Many people have wondered whether the events that happened in 2008 could have been prevented. The answer is both, yes and no, and here are the tools and the myth that surround their use to paint the whole picture.

Ignoring red flags invites disaster

Financial statements, specifically balance sheets statements of cash flows, clearly reflected a significant likelihood that companies company would fail. Most financial statements of the companies that failed revealed that, along with their extraordinary leverage the companies were generating negative cash flows from their operations.

At a minimum the financial statements spoke loudly and clearly at the companies like Lehman Brothers, American International Group or J.P. Morgan needed to recapitalize their finances to reduce their debt and strengthen their financial position. But, there were no ears to hear and no eyes to see, and a lot of greed to hide everything.

Understand accounting and financial reporting

It is our job to understand accounting and financial reporting issues of the companies in which we are invested or which we are considering making an investment. Critical finance skills and how to read, interpret and understand financial statements with the goal of making us better investors and business people is therefore necessary.

Accounting and finance make up a core part of any business curriculum because they are critical functional areas within any organization, therefore effective managers business owners and investors alike should be fluent in the accounting and finance lexicon.

What are accounting and finance exactly

Accounting is the language of business, is an important means by which organizations communicate to key constituents and facts and figures how they are performing and how effectively they are fulfilling their strategic goals and objectives.  Finance puts the language in the stories of accounting to practical use and focuses on how accounting information is used to make certain decisions.

Accounting data and financial statements tell stories that is some people may look at financial statements and merely see a lot of numbers on pieces of paper and that is certainly true. There are plenty of numbers on any financial statement you might review but those numbers communicate a tremendous number of things about an organization.

Accounting disclosures and financial information

Regardless of how financial reports look, they must include several key things including an overview of the company’s business and operations some discussion and analysis of financial results financial statements and related footnotes an independent audit report and several other required disclosures.

There are five financial statements disclosed in annual reports: the balance sheet, the income statement, the statement of cash flows, the statement of comprehensive income, and finally, the statement of shareholders equity. An annual report is not complete without these five financial statements and they can be found in every quarterly report as well.

The balance sheet

Often called the statement of financial position which details what an organization owns its assets as well as what it owes its liabilities and debts. All the information on the balance sheet is as of a particular point in time typically the end of the fiscal quarter or year.

If assets exceed liabilities the difference is called shareholders equity if liabilities exceed assets generally not a good thing that would indicate a shareholder deficit. The balance sheet will help tell us how liquid an organization is how much it has invested in working capital things like inventory and accounts receivable as well as how much debt the company has and therefore how leveraged or risky it appears to be.

The income statement

Often called the statement of operations the profit and loss statement or statement of revenues and expenses this is probably the financial statement gets the most attention from Wall Street and the media since it includes such key metrics as revenues net income and earnings-per-share, which are widely cited and significantly impacts stock prices.

However, unlike the balance sheet which is prepared as of a particular point in time at the end of a particular quarter or fiscal year, the income statement reflects operations during a particular period of time for example the entire three months of the quarter or 12 months of the fiscal year. It starts with revenues subtracts costs and expenses and ends with net income or loss or net surplus or deficit for nonprofit organizations
and constitutes the accountants best effort at measuring economic performance of an organization during a given period of time.

The statement of cash flows

This statement reports for certain period of time the amount of actual cash either generated or consumed by an organization, that is weather the organization actually increase its cash balance during a particular period or not. This lays out the differences between reported profits or losses under accrual accounting and the actual cash inflows or outflows of the organization during that same period.

The document segments the cash flows into three distinct but logical buckets: cash flow from operating activities, cash flows from investing activities and cash flows from financing activities.  The state of cash flows is extremely important as it tends to be the most objective of the financial statements since cash is cash and harder to fudge.

Accounting and financial myths

Accounting is black and white – perhaps people believe that because accounting involves so many numbers and figures and is rules-based. It must be scientific and objective, unfortunately this just isn’t the case. There are number of estimates that pervade the financial statements and there is plenty of judgment and subjectivity involved in application of particular accounting rules.

There must be one important figure –  People often assume that there must be one important figure that investors or others should look at to evaluate financial performance weather that figure is revenues net income earnings-per-share or something else. In fact, the most common question my accounting students ask is what’s the most important metric that they should look at within the financial statements.

Accounting in a company should have only one set of records –  Having more than one set of books might sound like fraud but in fact is actually business as usual, but most organizations have at least two sets of accounting records one for creditors lenders and shareholders and the other for the tax authorities.

Financial statements tell us how much a company or organization is actually worth –  This is definitely inaccurate, since – for example – the balance sheet may indicate what a firm owns and owes but as we will discuss most assets are not reported at their fair market values and in fact some very valuable assets might be omitted from the balance sheet entirely.

Accounting and Finance Tools, an overview

  1. a company that is complying with generally accepted accounting principles must prepare five key financial statements: balance sheet income statement statement of cash flows statement of comprehensive income in the statement of shareholders equity;
  2. General Accountancy Practices require the use of accrual accounting, so reported profits are not equal to actual firm cashflows;
  3. because the application of General accountancy Practices require significant judgment and lots of subjectivity we need to closely examine and evaluate the financial statements of any organization we may be interested in;
  4. the financial statements provide important clues and critical data to help us value companies, but do not directly provide or disclose those values.