin Fridson and Fernando Alvarez, Financial Statement Analysis: A Practitioner’s Guide (Hoboken: Wiley, 2011), 5.

ii Debit entries increase assets and expenses, and decrease income, liabilities, and owner’s equity.  Credit entries increase income, liabilities, and owner’s equity, and decrease assets and expenses.

iii With computerized accounting software, the process of recording journal entries and posting to ledgers is done “behind the scenes”.  However, investors should still have a basic understanding of the role of journals and ledgers in the accounting process.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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