This article was republished from a post on the Invest Before the Street blog

Financial accounting. Who needs it?

Accounting existing for two basic reasons:

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  • To track how much money companies make
  • To track what they own (assets)/ what they owe (debt)

Of course it’s much more complicated than that, but let’s kept it simple for now.

A company’s financial statements are divided into three primary segments:

  • Income Statement
  • Cash Flow Statement
  • Balance Sheet

The best way to understand financial accounting? Pretend like you own a business.

Today you are officially the new owner and accountant of a retailer selling sporting goods. It’s the end of the year, so it’s time to put together all the financial statements. There are a few different types of financial accounting methods, IFRS and GAAP being the two big ones, and we are going to use GAAP accounting in this example.

The Income Statement

First off, we begin with our sales, or revenue. This year we sold $1,300 in merchandise, and it cost us $575 to buy that merchandise. Therefore, our Revenue equals $1,300 and our Cost of Goods Sold (COGS) equals $575. If we subtract those two, we see that we earned a Gross Profit of $725 for the year. So far, our Income Statement should look like this:

We did have other costs as well though. We had salaries to pay, administrative costs, etc. These costs all add up to $240, and we call them our Selling, General & Administrative costs (SG&A). We’ve also been spending $50 a year on research and development (R&D) of new products.

Another odd thing happened this year. We decided to buy new carpeting for the store since the previous carpet was getting super old. It cost $50 for the new carpeting. This is an unusual cost though. It’s not like every year the business has to put in a new carpet. This will make our profitability look much lower than it normally does. How can we handle this?

A Quick Lesson on Expensing vs Capitalizing Costs

A company can ‘expense’ its costs or ‘capitalize’ its costs.

Most normal day-to-day costs are ‘expensed’ on the Income Statement like we’ve done so far.

Less frequent larger maintenance or growth related costs can be ‘capitalized’, meaning they are listed as a ‘Capital Expenditure’ on the Cash Flow Statement, instead of an expense on the Income Statement.

Great! Now we can just get rid of that cost on the Income Statement right? Nope, nothing in accounting is that simple.

What if we could spread out the cost of the carpet over the amount of years we expected the carpet to last for? When we capitalize a cost, a line item called Depreciation & Amortization (D&A) is created that does just that. If we think the carpet will last 10 years, we take the $50 cost, and divide that by 10 to get our annual Depreciation & Amortization expense of $5. We list this expense on the Income Statement every year for the next 10 years. This is called ‘depreciating’ or ‘amortizing’. This expense is also referred to as a non-cash expense, because technically we aren’t paying that $5 expense every year. As you’ll see later on, this is added back on our Cash Flow Statement to properly reflect the cash flow of the business for the year.

Let’s take a look at our Income Statement now.

As you can see we’ve now included our SG&A expense, R&D and our Depreciation & Amortization Expense. Now you may ask, “Why is our Depreciation & Amortization expense $65 and not the $5 we just calculated?”. Well, in the past the company must have had other capital expenditures that is also ‘depreciating’ or ‘amortizing’ over time. As you’ll see, Depreciation & Amortization increases by $5 from 2014 to 2015 to reflect our carpet transaction. Now remember, this isn’t actually a real expense. It’s a hypothetical, non-cash expense created by accounting. Later on, I’ll show you how this is added back on the Cash Flow statement to properly reflect the cash flow on this business.

By subtracting our SG&A and D&A from our gross profit, we get our Operating Income, also known as Earnings before Interest & Taxes (EBIT).

So what else is left? Well, really only two things: our Interest Expense and Taxes. Let’s start off with our Interest Expense.

What is Interest Expense? It’s just the interest you have to pay on a loan. Let’s say this retailer borrowed $500 from the bank for 10 years at a 10% interest rate to fund some purchases. This means that every year for 10 years you owe the bank $50 in interest expense ($500 * 10% interest). Since this is a cost that the business has to pay every year, we need to include in on our Income Statement like this:

Subtracting the interest expense from our EBIT gets us our Pretax Income, also known as Earnings Before Taxes (EBT).

Last, but not least, our business has to pay taxes of course. The standard corporate tax rate in the US is 35%. We get taxes based on our Pretax Income. Therefore, our taxes for this year will be $96 ($320 * 35%). Let’s see how our Income Statement looks now:

After we subtract our taxes from our Pretax Income, we get our Net Income, which represents the profit of our business. We earned $224 this year. Not too bad!

The Cash Flow Statement

The Income Statement helped us identify how much profit our business generated this year.

The Cash Flow Statement will help us identify how much cash went in and out the door this year.

Let’s get started. We always begin with our Net Income. From there we take our non-cash expenses, like Depreciation and Amortization and add them back since we actually didn’t pay those expenses. We can pull these numbers right from the Income Statement.

Now there is a big quirk with the Cash Flow Statement. Let’s say you sold something to one of your friends. Ever have them pay you online with something like PayPal or Venmo? You know how it can take a few days for that money to get into your bank account? If this were for a business, this could cause some issues.

Imagine if you sold something to someone on December 31st 2014 who paid with a credit card, but the money didn’t actually get into your bank until January 5th 2015 because it had to ‘process’. You can book the revenue for 2014, but you really didn’t get paid until 2015.

On the other hand, you could have purchased some supplies from a supplier on December 31st, but your money wasn’t taken from your bank account until January 5th. You can book the cost for 2014, but you didn’t actually pay for anything until 2015.

When you do your financial accounting for 2014, how do you handle this? You technically had both the sale and purchase of supplies happen on the December 31st, but the movement of the cash didn’t happen until January 5th.

To fix this issue, a line item called Change in Working Capital is created on the Cash Flow Statement

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