Financial Accounting

Assets = Liabilities + Owners’ equity. On the left, the resources the business controls. On the right, where they came from — what it borrowed, and what its owners put in or left in. The two sides describe the same pile of value from opposite directions, which is why the equation can never break.

Every transaction — taking a loan, buying inventory, performing a service, ordering stationery — lands somewhere in that equation and moves it without unbalancing it.

Accounting standards exist so that two companies describing themselves are describing themselves the same way. FASB writes US GAAP; the IASB writes IFRS, which most of the rest of the world uses. Underneath the standards sit a handful of principles that do most of the work.

Debits go on the left, credits on the right. They do not mean good and bad — they mean increase or decrease depending on which kind of account you are touching. Assets and expenses rise with a debit and fall with a credit; liabilities, equity and revenue do the reverse.

Every entry has at least two lines, and total debits must equal total credits. That constraint is what keeps the accounting equation in balance automatically, rather than by anyone checking.

Cash accounting records things when money moves. Accrual accounting records them in the period they relate to, whatever the bank is doing — revenue when it is earned, expenses when they are incurred. Nearly every company of any size uses accrual, and GAAP requires it.

The balance sheet is a snapshot: everything the business owns and owes as of one specific date. The income statement is a film: all the revenue and expense activity over a period. The difference between them is the difference between real accounts, which carry a cumulative balance, and nominal accounts, which report one period and then reset to zero.

Under US GAAP the balance sheet runs current assets, non-current assets, current liabilities, non-current liabilities, equity — most liquid first within each group. IFRS generally reverses it, least liquid first, and puts equity before liabilities.

An explicit transaction has a cash movement, a piece of paper, and a moment that obviously triggers an entry. An implicit one has none of those — no resources move, no invoice arrives, and the only thing that happened is that time passed. Those need judgement about when to record and how much.

Profit is an opinion built from judgements about timing; cash is a fact. The statement of cash flows splits every movement into operating, investing and financing — and the pattern of those three signs tells you more about a company’s situation than most of the individual numbers.

Converting net income to operating cash flow under the indirect method comes down to four rules: an increase in an operating current asset is subtracted, a decrease is added; an increase in an operating current liability is added, a decrease is subtracted.

Return on equity is net income divided by owners’ equity, and on its own it tells you almost nothing about how a business works. The DuPont framework breaks it into three factors that do.

Forecasting is accounting pointed the other way. Pro-forma statements are the standard output, usually built with the percent of sales method: project sales, then find which line items track them. Cost of goods sold usually does. Property, plant and equipment usually does not — for that you read the notes about planned capital expenditure. Income tax expense is generally estimated as a percentage of income before taxes.

Free cash flow then tells you how much actual cash the business generates for investors or new projects. And because a dollar today is worth more than a dollar next year, comparing projects honestly means discounting everything back to the present.

Everything above, compressed to the sentences worth carrying around.