Everyone loves a good story and most stories are told with words and emotional phrasing. In business, however, we have to tell a story using accounting and that story is going to be told in statements and footnotes.
Before we can create the statements and write the explanatory footnotes, accountants have to follow basic rules and principles designed for different users of financial information. We’ll discuss the users/readers of financial reports later.
Let’s Introduce the Basic Statements
There is a balance sheet, income statement, cash flow statement, statement of owner’s equity, and very important explanatory footnotes that will explain the story told in the statements in much greater detail.
It can be helpful to students to view the balance sheet as a “photograph/picture” of the business at a particular moment in time, such as December 31st. The picture describes the assets of the business and how they were financed by debt and owner’s equity. Assets = Debt + Equity.
However, the income statement and cash flow statements tell a story similar to a “movie” over a period of time, such as a year. The movie explains the activity and transactions over the year. Both will need explanatory footnotes to highlight certain information.
Accounting Comedy Moment
There is an old wise accounting frog who sits in a pond and repeats the same two words over and over again, “Debt, Credit”, “Debt, Credit”, “Debt, Credit”.
Learning the basics of debits and credits to tell the story in accounting can be done easily with practice and study. However, the art and science of telling a business story are anchored in the ‘appropriate’ approach to recording transactions and organizing them in the ‘right’ way for the telling of the story about business activity for each user/reader of the business story.
The approach involves accounting based on rules and principles that differ based on the user’s needs. Some rules and principles are very clear and simple while others involve judgment and calculations which can be subject to different interpretations by different accountants. It can become complex.
Learning the basics of debits and credits to tell the story in accounting can be done easily with practice and study.
There are investors who own equity in public and private companies. The statements created for the investor in a public company are required to be reported under generally accepted accounting principles (GAAP) in the United States. For example, you can take a look at Apple’s annual financial statement: https://www.sec.gov/ix?doc=/Archives/edgar/data/320193/000032019321000105/aapl-20210925.htm
However, companies in other countries follow other rules and principles such as International Financial Reporting Standards (IFRS). The approaches to accounting will differ.
Other users have different needs. There are regulators for different industries, such as insurance regulators; there are taxing authorities such as the U.S. Government, international governments and the fifty United states who all make up laws to tax income. The laws will govern how accountants need to prepare reports for external compliance regulators.
There are internal users of financial information. Approaches to management accounting will be different than the accounting for external users (i.e. investors, regulators, and taxing authorities). Internal users will follow ‘management accounting’ rules and those rules will help the management of a company make important managerial decisions.
Often, a regulator of a business in a particular industry has a main goal such as making sure that the business will remain solvent, (i.e. not go bankrupt). A financial report for an insurance or bank regulator will require the company to make certain calculations that are not of any concern to a taxing authority.
For example, regulators want to know that banks have enough access to cash to return funds to depositors and that insurance companies have enough cash available to pay insurance claims.
A tax return filing with a taxing authority will often be prepared following laws that require a company to pay an income tax whenever the company collects money from customers, even if the earnings process is not yet complete. Those laws won’t allow an expense as a deduction if that expense is prepaid for something way in the future or if the cash is anticipated to be paid in the future.
Meanwhile, the same company will prepare financial reports to investors of its revenue and expense on an income statement. The revenue can only be recorded once the ‘earnings process is complete’ – and that can be simple or complex. Expenses will include both the amounts of cash disbursed and all amounts anticipated to be paid in the future. Those are called ‘accrued for expenses’ (i.e. accruals).
It bears repeating that while the taxing authority says to pay tax on cash collected, the rules for financial reporting might state that the earnings process is not complete for revenue reporting and future payments anticipated must be recognized as expenses. The taxing authority might not allow a deduction of certain items that are expenses for financial reporting.
That’s just the tip of the iceberg. There are many more examples. When you need a good laugh, just start babbling like the wise accounting frog: “Debit, Credit”, “Debit, Credit”!