Accounting Made Simple

1. Accounting Equation: The Foundation of Financial Truth

The Accounting Equation states that at all times, and without exceptions, the following will be true: Assets = Liabilities + Owners’ Equity

The bedrock principle. The accounting equation (Assets = Liabilities + Owner's Equity) is the cornerstone of all accounting practices. It dictates that a company's resources (assets) are funded by either what it owes to others (liabilities) or the investment of its owners (equity). This equation must always balance, ensuring that every transaction is accounted for from two perspectives.

Breaking it down. Assets are what a company owns, including cash, inventory, and equipment. Liabilities represent debts owed to creditors, such as loans and accounts payable. Owner's equity is the residual value of the business after liabilities are deducted from assets, representing the owner's stake in the company.

Real-world example. Imagine a small business owner purchases a $10,000 delivery van using a $6,000 loan and $4,000 of their own money. The van (asset) is worth $10,000. The loan (liability) is $6,000, and the owner's investment (equity) is $4,000. The equation balances: $10,000 (Assets) = $6,000 (Liabilities) + $4,000 (Equity). This equation is the foundation for understanding a company's financial health.

2. Balance Sheet: A Financial Snapshot in Time

A company’s balance sheet shows its financial situation at a given point in time.

Point-in-time view. The balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific moment. It's like a photograph of the company's financial position, revealing what it owns and owes at that particular time. Unlike the income statement, which covers a period, the balance sheet is a static view.

Key components. The balance sheet is divided into three main sections: assets, liabilities, and owner's equity. Assets are further categorized as current (expected to be converted to cash within a year) and non-current (long-term assets like property, plant, and equipment). Liabilities are also divided into current (due within a year) and long-term (due beyond a year).

Interpreting the balance sheet. By analyzing the balance sheet, stakeholders can assess a company's liquidity (ability to meet short-term obligations), solvency (ability to meet long-term obligations), and overall financial stability. For example, a high level of current assets compared to current liabilities indicates strong liquidity. A balance sheet is a critical tool for investors and creditors.

3. Income Statement: Tracking Performance Over Time

A company’s income statement shows the company’s financial performance over a period of time (usually one year).

Performance over a period. The income statement, also known as the profit and loss (P&L) statement, summarizes a company's revenues, expenses, and profits over a specific period, such as a month, quarter, or year. It's like a video showing the company's financial performance over time, revealing how well it generated revenue and managed expenses.

Key metrics. The income statement typically starts with revenue, then subtracts the cost of goods sold (CoGS) to arrive at gross profit. Operating expenses (such as rent, salaries, and marketing) are then deducted from gross profit to calculate operating income. Finally, non-operating items (like interest income or expenses) are added or subtracted to arrive at net income, the bottom line.

Analyzing profitability. The income statement provides insights into a company's profitability and efficiency. Key ratios, such as gross profit margin (gross profit divided by revenue) and net profit margin (net income divided by revenue), can be calculated to assess how effectively the company is controlling costs and generating profits. The income statement is essential for understanding a company's financial health.

4. Statement of Retained Earnings: Bridging the Financial Statements

The statement of retained earnings functions much like a bridge between the income statement and the balance sheet.

Connecting the dots. The statement of retained earnings (SRE) reconciles the beginning and ending balances of retained earnings, which represents the accumulated profits of a company that have not been distributed to shareholders as dividends. It acts as a bridge between the income statement (which reports net income) and the balance sheet (which includes the ending retained earnings balance).

Key components. The SRE starts with the beginning retained earnings balance, adds net income from the income statement, and subtracts dividends paid to shareholders. The result is the ending retained earnings balance, which is then reported on the balance sheet.

Understanding retained earnings. Retained earnings is not the same as cash. It represents the cumulative profits that have been reinvested in the business or used to pay off debt. A healthy retained earnings balance indicates that a company has been profitable and has chosen to retain earnings for future growth. The SRE is a critical tool for understanding a company's financial health.

5. Cash Flow Statement: Following the Money

The cash flow statement does exactly what it sounds like: It reports a company’s cash inflows and outflows over an accounting period.

Tracking cash movements. The cash flow statement (CFS) reports all cash inflows (cash coming into the company) and cash outflows (cash leaving the company) during a specific period. It provides a clear picture of how a company generates and uses cash, which is essential for assessing its liquidity and solvency.

Three categories. The CFS is divided into three main sections: cash flow from operating activities (related to the company's core business operations), cash flow from investing activities (related to the purchase and sale of long-term assets), and cash flow from financing activities (related to debt, equity, and dividends).

Interpreting cash flow. Analyzing the CFS can reveal important insights about a company's financial health. For example, positive cash flow from operating activities indicates that the company is generating sufficient cash from its core business to cover its expenses and invest in future growth. The CFS is a critical tool for understanding a company's financial health.

6. Financial Ratios: Unlocking Insights from Financial Statements

Of course, now that you know how to read financial statements, a logical next step would be to take a look at the different conclusions you can draw from a company’s financials.

Analyzing financial health. Financial ratios are calculations that use data from financial statements to assess a company's performance and financial health. They provide a standardized way to compare a company's performance to its peers, industry averages, and its own historical performance.

Key categories. Financial ratios are typically categorized into four main groups: liquidity ratios (measuring a company's ability to meet short-term obligations), profitability ratios (measuring a company's ability to generate profits), solvency ratios (measuring a company's ability to meet long-term obligations), and efficiency ratios (measuring how efficiently a company uses its assets).

Examples of ratios.

• Current Ratio: Current Assets / Current Liabilities (Liquidity)
• Gross Profit Margin: (Revenue - COGS) / Revenue (Profitability)
• Debt-to-Equity Ratio: Total Debt / Total Equity (Solvency)
• Inventory Turnover: COGS / Average Inventory (Efficiency)

By calculating and analyzing financial ratios, stakeholders can gain a deeper understanding of a company's financial strengths and weaknesses.

7. GAAP: Standardizing the Language of Business

In the United States, Generally Accepted Accounting Principles (GAAP) is the name for the framework of accounting rules used in the preparation of financial statements.

Consistent accounting rules. Generally Accepted Accounting Principles (GAAP) is a set of accounting standards and guidelines used in the United States for preparing financial statements. GAAP ensures that financial statements are presented in a consistent and transparent manner, allowing investors and creditors to compare the financial performance of different companies.

Who must follow GAAP? Publicly traded companies in the United States are required to follow GAAP when preparing their financial statements. This requirement is enforced by the Securities and Exchange Commission (SEC). Many private companies also choose to follow GAAP to enhance the credibility of their financial statements.

Benefits of GAAP. GAAP provides a common framework for accounting, reducing the risk of fraud and misrepresentation. It also makes it easier for investors and creditors to understand and analyze financial statements, leading to more informed investment decisions. GAAP is essential for maintaining the integrity of the financial markets.

8. Debits and Credits: The Double-Entry System

Likely the single most important aspect of GAAP is the use of double-entry accounting, and the accompanying system of debits and credits.

Two sides to every story. Double-entry accounting is a system in which every transaction affects at least two accounts. For every debit (an increase in assets or expenses, or a decrease in liabilities or equity), there must be an equal and opposite credit (an increase in liabilities or equity, or a decrease in assets or expenses). This ensures that the accounting equation (Assets = Liabilities + Owner's Equity) always remains in balance.

Debits and credits explained. Debits are recorded on the left side of an accounting entry, while credits are recorded on the right side. The specific accounts that are debited and credited depend on the nature of the transaction.

Example transaction. A company purchases $1,000 of inventory with cash. The journal entry would be:

• Debit Inventory (an asset) for $1,000
• Credit Cash (an asset) for $1,000

This entry increases the inventory account and decreases the cash account, maintaining the balance of the accounting equation.

9. Cash vs. Accrual: Timing is Everything

In order to be in accordance with GAAP, however, businesses must use a method known as “accrual accounting.”

Two accounting methods. There are two primary methods of accounting: cash accounting and accrual accounting. Under the cash method, revenue is recognized when cash is received, and expenses are recognized when cash is paid. Under the accrual method, revenue is recognized when it is earned, and expenses are recognized when they are incurred, regardless of when cash changes hands.

GAAP requires accrual. GAAP requires that companies use the accrual method of accounting. This is because the accrual method provides a more accurate picture of a company's financial performance by matching revenues and expenses to the periods in which they are earned or incurred.

Example of accrual accounting. A company provides services to a customer in December but does not receive payment until January. Under the accrual method, the company would recognize the revenue in December, when the services were provided, rather than in January, when the cash was received. Accrual accounting is essential for providing a true and fair view of a company's financial performance.

10. Depreciation & Amortization: Spreading the Cost of Assets

When a company buys an asset that will probably last for greater than one year, the cost of that asset is not counted as an immediate expense.

Allocating asset costs. Depreciation and amortization are accounting methods used to allocate the cost of an asset over its useful life. Depreciation is used for tangible assets (like equipment and buildings), while amortization is used for intangible assets (like patents and trademarks).

Straight-line method. The most common method of depreciation and amortization is the straight-line method, which allocates an equal amount of the asset's cost to each period of its useful life.

Example of depreciation. A company purchases a machine for $10,000 with an estimated useful life of 5 years. Using the straight-line method, the company would record $2,000 of depreciation expense each year ($10,000 / 5 years). Depreciation and amortization are essential for matching the cost of assets with the revenue they generate over time.

11. Inventory & CoGS: Tracking the Flow of Goods

Under GAAP, there are two primary methods of keeping track of inventory: the perpetual method and the periodic method.

Managing inventory costs. Inventory is a significant asset for many companies, and it's important to track the cost of inventory accurately. There are two primary methods of accounting for inventory: the perpetual method and the periodic method.

Perpetual vs. periodic. Under the perpetual method, inventory levels are updated continuously with each purchase and sale. Under the periodic method, inventory levels are only updated at the end of each accounting period.

Cost of Goods Sold (COGS). Cost of Goods Sold (COGS) represents the direct costs associated with producing or acquiring the goods that a company sells. COGS is a key expense on the income statement and is calculated differently depending on the inventory method used. Accurate inventory accounting is essential for determining a company's profitability.

Last updated: April 1, 2025