Finance and Accounting (Richard A. Lambert) — bullet points

  • The 3 Fundamental Financial Statements: The Balance Sheet, Income Statement, and Cash Flow Statement.
  • Understanding how the three are linked is vital to assessing a company’s strengths and weaknesses. Together they provide a fuller picture of a company’s current financial status and offer a glimpse into its future.
  • What distinguishes the three statements? The balance sheet lists the resources (assets) the firm has acquired and still retains, as well as how they were acquired (liabilities and owners’ equity). The balance sheet is analogous to a snapshot; it represents the financial position of the firm at a specific point in time (for example, at the end of the quarter or year). Income statements report the profitability of the firm during the period. Cash flow statements provide information about the inflows and outflows of cash during the period.
  • These latter two statements therefore help provide information about how and why the firm’s financial status has changed since the end of the prior period. Profitability (value generated) and liquidity (cash generated) are not the same thing, however, which is why we have two different statements.
  • Owners’ equity is the residual interest in the assets of an entity that remains after deducting its liabilities. This is sometimes called the “net assets” or “net worth” of the firm. It comes from the following sources: Contributed capital: amounts the company obtains by selling shares. This is sometimes called common stock or paid in capital. Retained earnings: the profits of the firm (these belong to the owners) that have been kept by the firm i.e., not paid out as dividends.
  • Considerable amounts of subjectivity and judgment are involved in the calculation of income from the income statement. The cash flow statement is generally the most objective of the statements. It is able to achieve this objectivity because it looks only at transactions and events that impacted cash this period; either a transaction or event impacted cash or it did not, there is little room for debate. One of the most useful functions of the cash flow statement is to group the inflows and outflows into three categories: Operating activities: collections from customers; payments to suppliers, employees, and other providers of services including interest and taxes. Investing activities: payments to acquire long-term productive and financial assets; receipts from disposition of those assets. Financing activities: receipts from issuing debt or equity securities; payments to retire debt and payments to shareholders to acquire shares or to pay dividends.
  • Another useful role for the cash flow statement is that it helps provide a check on the believability of the firm’s profit numbers. If profits are received in the form of cash, you know you have this amount in hand. Profits that aren’t cash are more subjective.
  • Ending Balance of Cash = Beginning Balance of Cash + Cash from Operations + Cash from Investing + Cash from Financing. Say the firm generates income of $1 million and pays no dividend; that is, the cash account changes by only $800,000. Where is the other $200,000? The cash flow statement will explain the difference.
  • What are the rules for recognizing revenue? The first important rule is that signing a customer to a contract is not enough to have that contract count in this period’s revenue. Instead, the risk and responsibilities of owning the product must have been transferred to the customer; he must have economic control of it. These rules exist to try to distinguish legitimate sales from fake ones. As an example of the latter, “bill and hold” arrangements, in which companies take credit for sales even though the customer does not actually want delivery until a later period, is a common way to illegally overstate or accelerate sales. “Side agreements” in which the seller agrees to take the goods back in a following period if the customer does not need them are similar.
  • Even if you have received payment by the customer, accounting rules prevent you from recognizing revenue until you have fulfilled your performance obligations to the customer; that is, until you have delivered the product or service.

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