Accounting Basics: Part One

Entities large enough to hire accountants tend to keep a different set of books for each of three purposes:

1) Dealing with the tax authorities,

2) Communicating with their own investors and creditors, and

3) Allowing their managers to engage in informed internal deliberations about mergers, spin-offs, prices, wages, and so forth. That is to say, there are three sorts of accounting: tax, financial, managerial.

The two sets of books that are designed for external communication, the tax and financial accounting books have a fascinating off-setting feature. The normal temptation in financial accounting will be to overstate revenue, and the normal temptation in tax accounting will be to understate it.  If you are a potential investor, and if you suspect the books they’re showing you are a bit too rosy, you’ll want to see the books they show the tax authorities.

At any rate, in what follows we will chiefly discuss financial accounting. There is a good deal of drama here: a company’s obligation to communicate honesty with the external world is, after all, of a piece with the general obligation to refrain from defrauding people or institutions into handing over money. There is a good deal of conflict as well: there will always be investors making the case, sometimes quite vocally, that they aren’t getting the real scoop.

We’ll focus, also, on the balance sheet, although we’ll have a few words to say too about another critical document, the income statement.

So: what’s a balance sheet? It’s a snapshot of the status of a business at a certain moment: say, as of the end of a year or quarter. It breaks down the various types of assets the business possesses, and assigns a valuation to each, then does the same to the various types of liabilities to which the business is subject. The value of the assets minus the value of the liabilities equals the businesses equity: this is sometimes called the fundamental equation of accounting.

Algebraically, A – L = Eq, which in turn implies that A = L + Eq.

That latter formulation gives to a balance sheet its typical format. It is divided into a left and right side. The assets occupy the left side. The liabilities occupy the top half, and equity the bottom half, of the right hand side of the sheet.

Typical assets listed under that heading in a balance sheet include: cash, accounts receivable, tools & equipment, inventory (that is, goods for sale).

Let’s talk about each of those four items a bit. The word cash seems clear enough. But in this context, the word doesn’t refer only to what’s sitting in the petty cash drawer or in a checking account. The word typically includes various “cash equivalents,” and there is some room for dispute over what is equivalent. There is a certain sort of scold who will maintain that only cash is cash, and that, for example, an account with a money market fund, even with near-immediate right of withdrawal and a solid safety record, isn’t quite “cash.” 

For purposes of portfolio planning, that’s a useful but of scolding. For purposes of laying out a balance sheet, though, it does no harm if we use “cash” as shorthand that includes other easily accessible liquid accounts.

Moving down the list: accounts receivable is the asset that reflects how much money the company has coming to it from customers who have received the business’ products on credit. Of course when these customers pay, the value of the “accounts receivable” is reduced. But every transaction has at least two balance-sheet consequences (hence the phrase “double entry bookkeeping,” a common description of post-Renaissance accounting). Typically a payment on account will require two entries, one reducing the “accounts receivable” and the other increasing the amount of cash on hand. If so, then it doesn’t affect the right-hand side of the balance sheet at all. The increase of one asset equals the decrease of another, and all is well.

Note, if our balance sheet obeyed the fundamental equation in the first place, and then we make these two offsetting changes on the right side of the ledger, the sheet will still obey that equation.  

More to come in due course.