SOME BASIC PRINCIPLES OF
FINANCIAL ACCOUNTING
As
seen by an amateur experienced in community-organization finances
by Hunter Ellinger (hunter.ellinger.org, hunter@ellinger.org)
(derived from a 1984
commentary written for the statements of Wheatsville Food Cooperative)
This summary is an attempt to demystify an area
often clouded in jargon. The financial
statements used in accounting are prepared and presented according to
traditions that have grown up over hundreds of years about the information that
bankers require from businesses that wish to borrow money from them. Understanding these traditions can give you
a valuable tool that will give you insight into the financial condition and
workings of a broad range of organizations (including non-profit and public
ones).
Many of the words used by accountants and
financial analysts have precise meanings that are more restricted than their
meanings in general use. This is not
just to confuse people; on the contrary, the precision is an attempt to avoid
the natural confusion that many people have encountered (often to their cost!)
in talking and thinking about money and business.
The natural way to think
about money is to watch the amounts you get paid or pay out as you go
along. (Accountants call these cash transactions
receipts and disbursements.)
If you have more money left at the end of the day (or month, or year)
than you started with, you have generated a surplus; if less, a deficit. This
cash flow accounting is
important — it determines whether your checks will bounce or not. But it does not give a dependable picture of
the financial health of an organization.
Consider a cooperative
grocery store’s typical Sunday (receipts of about $25,000 and no disbursements)
and a typical Friday staff payday (receipts of about $20,000 and disbursements
of about $40,000). Does the store
“make” $25,000 on Sunday and “lose” $20,000 on Friday? Clearly not. To calculate profit and loss (earned income
less expenses), these types of correction are needed:
[1]
Match expenses
to the income they generate. Thus the
cost of the goods sold Sunday should be subtracted from Sunday’s income, as
should the wages earned by staff members that day and a fair share of the rent
and other expenses accrued that day, regardless of when those expenses
are actually paid. This “accrual
accounting” method shows that the profit for Sunday is only the few hundred
dollars by which the income for that day exceeds the total of the expenses
associated with it. There is a similar
profit for the Friday payday, since most of the payroll expense is matched
against the revenues from the other days of the week.
Various accrual accounts with names such as “prepaid expenses”, “deferred revenues”, and “accounts payable” are used to report any portions of revenue or expense that will be received or paid in a different period from when they became binding obligations. This ensures that any such obligations increase or decrease profits for the correct period, as appropriate to comply with the "matching principle" listed here.
[2] Exclude
capital transactions. Part of the receipts
may be investments or loans by the cooperative’s members or other people. Because this money (like a rental deposit)
will eventually be paid back to its source, the organization must not count it
as income. Also, disbursements for debt
repayment must not be counted as expenses, since the money repaid removes the
debt; in effect, it belonged to the lender all along.
[3] Report the value of
assets at cost until they are sold or consumed. Disbursements to purchase assets (inventory,
equipment, etc.) are not immediately counted as expenses, since the organization
still has the same value in different form.
When an
asset is sold, then both the expense and the income are recorded, with the difference between the purchase
and sale price is recorded as profit (or loss). If an asset such as a cash register is used up gradually rather
than sold, a portion of its cost is counted as an expense each year of its
useful life; this is the source of those mysterious amortization and depreciation
expenses.
The "cost principle" has some
weaknesses. It ignores any changes in
the value of an asset due to inflation, for example, and thus tends to
understate replacement costs. It also assumes
that purchased assets are worth what was paid for them; this may be a good
initial estimate, but it becomes less dependable as time goes on and is subject
to manipulation if the purchases were not honest market-value transactions. Assets are supposed to be “written down” if
it becomes clear that they are worth substantially less than their stated value,
but it is hard to tell if this is being done fairly. In spite of these pitfalls, valuing assets at cost has been found
to be the best foundation for accounting.
But you should always look at the nature of the assets to see if their
stated values are reasonable.
All these terms and rules
are intended to permit you to see past the surface variations of the cash flow
to the true performance of the business (in the long term, cash-flow and
accrual-basis accounting should give about the same results). Remember that accounting rules
make sense,
and ensure that the story told by the reported numbers is coherent. When you examine a financial statement,
don’t stop until you understand the story that is being told.
Operating Statement: This accounting statement, sometimes called the Income Statement, the Statement of Revenue and Expenses, the Profit/Loss Statement, or the Statement of Change in Net Assets, describes the way an organization earns money and expends it over some period of time. It uses the accrual adjustments described above, so that its final total (i.e., the “bottom line”) reports accrual-basis profit or loss rather than the cash-basis surplus or deficit. It does not describe what the organization owns or owes (see the Balance Sheet). The operating statement describes the organization's financial performance during a time period , not its condition ; it tells what direction the organization is going financially, not where it is. Note that many kinds of capital financial transactions (such as borrowing money or buying assets) have no effect on the operating statement, although some operating-statement expenses, such as annual depreciation costs and the interest charged on the organization’s debts, indirectly reflect the effect of earlier capital transactions.
Balance Sheet: This accounting statement is a snapshot of financial condition at a particular moment,
usually the end of a fiscal year or intermediate reporting period. It tells what the organization owns
(“assets”), what it owes (“liabilities”), and the difference between the two
(“net worth” or “net assets”). The
change of particular accounts from one year to the next is often more
informative than their absolute values, and balance sheets are almost always
provided in pairs, one at each end of the period for which an operating statement
is supplied. The change in net worth
between two balance-sheet dates is always equal to the profit or loss for the
corresponding period.
The assets and liabilities
in a balance sheet are classified as to whether or not they are expected to
provide or require cash during the next year, with the ones that meet this
standard classed as current assets or liabilities, in contrast to those
that are long-term (sometimes called fixed). The
excess of current assets over current liabilities is called working capital, and gives an
indication of the liquidity
of an organization (i.e., how well positioned it is to meet its
obligations in the near future).
Statement of Cash Flows: Even though cash is not a dependable indicator of financial performance, it is very important both because adequate cash is needed for operations and because the pattern of cash disbursements and receipts can yield insights into an organization’s financial story. The cash-flow statement is similar to the operating statement in covering a period of time, but it reports totals of cash transactions rather than of accrual-basis revenues and expenses.
Managerial Analyses and Projections: In addition to the standard financial statements, which must be prepared according to rather inflexible rules to ensure that external parties (such as banks) can reasonably depend on them, organizations will often want to prepare financial analyses for use in their own planning. For that purpose, where it is important to make good use of all the knowledge available, it is appropriate to include corrections (e.g., for the impact of inflation on asset value) that are not allowed in the standard statements. It is also permissible to use estimates and projections rather than just auditable numbers. But it is essential that all such deviations from standard methods be explained (and justified, to the extent possible) as part of the analysis.
Pro-forma statements: A common type of managerial financial statement is one that gives the financial results that would occur under certain conditions. Sometimes this is meant as a serious prediction, but often it is just exploratory. Called pro-forma statements, they are much more useful than they might seem because they force the construction of a coherent set of numbers. This makes critical analysis much easier ("Are you really going to double sales without increasing labor costs?"), and assist greatly in building an economic model for the organization.