Accounting

• 1. The balance sheet and the fundamental principle
• 2. Creating a balance sheet
• 3. The profit & loss account and cash flow statement
• 4. Creating the profit & loss account and cash flow statement
  • P&L statement (a.k.a. income statement)
  • Cash flow statement
• 5. Accounting in practice
• Chapters 6.–12. (the last 20%)
• A collection of useful links

• Stuff the company owns
• Stuff the company is owed. Usually money, but can be anything.

Stuff that the company owes to others. Usually money, but can be anything.

• Capital invested (money put into the company by the shareholders when founding the company, and at any point after that)
• Retained profit (the earnings, i.e., savings, from the stuff that the company sells)

This is the money that the shareholders would get if the company sold all of its assets and paid off its liabilities — in principle. In practice it's not that simple, but accounting standards use a "going concern" that assumes that the company is not being sold off right now.

$\text{Claims} = \text{Shareholders' equity} + \text{Liabilities}$.

A claim is a demand of ownership.

The etymology of the word "claim" is closely related to physically shouting, with the aim of signaling/demanding the ownership of something.

https://www.youtube.com/watch?v=vC0t7-XvIDE

$\text{Assets} = \text{Claims}$.

The two sides of the equation must always balance out. That's why it's called a balance sheet.

$\text{Claims} = \text{Shareholders' equity} + \text{Liabilities}$.

All of the company's assets are claimed by someone:

• The shareholders of the company
• Lenders (e.g., banks)
• etc.

Note: The company itself doesn't actually own anything. Its ownership is fully claimed by other entities.

https://en.wikipedia.org/wiki/Accounting_equation

In the balance sheet, people split assets and liabilities into current and long-term:

• Assets
  • Current assets: stuff that you expect to turn into cash in $\leq$ 1 year
  • Long-term assets (a.k.a. non-current assets): "forever" stuff
    • Fixed assets (a.k.a. tangible assets): physical things like buildings, machines, office equipment
    • Intangible assets: non-physical things like patents, brand reputation. Related to goodwill ("liikearvo").
• Liabilities
  • Current liabilities: stuff that you expect to have to pay in $\leq$ 1 year
  • Long-term liabilities (a.k.a. non-current liabilities): stuff that you expect to have to pay in $\gt$ 1 year

• Assets = "Vastaavat" or "Varat"
  • Current assets = "Vaihtuvat vastaavat" or "Lyhytaikaiset varat"
  • Long-term assets = "Pysyvät vastaavat" or "Pitkäaikaiset varat"
    • Tangible assets = "Aineelliset hyödykkeet"
    • Intangible assets = "Aineettomat hyödykkeet"
• Claims = "Vastattavat" or "Oma pääoma ja velat"
  • Shareholders' equity = "Oma pääoma"
    • Retained profit = "Kertyneet voittovarat" or "Pidätetyt voittovarat"
  • Liabilities = "Vieras pääoma" or "Velat"
    • Current liabilities = "Lyhytaikaiset vastattavat/velat"
    • Long-term liabilities = "Pitkäaikaiset vastattavat/velat"

See:

• https://www.aalto.fi/sites/g/files/flghsv161/files/2020-03/English_Finnish_Accounting_Dictionary.pdf
• https://relipe.fi/wp-content/uploads/tase-fi-sv-en.pdf

Sample Small Business Balance Sheet

Assets (current)		Liabilities and Owners' Equity
Cash	$6,600	Liabilities
Accounts Receivable	$6,200	Notes Payable	$5,000
Assets (fixed)		Accounts Payable	$25,000
Tools and equipment	$25,000	Total liabilities		$30,000
		Owners' equity
		Capital Stock	$7,000
		Retained Earnings	$800
		Total owners' equity		$7,800
Total	$37,800	Total		$37,800

https://en.wikipedia.org/wiki/Balance_sheet

A basis of accounting is the time various financial transactions are recorded. The cash basis and the accrual basis are the two primary methods of tracking income and expenses in accounting.

https://en.wikipedia.org/wiki/Basis_of_accounting

• Accrual basis
  • When something is sold, its income is recognized (recorded) immediately, even if cash has not been received yet. You expect to receive the cash.
  • When something is bought, its expense is recognized (recorded) immediately, even if cash was not sent yet. You expect to pay.
• Cash basis
  • Income and expenses are recorded only when cash changes hands

The accrual method is generally required for companies that file audited financial statements and is required under the generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Boards (FASB).

The key advantage of the cash method is its simplicity—it only accounts for cash paid or received. Tracking the cash flow of a company is also easier.

https://www.investopedia.com/ask/answers/09/accrual-accounting.asp

Unblended costs represent your usage costs on the day they are charged to you. In finance terms, they represent your costs on a cash basis of accounting.

Viewing your amortized costs is useful in cases in which it doesn’t make sense to view your costs on the day that they were charged. Or, as many of finance owners say, it’s useful to view costs on an accrual basis rather than a cash basis.

https://aws.amazon.com/blogs/aws-cloud-financial-management/understanding-your-aws-cost-datasets-a-cheat-sheet/

The double-entry system of bookkeeping standardizes the accounting process and improves the accuracy of prepared financial statements, allowing for improved detection of errors. All types of business accounts are recorded as either a debit or a credit.

A business transaction is an economic event that is recorded for accounting/bookkeeping purposes.

There are five different types of accounts that all business transactions can be classified:

• Assets
• Liabilities
• Equities [e.g., shareholders' equity]
• Income [revenue]
• Expenses

For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will raise the company’s assets and the loan liability will also rise by an equivalent amount.

If a business buys raw materials by paying cash, it will lead to an increase in the inventory (asset) while reducing cash capital (another asset).

https://www.investopedia.com/terms/d/double-entry.asp [Emphasis mine]

• Debit:
  • Increase
    • Assets
    • Expenses
  • Decrease
    • Liabilities
    • Revenue (income)
    • Equity
• Credit:
  • Decrease
    • Assets
    • Expenses
  • Increase
    • Liabilities
    • Revenue (income)
    • Equity

The terms debit (DR) and credit (CR) have Latin roots.

Debit comes from the word debitum and it means, "what is due."

Credit comes from creditum, meaning "something entrusted to another or a loan."

https://www.investopedia.com/ask/answers/04/072304.asp

Debit
An entry that represents money entering an account.

Credit
An entry that represents money leaving an account.

https://matheusportela.com/double-entry-bookkeeping-as-a-directed-graph

Seems needlessly complex. Is all of this stuff about "debit" and "credit" a way to avoid using negative numbers? Yes, some of it at least. But I can see how not using negative numbers even today would help prevent errors, since signs are small and easy to miss visually, and in some cases it might be more confusing to use a sign instead of "incoming" (debit) and "outgoing" (credit).

Always do this translation when thinking about "debit" and "credit":

• Debit increases incoming money (e.g., in the assets account)
• Credit increases outgoing money (e.g., in the liabilities account)

When money increases in one account, you must always decrease same amount of money from another account to satisfy the accounting equation.

See also:

• Debits vs credits: https://news.ycombinator.com/item?id=23971190
• Double-entry bookkeeping (debits and credits) for developers: https://www.moderntreasury.com/journal/accounting-for-developers-part-i
  • "Accounts that represent funds you own, or uses of money, are debit normal accounts."
  • "Accounts that represent funds you owe, or sources of money, are credit normal accounts."

The steady reduction in the value of something across time.

For example, assume you buy a car for 20 000 and expect it to last for 10 years. It would depreciate like this:

set xtics 1
set ytics 2000
set xrange [0:11]
set yrange [0:22000]

f(x) = 20000 - x*(20000 / 10)
plot f(x) title "Car's value"

• GAAP:
  • $\text{Assets} = \text{Claims} = \text{Liabilities} + \text{Shareholders' equity}$
• IFRS:
  • $\text{Assets} - \text{Liabilities} = \text{Net assets} = \text{Shareholders' equity}$

The balance sheet is always created on the assumption that the company is not being sold, but is instead a "going concern".

When a company is doing badly and is being sold, in practice, it might not be possible to get as much money for the company as you would assume by looking at the net assets (i.e., shareholders' equity) on the balance sheet.

A going concern is an accounting term for a business that is assumed will meet its financial obligations when they become due. It functions without the threat of liquidation for the foreseeable future, which is usually regarded as at least the next 12 months or the specified accounting period (the longer of the two).

https://en.wikipedia.org/wiki/Going_concern

• Depreciation = "Arvonvähennys", "Arvon aleneminen", "Poistot"
• Accruals basis = "Suoriteperusteinen"
• Cash basis = "Kassaperusteinen"
• Double-entry bookkeeping = "Kahdenkertainen kirjanpito"
• Going concern = "Jatkuvuuden periaate", "Toiminnan jatkuvuus"

• Definitive: tells the current values of the company's assets and liabilities
  • Balance sheet
• Descriptive: tells how and why the profit/loss and cash/overdraft balance changed during the past year
  • P&L statement (a.k.a. income statement)
  • Cash flow statement

The P&L statement tells you how and why the retained earnings row (in the shareholders' equity account) of the balance sheet changed.

The cash flow statement tells you how and why the cash balance row (in the assets account) of the balance sheet changed.

You could create descriptive statements for any other rows of the balance sheet as well, but these two are the most important, which is why companies always create them.

A.k.a. income statement.

Fitness Equipment Limited
                                  INCOME STATEMENTS
                                    (in millions)

Year Ended March 31,                   2019         2020
-------------------------------------------------------------
Revenue                            £ 14 580.2     £ 11 900.4
Cost of goods sold                   (6 740.2)      (5 650.1)
                                   -----------   ------------
Gross profit                          7 840.0        6 250.3
                                   -----------   ------------

Operating expenses (OpEx)            (3 624.6)      (3 296.3)
                                   -----------    -----------
Operating profit (EBIT)               4 215.4        2 954.0
                                   -----------    -----------

Gains from disposal of fixed assets      46.3            -
Interest expense                       (119.7)        (124.1)
                                   -----------    -----------
Profit before tax                     4 142.0        2 829.9
                                   -----------    -----------

Income tax expense                   (1 656.8)      (1 132.0)
                                   -----------    -----------
Profit (or loss) for the year       £ 2 485.2      £ 1 697.9

https://en.wikipedia.org/wiki/Income_statement

Also check profit & loss statements as Sankey diagrams: https://www.sankeyart.com/sankeys/public/31890/

$\text{Revenue} - \text{COGS} = \text{Gross profit}$

$\text{Gross profit} - \text{OpEx} = \text{Operating profit (a.k.a. operating income, EBIT)}$

$\text{Operating profit} - \text{Interest} = \text{Profit before taxes}$

$\text{Profit before taxes} - \text{Taxes} = \text{Profit after taxes} = \text{Net income}$

Revenue [a.k.a. sales, income, "top line"] is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. source

Cost of goods sold (COGS) [a.k.a. cost of sales] is the book value of goods sold during a particular period. source

Book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original acquisition cost of the asset minus any depreciation, amortization or impairment costs made against the asset. source

An operating expense (opex) [a.k.a. SG&A, or Selling, Generative and Administrative expenses] is an ongoing cost for running a product, business, or system.

Its counterpart, a capital expenditure (capex), is the cost of developing or providing non-consumable parts for the product or system.

For example,

• the purchase of a photocopier involves capex,
• and the annual paper, toner, power and maintenance costs represents opex.
  • For larger systems like businesses, opex may also include the cost of workers and facility expenses such as rent and utilities.

In short, this is the money the business spends in order to turn inventory into throughput.

https://en.wikipedia.org/wiki/Operating_expense

OpEx are short-term expenses and are typically used up in the accounting period in which they were purchased.

CapEx and OpEx are reported differently, as CapEx resides on the balance sheet and OpEx resides on the income statement.

https://www.investopedia.com/ask/answers/112814/whats-difference-between-capital-expenditures-capex-and-operational-expenditures-opex.asp

The operating expenses don't include things that are related to the company's funding structure (i.e., how the company is funded), like debt, dividends, tax, etc.

• Top line: Revenue
• Bottom line: Net income

Literally the first and last rows in the P&L statement.

In economics, the rate of interest is the price of credit [e.g., debt], and it plays the role of the cost of capital.

https://en.wikipedia.org/wiki/Interest

For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital.

The cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk; this is the opportunity cost of capital.

https://en.wikipedia.org/wiki/Cost_of_capital

Statement of Cash Flow - Simple Example for the period 1 Jan 2006 to 31 Dec 2006
Cash flow from operations	$5,000
Cash flow from investing	($1,000)
Cash flow from financing	($2,000)
Net cash flow	$2,000
Parentheses indicate negative values

The cash flow statement shows the sources of a company's cash flow and how it was used over a specific time period. It is an important indicator of a company's financial health, because a company can report a profit on its income statement, but at the same time have insufficient cash to operate.

As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

https://en.wikipedia.org/wiki/Cash_flow_statement

• Operating activities: Everything related to the operations of the company. Buying and selling inventory, paying expenses, paying interest on debt, receiving interest on loans, buying more printer ink and paper, upgrading software, etc.
• Capital expenditure (capex): Expenses on fixed assets (i.e., non-current assets). For example, buying or selling a printer, a car, or a building. Capex enables the operating activities.
• Returns on investments and servicing of finance: Paying of interest on debt (i.e., expense) and returns on investments such as dividends or interest received from investments (i.e., income)
• Taxation: Paying taxes on profits
• Equity dividends paid: Dividends paid to the shareholders of the company
• Financing: Any activities that are relating to the funding of the company, like borrowing money

Note: That terminology might be UK-specific. In many places I see this simpler way to subdivide the cash flow statement:

• Operating activities
• Investing activities
• Financing activities

This principle explains why cash flow statements look like they do.

As you can see, for a specific time period, the cash flow and operating profit are usually not the same, even though (theoretically) in the long term they are.

The book says that the cash flow statement starts with operating profit, but from what I've seen, US cash flow statements more often start with net income, i.e., profit after interest and taxes. The book makes this confusing...

The book focuses on UK/European accounting. Looks like this is a difference between US (GAAP) and European (IFRS) accounting standards:

The starting point of the statement of cash flows varies under IFRS Accounting Standards; net income is the starting point under US GAAP.

Under IFRS Accounting Standards, companies may use different starting points for reporting operating cash flows under the indirect method – e.g. profit or loss, profit or loss from continuing operations, profit or loss before tax or operating profit or loss.

https://kpmg.com/us/en/articles/2022/ifrs-accounting-standards-us-gaap.html

The cash flow statement starts with net income at the top, and the next lines adjust that number to arrive at net cash flow.

• Input (from the P&L statement): accrual basis net income
• Output (in the cash flow statement): cash basis net cash flow

This is a confusing part of the cash flow statement. The cash flow statement basically starts with the net income (i.e., the "bottom line" of the P&L statement), and then adds more lines below it to adjust/fix/tweak the numbers until the end result fully explains changes in cash blance.

The adjustments/fixes/tweaks are usually under the heading "Adjustments to reconcile net income to net cash provided by operating activities".

One of those adjustments is depreciation. You add (not subtract) depreciation to the cash flow statement to offset the cash flow positively. This is because depreciation was calculated into net income (i.e., depreciation reduced net income in the P&L statement), but depreciation doesn't affect cash flow, so we must add back the depreciation to net income to get a realistic cash flow number.

https://www.reddit.com/r/Accounting/comments/sj91e3/depreciation_adjustment_to_cash_flow_statement/

Remember this: If all of the company's income and expenses were in cash, the net income would equal cash flow. We only get into all this trouble because of accrual basis accounting, where we record some incoming or outgoing payments (i.e., revenue and expenses) before any cash actually changes hands.

In accounting, reconciliation is the process of ensuring that two sets of records (usually the balances of two accounts) are in agreement.

https://en.wikipedia.org/wiki/Reconciliation_(accounting)

Example sentence:

The cash flow statement is specifically designed to reconcile net income (which is an accrual-based measure) to cash flow (a cash-based measure).

Dictionary definitions:

• Act of bringing about agreement or harmony
• State of harmony
• To bring together again
• Reunite
• Restore
• To make things compatible or consistent

The three financial statements are not strictly hierarchical like this, but at the time of writing, I find it helpful to think of them like this:

• Balance sheet (A snapshot of the company's assets, liabilities and shareholders' equity)
  • P&L statement (Tells you how and why the "Retained earnings" line of the balance sheet changed)
    • Cash flow statement (tells you how and why the "Cash and cash equivalents" line of the balance sheet changed, starting from the last line of the P&L statement, "Net income")

That hierarchy gives me a starting point in the order of importance: first worry about the balance sheet, then worry about P&L, and if you really know what you're doing, look at the cash flow statement.

• P&L statement (income statement) = "Tuloslaskelma"
  • Revenue (net sales, "top line") = "Liikevaihto"
  • Cost of goods sold (cost of sales) = "Myytyjen tuotteiden hankintameno"
  • Gross profit (gross income, sales profit) = "Myyntikate", "Bruttokate", "Bruttovoitto", "Kokonaistuotto"
  • Operating profit (operating income, EBIT) = "Liikevoitto", "Liiketulos"
  • EBITDA = "Käyttökate"
    • = Bullshit earnings?
  • Operating expenses (OpEx) = "Käyttökustannukset", "Käyttömenot", "Juoksevat kulut"
  • Financial expenses = "Rahoituskulut"
  • Capital expenses = "Pääomakulut"
  • Interest expenses = "Maksetut korot"
  • Profit before taxes = "Tulos ennen veroja"
  • Income taxes = "Tuloverot"
  • Depreciation and amortization = "Poistot ja arvonalenemat"
  • Net profit (net income, net earnings, "bottom line") = "Tilikauden tulos", "Tilikauden voitto"
• Cash flow statement = "Rahoituslaskelma", "Rahavirtalaskelma"
  • Operating activities = "Liiketoiminta", "Operatiivinen toiminta"
    • Net income = "Tilikauden voitto"
    • Capital expenditure (CapEx) = "Pääomamenot"
    • Adjustments (to reconcile net income to net cash provided by operating activities) = "Oikaisut"
      • Interest expenses = "Maksetut korot"
      • Income taxes = "Tuloverot"
    • Cash flow from business operations = "Liiketoiminnan rahavirta", "Liiketoiminnan kassavirta"
  • Investing activities = "Investoinnit"
    • Cash flow from investments = "Investointien rahavirta"
  • Financing activities = "Rahoitus"
    • Cash flow from financing = "Rahoituksen rahavirta"

Useful video about the difference between these three expense categories.

• Operating expenses
  • Expenses that (in theory) only affect the current period
  • Cost of labor, materials, etc.
• Financial expenses
  • Non-equity financing of the business
  • Interest payments on debt, etc.
• Capital expenses
  • Equity (pääoma) financing of the business
  • Expenses that (in theory) have an effect in the long term
  • Basically, investments
  • Buying land and equipment
  • These expenses go into the balance sheet as assets, and are then depreciated (amortized) as OpEx across time

• Bookkeeping: the process of recording the daily transactions of the company (with credit and debit entries)
• Accounting: the process of converting the bookkeeping records into accounts