Accounting and Financial Statements
Accounting is the language of business, and financial statements summarize the various underlying accounting entries. Accounting, especially through financial statements, allows us to understand a business and make better investment decisions, but it also allows us to improve our personal financial lives.
The building block for accounting is the accounting equation: Assets = Liabilities + Equity. Every transaction impacts the accounting equation and think of a transaction as an economic event that occurs during the operation of a business. Each transaction, when recorded, impacts the accounting equation, whether by increasing or decreasing assets, liabilities, or equity.
These transactions are recorded in the firm’s Trial Balance, and the Trial Balance includes every single debit and credit. Double entry accounting uses debits and credits, and the total value of debits must equal the total value of credits.
Assets and expenses increase with a debit and decrease with a credit.
Liabilities, equity and revenue increase with a credit and decrease with a debit.
When looking at financial statements it is also important to know that most companies use accrual accounting, which is the method of accounting that recognizes economic events in the period they occurred regardless of when cash is exchanged. In contrast, cash accounting recognizes revenue when cash is received from the customer, and expenses are recognized when payment is made to suppliers.
As transactions are recorded as debits and credits and go through the accounting cycle, they are shown in the Trail Balance, but the Trial Balance is not an efficient way to get insight to a company, so the Trial balance is summarized in financial statements: Balance Sheet, Income Statement, Cash Flow Statement, and Changes in Owner’s Equity. Each statement serves a specific purpose for investors.
The Balance Sheet show’s a company’s financial position at a specific date and is a snapshot of the business at a specific point in time. The Balance Sheet is also called the Statemen of Financial Position, and it reflects the history of every single transaction that a company has recorded.
The Income Statement shows the firm’s revenue and expenses during a specific period, which is often referred to as the fiscal year. The Income Statement is also called the Statement of Financial Performance. Since the Income Statement measures financial performance over a given period, all income and expense accounts reset to zero at the end of the accounting period. Unlike the Balance Sheet the Income Statement does not reflect transaction history.
The Cash Flow Statement shows the changes in Balance Sheet accounts and Income Statement accounts that impact cash and cash equivalents. It is organized by Operating Activities, Investing Activities, and Financing Activities. The Cash Flow Statement in a way reverses accrual accounting and it shows where cash is generated as a source of funds, and where it went as a use of funds.
The Changes in Owner’s Equity summarizes all changes in shareholder’s equity accounts for the accounting period.
Each financial statement is used for specific information and when used with footnotes found in annual reports and securities filings, they provide investors important company information, and they also serve as a basis to construct financial rations needed for additional analysis. The principles underpinning accounting for companies, however, are also applicable to help investors manage their personal financial lives.