One of the most important things any investor needs to consider before buying stocks is their understanding of accounting and numbers in general.
It is imperative to have a broad understanding of different accounting standards, how these influence a company's results and how revenue is recognized and assets are recorded on the balance sheet. This is not an exhaustive list of accounting qualities the average investor needs to know. It is just a list of what I believe to be the most prominent areas where investors can trip up.
Not understanding how different accounting standards can influence the figures and not understanding how revenue is recognized on the accounts are two factors that can lead to significant issues for investors who do not understand these qualities.
I could even go so far as to say that investors who do not have an understanding of basic accounting principles should not buy individual equities. One of the best ways to reduce risk in an investment is through research. Without understanding how the numbers fit together, one cannot conduct a detailed due diligence process. It would be like trying to fly a plane without any instruments. Success might be possible, but there will be a lot of disasters along the way.
Developing an understanding
Learning accounting basics does not have to be a drawn-out process. In fact, I'd say that to generate the sort of knowledge required to be a good investor, one does not have to undertake rigorous accounting examinations.
There is a significant distinction between a good accountant and a good investor. Just because the numbers add up, it does not mean a business will be a good investment. That is why investors need to develop a broad understanding of accounting. It can help one develop the framework for research without placing too much focus on one particular skill set.
This is the approach Warren Buffett (Trades, Portfolio) has employed over the past seven decades. Rather than going out and enrolling himself in accounting courses, he has learned the process in the real world. The Oracle of Omaha explained his approach to accounting at the 2003 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders:
"Once you know the basics of it, by reading good business articles that deal with accounting issues, accounting scandals, that sort of thing. I mean, what you really need to know is you need to know how the figures are put together, the underlying principles of it, and then you have to know what can be done with those. And — you start with the accounting figures as the raw material of understanding a business, but you have to bring something additional to that."
It seems Buffett was trying to say that once an investor has built up a general understanding of accounting, how it works in real life and the pitfalls investors and companies may encounter, it is easy to build a framework around these ideas.
Charlie Munger (Trades, Portfolio) added his thoughts after Buffett's comments:
"You start by learning the basic rules of bookkeeping, which are sort of like the basic rules of addition and subtraction. And then you have to spend a lot of time before that accounting gets related to the larger reality, and that’s a lifelong process."
Put another way, it seems as if Munger believed that just by having the basics of accounting covered, investors are in a better place. With these foundations in place, they can then build and develop the ideas using real-world examples, which could be far more insightful than the examples provided in accounting textbooks.
Understanding the numbers is not a simple process, but having the basics covered is the first stage of building the knowledge required to be a good investor.
