Essential Principles of Accounting and Corporate Finance

Posted on Feb 27, 2026 in Accounting and Finance

1. Generally Accepted Accounting Principles (GAAP)

GAAP, which stands for Generally Accepted Accounting Principles, refers to the rules and guidelines that companies follow to prepare financial statements. They were developed over time through common practice, and different countries have different GAAP (e.g., US GAAP, German GAAP). GAAP are necessary because they:

Make financial information useful;
Allow comparison over time;
Allow comparison between different companies.

Without GAAP, financial statements would not be comparable or reliable. IFRS (International Financial Reporting Standards) are international standards that are more principle-based rather than rule-based.

2. Quality of Information and Data

For accounting information to be useful, it must possess these qualities:

Reliable: Information is true and accurate; it represents what really happened (representational faithfulness); it can be verified by others; and it is unbiased.
Relevant: Important enough to influence decisions; timely (available when needed); and helps to predict future performance.
Consistent: The same accounting rules are used each period, allowing for the comparison of performance over time.
Comparable: Comparable from year to year, between similar companies, and against industry averages.

3. Four Crucial Principles of Financial Accounting

Measurement Principle

Determines how much is recorded. Amounts must be:

Objective: Based on evidence.
Verifiable: Confirmed by a third party.

Transactions between independent parties (arm’s-length transactions) are considered objective.

Historical Cost Principle

Assets are recorded at their original purchase price; values usually do not change unless another transaction occurs.

Revenue Recognition Principle

Revenue is recorded when it is earned, usually when goods are delivered or services are performed.

Expense Recognition Principle

Expenses are recorded in the same period as the related revenue; this helps calculate profit or loss correctly.

4. Constraints: Materiality and Conservatism

Materiality: An item is material if it is large or important enough to influence decisions. Only material items must strictly follow GAAP.
Conservatism: When there is uncertainty, do not overstate income or assets, and do not understate liabilities or expenses. Always choose the most cautious option.

5. Balance Sheet: Assets and Liabilities

Assets

Economic resources owned or controlled by the company.

Current Assets: Turned into cash within one year (e.g., cash, receivables, inventory).
Noncurrent (Long-term) Assets: Used for more than one year (e.g., buildings, machinery).
Order of Liquidity: Assets are listed from most liquid to least liquid.

Liabilities

Amounts the company owes to others.

Current Liabilities: Paid within one year (e.g., accounts payable, salaries payable).
Noncurrent Liabilities: Paid after more than one year (e.g., long-term loans).

6. Shareholders’ Equity

Shareholders’ Equity represents the owners’ claims on the company’s assets. It includes:

Contributed Capital: Money invested by owners/shareholders.
Retained Earnings: Profits earned and kept in the business.

Equity = Assets − Liabilities

7. Income Statement

The Income Statement shows performance over a specific period.

Revenues: Earnings from selling goods or services.
Expenses: Costs incurred to generate revenue.
Net Income (Net Profit): Revenues – Expenses; what remains after all expenses are deducted.

GAAP rules: Revenue is recognized when earned, and expenses are recognized when incurred.

8. Adjustments to the Books

At the end of each accounting period, companies review all assets and liabilities. Adjustments ensure balances are correct and keep the accounting equation in balance. Important: Sales are recorded when goods/services are exchanged; expenses are matched to revenue; cash timing does not matter.

9. Accruals and Deferrals

Adjustments are required at period end:

Accruals: Action first, cash later. Revenue is earned or an expense is incurred before cash is received or paid (e.g., salaries payable).
Deferrals: Cash first, action later. Cash is paid or received before revenue or an expense is recognized (e.g., prepaid insurance).

10. How Investors Use Accrual Accounting Information

Accrual accounting gives a better picture of performance than cash accounting.

Owners (Shareholders): Take more risk, share in profits, and have potential for higher returns.
Creditors: Take less risk, receive interest and repayment, have first claim on assets, and must be paid before owners.

11. Detailed Balance Sheet Structure

The balance sheet shows the financial position of a company at a specific date.

Assets (Use of funds): Resources used by the company.
- Fixed (Non-current) Assets: Intangible assets (patents, licenses); Tangible assets (buildings, machines); Financial assets (shares, bonds).
- Current Assets: Inventories (goods for sale or production); Accounts receivable (money customers owe); Cash (cash and bank balances).
Liabilities + Owners’ Equity (Source of funds): Obligations and capital.
- Owners’ Equity: Capital provided by owners; Retained earnings.
- Provisions: Pension, tax, and guarantee provisions.
- Liabilities: Bonds payable, bank loans payable, accounts payable.

12. Capital Budget Decision

The capital budget decision involves long-term investments. It asks: What long-term investments should the firm engage in? It focuses on fixed assets and investments that last many years, such as new machines, buildings, or financial investments.

13. Capital Structure Decision

This decision is about how to finance investments. It asks: How can the firm raise the money for the required investments?

Debt financing: Bank loans, bonds payable.
Equity financing: Share capital, retained earnings.

This decision affects the liabilities and equity side of the balance sheet. The goal is to find the best mix of debt and equity to minimize the cost of capital.

14. Net Working Capital Investment Decision

This focuses on short-term financial management. It asks: How much short-term cash flow does a company need to pay its bills?

Net Working Capital = Current Assets − Current Liabilities

Importance: Ensures liquidity and allows the company to operate day-to-day. Too little creates a risk of insolvency; too much is an inefficient use of money.

15. Investment vs. Finance

Investment: The commitment of money today to receive future payments. Investors expect compensation for the time value of money, inflation, risk, and uncertainty. Cash flow starts with an outflow (−) at time 0, followed by future inflows (+). Investments appear on the asset side.
Finance: Concerned with raising funds to support investments and operations. Cash flow starts with an inflow (+) for the company, followed by outflows (−) such as interest or repayments. Financing is shown on the liabilities side.

16. Legal Forms of Business Organizations

Limited Partnership: At least two partners; one has unlimited liability, and one has limited liability.
Limited Liability Company (LLC): Separate legal entity; owners have limited liability (e.g., Dornier).
Stock Corporation: Legal entity; shareholders are liable only for their investment; capital is divided into shares; can be listed on the stock exchange (e.g., Volvo).

17. Cash Flows and Financial Markets

This describes how money moves between a company and the financial markets. The main actors are the firm, financial markets, government, and stakeholders.

The firm raises money by issuing shares (equity) and debt.
The firm invests in current and fixed assets.
The firm generates cash from operations.
Cash is used to pay interest/dividends, pay taxes, and reinvest in the firm.

18. Monetary Concept of Capital Flows

Describes cash inflows and outflows inside and outside the company:

Capital Raise (External Financing): Money raised from outside (e.g., issuing shares, taking loans).
Capital Withdrawal: Money leaving the firm (e.g., dividend and interest payments).
Capital Return (Internal Financing): Cash generated from sales and operations (main source of internal funds).
Capital Investment: Use of capital for operations and asset investments.

19. Payment Streams

Payment streams start at time t₀ (decision time). Periods are usually years, and payments occur at the end of each period. The planning period equals the useful life of an investment.

Types: Cash inflows (+) (receipts, proceeds) and cash outflows (−) (payments, withdrawals).
Characteristics: Amount, time, and risk (degree of uncertainty).

20. Interrelation of Financial Statements

Balance Sheet: Shows financial position at the beginning and end of the period.
Income Statement: Shows revenues, expenses, and profit/loss during the period.
Cash Flow Statement: Shows cash inflows and outflows.

Key idea: Income ≠ Cash. Revenues and expenses affect profit, while cash flows affect liquidity.

21. Firm Value Maximization in Finance

Investment Decision: Invest in projects with returns higher than the hurdle rate. Consider the size, timing, and risk of cash flows.
Financing Decision: Choose the right mix of debt and equity; minimize cost of capital; match financing to asset type.

22. Interest and Opportunity Cost

Interest is the price of money for a certain period, usually expressed per year (p.a.). It reflects time preference, liquidity preference, opportunity costs, and risk.

Opportunity Cost: The value of the best alternative not chosen. For owners, this includes lost interest from alternative investments.
Perfect Capital Market: No transaction costs, no taxes, perfect information, and no market power. Investment interest rate (i^I) = debt interest rate (i^D) = i.
Imperfect Capital Market: At least one assumption is not fulfilled; i^I ≠ i^D.

23. Economic Principles of Investments

The economic principle is to achieve the greatest possible result with available resources. In practice, this means achieving the highest capital gain for shareholders through goal-oriented investments, careful selection, and focusing on profitability.

24. Importance of Investment Calculation

Business perspective: Companies must stay competitive for customers, employees, and capital.
Economic perspective: Investments drive growth, competitiveness, and wealth.
Role: Helps distinguish between profitable and unprofitable investments.

25. Main Questions in Investment Analysis

Advantageousness: Is the investment profitable? Should it be realized?
Ranking Order: Which investment is better among mutually exclusive alternatives?
Marginal Price: What is the maximum purchase price at which the investment is still advantageous?

26. The Investment Planning and Decision-Making Process

Initiation / Stimulation: Reasons include capacity bottlenecks, repairs, or strategic planning (SWOT).
Assessment / Evaluation: Technical and financial evaluation (cash flows, useful life, affordability).
Investment Decision: Define decision rules and choose the investment.
Investment Implementation: Implement the project, monitor success, and report.

27. Types of Investments

By Object: Property (buildings), Financial (shares), Intangible (software, patents), and Projects.
By Function: R&D, Production, Sales, and Administration.
By Purpose: Initial, legal/social security, maintenance/replacement, expansion, rationalization (cost reduction), and innovation.

28. Dynamic Investment Methods

Dynamic methods evaluate investments using cash flows, considering both amount and timing. Payments at different times are converted to the same point in time via discounting (to present value) or compounding (to future value). These methods fully consider time, interest, and risk.

29. Principle of Causation

Only payments directly caused by the investment object (IO) are included.

Outflows: Purchase price, material/salary payments, construction, and demolition costs.
Inflows: Sales revenues, subsidies, and residual value.

30. Time Value of Money (TVM)

Money today is worth more than the same amount in the future because of time preference, inflation, and risk. The required rate of return = risk-free rate + risk premium.

31. Factors Influencing the NPV

The Net Present Value (NPV) depends on:

Time: Later payments have lower present values.
Value: Higher cash flows lead to a higher NPV.
Discount Rate (r): Higher interest or risk leads to a lower NPV.

32. Annuity Methods

An annuity is a series of equal payments over time. The Annuity Present Value Factor converts a constant payment stream into a present value. The Annuity Method distributes all cash flows evenly over the useful life to transform complex investments into annual profits for easier interpretation.

33. Capital Value Method vs. Annuity Method

Capital Value Method (NPV): Measures total surplus at a single point in time (t₀); focuses on wealth maximization.
Annuity Method: Measures average surplus per period; focuses on income per year.

34. Venture Cycle Phases

Pre-seed / Seed phase: Idea generation, R&D, and proof of concept; no revenues, high risk.
Start-up phase: Market launch and first revenues; losses possible (“valley of death”).
Growth phase: Rapid growth and break-even point; increasing company value.
Maturity / Exit phase: Stable revenues and investor exit (IPO, sale, buy-back).

35. Financing Strategy

Strategy follows finance: The business idea is limited by available funds (e.g., bootstrapping).
Finance follows strategy: The idea is defined first, and financing is raised to support it (e.g., venture capital).

36. Internal and External Financing

Internal Financing

Self-financing: Sweat equity, moonlighting, and customer advances.
Profit retention: Keeping profits in the firm rather than distributing them.
Asset restructuring: Sale of unused assets or receivables (factoring).

External Financing

Equity Financing: Investors receive ownership; no repayment obligation; dilution of control.
Mezzanine Financing: Hybrid of equity and debt; subordinated loans with limited voting rights.
Debt Financing: Loans and bonds; requires interest and repayment; interest is tax-deductible.

37. Financing Instruments and Organizations

Instruments: Bootstrapping, bank loans, venture capital, bonds, and public funding.
Sole Proprietorship: One owner, unlimited liability, limited capital access.
Partnership: Two or more owners, shared management, unlimited liability.
Corporation: Separate legal entity, limited liability, easier capital raising via IPO.

38. Markets and Trading

Market Types: Physical vs. financial; money vs. capital; spot vs. future; primary (new issues) vs. secondary (trading).
Trading Procedures: Classified by location (physical vs. electronic) and order handling (auctions, dealer markets, automated platforms).

39. Specialized Equity Financing

Venture Capital: Financing for young, innovative firms; high risk/return; includes support; exit in 3–7 years.
Business Angel: Private individual providing early-stage capital and networks.
Private Equity: Later-stage investment focusing on growth, restructuring, or IPO preparation.
Corporate Venture: Equity provided by established companies for strategic focus.

40. Exit Strategies and IPOs

Exit strategies include buy-backs, sales to strategic investors, or an Initial Public Offering (IPO). An IPO is the first public sale of shares on the primary market, enabling liquidity, growth, and brand visibility, though it involves high costs and regulation.

41. Debt Capital and Bonds

Debt features fixed maturity, interest, and repayment obligations. Repayment methods include:

Bullet loan: Principal repaid at maturity.
Amortizing loan: Constant principal payments.
Annuity loan: Constant total payment.

Bonds are securitized loans. Variants include Zero-Coupon Bonds (issued at a discount), Convertible Bonds (can be converted into shares), and Bonds with Warrants (detachable options to purchase shares).