In short, financial statements are essential in managing a business and in raising the capital a business needs to operate. Internal financial statements used by managers don’t circulate outside the business if they contain confidential and proprietary information. Internal financial statements are distributed on a need-to-know basis within the business; they contain more-detailed information than the summary-level information presented in external financial statements distributed to lenders and shareholders of a business. But both the internal and external financial statements use the same accounting methods. Businesses keep only one set of books, but they “keep secrets” that aren’t disclosed in their external financial reports.
Business managers, business lenders, and business investors should understand certain characteristics and limitations of financial statements. I explain the truth of these important points in this post: recognizing the indispensability of financial statements, being cool with estimates, living in multiple realities: economic reality and cash flow reality, dressing statements for success.
Financial statements, which are one of the main products of the accounting system of a business, serve two broad purposes:
- They help managers manage the profit performance, cash flows, and financial condition of a business.
- They serve as a pipeline of information to business lenders and investors. Without this financial information, lenders would balk at loaning money to a business and investors would refuse to invest their hard-earned money in a business.
Accounting Rules and Standards Matter
I have seen very, very few maverick financial statements. Almost all financial statements are prepared using generally accepted accounting principles (GAAP) and/or international accounting standards [IAS]. Financial statement readers can assume that American GAAP or the international equivalent have been applied in preparing the financial statements and that there aren’t any significant deviations from these rules of the game. If financial statements are prepared on some other basis of accounting, the business should make this fact very clear in its financial report.
These accounting rules and standards don’t put a business in an accounting straitjacket. A business still has wiggle room in the application of GAAP. For instance, both accelerated and straight-line depreciation expense methods are equally acceptable, and a business can adopt either conservative or liberal (aggressive) accounting methods for recording profit, which also affect the values reported for assets and liabilities in its balance sheet. A business has the choice among alternative methods in many areas of accounting.
Accurateness Vs Estimates [They Are Keys]
Looking at all the numbers in a financial statement, you may assume that they’re accurate down to the last dollar. Not true! The balance in the cash account is exact, but virtually every other number you see in a financial report is based on an estimate. The amounts of expenses, revenue, assets, and liabilities are calculated down to the last dollar, but they’re based on estimates, and estimates never turn out to be accurate down to the last dollar. For example:
- Consider depreciation expense. A business estimates the future useful life of a fixed asset (long-term operating asset) and allocates its cost over this useful life.
- Accounts receivable — the business estimates how much of the total balance of its accounts receivable will turn out to be bad debts. Yet another example is the accrued liability for product warranty and guarantee costs that will be paid in the future. This amount is only an educated guess.
Estimates are unavoidable in accounting. Most businesses have enough experience to make pretty good estimates, and they consult experts when they need to. A business can nudge an estimate toward the conservative side or the liberal side. For instance, it can estimate that its future product warranty and guarantee costs will be fairly low or fairly high. Usually, arguments exist on both sides, and the business ends up having to make a somewhat arbitrary estimate.
Some estimates are particularly difficult to make, such as the liability for future post-retirement medical and health benefits that a business promises its employees. Another difficult estimate concerns product recalls. Estimating the cost of a major lawsuit in which the decision may go against the business is very difficult. My advice is to be alert in reading financial statements to see if the business is facing any issue that’s particularly difficult to estimate.
Financial Statements Are Interconnected Each Other
The three primary financial statements — the income statement, the balance sheet, and the statement of cash flows — appear on separate pages in a financial report and therefore may seem freestanding. In fact, the three financial statements are intertwined and interconnected. Accountants assume that the reader understands these connections, so they don’t connect the dots between corresponding accounts in different financial statements.
Understanding these tentacles of connection between the statements is extremely important, especially for interpreting the statement of cash flows. For example: an increase in accounts receivable during the year that’s reported in the balance sheet causes a decrease in cash flow from operating activities. Profit activities are reported in the income statement, but the results of profit are reported in the balance sheet.
Accrual Basis Is Used to Record Profit, Assets, and Liabilities
The vast majority of businesses must use the accrual basis of accounting to determine profit or loss and to keep track of their assets and liabilities. Simply put, the accrual basis must be used to reflect economic reality. The following are three examples of the accrual basis at work:
- A business makes a sale on credit, accepting the customer’s promise to pay at a later date and delivering the product. The accountant records the sale by an increase to an asset called accounts receivable.
- A business buys a building or machine that will be used many years in its operations and pays cash for the asset. The cost of the asset isn’t charged to expense right away. Rather, the cost is allocated to expense over the estimated useful life span of the asset.
- A business records an expense now even though it will not pay for the expense until sometime later. To record the expense, a liability is increased; later, when the expense is paid, the liability is decreased.
Some small businesses don’t sell on credit, don’t carry inventory, don’t invest in fixed assets (long-term operating resources), and pay their bills quickly. They may use the cash basis of accounting instead of the accrual basis. Basically, all they do is keep a checkbook.
Cash Flow Differs from Accrual Basis Profit
The accrual basis of accounting [see the preceding section], even though it reflects economic reality, causes one point of confusion: Many people look at the bottom-line profit or loss number in the income statement and jump to the conclusion that it’s the amount that cash increased or decreased for the period. Indeed, the expression “a business makes money” suggests that making a profit increases the business’s cash account the same amount. But cash flow from profit—the net increase or decrease in cash from the sales and expense activities of a business for a period—almost always differs from the amount of bottom-line profit or loss reported in its income statement.
In one sense, you can blame accounting for speaking with a forked tongue: The income statement reports one number for profit (net income), and the statement of cash flows reports another number for profit (cash flow from operating activities). There’s the accrual basis number in the income statement and the cash basis number in the statement of cash flows.
Essentially, a financial report has two versions of profit. The amount of cash flow from profit (operating activities) in the statement of cash flows tells you what profit would have been on the cash basis of accounting. The statement of cash flows explains why the cash flow from profit is different from the net income for the period.
The main (but not only) difference between cash basis and accrual basis profit accounting is depreciation. On the accrual basis, depreciation expense is deducted from sales revenue to determine profit, which is correct of course. From the cash flow point of view, in contrast, depreciation isn’t bad but good. The cash inflow from sales revenue, in part, reimburses the business for using its fixed assets. In other words, depreciation for the year is recovery of the cash invested in fixed assets in prior years. Money is returning to the business.
P&L and Balance Sheet Values Can Be [and Often] Are Manipulated
I’m sure you’ve heard about business managers “massaging the numbers” to make profit for the year look better or to make the financial condition of the business look better. Managers can and do lay a heavy hand on the accounting process — to pump up sales revenue or to deflate expenses for the year in order to meet pre-established profit goals or to dampen the volatility of reported earnings year to year.
There’s no end to the tactics for manipulating accounting numbers. Rather than presenting a litany of the techniques for massaging the numbers, I would offer two observations:
- Massaging the numbers is expected, and one may even argue that business lenders and investors encourage it—mainly on the grounds that a business is entitled to put its best face forward. Independent CPA auditors go along with a reasonable amount of accounting manipulation.
- There’s a big difference between massaging the numbers and cooking the books. Cooking the books is the playful name for a serious crime, accounting fraud, in which fictitious sales are recorded, expenses aren’t recorded, liabilities are hidden, or assets are overstated. Accounting fraud is a felony (if one gets caught and convicted, that is).
Financial Statements May Be Revised Later [to Correct Errors and Fraud]
One ominous financial reporting development over the last decade bothers most accounting experts a great deal: An increasing number of businesses revise their financial statements after releasing them to the public. I’m speaking about businesses whose securities are traded in public markets (such as the New York Stock Exchange and NASDAQ). Private businesses don’t release their financial reports to the public at large, so their financial reports probably aren’t revised and restated as frequently as those of public businesses.
By their very nature, financial statements are tentative and conditional. One of the first things you learn in studying accounting is the going concern assumption. The accountant assumes the business will continue to operate for an indefinite period of time and isn’t planning to shut down and liquidate its assets. Financial statements are conditional — the condition being that business will continue to operate in a normal fashion. (If a business is in the middle of bankruptcy proceedings, on the other hand, the accountant has to reckon the chances of the business continuing in operations.)
It’s amazing to me that most financial report revisions are made to correct major accounting errors and accounting fraud. How did these errors slip through the system in the first place?
Undoubtedly, the Enron scandal has made people more aware of the possibility of accounting fraud. But even before Enron happened, the pace of financial report revisions had accelerated. All you can do is to take any financial report with a grain of salt and keep in mind that the financial statements may contain serious errors.
Some Asset Values Are Current [but Others May Be Old]
The balance (amount) of an asset in a balance sheet is the result of the entries (increases less decreases) recorded in the account. A balance sheet doesn’t disclose whether the ending balance in an asset is from recent entries or from entries made years ago. How recent an ending balance is depends on which asset you’re talking about and which accounting method is used for the asset. For example:
If a business uses the FIFO method for its cost of goods sold expense, its inventories balance is from entries recorded recently. In contrast, if the company uses the LIFO method, its inventories balance is from older entries. How much older? Well, one major equipment manufacturer has been using LIFO for many years and part of its inventories balance goes back more than 50 years.
The balance of property, plant, and equipment typically consists of fixed assets that have been on the books for 5, 10, 20, or more years. You should never confuse the original costs in this asset account with the current replacement value of the assets. On the other hand, the accounts receivable balance is current, as is cash, of course.
The footnotes to the financial statements may include information on the current replacement values of certain assets. For example: if a business uses LIFO and has a large gap between the FIFO and the LIFO balances. In this situation, the business discloses an estimate of the FIFO amount for its inventories.
Financial Statements Leave Interpretation to Readers
One guiding rule of financial reporting is to let the financial statements speak for themselves. The financial statements and footnotes report the facts but don’t interpret what the facts mean or what the facts portend. The assessment and forecast of a company’s financial performance and condition are left for the readers to tackle.
Having said that, I should quickly point out that the chief executive and other top-level officers of public companies include a good deal of commentary and their interpretations of the company’s financial performance in annual financial reports. Indeed, it’s useful to carefully read the Management Discussion and Analysis (MD&A) section in a public company’s annual financial report. But keep in mind that getting the top officer’s take is like asking the captain of a ship how the voyage went when the passengers may have quite a different opinion.
Financial Statements Tell the Story of a Business
Financial statements tell the story of the business. How well or poorly individual investors in the business have done isn’t information you can find in the financial statements. Some shareowners in a business may have had their money invested in the business from day one, whereas other original investors may have sold their shares. The business doesn’t record the prices they received for the shares; in other words, dealings and transactions among shareowners aren’t recorded or reported by the business. This activity is none of the business’s business.
The owners’ equity accounts in a balance sheet report only the original amounts invested by shareowners. What has happened since then in the trading of these ownership shares isn’t captured in the financial statements — unless the business itself bought some of the shares from its shareowners. You might find it very interesting to compare the current market price of stock shares you own with the stockholders’ equity balances reported in the company’s balance sheet. In a rough sort of way, this is like comparing the current market value of your home with the cost you paid many years ago.