What is accounting?

Accounting is the procedure of data entry and recording, summarizing, analyzing, and reporting of financial data.

We can sympathize with you if you think that sounds boring. However, Warren Buffett called accounting “the language of business.” If you want to invest like he does, you must learn the basics of accounting.

Five Basic Accounting Principles

1. Revenue recognition
   
   This accounting principle states that revenue is recorded at the time of the transaction or when it is earned, not when payment is received.
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2. Matching Principle
   
   The matching principle ensures that revenue and related expenses are recorded in the same accounting period to represent a business's profitability accurately.
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3. Historical cost
   
   Assets are recorded at their acquisition cost, keeping an asset from being overvalued on a company's books.
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4. Full disclosure
   
   This principle requires companies to ensure that all relevant information is available to anyone reviewing the business's financial statements.
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5. Objectivity principle
   
   This requires all company financial statement information to be authentic, relevant, and accurate.

Five Categories of Accounting

1. Assets
   Assets are all properties and items owned by a company that have value. This includes tangible assets (things that can be touched) such as real estate, factories, and equipment. They also include intangible assets (things that can't be touched), such as goodwill from past acquisitions, copyrights, and patents.
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2. Liabilities
   Liabilities are all of a company's financial obligations owed to others.
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3. Shareholder Equity
   This is the equivalent of a person's net worth on paper. It is theoretically equal to the dollar amount that would be returned to shareholders if the company's assets were liquidated and debt settled.
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4. Expenditures
   These are a company's expenses, such as supplier costs and employee salaries.
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5. Income
   This is a company's profits, the total amount earned after all expenses have been accounted for and paid.

Accrual Accounting vs. Cash Accounting

Accrual accounting and cash accounting methods are both useful in their own ways. This is why investors need both the income and the cash flow statements to get a company’s complete financial picture.

Accrual accounting anticipates financial events and transactions, while cash accounting records them as they occur (e.g., when the cash actually leaves the customer and is received by the business).

Accrual accounting follows the matching principle (see above), ensuring that revenue and related expenses are recorded in the same accounting period to represent a business’s profitability accurately.

Cash accounting does not follow the matching principle, meaning that revenue and expenses might not be matched to the period in which they were incurred or earned.

Many small businesses will only use cash accounting because it is simpler (bookkeeping only requires that cash movement be recorded) and accurately reflects a company’s cash position.

Double Entry Accounting

This system of bookkeeping records every transaction in two different accounts - one credit and one debit.

The amounts for each must be equal.

This check and balance system ensures accuracy.

Journal vs. Ledger

Journal entries consist of original entries of debits and credits, the totals of which should be equal.

Journals are then transferred to the appropriate ledger accounts.

Ledger accounts are the final entries that summarize and classify transactions.

Financial Statements

1. The Income Statement
   Shows a business's profit or loss during a period.
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2. The Balance Sheet
   Shows a company's assets, liabilities, and shareholder equity at a specific time.
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3. The Cash Flow Statement
   Shows the inflows and outflows of cash over a period.

Types of Accounts

1. Real
   Consists of tangible and intangible assets.
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2. Personal
   Accounts for individuals, groups, entities, banks, etc.
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3. Nominal
   Accounts related to gains, losses, expenses, and income.

Fields of Accounting

1. Financial accounting
   Financial accounting is the accounting related to preparing the three financial statements.
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2. Managerial accounting
   This is the accounting used to prepare reports for internal use within a company.
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3. Cost accounting
   This accounting measures the performance of resources.

Key Takeaway

In summary, grasping the fundamentals of accounting is vital for investors who want to navigate the complexities of financial statements effectively.

By understanding key accounting principles, categories, and the interplay between financial statements, investors can gain deeper insights into a company’s financial health. This knowledge not only enhances investment decisions but also aligns with Warren Buffett's perspective on accounting as the essential language of business.

Ultimately, a solid foundation in accounting empowers investors to evaluate profitability, assess risks, and identify opportunities in the marketplace.