government regulators of business, entrepreneurs, anyone thinking of becoming an entrepreneur and starting a business, and, yes, even economists should know the basics of financial statement accounting. We’ve noticed that even experienced business journalists, who ought to know better, sometimes refer to the balance sheet when they’re talking about profit performance. The bottom line is found in the income statement, not the balance sheet!
Accounting as a Form of Art
Throughout this book, you read references to accounting being more of a form of art than an exact science. We are not implying that accountants and the profession of accounting don’t have to follow specific rules, standards, and guidelines; as you see in Chapter 2, a very robust set of rules and authoritative organizations have been established to provide guidance to accountants in plying their trade.
However, it should be noted that accounting is by no means an exact science because accountants are constantly having to use estimates, complete complex financial analyses, and evaluate data (that always seems to be a moving target) when preparing financial information, reports, and statements. Further, economic conditions are constantly changing and evolving at what seems like the speed of light these days (such as with Covid-19’s impact in 2020 and beyond), making the accountant’s job even more challenging. You would be amazed at how even the slightest change in an assumption or data point used, such as increasing the interest rate used to calculate the estimated current value of future obligations, can impact the overall financial results of a business.
To reiterate one of our primary goals, the purpose of the concepts and topics presented in this book is not to provide a detailed overview of technical accounting rules or guidelines, such as the theory behind accounting for capital asset leases or applying Black-Scholes to account for stock option expense, but rather to offer a 10,000-foot overview of accounting and key concepts every business must address, starting with the following fundamental statement.
These generally accepted accounting principles are “a set of rules that encompass the details, complexities, and legalities of business and corporate accounting.” These rules are established by various accounting organizations, boards, and groups, with the primary group being the Financial Accounting Standards Board (FASB), which uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices.
There you have it — when producing financial information, businesses should adhere to GAAP as established by FASB. Seems simple enough, but as you work through the remainder of this book, it should become abundantly clear that GAAP is more or less a series of guidelines that businesses can use to provide a certain amount of leeway when actual financial information is produced. Or maybe the best way to think of it is referring to this quote from Captain Barbossa from the Pirates of the Caribbean franchise: “And thirdly, the code (translation to accounting — GAAP) is more what you’d call guidelines than actual rules.” Yes, very good guidelines but guidelines nonetheless that provide accountants with a reasonable amount of leeway when preparing financial information.
Chapter 2
Introducing Financial Statements
IN THIS CHAPTER
Chapter 1 presents a brief introduction to the three primary business financial statements: the income statement, the balance sheet, and the statement of cash flows. In this chapter, you get more tidbits about these three financials, as they’re sometimes called. Then, in Part 2, you really get the goods. Remember when you were learning to ride a bicycle? Chapter 1 is like getting on the bike and learning to keep your balance. In this chapter, you put on your training wheels and start riding. Then, when you’re ready, the chapters in Part 2 explain all 21 gears of the financial statements bicycle, and then some.
For each financial statement, we introduce its basic information components. The purpose of financial statements is to communicate information that is useful to the readers of the financial statements, to those who are entitled to the information. Financial statement readers include the managers of the business and its lenders and investors. These constitute the primary audience for financial statements. (Beyond this primary audience, others are also interested in a business’s financial statements, such as its labor union or someone considering buying the business.) Think of yourself as a shareholder in a business. What sort of information would you want to know about the business? The answer to this question should be the touchstone for the accountant in preparing the financial statements.
The financial statements explained in this chapter are for businesses. Business financial statements serve as a useful template for not-for-profit (NFP) entities and other organizations (social clubs, homeowners’ associations, retirement communities, and so on). In short, business financial statements are a good reference point for the financial statements of non-business entities. There are differences but not as many as you may think. As we go along in this and the following chapters, we point out the differences between business and non-business financial statements.
Toward the end of this chapter, we briefly discuss accounting standards and financial reporting standards. Notice here that we distinguish accounting from financial reporting:
Accounting standards deal primarily with how to record transactions for measuring profit and for putting values on assets, liabilities, and owners’ equity.
Financial reporting standards focus on additional aspects such as the structure and presentation of financial statements, disclosure in the financial statements and elsewhere in the report, and other matters.
We use the term financial accounting to include both types of standards.