Why should an investor understand accounting?

Investors use financial statements to obtain valuable information used in the valuation and credit analysis of companies. This makes it important to understand how business accounting is done and which principles guide financial statement preparation. Knowledge of accounting helps investors determine an assets' value, understand a company's financing sources, calculate profitability and estimate risks embedded in a company's balance sheet.

Understanding a company's classification of its assets, liabilities and valuation methods in financial accounting is paramount in investment and credit analysis. For example, according to U.S. Generally Accepted Accounting Principles (GAAP), the asset value is, for the most part, based on historical cost and does not reflect its market value. Therefore, obsolete equipment with positive book value may be worthless if the company attempts to sell it. Also, the value for a certain class of assets is based on management's judgment and may not reflect its true economic value.

For instance, if the value of the company's goodwill is based on unrealistic assumptions, the management may have to take a large earnings charge in the future. Investors who have a strong knowledge of business accounting can be ahead of the curve by identifying such problems early on.

Another question that business accounting helps answer relates to the mix of debt and equity used to finance a company's operations. The ability to identify debt and equity is crucial in determining the company's value since the debt-to-equity ratio is commonly used in measuring a company's idiosyncratic risk. Although most information on debt and equity comes from the balance sheet, certain debt items require further digging and deep knowledge of business accounting.

For example, companies often choose to lease property instead of buying it. Under the U.S. GAAP, operating leases are not required to be included as a liability. However, operating lease payments are akin to debt payments, and investors may wish to treat the present value of operating leases as debt.

Profitability is the cornerstone of ratio analysis and investment valuation. Financial analysis is based on the company's future earnings, and most earnings predictions use current profits as a base. Investors with a strong grasp of financial accounting can quickly decipher whether certain line items on the income statement are non-recurring and are not expected to occur in the future.

Estimating uncertainty or risk of assets is one of the most important steps in investment valuation. Although financial statements do not estimate risk directly, they provide many useful disclosures in the notes, which help identify risk. Investors with strong accounting backgrounds use a company's financial reports to identify key risk areas that can point to potential losses in asset values. Also, investors use financial statements to calculate financial ratios that assist in estimating a company's liquidity and default risks.

Finally, investors may need to possess extensive knowledge of different accounting standards to compare companies from different countries. Although accounting principles gradually converge across the globe, differences still persist and complicate the comparability of financial records.