Overview – Understanding the Language of Finance
It doesn’t take long for new investors to realize that they’ll need to work with numbers on a regular basis. After all, every good investment decision is contingent on high-quality analysis, and this analytical work will almost always involve studying the numbers.
Many investors have strong analytical skills and equally strong numeracy, which is great. However, while many investors have the know-how to pick apart numerical data, knowing how those numbers relate to one another and how they came about in the first place is an entirely different matter.
Why are the financial statements presented the way they are, and not in some other format? How are certain figures calculated, and what exactly goes into those calculations? The answer lies in the underlying language used to create these documents: accounting.
What Is Accounting?
Accounting is a very broad field of expertise, filled with countless rules, principles, and nuances. Because of accounting’s breadth and depth, a full discussion about it is well beyond the scope of this article.
Fortunately, investors don’t need to be Chartered Professional Accountants in order to understand financial data. That being said, investors should at least be aware of some major accounting concepts, specifically ones that apply to financial statements.
Put simply, accounting identifies and records the economic events of an organization, and communicates this information to the relevant users (managers, employees, creditors, investors, etc).
Modern accounting follows a “double-entry” system, that is, every accounting transaction has an equal but opposite effect on at least two different accounts. These entries are recorded as either a “debit” or a “credit”. If you look at a ledger, debits are always recorded on the left-hand side, whereas credits are recorded on the right-hand side.
For example, imagine a company is owed $100 in receivables, that is, they are expecting to receive $100 in payment from a customer.
One day, the customer pays this outstanding balance in cash. In the eyes of accounting, the receivables account is decreased by $100 (credit of $100), and the cash account is increased by $100 (debit of $100).
When recording this transaction in the company’s books (i.e., their financial records), the transaction will affect the cash and receivables accounts in this manner:
In its most basic form, accounting is simply a record-keeping system that keeps track of every debit and credit that every organization incurs over a set amount of time known as the “fiscal period”. An organization’s fiscal year doesn’t necessarily have to be the same as the calendar year (i.e. January – December).
Double-entry accounting represents the fundamental concept of this vast field. Every equation, concept, and principle builds off of this very simple idea. A large corporation’s financial statements may seem very intimidating at first, but they ultimately serve the purpose of reporting all economic transactions this corporation took part in over a set time.
Of all the equations used in accounting, there are a couple that investors should, at the very least, be aware of; these equations are:
[1] The Accounting Equation: Total Assets = Total Liabilities + Total Shareholder Equity
[2] The Net Income Equation: Net Income = Revenue – Expenses
These equations, though simple, are so important because they dictate how the financial statements will be formed.
The Financial Statements and Accounting
What the three financial statements are, and what sort of information is contained in them, have already been discussed. To make this section easier to understand, it’s highly recommended to first read the article that goes over the financial statements.
To make this discussion more concise, the assumption is that you have read the aforementioned article, or are already familiar with the financial statements and what they contain.
Accounting Concepts: The Accounting Equation
First, let’s start by looking at the balance sheet. As we know, the balance sheet reports the assets, liabilities, and equity that a company has at a specific point in time.
In theory, putting together the balance sheet isn’t an overly difficult task. You simply need to identify which items are classified as assets, liabilities, and equity, group them together, then find the total for each.
Putting together a balance sheet requires an understanding of Equation [1]. The total value of all assets must always equal the total value of the liabilities plus equity. There are no exceptions to this rule – if Equation [1] isn’t balanced, then the balance sheet is incorrectly put together.
Fortunately, virtually all balance sheets of any publicly traded corporation are thoroughly audited; the value of total assets, along with the value of total liabilities + equity, are clearly reported and verified. Below is the balance sheet of Manulife Financial as of December 31, 2020:
As we can see, the total assets and total liabilities plus equity are equal, therefore satisfying Equation [1]. Because of this, we can confidently say that the balance sheet is in order and can assess each line item without worrying about the possibility of the balance sheet not being balanced.
Remember, every balance sheet must balance (hence the name “balance sheet”). A simple check to see if this condition is met never hurts to do.
Accounting Concepts: The Net Income Equation
Looking at the income statement, we have a similar situation, except this time the equation that dictates this financial statement is Equation [2].
The number that most people focus on in this statement is net income, or net profit, found at the bottom of the document (hence the popular term “bottom line”). Companies disclose what their sources of revenue are as well as all their expenses.
Net income is always the difference between revenue and expenses. If Equation [2] isn’t balanced, then we know for certain the income statement was put together incorrectly.
In Manulife’s statement of income, we see that Equation [2] is indeed satisfied:
If you take the time to do the math yourself, you’ll quickly learn that everything is in order: subtracting total expenses [72,137] from total revenue [78,908] gives us net income before income taxes [6,771]. After subtracting income taxes, the final net income figure is 5,576 million CAD.
Like before, checking to see if Equation [2] is satisfied never hurts to do.
Accounting Concepts: Indirect Method
Finally, we arrive at the cash flow statement. The entry that we’ll specifically focus on is the cash from operating activities.
To arrive at the final cash from operating activities figure, most companies use the indirect method, that is, they start with the net income then “add back” the relevant line items to the net income figure. The end result is the cash from operating activities.
In the cash flow statement below, look at the line item that says “adjustments”, under the section listed as “operating activities”.
Put very simply, the indirect method works by adding back and deducting certain items to get an accurate figure of the cash an organization gained (or lost) during a period of time.
For example, depreciation is usually listed as an expense (in this case, Manulife has very few, if any, tangible assets so they don’t report depreciation). Because no cash is actually spent to “pay” for depreciation, this expense is added back to net income, thereby increasing the cash from operating activities.
A full discussion of the indirect method is beyond the purpose of this article, but again, that’s beside the point. What’s important is that an investor knows about the indirect (and by extension, direct) method, and why these adjustments are being made to the net income in the first place.
Understanding the Financial Statements Means Understanding the Language Used to Create Them
As you can see, the three major financial statements are put together by adhering to specific accounting principles. Although financial statements may vary between different enterprises, at their core, they all present the same information and were put together by following the principles.
Anyone can look at financial data and take a stab at what the numbers mean, but to truly understand what’s going on an investor needs to be familiar with accounting.
Now, to reiterate what was said earlier, investors don’t need to be highly experienced accountants, but accounting directly impacts the information that investors work with, so investors should at least have a basic understanding of how accounting works and how it affects the decisions they make.
Imagine you have no knowledge of accounting at all, and one day you decide to go through a company’s financial statements as part of your due diligence.
Unknown to you, this company’s statements are flawed. The balance sheet doesn’t balance, the net income figure is incorrectly calculated, and the items added back to net income on the cash flow statement shouldn’t be added back in the first place.
However, because of your lack of accounting knowledge, you don’t pick up on those errors, and you proceed to mistakenly believe that everything is in order.
Such a situation is very unlikely, but it’s still an investor’s responsibility to remain vigilant. Therefore, an investor must equip themselves with the necessary skills and knowledge needed to avoid any potential traps.
There are many reasons behind the downfall of the now-defunct Enron, but one of the major causes of their downfall was the fact that they used some very “creative” accounting tactics. An intelligent investor would’ve immediately noticed the shoddy accounting and divested as quickly as possible.
This may sound a bit pessimistic, but the reality is that not every company that investors interact with will be honest, and some of them will do whatever it takes to attract investment dollars, even if the investors get little value in return.
If an investor wants to avoid being misled when looking at financial statements, the first step to avoid this is to learn the language that was used to write these documents in the first place.
Being Aware of Accounting Standards and Changes
As the business world continues to evolve, so too do accounting standards and best practices.
Most countries around the world follow the International Financial Reporting Standards (IFRS). IFRS changes all the time, with new standards being released every few years.
When analyzing the financial data of companies around the world, it’s best to first understand what accounting standards they follow. It’s important to note that countries adopt reporting standards, not individual, publicly traded companies.
For example, Canada adheres to IFRS whereas the U.S. adheres to their own reporting standard known as US GAAP (Generally Accepted Accounting Principles). The U.S. (specifically, the SEC) intends to switch to IFRS, but the transition has been slow.
Again, investors don’t need to be experts on all accounting standards, but they should at least be aware that these standards exist and know what they cover. For example, at the time of this writing, IFRS has 17 issued standards that cover a variety of topics such as share-based payment, consolidated financial statements, and insurance contracts.
Regardless of what accounting standard you run into, it would be wise to at least familiarize yourself with what the standard covers, and to be aware when the standard introduces any changes.
Wrapping Up
Accounting is the language of finance. Any time financial information needs to be shared, people and organizations follow specific rules and practices to compile and present this information in an orderly fashion.
Investors work with financial data all the time, and the financial statements are put together by following specific accounting principles, so it’s in an investor’s best interests to at least have a basic understanding of what accounting is and how it works.
Naturally, accounting standards and best practices change as the business world continues to evolve every day. So, investors should at least be aware of what these standards entail and when changes come into effect.
