Accounting for Finance: The Financial Statements – An Overview

The Accountant’s Role

In the view of Aswath Damodaran, it is the role of accounting:

  • To check transactions and operations, as they occur
  • To record them in a consistent manner
  • TO report the results in standardized form

Much as accounting wants to makes itself more relevant and central to businesses, it is not the role of accounting:

  • Forecast the future, no matter how tempted.
  • Value assets or operations.

Bluntly put, an accountant is a historian, chronicling events that have already occurred, not predicting the future.

The Accounting Questions

  • What do you own? List out the assets that a business has invested in, and how much it spent on those investments and perhaps what these assets are worth today.
  • What do you owe? Specify the contractual commitments that a business has to meet, to stay in business. Simply put, this should include all borrowings, but is not restricted to those.
  • How much money did you make? Measure the profitability of the business, both with accounting judgments on expenses, and based upon cash in cash out,

The Accounting Statements

  • The balance sheet, which summarizes what a firm owns and owes at a point in time, as well as an estimate of what equity is worth ( through accounting eyes ).
  • The income statement, which reports on how much a business earned in the period of analysis, while providing detail on revenues and expenses.
  • The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis and allows for a measure of cash earnings ( as opposed to accounting earnings ) and cash flows.

Balance Sheet

Balance Sheet

Long term: > 1 year

Short: within a year.

Income Statement

Income Statement

Statement of Cash Flows

Statement of Cash Flows

The Interconnections

The interconnections of balance sheet, statement of income and statement of cash flow

To make sense a company we need to real all 3 statements and their inter connections.

The Accounting Standards

  • Accounting is a rule-driven process, and over time, those rules have been formalized, especially for publicly traded companies. This formalized is driven by two considerations:
    • Standardization, to allow for a comparisons across companies
    • First principles, to ensure that earnings, asset value and cash flows measure what they are supposed to measure.
  • While accounting standards around the world remain different, they have converged ( for the most part ) around two standards:
    • GAAP ( Generally Accepted Accounting Principles ), representing rules developed by FASB ( Financial Accounting Standards Board ) to cover US financial reporting.
    • IFRS ( International Financial Reporting Standards ), representing rules developed by IASB ( International Accounting Standards Board ) for companies listed globally, follows by about 90 countries as of 2020.

The Bottom Line

  • The raw material that we use to do financial analysis and valuation almost always takes the form of accounting statements.
  • Consequently, it behooves us all to understand how accountants think ( even if we disagree with them ) in putting these statements together.
  • The challenge is that accounting thinking keeps changing, as we move through time, and we have to understand those changes ( both the what and the why ), to keep up with them.

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