Accounting 101: How I Learned the Basics of Financial Statements from My MBA Program #MMBA5

The MBA program at LBS has reintroduced me to the fundamentals of accounting and I am enjoying it. I wrote my last accounting exam in 2019 and I have not studied accounting ever since. My interaction with accounting has been via my job in which I use an accounting software that does all the work for me in terms of posting entries into the accounts.

However, the Corporate Financial Accounting course has taught me how to prepare an income statement, a balance sheet, and a cash flow statement by hand, entry by entry and line item by line item. In this blog post, I will share some of the basic concepts and terms related to accounting that I learned from this course.

Elements of Financial Statements 

Financial statements are written records that convey the business activities and the financial performance of a company. They are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. There are five elements of financial statements:

Assets: These are resources acquired by the company to carry out its business operations.

Owner’s Equity: This relates to funding of a company by contributions from the owners. It also represents the residual interest of the owners of the business after liabilities have been deducted from assets.

Liability: This refers to another source of funding for a business using debt. It relates to amounts owed by the business to various stakeholders ranging from banks to suppliers.

Revenue: This relates to sales or income generated from the company selling its products or rendering its services.

Expenses: This relates to outflow of cash towards settling obligations of the company.

Types of Financial Statements 

All financial statements are prepared based on the above five elements. There are four types of financial statements:

Balance Sheet: This is a snapshot of the financial position of a business as at a particular date. It shows the total assets, liabilities, and owner’s equity of the business.

Income Statement: This is a statement that shows the profit or loss generated by a business within a set period of time. The profit or loss is determined by deducting all costs and expenses that the business incurred during the period from the total revenue.

Cash Flow Statement: This is a statement that shows all cash inflows and outflows of the business within a period of time. It shows how the business manages its cash from operating, investing, and financing activities.

Statement of Changes in Equity: This measures how the owner’s equity has changed as a result of the profit or loss generated within a period of time. It also shows the effects of other events that affect owner’s equity, such as dividends, share issues, or share buybacks.

Fundamental Concepts of Accounting 

There are two fundamental concepts that guide the preparation of financial statements:

1. Going Concern: This means that the financial statements are prepared with the assumption that the business entity will continue to operate in the future and there are no indications that the business will be insolvent in the next 12 months. This is important for financial statement users if they will make decisions based on the information presented in the financial statements.
2. Accrual Concept: This concept says that transactions are recorded when they occur as opposed to when cash is received or paid. Hence, revenue should be recognized when it is earned and expenses should be captured when they are incurred.

These concepts set the foundation for preparing financial statements. They also imply that there is an equation that balances the sources and uses of funds for a business. This equation is called the Accounting Equation and it states that:

Assets = Owner’s Equity + Liability

This equation presents the notion that the value of sources of funds for a business must equal the assets; the business has these assets to carry out its operations. This equation is represented in the balance sheet.

In my blog posts next week, I will explore the line items in each financial statement and how they are calculated and interpreted. Stay tuned!