Guide to Basic Accounting

Credit analysts must be proficient in basic accounting concepts, GAAP guidelines and FASB statements and interpretations. The key for credit analysts is that although the financial statements are a history lesson by the time one sees them, they do provide data to indicate the trend of a company's earnings and condition, and the trend indicates as to whether past strategic decisions by management are now producing positive results.

The GAAP acronym stands for Generally Accepted Accounting Principles, which are the accounting rules and guideliens as articulated by the Financial Accounting Standards Board (FASB). The United Kingdom has its own GAAP guidelines and there is presently the movement toward the adoption of a global common International Accounting Standards (IAS).

Financial statements are a record of a company's accounts, financial condition and the results of its operations at a given point in time. The financial statements include the Balance Sheet, Income Statement (also sometimes referred to as a Profit and Loss statement), and the Statement of Cash Flows. Many large company's also include a Statement of Change in Stockholder's Equity or Statement of Reatined Earnings. The Balance Sheet is divided into three accounts: Assets, Liabilities and Stockholder's Equity. The Income Statement has 2 major accounts: Income or Revenue and Expenses. The Statement of Cash Flows has 3 accounts: Net Cash Provided/Used by Operating Activities, Net Cash Provided/Used by Investing Activities and Net Cash Provided/Used by Financing Activities. In the U.S., at the very least a company must present a balance sheet and an accompanying income statementfor the period together to meet a minimum GAAP requirement.

In the United States, GAAP accounting is based on the accrual system, which is an estimate of booking income when earned (not actually received) and expenses when incurred (not actually paid). This requires that a company accurately estimate any non-cash revenue was earned within a given period (revenue recognition) and accurately estimate how much in related expenses were incurred in earning that revenue.

Accounting and bookkeeping in the United States is based on the a double entry system for recording financial transactions any copmpany may engage in. Accounting is also based on the accrual concept (as opposed to a cash concept). The individual entry for the transaction describes its reason (for instance, wages paid, rent paid, payment for services dispensed or goods sold), and the source of the transaction (cash or credit).

The double entry system means that there are always 2 entries per a transaction. The basic accounting equation is:

Assets = Liabilities + Stockholder's Equity

For instance, if a company is started with a $50,000 investment, the accounting equation would mandate.

Assets = Liabilities + Stockholder's Equity
$50,000 (Cash) = $50,000 (Equity)

If the company purchases $4,500 in production equipment with a $4,500 bank loan, then the new balance of the accounts looks like:

Assets = Liabilities + Stockholder's Equity
$54,500 (Cash + Equipment) = $4,500 (Loan) +$50,000 (Equity)

The basic accounting equation can be solved for its various components:

Assets = Liabilities + Owners' Equity
Liabilities = Assets - Owners' Equity
Owners' Equity = Assets - Liabilities

The Asset, Liabaility and Stockholder's Equity accounts all have transaction accounts that are included under these three main accounts. For instance, under Assets one would find Cash, Accounts Receivable, Inventory, Equipment, etc., or any any type of asset that was created during the normal course of the company's business operation.

The accounting process begins with basic bookkeeping, which involves recording financial transaction in order of occurrence in a General Journal and then recording (posting) the same transaction in the proper account (i.e., rent payment, equipment purchase) in a General Ledger. Each transaction posted to the Ledger account must update the running balance in the account. The balance in the Ledger on a given date is what will be entered into the financial statements. For instance, a Ledger balance of $3,575 in the Accounts Receivable ledger account on March 31st would be entered onto the Asset account of the Balance sheet for those monthly or quarterly March 31st financial statements.

Entries into the Journal and Ledger follow the Debit and Credit accounting guidelines. Debit and Credit refers to a column entry in the Journal or Ledger, and Debit refers to the Left Column and Credit refers to the Right Column. A typical Journal entry would look like:



It is sometimes difficult to remember when to use a Debit or Credit in a Journal or Ledger. First, it should be remembered that there are Journal and Ledger account entries for both Assets, Liabilities and Stockholder's Equity accounts. Additionally, for ever entry in an Asset Journal or Ledger account there must be a matched (double) entry into either a Liability or Stockholder's Equity Journal or Ledger account.

An Asset account (for instance, Cash) will increase with an entry in the Debit / Left column.

March 7Payment received for services$750 $750

An Asset account (again, Cash) will decrease with an entry in the Credit / Right column.

March 8Payment disbursed for office supplies $200$550

However, a Liability account (for instance, Accounts Payable) will increase with an entry in the Credit / Right column.

March 8Payment (Check No. 301) disbursed for office supplies $200$200

Thus, Asset accounts and Liability accounts always increase through opposite entries (Debit for Asset accounts and Credit for Liability accounts). They will also decrease through opposite accounts (Credit for Asset accounts and Debit for Liability accounts).

Revenue accounts will also increase with a Credit entry with a corresponding increase (Debit) in an Accounts Receivable (Asset) account.

Most companies conduct sales and services on granted terms (credit sales, for instance, payment is due in 30 days of receipt of the service or goods by the customer). Conversely, the same company may pay its bills based on the terms accorded to it by its own supplier(s). Thus, the Income statement will indicate accumulated income and expenses as of a certain date while the Accounts Receivable account and Accounts Payable account on the Balance sheet will indicate what still is pending.

Cash Flow Statement (GAAP)

The Cash Flow Statement was first defined by the Financial Accounting Standards Board (FASB) in 1987. The Cash Flow Statement has three cash flow accounts:

1) Operating Cash Flow generated by normal business operations.
2) Investing Cash Flow from the purchase or disposal of assets such as plant buildings, real estate, investment portfolios, equipment.
3) Financing Cash Flow from investors or long-term creditors.
Operating Cash Flow
Net Income After Tax
+ Depreciation and amortization
+/- Decrease (Increase) in Accounts Receivable
+/- Decrease (Increase) in Inventory
+/- Decrease (Increase) in Other Current Assets
+/- Increase (decrease) in Accounts Payable
+/- Increase (decrease) in Accrued Expenses
+/- Increase (decrease) in Other Current Liabilities
Total Operating Cash Flow
Investing Cash Flow
+/- Decrease (Increase) in Fixed Assets
+/- Decrease (Increase) in Notes Receivable
+/- Decrease (Increase) in securities, investments
+/- Decrease (Increase) intangible, noncurrent assets
Total Investing Cash Flow
Financing Cash Flow
+/- Increase (decrease) in Borrowings
+/- Increase (decrease) Capital Stock
- Dividends Paid
Total Financing Cash Flow
Cash at beginning of period
Cash at end of period