A brief lesson in financial statements

So many people have NO clue what I do, or rather what I did working at a public accounting firm.

Do you either directly or through your retirement fund own shares of a Company? Essentially you provide a Company equity (funds) in consideration for the expectation that management will take those funds and create value, or rather provide you with a positive return on your investment. Well, how in de heck does one create value? What does value even mean?

Basically a share represents the value of a Company divided amongst many owners. There are several sophisticated methods available to assign value to a Company; however, what one really needs to know can be derived from the three basic financial statements:

The Balance Sheet: Assets = Liabilities + Equity. This is at one single point in time. Similar to your monthly bank statement.

The Income Statement: Revenue - Expenses = Net Income. It shows activity over a period of time. This would be like compiling all of your monthly bank statements for the year to see how much money was deposited (revenue) and how much money you spent (expenses) over the entire year. If at year end you have a net loss, your overall equity decreases; however, if you have net income, your overall equity increases. Equity can be akin to savings.

Statement of Cash Flows: Shows how cash was provided used. The difference between this and the income statement is that due to accounting rules, there are several non-cash related transactions. For example, when you buy a car you pay $25,000. The second it drives off the lot, it's worth $20,000. Your cash flow was limited to an outflow of $25,000; not $20,000. The income statement would take into account this phantom $5,000 difference ($25k-$20k=$5k); whereas the statement of cash flows would not.

For publicly traded Companies these financial statements, along with notes to the consolidated financial statements, are required to be 'fact checked' by an independent party (aka the Auditor, aka ME).

Value is created when a Company makes a dollar out of 15 cents. You give a Company funds and it improves effectiveness and efficiency of operations resulting in greater productivity. The more they produce, the more customers buy. Essentially the goal is to improve effectiveness and efficiency in such a way that it takes less to produce more.

The Company has an incentive to overstate assets/revenue and to understate liabilities/expenses because it wants to appear as attractive as possible to attract your hard-earned (or McCain's easy come easy go) money. My job as an auditor is synonymous with building trust. For example, the balance sheet may indicate that a Company has $1,000,000 worth of cash. Well, how does the investor trust that the Company is not making this amount of cash up? As an FYI, having excess cash can tell you quite a bit about a Company's goals. An increasing cash account may indicate that a Company intends to make acquisitions to grow their business...which could be risky if not adequately managed. Having too much cash can also mean that management is not adequately managing your invested money to create wealth. Anywho - back to the $1 million. My job entails directly contacting the bank to confirm that the Company, in fact, had $1 million in its account. That's like if you told me that you had $5,000 in your account. Instead of asking you twice about it, I'd simply directly call your bank. Now in real life this wouldn't work b/c I don't have your passwords; however, the beauty of being an auditor is that I can see and ask whatever the hell I want to!

One of the goals of the Financial Accounting Standards Board (FASB), Securities Exchange Commission (SEC, not that unstoppable football division) and the Public Company Accounting Oversight Board (PCAOB) is to create guidelines and standards that ensure that financial statements are comparable. Like if you pick up the financial statements of Kraft, will the information be relatively consistent with the financial statements of General Mills? It should be. These regulators also aim to ensure that financial statements are transparent. Enron essentially painted a false picture of its financial condition. In a nutshell, Enron created 'off-shore' entities that it excluded from it's reported financial statements, so investors did not know about debts. That's like me entering a marriage, but not telling my fiance that my credit score is 1. I become a liability to him upon our union (okay, love yada yada yada, you get what I'm saying).

As easy as all that may sound, it requires critical analysis of the facts before you, which may or may not be obvious. Furthermore, the guidelines and standards are principle based, rather than rules based. Instead of saying, you CAN'T do that, the guidelines would say, "the goal and essence of this transaction should be xyz. But have you considered these factors?"

Any questions? lol

I am LAME for writing that. But I'm smiling :-) Being a CPA makes me happy.