Investors need to be equipped with sufficient knowledge to make informed choices regarding their investments. It’s not a stretch to say that ideally, we as investors should have knowledge in many disciplines in order to ensure we can make optimal decisions, although realistically, it is difficult to gain competence in a wide variety of subjects.
However, I would assert that learning accounting would be one of the core necessities when it comes to investing, as accounting is, after all, the language of business.
A key pillar of investing
So why is accounting so crucial when it comes to investing? It is because learning basic accounting concepts and techniques allows us to better appreciate financial statements released by listed companies, and equips us with the basic knowledge to understand if a company is doing well or poorly. In addition, knowledge of accounting allows us to spot unusual items within financial statements quickly, and to be able to discern if a company’s management may be overly-aggressive in recognising revenue, for instance.
Note that accounting is a discipline which allows for a wide range of options on how to classify certain items within the financial statements – it is up to the discretion of the company on which option it would like to use, as long as it is able to justify the decision. If we are aware of these accounting concepts, we can then decide for ourselves if such decisions are justified, or if the company is simply seeking to sweep problems under the carpet. So, which areas of accounting should investors get a basic grasp of?
The key aspects of accounting
Four areas of accounting are especially important in today’s environment: (1) Revenue recognition; (2) depreciation and fixed asset policy; (3) accrual versus cash accounting; and (4) mark-to-market accounting. Let me explain why.
Revenue recognition allows a company to recognise revenue at various points within the sales cycle. The problem is some companies may aggressively recognise revenue even when their goods and services have yet to be delivered.
Depreciation policy is important because some companies may depreciate their assets over longer useful lives than the norm, hence booking in a lower expense per year in order to make their profits look better.
Accrual versus cash accounting is an essential core concept of accounting whereby revenue is not equal to the inflow and outflow of cash – we should understand that ultimately, cash prevails and the cash flow statement should be treated with greater importance than the income statement.
Finally, mark-to-market accounting is even more relevant in today’s world as more companies hold listed securities or make acquisitions. Mark-to-market accounting assesses the investments to see if there are any impairments to be made, which would flow down to the bottom line as large expenses if so.
The above illustrates the importance of understanding basic accounting concepts to ensure that we stay knowledgeable on how companies report their finances.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.