The golden rule of accounting goes like this:
Assets = Liabilities + Equity
While the accounting formula seems intuitive, going deeper into the details requires understanding. Before you buy a stock using fundamental analysis, you have to read a financial report.
Financial reports are published by publicly listed companies to inform shareholders of the state of their finances. They also offer information for potential investors to determine if they are a worthy investment.
Here are the accounting terms you need to understand before reading a financial report.
Assets
Assets are the things that a business owns. From the cash in their bank, to the stationery supplies in their cabinet, to the delivery van in the drive-way. As long as the company owns something that has monetary value, it is an asset.
Intangible assets (i.e. non-physical assets) are included, such as patents and copyrights. Additionally, anything the company is owed, such as future payments from customers is also considered an asset.
In a balance sheet, assets are categorized to make the accounting easier.
- Current assets
Current assets are anything that is liquidated or used up within one year. This includes inventory or cash.
- Investments
The investments contain long-term holdings that are not usually used in operating the business. Examples of investments include shares in other companies, mutual funds, and municipal bonds.
- Fixed assets (i.e. “property, plant, and equipment”)
Fixed assets have long lives. They are used to support regular operations of the company. For example, the office building, trucks, factories, desks, and computers.
- Intangible assets
Intangible assets are long-term assets that are non-physical. Nonetheless, they still have monetary value, such as a patent, copyright or a trademark. This includes the company’s logo and slogan.
Liabilities
Everything a business owes to another person or organization is a liability. Liabilities are categorized into two groups: current liabilities and long-term liabilities. The difference between both categories is when they are due.
Current liability: Due within one year
Long-term liability: Due later than a year
Current liabilities usually come from daily business activities, such as purchase of inventory. Long-term liabilities are usually things like loans taken to finance the company’s downturn or business expansion. Current liabilities for service-providing companies (e.g. concert organizers) consists of work a customer has paid in advance (e.g. concert tickets). These liabilities are usually labelled “unearned revenue”.
Equity
Equity is how much the company owns. For example, the business owns a shop that costs $1mil. They pay $400k, and takes a bank loan of $600k. The difference between the shop’s value and how much the firm owes the bank is their equity.
This is because: Equity = Assets – Liabilities
Revenues, Costs, and Expenses
A business cannot survive in the long run without consistent profits.
Revenues, costs, and expenses are needed to determine profit. Every business has revenues and expenses.
The Profit Equation:
Profit = Revenues – Costs (e.g. cost of goods sold) – Expenses (e.g. Insurance expense, depreciation expense)
When there is a positive number, the company is making profits. When it’s negative, the company has made a loss for the period (yearly, or quarterly).
Gross profit simply is taking the revenue subtracting the direct cost of the product. For example, an iPhone is sold for $1,000, while the aluminum casing, microchips and screen cost $100. Therefore, the gross profit is $900.
Debits and Credits
Many people get confused about debits and credits when taught accounting basics. It is a common misconception that debit means a plus, and credit is a minus.
Every single accounting transaction has a debit side and a credit side. Both sides have to be equal. All debits to left and all credits to the right.
Whether a debit adds or subtracts depends on the type of account you are looking at. The following table below shows how debits and credits affect the various accounts.
| Type of Account | Debit | Credit |
| Asset | Increase | Decrease |
| Liability | Decrease | Increase |
| Equity | Decrease | Increase |
| Revenue | Decrease | Increase |
| Expense | Increase | Decrease |
What Is A Transaction
Every transaction has both a debit and a credit that must balance.
For example, you write a check to pay your mobile phone bill. The transaction would be debit to mobile telecom expense and a credit to cash. Suppose you charged your phone bill to a credit card. You would still debit mobile telecom expense, but now credit card payable (a liability account) would fall under the credit side.
Later, you pay your credit card bill. That transaction includes a debit to credit card payable and a credit to cash. The liability account with credit card payable will be decreased with a debit (the payment reduces the balance). The cash account (under assets) decreases too with a credit.
Top Image Credit: DollarsAndSense.sg
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