1.2 Financial Statements and Acccounting

Accounting can be a fascinating topic for many students, but it can seem unnatural or even frustrating to others. A common complaint is that much of accounting and bookkeeping seems to be unnecessarily complicated. Actually, there are usually reasons for the complexities seen in accounting, and we'd like to take you back to the basics and help you understand "why."

Cash in Business

To begin, it's essential to understand what cash means in an accounting/finance sense. Yes, "cash" refers to paper dollars and coins, but in popular culture this is sometimes the only thing people mean when they refer to "cash." In a business sense, cash generally includes items beyond physical paper bills or coins in possession.

Cash refers not just to these bills and coins but to funds on deposit at banking institutions (for example, a checking account) or even within money markets (places where your actual cash is loaned out for very short periods…perhaps a day or so). Some practitioners have more strict definitions about what is considered "cash" than others, but in all cases for an item to be "cash" it must be very liquid, which is to say it can be quickly redeemable for bills and coins if the owner desires. This is important because the essence of cash is that it is readily available when a business wants to make a purchase, buy an investment, or pay a bill.

If all business were conducted on a "Cash Only" basis, then what we think of as modern accounting would be largely unnecessary. To keep track of a business' finances, one would need only to monitor how much cash is on hand, where it has come from, and where it has gone. In early economies, such a simple cash system (often using precious metals like gold or silver coins) was the first step following a simple bartering economy and allowed more households and businesses better choices on what to buy with their earnings.

In the modern day, economies have expanded much further. The good news is that developments like credit cards, lines of credit, retirement pensions, and capital acquisitions have made for a better world. Households and businesses have more ability to choose exactly the kinds of investments and purchases that they please (if you have studied economics formally, you will note this is the concept of having higher "utility"). Additional developments like electronic banking have also greatly reduced the likelihood of human error in managing money and the danger of needing to hold large amounts of valuable cash in a home or office.

While they have made financial lives better, a primary downside of all of these developments is the much higher level of complexity seen in accounting and bookkeeping. For example, the use of credit, both for customers purchasing from a business and for the same business buying from its vendors, means that just looking at raw "cash" levels doesn't provide the whole story on how a company is doing. Some customers will pay the business quickly, others will pay it much later (or not at all!). Additional complexities include liabilities, like retirement pensions or taxes, that may not be due for some period of time. While these items have not yet cost a business any cash, they should be acknowledged and prepared for.

Cash Flow vs. Income

As a primary example of the role of modern accounting, consider the difference between "cash flow" and "income." Cash Flow tracks only liquid dollars, and is therefore positive when cash balances increase and negative when cash balances decrease. On the other hand, income is a much more technical accounting concept. In general, cash flows and income are linked. Businesses with positive incomes will demonstrate positive cash flows, over time. However, cash flows and income can be substantially different in some ways too. For example, a company might be making a lot of accounting profit from credit customers, but if there is a large delay in collecting payments, then the company risks its future should it run out of cash to pay vendors for raw materials in the meantime.

Conversely, a company might be doing well in terms of cash flow currently, but if large debts to the government (via taxes), retirees (via pensions) are on the horizon, or if the company needs to consider costly expansions, today's cash surpluses might still not be a guarantee of a prosperous future.

Income allows us to see a more complete picture of a company's performance over a period of time than simply measuring cash flow. Income recognizes sales and purchases on credit (and not just "cash" transactions). Income also takes large, expensive assets like computer systems or vehicles and recognizes that their value depreciates gradually over time. Furthermore, income calculations, rather than simple cash flow figures, are used by governments in order to calculate taxes due since income calculations are generally considered more relevant to a business' performance over a period of time.

Basic Accounting Statements

Accounting is definitely more complex than in ancient economies because of all the noncash possibilities available today. To help interpret and understand financial accounting information, experts rely on four basic accounting statements which aid in describing all of the detail of a business' bookkeeping, including transactions that have not directly involved any cash.

Balance Sheet

The first accounting statement is the balance sheet which describes what a company owns, and how much each item is worth, under the heading assets. The balance sheet then describes how these assets came to be. Funds borrowed in order to acquire assets are called liabilities. Funds the owners provide in order to acquire assets are called equity. This foundation thus describes the "primary" (or "fundamental") accounting equation: Assets = Liabilities + Equity.

The balance sheet is a "snapshot." That is, it describes exactly what a business owns, and what it owes, at one instant (most commonly at the end of a year). The other three financial statements are different in that they describe activities that happen over a period of time (most commonly over one year or one quarter).

Income Statement

The income statement describes the revenues earned and the expenses incurred over a period of time. While some of these items are in cash, others (for example, depreciation) are not, and thus it is with the help of the income statement that we can see the detailed calculation of a business' income (as opposed to its cash flow) over a period.

Generally speaking, the goal of a business, over time, is to recognize accounting profit, which is positive income. When this occurs, the income is added to the equity of the balance sheet, and cash or other assets are acquired so that the primary accounting equation holds. Thus, over time, a business grows in value as its equity value increases.

Statement of Cash Flows

"Cash" is only one line on many balance sheets, but because cash is so important, an entire financial statement known as the statement of cash flows provides the reader a more detailed look at why cash went up or down over a period (often a year or a quarter). It begins with the starting cash position to begin the period and describes the transactions in the period leading to a final cash balance (which matches that seen on the balance sheet). This provides extra information on liquidity so that a company might know whether it is in good position to pay vendors, employees, retirees and taxes.

Equity Statement

The final financial statement is the equity statement. This statement describes how the value of equity (also seen on the balance sheet) has changed over a period (usually a year or a quarter). Because equity roughly represents the value of a company at a set point, it is natural for owners to want to see how the value of their ownership has developed. When companies recognize positive incomes, these incomes make the retained earnings portion of the equity go up, and so the entire company has gotten more valuable. Typically, this would be accompanied by a positive cash flow, though as previously noted, a company could have a discrepancy where its equity went up while its cash flow went down, such as when a large, expensive asset is purchased in the same period as the positive income is earned.