many argue that this cash flow figure is more important than bottom-line profit for the period. Well, we’ll see about that!
Also, it’s common for many businesses to include a summary of changes in their owners’ equity accounts during the year. Typically it’s called a statement of changes in stockholders’ equity. We could argue that it’s not a full-fledged financial statement, but there’s little point in arguing semantics here — although the other three financial statements (balance sheet, income statement, and cash flows statement) are “full-size” statements. Larger, public corporations are required to present this statement, whereas smaller, private businesses have more leeway in deciding whether to include such a summary. We explain the statement of changes in stockholders’ equity in Chapter 2.
Remembering management’s role
We explain more about the three primary financial statements (balance sheet, income statement, and statement of cash flows) in Chapter 2. They constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business’s financial affairs. These individuals have invested capital in the business, or the business owes them money; therefore, they have a financial interest in how well the business is doing.
To keep informed about what’s going on and the financial position of the business, the managers of a business also use these three key financial statements. These statements are essential in helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that isn’t reported in the three basic financial statements. (In Chapter 13, we explain these additional reports.)
The three primary financial statements constitute a business’s financial center of gravity. The president and chief executive officer of a business (plus other top-level officers) are responsible for seeing that the financial statements are prepared according to applicable financial reporting standards and according to established accounting principles and methods.
We’ve met more than one business manager who doesn’t have a clue about his or her financial statements. This situation is a little scary; a manager who doesn’t understand financial statements is like an airplane pilot who doesn’t understand the instrument readouts in the cockpit. Such a manager could run the business and “land the plane safely,” but knowing how to read the instrument panels along the way is much more prudent.
Business managers at all levels need to understand financial statements and the accounting methods used to prepare them. Also, lenders to a business, investors in a business, business lawyers, 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
