The Basics: Balance Sheets and Income Statements

Accounting, the lingua franca of all business, begins with keeping track of where the money is and where it's going. The balance sheet is an instant photograph that shows an organization's financial position at a given moment in time. On one side, the balance sheet lists assets, or things the company owns - cash, land, buildings, office equipment, IOUs from customers, patents and a panoply of other things. (The possibilities for what can be counted as assets are literally endless.) On the other side are liabilities, which is what the company owes to bankers, suppliers, other creditors and employees. The liabilities side of the balance sheet also includes equity, which is the owners' (or shareholders') stake in the company.

Every transaction gets recorded on the balance sheet. At any point - at the end of the third quarter, after receiving cash for a palette of machinery or after paying the office telephone bill - adding up the two sides of the balance sheet must show that assets equal liabilities plus equity. The equity part of the equation is where the action happens. In good times (when assets are more than liabilities), equity rises. When liabilities exceed assets, then owners' equity makes up the difference; if that difference is great enough, owners' equity can even turn to a negative number.

The income statement measures a company's ability to earn profits over a period of time (such as a quarter or a year). The income statement shows net income (or profits), which is the difference between revenue (the amount of money taken in for goods and services sold) and expenses (the cost of goods and services consumed while earning revenue). The more revenue surpasses expenses, the more profits a company earns, the more "black ink" flows, the better the enterprise is doing, and everyone - the board, the executives, you, the stockholders - is happy. Reverse that ratio, and there's trouble in River City.

The Fun: Accounting

Accountants are artists working in the medium of money. As artists, they can create realistic portraits of their subjects - warts and all - or they can create idealized, flattering illusions, which is how Enron appeared to be a Fortune 10 company one day and a bankrupt wreck the next. Fortunately, there are rules. These rules, or standards, established by professional organizations and the government (as with laws such as Sarbanes-Oxley in the US, which altered the responsibilities of those who vouch for the company's books), are called generally accepted accounting principles (GAAP). GAAP provide for common terms so that the activities of very different businesses - automakers, airlines, grocery stores - can be recorded and evaluated similarly. The following terms describe some of the universal concepts that are intended to reflect the way businesses actually function.

• Accrual basis accounting is required of all publicly traded companies. It calls for the enterprise to recognize revenue during the period in which it is earned, and to report expenses related to that revenue in that same period. If, for example, a company sells a shipload of TVs (or an IT organization sells a quantity of services) at the start of a quarter, it records that as revenue earned during that quarter, whether or not it has been paid (though the company should be able to demonstrate that it expects to collect payment).

Accrual basis accounting records expenses (purchase of materials, shipping costs, labour) related to producing those goods and services in that same quarter. Some private companies and individuals may use cash basis accounting, which records revenue when payments arrive and logs expenses whenever those bills are paid.

• Depreciation acknowledges the reality that assets lose value over time. Depreciation is treated as an expense on a company's balance sheet, and it comes in two flavours. The first, straight-line depreciation, reduces an asset's value at a constant rate. For example, Company ABC records as a depreciation expense the value of its $20,000 truck by $2000 every year for 10 years. The second method, called accelerated depreciation, is when that same truck is written off over a shorter period - $10,000 for the first year, $5000 the next and $5000 the third. Companies generally try to depreciate assets as slowly as possible because that gives them less expense and more income, and pretties up the balance sheet. However, if a company is looking for a bigger tax break on a particular asset, it might want to accelerate the depreciation.

• Historical value is the price you pay for an asset when you buy it. Accountants use historical value when recording assets such as land (which, in the absence of wars, earthquakes and economic disasters, generally does not depreciate) and buildings (which suffer wear and tear) on a company's balance sheet.

Because this convention doesn't account for market conditions, a widget maker that sells a piece of land it has owned since 1950 and that has increased in market value could see a boost to its quarterly results that has nothing to do with the widget business. If the revenue derived from the sale represents a nonrepeatable event, or is otherwise unusual, the company must note it as such. And this gets to an important point about accounting: It covers everything a company does whether or not it relates to its primary function as a business. That's why analysts create so many measures to gauge a company's performance. Take three simple ones: cash flow, operating income and earnings per share.

Cash flow gives a picture of cash receipts (from customers, investments or other activities) and cash payments a company makes (including debt, interest and dividends) during a given period. The question any analyst will ask is: What's left after all the payments are made? The answer will indicate how well a company is run.

Operating income is one measure of a company's ongoing business health. It accounts for revenues the company takes in and subtracts the everyday costs of doing business. It doesn't include extraordinary items that occur infrequently or, typically, income or expenses related to investments.

Earnings per share computes a publicly traded company's performance by taking its net income (its profits) and dividing it by the average number of shares of its outstanding stock. A bread-and-butter financial analysis called price-earnings ratio takes this a step further by taking the company's stock price and dividing it by its earnings-per-share figure.

Public companies must state their earnings per share on their quarterly and annual income statements. This is one of the big rules intended to ensure that people (or institutions) investing in a company are not buying the proverbial pig in the poke. (A poke is a sack, or bag. A sly farmer would tell a yokel that the poke he was buying contained a suckling pig. Upon arriving home, the yokel would find a cat. Sometimes, however, the sly farmer would be clumsy, and before he could conclude the sale, he'd "let the cat out of the bag".)