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Corporate Finance and the Entrepreneur

Posted by Seth Elliott On August - 10 - 2010

AccountantI have received a number of questions from entrepreneurs (and would-be entrepreneurs) lately that are related primarily “corporate finance.” For those unfamiliar with the term, it broadly addresses the area of finance that deals with the financial decisions made by business enterprises, including tools and analyses, in order to maximize value. A related component references investment banking functions, specifically valuation and raising capital.

I’ve found over time that many entrepreneurs are at best bewildered and at worst dismayed when the time comes to addressing these corporate finance elements. As such, I’ve decided to offer a series of posts here at the Unchained Entrepreneur that will specifically examine various components that you need to know. We’ll take a look at financial statements, financial projections, tools for valuation, and related concepts in a way that, hopefully, you will find practical and useful.

We’ll begin with financial statements . . . except you can’t understand financial statements without first understanding the basics of accounting. Accounting, as defined by the American Institute of Certified Public Accountants is “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.” Let’s examine several components of accounting that you should know, in order to move towards comprehending financial statements.

Don’t worry! We’re not going through a course of accounting and financial statement analysis. Instead, we’ll examine core concepts that you need to understand as an entrepreneur in order to build effective financial projections, value your company and discuss nuances with potential financing sources (all of which we will examine during the course of this series).

Double Trouble

Accounting, as we know it today, is almost always in a form that is known as “double-entry bookkeeping.” This type of system originated in the late 13th century in the Italy. By the end of the 15th century, a method for double-entry accounting had been codified and was widely used by merchants in Venice and other Italian city states.

The concept of double entry accounting is quite simple. Every financial event (or transaction) changes (at least) two entirely separate accounts. Accounts refers to assets, liabilities, income, expenses or equity – which we will explore in greater detail in future posts on this subject. Essentially, double entry accounting tracks the transfer of money from one account to another. Just like the law of conservation of energy, double entry accounting assumes that money is never “lost” or “created.” In each instance, the affect on one side of a financial ledger is balanced by a corresponding affect on another side. Among other uses, this allows you to “reconcile” your accounts, making it much easier to catch errors.

Our purpose is not to delve too deeply into the specifics of double entry accounting. It is, however, important that you understand this core concept underpins modern financial statements. It is best synthesized in the equation EQUITY = ASSETS – LIABILITIES. We will examine those concepts further as we proceed.

I Will Gladly Pay You Tuesday. . .

In addition to double-entry bookkeeping, it’s valuable to understand the difference between “cash basis” and “accrual basis” accounting.

Most entrepreneurs use cash basis accounting early in their companies’ lives. As implied by the name, this simply means that you record financial events and transactions in your financial records when funds (cash) actually change hands.

For example, assume that you agree to build a web page for a client for $250. You complete the page and invoice your customer. However, it turns out he has gone on vacation for two weeks. Upon his return, he sends you the $250 payment you are due. Using cash basis accounting, you record the transaction only once you have received that payment.

Accrual basis accounting works differently, recording financial transactions as they occur (rather than waiting for funds to change hands). In our previous example, you would record the transaction as soon as you performed the work and invoiced the customer, even though the payment had not yet been made.

Other than small, service firms, most businesses eventually move to accrual basis accounting. Accrual basis accounting is designed to capture and portray all of the economic activity of the firm. This becomes important (as we will see in future posts about valuation), because it provides a broader scope of information on the activities of the firm.

The Tax Man

Of course, accounting is also used for the purposes of tax reporting to governments. The methods and mechanisms by which you calculate your financial transactions and history are the foundation for determining funds due (or owed to your company by) federal, state and local governments.

Interestingly, many companies create two completely different sets of financial statements – one for tax reporting and the other for operational use (and investor/financing reporting). This process allows you to showcase your performance in the best possible light, while minimizing total tax burdens. This is completely legal and legitimate (at least in the United States), if the methods you use for your tax accounting are in compliance with IRS rules and regulations. Naturally, this can create a great deal of confusion – sometimes intentionally so! Companies that do choose to keep two sets of books are required to reconcile the differences pursuant to an IRS tax schedule. This ensures that any differences between the two separate disclosures are properly documented.

Now you’ve absorbed some of the key concepts from the esoteric world of accounting. Refer back to these throughout the learning process whenever you are uncertain.

In the next post, we’ll discuss Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), major components of Financial Statements and types of accountant produced data.

You may wish to review other posts in this series, including:

Leaping the GAAP

The Entrepreneur and the Income Statement

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About the Author

I have spent the last 15 years advising entrepreneurs on starting and growing their businesses, as well as assisting in financing those growth efforts. I have also been an entrepreneur on several occasions myself. By writing this blog, I hope to provide actionable advice on how to achieve your goals and become more successful.