Accounting basics

A company can report a profit every year and still run out of cash. A bank can look healthy until the day its depositors leave. The accounts tell you which risks are building, if you know where to look.

Every company that publishes accounts tells its story in three main statements. Each answers a different question. Think of a photo and two short films.

The balance sheet lists the company's assetsSomething a company owns or controls that is expected to bring it economic benefit, such as cash, stock or machines. on one date, usually the last day of the financial year. On the other side it shows how those assets were paid for: with liabilitiesAn amount the company owes to someone else, such as a loan or an unpaid bill. (money owed to others) or with equityWhat is left for the owners: assets minus liabilities. Also called shareholders' funds or net assets. (money that belongs to the owners). The two sides always add up to the same total. That is not luck. Accountants use double-entryRecording every transaction in two places, so the accounting equation always balances. bookkeeping: every transaction is recorded in two places, so the balance is kept at every step.

The income statement covers a period, such as a year. It starts with revenue, the money earned from sales, and takes away the costs of earning it. What is left is profit, also called net income or earnings. It follows the accrualsThe rule that income is recorded when it is earned and costs when they are incurred, not when cash changes hands. rule: a sale counts when it is made, even if the customer pays later, and a cost counts when it is used up, even if the bill is paid later.

The cash flow statement covers the same period but tracks only cash. It sorts every cash movement into three groups:

• Operating: cash from running the business, such as takings from customers and wages paid.
• Investing: cash spent on, or received from selling, long-lived assets such as machines.
• Financing: cash from lenders and owners, and cash paid back to them.

Why profit and cash differ. Suppose a café spends $40,000 on coffee machines that will last 5 years. All the cash leaves on day one. But the machines earn money for 5 years, so the income statement charges a share of their cost each year. That yearly charge is depreciationSpreading the cost of a long-lived asset, such as a machine, over the years it is used.. In year one, cash falls by $40,000 while profit falls by only $8,000. Bills paid late, customers paying late, and stock bought before it is sold all push profit and cash apart in the same way.

How they link. Profit that is not paid out to the owners as dividends is kept in the business and added to retained earningsThe total of past profits kept in the company rather than paid out to owners as dividends., part of equity on the balance sheet. The cash flow statement explains why the cash line on the balance sheet moved between two dates. Alongside the three statements, companies also publish a statement of changes in equity and many pages of notes that explain each figure.

One equation sits under every balance sheet ever drawn up. Here it is, built one piece at a time.

The income statement and the cash flow statement each add up in one line too:

All three are identities: true by construction for every company, not estimates.

Example Café Ltd is a made-up coffee shop in Chicago, reporting in US dollars. Step through its first year one transaction at a time. Before each step, guess which lines will change. Check that the equation holds every time.

At the end of the year the café made a profit of $18,000, after tax at 20% on profit before tax of $22,500. Yet its operating activities brought in $33,500 of cash. Where did the difference come from? Analysts answer this with the indirect method: start from profit and undo everything that was not cash. Try each step before you reveal it.

Two more figures to note. Gross profit, revenue minus the cost of the coffee sold, is $102,000. The interest of $1,500 sits in operating cash flow here, as US GAAP requires. IFRS has given companies a choice between operating and financing for interest paid, so always check which one a company used before comparing two of them.

Accounting standards are set by the IASB for IFRS and by the FASB for US GAAP. Banks and insurers use the same three statements, but their lines look very different, as the next lessons show. Regulators start from these accounting figures and then adjust them to measure capital (L1.8.06). Later levels return to the accounting rules that matter most for risk: expected credit losses under IFRS 9 and CECL, and insurance contracts under IFRS 17.

• The balance sheet is a snapshot on one date: assets on one side, liabilities and equity on the other.
• Assets = liabilities + equity, always. Equity is what is left for the owners after all debts.
• The income statement shows profit over a period, using the accruals rule rather than cash.
• The cash flow statement sorts cash into operating, investing and financing, and explains the change in the cash balance.
• Retained profit links the income statement to equity; depreciation, stock and unpaid bills are why profit and cash differ.
• IFRS and US GAAP use different names for the same statements: check which one a company follows.

Asset

Something a company owns or controls that is expected to bring it economic benefit, such as cash, stock or machines.

Liability

An amount the company owes to someone else, such as a loan or an unpaid bill.

Equity

What is left for the owners: assets minus liabilities. Also called shareholders' funds or net assets.

Accruals

The rule that income is recorded when it is earned and costs when they are incurred, not when cash changes hands.

Depreciation

Spreading the cost of a long-lived asset, such as a machine, over the years it is used.

Inventory

Goods held to be sold or used in making sales, such as coffee beans in a café.

Retained earnings

The total of past profits kept in the company rather than paid out to owners as dividends.

Double-entry

Recording every transaction in two places, so the accounting equation always balances.

IFRS

International Financial Reporting Standards, set by the International Accounting Standards Board (IASB).

US GAAP

US Generally Accepted Accounting Principles, set by the Financial Accounting Standards Board (FASB).