Understanding Basic Accounting

We all use basic accounting throughout our lives – whether we realize it or not

Accounting is an aspect of investing that many investors would rather avoid. For most investors, their background does not involve accounting and it just seems like one of those obscure financial things that’s best if it’s ignored.

So why bother with accounting. To put it simply, money is a motivator. The more money you make, the more you are worth. Similarly, the more money a company makes, the more the company is worth. Now if you bought shares in this company, the more your shares are worth.

Stock investors who have a basic understanding of accounting are at an advantage and can more readily profit from the stock market. The investor has no need to become an accountant, as accounting is designed to provide monetary information in a summarized format that the average person can readily read.

The typical investor actually knows a lot more about accounting than they think. They are using accounting whenever they deal with money, whether it’s receiving their pay check or paying for their groceries. So just exactly what is accounting?

Accounting is all about recording money, where it came from, where it was spent and how much you are left with! Investors are dealing with this in their personal life and with their investments.

The easiest way to understand the basic concepts of accounting is to relate it to the investor’s personal finances. That way the investor already has a familiarity with it, which makes the concepts easier to relate to. Arbitrary figures will be used for illustrative purposes to help explain the main accounting terms and concepts.

Your Personal Income Statement

The first concept in accounting is to record how much money you earn (this is referred to as your revenue) and record how much you spend (this is referred to as your Expenses). This is your personal income statement.

How much you get to keep is the difference between your revenue and your expenses (which is referred to as your Net Income).

This can be illustrated using a hypothetical example as shown in Table 1. for one month of income and expenses.

Table 1. Example of a personal

income statement

Utility Bills-$300
Net Income$4,300

As can be seen from Table 1. above, the hypothetical investor’s monthly income is $8,200 which comes from a combination of their salary and from stock dividends. But the investor does not keep all of this money as they have expenses which came to $3,900. This was money spent on living expenses and if the investor did not spend this money, they would not be in a position to earn their revenue. After all, you have to eat, you need electricity and you need general transport which includes traveling to work. In addition there is also a tax liability.

The money the investor actually gets to keep is less than their income as they have expenses. The money that’s left over is the net income which comes to $4,300.

Displaying the summarized monetary information in a tabular format is referred to as a financial statement. Since Table 1. displays income related information, it is referred to as an income statement.

Understanding the Financial Statements - Understanding Basic Accounting; picture of an investor putting money into a piggy bank showing basic accounting principles used

It is common practice not to show the negative sign on the income statement. This means that negative numbers or subtractions are implied by the term used such as costs or expenses.

The period of time that the income and expenses are recorded over is referred to as an accounting period. The hypothetical example in Table 1. used a monthly accounting period. Companies listed on U.S. stock exchanges typically use a three month accounting period and also a yearly accounting period.

Your Personal Balance Sheet Statement

The second concept in accounting is to record how much you are worth. This is done by recording the dollar value of everything you personally own (this is referred to as your Assets) and by recording the dollar amount of all the money you owe (this is referred to as your Liabilities). This is your personal balance sheet statement.

How much you are worth is simply calculated by subtracting your liabilities from your assets (what you own minus what you owe). Your worth is referred to as your Net Assets, which is also known as your Net Worth or your Equity.

This can be illustrated using a hypothetical example as shown in Table 2.

Table 2. Example of a personal balance

sheet statement

What you ownWhat you owe
Net Assets$430,000

As can be seen from Table 2. above, the hypothetical investor’s assets are worth $670,000 but they owe 240,000 in loans. If the investor sold everything they own and repaid all their loans, they would be left with $430,000 which is what their net assets are.

Understanding the Financial Statements - Understanding Basic Accounting; picture of a sign with a bright blue background showing the word asset in large white font capital letters

Now since the investor probably has a spouse (and assuming no prenuptial agreement) then the investor’s share is half of the net assets which is $215,000. Thus, the investor and their spouse are both shareholders’ of the net assets and each share is worth $215,000.

The information displayed in Table 2. is of an assets and liabilities nature and is referred to as a balance sheet statement.

The balance sheet statement produced by accountants do not show the assets and liabilities side by side, but actually show the assets first and then show the liabilities below the assets. An actual balance sheet statement shows the current year along with the previous year or two side by side. The reason the assets and liabilities were shown side by side in Table 2. is that it is easier to understand the concept of what is owned and what is owed, even though real balance sheets are not displayed in this manner.

Table 3. shows the investor’s personal balance sheet statement again for the current year and also shows the previous year side by side

Table 3. Example of a personal balance

sheet statement

Total Assets670,000660,000
Furniture loan30,00035,000
Car loan10,00015,000
Total Liabilities240,000270,000
Net Assets430,000390,000

Showing the previous year’s assets and liabilities along side the current year allows an investor to readily compare any changes in assets and liabilities from year to year.

It is common practice not to show the negative sign on the balance sheet statement. This means that negative numbers or subtractions are implied by the term used such as liabilities.

Your Personal Cash Flow Statement

The third concept in accounting is similar to the income statement. Referring to Table 1. while the income statement recorded the amount of money earned and the amount of money that was spent in a particular month, it does not take into account that money spent can be spent on a credit card and actually paid for a couple of months later. Similarly, money earned from say dividends is always paid some weeks after the ex-dividend date.

While the income statement records when the hypothetical monthly income and expenses occurred, the cash flow statement records the month when the income (such as a dividend payment) is actually received and the month when an expense (such as groceries paid on a credit card) is actually paid.

If the dividend payment were received on the ex-dividend date and if all expenses were paid at the time they occurred (no credit cards), then the cash flow statement will be exactly the same as the income statement and thus make it surplus. But in the real world of credit, the cash flow statement is required to record the period when the actual payments were received and paid.

Table 4. shows a more realistic cash flow example for three months. The dividends are not normally paid monthly but every three months. Also the utility bills we will assume are paid every three months rather than monthly, but are paid in the second month in Table 4.

Table 4. Example of a personal cash flow statement

Month 1Month 2Month 3
Total income8,0008,0008,600
Utility bills09000
Total expenses3,6004,5003,600
Net income cash4,4003,5005,000

While the income statement in Table 1. showed the income and expenses, the cash flow statement shows when the income is received and when the expenses are paid. Thus, the monthly Net Income in cash varies over the three monthly periods shown in Table 4. rather than the fixed $4,300 from Table 1.

An actual income statement shows the Net Income as a summarized item rather than splitting it into Income and Expenses and detailing it as shown Table 4. It was shown this way to help the investor understand the concept of cash flow. It is common practice to show the negative values on the cash flow statement with brackets for each summarized item that has a negative result.