Part 1, Lesson 1
Prior to learning how to research and value companies, every investor must have a solid understanding of financial accounting. We cannot stress the importance of learning the basics of accounting prior to attempting to research and value companies. Accounting is the pre-requisite to investing in the same manner that biology is a pre-requisite to medical school.
Therefore, the first 13 lessons of this investment guide will focus on bringing new investors up to speed on the basics accounting principles that will be helpful in your investment journey. Please note that the accounting portion of this investment guide is not meant to be a comprehensive course on financial accounting. New investors should view these accounting lessons as the first step in becoming a better investor, and we would encourage all investors to deepen your understanding of accounting after reading through this guide.
What is financial accounting?
Financial accounting is the framework in which information about a business, non-profit, or government organization is communicated. In its most basic form, accounting is essentially a collection of rules which have been established and adopted to create a “common language” by which individuals can communicate information about an organization.
In the United States, investors follow a collection of rules referred to as GAAP – “Generally Accepted Accounting Principles.” Internationally, investors follow a different set of rules commonly referred to as IFRS – “International Financial Reporting Standards.” Although many of the principles of GAAP and IFRS accounting overlap, this guide will focus exclusively on GAAP.
When publicly-traded US companies publish financial statements, these businesses create statements that adhere to the principles of GAAP accounting.
What are the different types of businesses that use financial accounting?
Every business must use financial accounting in the preparation of their financial statements. This includes sole proprietorships, limited liability companies (LLCs), partnerships, and corporations. While there are legal differences and tax differences between these types of entities, the principles of accounting do not change for different types of businesses.
For purposes of this guide, we will focus our discussion on corporations since most publicly traded companies are established as corporations.
Are there different types of accounting aside from financial accounting?
Yes. Financial accounting deals primarily with the preparation and interpretation of financial statements that comply with GAAP. There are other forms of accounting that are used for different purposes. As an investor, the other important branch of accounting to have some understanding of is tax accounting. Tax accounting deals specifically with the determination of income tax liability owed to the Internal Revenue Service (IRS) and state/local taxing authorities.
Importantly, financial accounting and tax accounting can differ substantially since financial accounting adheres to GAAP whereas tax accounting adheres to the tax code written and approved by the federal government. Later in this guide, we will discuss how certain topics such as depreciation expense can differ under GAAP financial accounting vs. tax accounting.
In addition to tax accounting, there is also managerial accounting that deals with budgeting, forecasting, and providing information for internal users. Audit is another branch of accounting that entails the review of company prepared financial statements by an independent accounting firm that will provide an opinion as to the fairness of the GAAP-prepared statements.
For example, Google’s internal accountants will prepare its GAAP financial statements, but Google currently uses Ernst & Young, one of the big four accounting firms, to perform an independent audit of its financial statements. Ernst & Young will follow a detailed audit process in order to issue an opinion on Google’s financial statements. This opinion will reflect whether Ernst & Young believes that Google’s financial statements are free from material misstatement and fairly reflects the financial position of the company. The audit process will evaluate the internal controls of the company but is not meant to be a fool-proof investigation to rule out fraud at the company. Due to the in-depth review associated with an audit, public company investors take comfort in having clean audit opinions.