Discussion 5
Reporting Assets
A. The Activity Statement
Activity statements track the amount and sources of resource inflows and
outflows for the organization. Inflows are generated by activities such as sales of goods
and services, grants and gifts, taxes and user fees, and investment income. Inflows are
classed by nature (e.g., gift, grant, sales revenue), source (e.g., government, foundation,
taxpayers, patients), and sometimes organizational unit (e.g., radiology, lab, pharmacy,
operating room). Outflows are the results of using resources in the process of generating
inflows. Outflows are classed by nature, often called object of expense (e.g., salary,
supplies, rent), function or program (e.g., provide housing, meals, medical care), or
organizational unit. Revenues and support represent the inflows that an organization has
received or is entitled to receive. Revenues are generally the result of an exchange for
goods or services that the organization has provided. Support represents other money that
the organization has received or is entitled to receive in the form of gifts, grants, and
other contributions. Taxes and user fees represent common types of government
revenues. Various types of government revenues are discussed further in Appendix 10-A.
Revenues and support result in an inflow of assets to the organization and an increase in
owners’ equity or net assets.
Expenses are outflows of assets. They represent decreases in owners’ equity or
net assets resulting from the consumption of assets. Expenses are costs incurred to help
generate revenues and support or to carry out the operating activities of the organization
in other ways. Expenses represent recognition of the use of resources in the operation of
the organization. For example, the labor of a nurse providing care to a patient is
consumed in that process and becomes an expense. Revenues and support represent
events that increase assets on the left and increase net assets (or owners’ equity) on the
right. Expenses are events that decrease assets on the left or increase liabilities on the
right, and decrease net assets on the right. The change in net assets (or net income) is
simply the difference between revenues and expenses. If revenues and support exceed
expenses, the organization has an increase in net assets. A for-profit organization in such
an instance would have a positive net income. If expenses exceed revenues and support,
the organization has a decrease in net assets, often referred to as a deficit or a loss.
Many organizations in the public service sector avoid use of the term net income,
or profit, which seems to infer that making profit is the reason for existence of the
organization. Instead they use terms such as surplus or deficit, or excess of revenues over
expenses, or simply change in net assets. All organizations need to measure their net
income, profit, surplus, excess of revenues over expenses, or increase in net assets (or net
loss, loss, deficit, excess of expenses over revenues, or decrease in net assets). This
allows them to determine whether their asset inflows exceed or fall short of their asset
outflows. The activity statement presents the financial results of operations for a time
period. Did revenues fall short of expenses for that period of time? Did revenues just
barely cover expenses? Perhaps revenues exceeded expenses by too much. Public service
organizations need to have adequate surpluses to sustain, update, and expand the services
provided. Failure to earn a profit, or at least break even, can endanger organizations. So
an increase in net assets is appropriate. However, since their mission is usually one of
public service, many not-for-profit or government organizations do not wish to maximize
their profits. For many public service organizations, profits are not the end in themselves,
but rather a necessary means if the organization is to be able to accomplish its mission.
An excessively large profit could indicate that the organization could provide more
services, lower the price it charges for its services, or lower taxes.
The purpose of the activity statement is to provide management with information
needed to steer the organization as necessary to best accomplish its objectives. Losses
may be acceptable at times. Profits may be deemed to be too high at times. The role of
financial accounting is to provide managers and outsiders with information about what
the results of operations were. Financial accounting does not pass judgment on whether
the results are good or bad. Rather, it provides the information that people can then use to
make their own judgments about whether performance has been good or bad, appropriate
or inappropriate, and what decisions should be made.
B. Recording Financial Events
Revenues are recorded if two requirements for revenue recognition are met:
Revenues must be (1) earned and (2) realized. The first requirement—being earned—is
met only if the organization has provided goods or services to the customer. If a legal
transfer has occurred that establishes a legal right to collect payment, then the revenues
have been earned and the first requirement is met. For the revenues to be realized, we
must be able to objectively measure the amount of money owed, and there must be a
reasonable likelihood of eventual collection. Not-for-profit organizations often receive
gifts and pledges of financial support. Support is a subcategory of revenue. The support
may be used to provide goods or services to the organization’s constituent group.
However, there is often no direct connection between the gift and the delivery of goods or
services. In the case of such support, the first requirement for recording the support is that
all conditions of the gift have been met. In other words, donations are recorded as support
even though the gift has not been received and even though no goods or services have
actually been provided. An allowance for uncollectible pledges would be needed, since
not all pledges are collected.
By contrast, if the organization received a general promise to provide a
contribution of an unstated amount, the support could not be recognized because we
cannot objectively determine how much will be contributed. In some cases of support,
specific conditions are created. For example, a philanthropist might offer to donate $10
million to a university if it changes the name of one of its buildings to her name. Since
there is a specific amount of money, there is objective evidence of the monetary value.
Since the donor is rich, there is reasonable certainty of collection. However, until the
building’s name is changed, no support is recorded. When the name of the building is
changed, all conditions have been met, and at that point the university can record a
contribution receivable as an asset and an increase in support or revenue.
Recording expenses is somewhat complicated by the fact that some types of
expenses are product costs and others are period costs. Product costs are those expenses
that are directly connected to providing goods and services. Period costs are those that
relate to the passage of time rather than the direct provision of services. Product costs are
treated as expenses based on the matching principle. The matching principle of GAAP
holds that we should record revenues and the costs of generating those revenues in the
same period. For example, if we treat a patient this year and record revenue for that
treatment this year, then all the costs of providing that treatment should be recorded this
year. If a technician provides service to the patient this year, thereby earning revenue for
the organization, but the technician is not paid until next year, the expense related to the
technician is recorded this year to match it with the revenues earned from the patient
treated. This is in line with the accrual basis of accounting, discussed in earlier chapters.
Period costs are incurred with the passage of time. For example, rent, interest,
management salaries, heat, and other costs are incurred largely irrespective of the specific
provision of services. These costs are treated as expenses in the time period incurred. For
example, rent for administrative office space for the month of December 2017 is recorded
as an expense of 2017 regardless of whether that rent is paid in 2017 or 2018. Another
way of thinking about this is that expenses are recorded when assets expire or are used
up. They can expire with the passage of time, such as rent on an office for a specific
month or year. The passing of time can be considered to be a “using up” or
“consumption” of the useful life of an asset. Or expenses can expire because they are
physically used up or consumed specifically in the process of providing goods and
services.
Suppose that Meals for the Homeless buys canned food for $1,000. The food has
a cost of $1,000. The word cost can be ambiguous. What did the food cost Meals? The
food cost $1,000. However, is the food an asset or an expense? Assets can be thought of
as cash or things that will become cash or things that will be consumed in the process of
providing the organization’s goods and services. Cash is clearly a valuable resource—that
is, an asset. Receivables will become cash when they are collected, clearly making them
valuable resources. Many assets, however, are unexpired costs. The cans of food, sitting
on the shelf at Meals for the Homeless, are an asset that is an unexpired cost. When the
cans have been opened, cooked, and served, the asset has been used up. It has been
consumed in the process of providing the organization’s services. Accountants would call
the food an expired cost at that point. An expired cost is an expense. Thus, the amount
spent on food was a cost. As long as the cost was unexpired, it was an asset. When the
asset was used up, it became an expired cost, or an expense.
Rather than considering how profitable this organization has been for this year in
isolation from any other information, providing multiple years’ worth of data gives the
user of the financial statement a better perspective on the results of operations. For
example, the $5,000 increase in net assets this year is modest. It represents only about
two and a half cents of profit from every dollar of revenues and support ($5,000 profit ÷
$196,000 Total Revenue and Support = .0255 or 2.55 cents of profit per dollar of revenue
and support). However, by having 2 years’ worth of data, we see that the modest increase
in net assets is a turnaround from the previous year, when Meals had a $7,000 decrease in
net assets. Meals’s performance is improving. In light of that prior loss, the current-year
increase can be placed within a context that allows the user of the financial statement to
make a more reasoned interpretation of the information. Annual balance sheets and cash
flow statements also generally provide 2 years’ worth of information for comparative
purposes.
An alternate presentation would be to truncate, or cut off, the three digits on the
right completely. In that case, the heading of the financial statement would have to
indicate that this has been done. Typical headings would say, “000’s omitted” or “in
thousands.” For very large organizations, data are rounded off or truncated to the nearest
hundred thousand or million dollars. For small organizations, financial statements
sometimes report figures to the nearest dollar. In terms of nature, we know how much of
the revenue is earned in exchange for meals provided versus how much of the
organization’s resources come from responses to fundraising efforts. In terms of source,
we know how much money was received directly from the organization’s clients, how
much came from the city and county, and how much came from each of the major types
of contributors (foundations, event attendees, telephone, and mail). We do not really have
information by organizational unit; we do not know revenues or support for one soup
kitchen versus another, or about soup kitchens versus delivery by van.
Why is it beneficial to know about revenues by nature, source, and unit? The
subcategorizations allow us to go beyond knowing simply whether we are making or
losing money. How good a job are we doing at fundraising? Are our revenues from meals
well matched with the costs of providing meals? If we start to lose money, what would be
the impact of eliminating our shelter counseling services? Are we getting more client
revenues per meal from costly van delivery service than from soup kitchens? Are
foundation grants falling—do we need to make a greater effort in that area?
Regardless of the choice made regarding the level of detail to report, the activity
statement must at least report revenues and support in a manner to disclose the total
amount of revenue and support received. Similarly, total expenses must be shown. In
addition to the straightforward expenses such as food, staff, and rent, four types of
expenses warrant further discussion: administrative and general, bad debts, depreciation,
and inventory used. To some, these expenses may seem irrelevant to the mission of the
organization. The mission of Meals is to provide food for the homeless. Why should it
spend money on such irrelevant overhead costs when it could better be spent providing
more meals or counseling the homeless to help them find shelter? Others would argue
that such a philosophy is shortsighted. First, all organizations need some administrative
supervision and coordination. Someone has to buy supplies; pay for rent, food, and
employees; file employee wage taxes; and do a host of other administrative activities
without which the organization could not survive.
How does an organization survive with primary revenue of $11,000 and primary
expenses of more than $100,000? For one thing, it has contracts with the city and county
for meals and counseling that generate another $30,000. Those contracts were negotiated
by administrators, whose salary is within the administrative and general category. One
might argue that at one time administrative costs were needed, but now that the city and
county contracts exist, the effort to renew them annually is minor. Note, however, that
even with the government contracts, the revenues still fall far short of the direct costs of
providing meals and counseling. Close examination of the activity statement reveals that
the revenue from fundraising is critical to keeping this organization afloat. Foundation
grants, the revenue from an annual ball, and telephone and mail solicitations raise
approximately $150,000. Without spending money on administrative and general
expenses, including fundraising costs, it is doubtful that this organization could survive.
What about the sharp 15 percent increase in this category? Financial statements
often raise more questions than they can answer. Potential red flags, such as the 15
percent increase, warrant management attention. There are a number of possible
explanations. For example, city contract revenue and direct client revenue for meals both
rose by more than 20 percent. Perhaps more administrative staff was hired to work on
increasing revenues from these sources. Another possibility relates to foundations.
Foundation grants were up by 40 percent. Note that the previous year the organization
lost money, and this year it made money. Suppose that the organization this year hired a
consultant for $10,000 to apply for foundation grants. Meals received $20,000 more from
grants in 2017 than in 2016. Perhaps there are even more applications still in the pipeline.
Some would argue that spending $10,000 on a consultant to achieve $20,000 of grants is
not cost-effective. Half of the grant money went directly to the consultant. Others would
argue that Meals had a loss the previous year and a profit this year. Without the
consultant and the extra foundation grants, Meals would have lost money again this year,
so the investment was worthwhile.
Bad debts, or uncollectible accounts, arise because not everyone pays us what
they owe us. Although we expect each individual client to pay, we also know that some
of them probably will not. We just do not know who. For instance, Meals for the
Homeless receives pledges in response to telephone and mail solicitations. Assume that
Meals’s history has shown that approximately 92 percent of all pledges are ultimately
collected. However, there is no way to know in advance which specific pledges will be
collected and which will not. It would understate financial support to ignore all pledges,
but it would overstate financial results to assume that we would collect 100 percent of the
pledges. The solution used is to record 100 percent of the pledges as support (or revenue)
and then also record 8 percent as a bad debt expense. This solution complies with the
matching principle of GAAP, placing the revenue and the related bad debt expense in the
same accounting period.
The allowance for uncollectible accounts shown on the balance sheet can be a
larger number than the bad debt expense on the activity statement. Suppose that Meals
gives people at least 2 full years to pay their pledge before deciding that a specific pledge
is uncollectible. At the end of the year, the balance sheet will show all receivables that
have not yet been collected. Included in that amount will be all of the amounts related to
pledges this year that have not yet been collected and all of the amounts related to
pledges made the previous year that have not yet been collected. While the activity
statement will show a bad debt expense related to just this year’s revenue, the balance
sheet will show an allowance for possible uncollectible accounts equal to 2 years’ worth
of bad debt expense.
Note that the balance sheet contains some pledges receivable from 2 years and
also contains the allowance from 2 years. The balance sheet reports the total allowance
for uncollectible amounts balance and the pledges or accounts receivable, net balance, but
not the individual years’ pledges receivable separately. Eventually the organization will
decide that a particular pledge will never be collected. At that point the specific pledge is
written of . This means that receivables are reduced for that one specific pledge. At the
same time, the allowance is also reduced. Suppose that on January 10, 2018, Charlie
Smith dies without paying a $500 pledge he made in 2016. Meals decides it will never be
able to collect that pledge.
Note that the net balance of $55,000 has not changed. This is because no asset is
consumed when the decision is made to write off an account. But there is a bad debt;
Charlie Smith is not paying his pledge. That is true. However, the expense was recorded
back in 2016 in the same year as the pledge was recorded as support. That way the
revenue and expense were both in the same year, and the matching principle of GAAP
was not violated. Lowering the specific pledge receivable and the allowance account
allows the net pledges receivable to remain unchanged. 3 3. In some cases, it is possible
for the allowance for uncollectibles at the end of the year to be lower than the bad debt
expense for the year. This could happen if some of the specific receivables from the
current year are recognized as uncollectible and are written off before the end of the year.
Although healthcare organizations have traditionally shown bad debts as an expense, the
Financial Accounting Standards Board (FASB) now requires that a healthcare
organization that does not assess its patients’ abilities to pay for care treat bad debt as a
deduction from patient service revenue on its operating statement. 4 Whether bad debts
are shown as a deduction from patient service revenue in the revenue section of an
operating statement (as for some healthcare organizations) or as an expense in the
expense section of the operating statement (as for other organizations), the organization’s
profit or increase in net assets will be the same.
Depreciation expense represents the allocation of the cost of a capital asset over
its lifetime, charging a share of its cost into each year that the asset is used by the
organization. This approach is required by the matching principle. Since we will use a
long-term asset to earn revenues over a number of years, it would not make sense in an
accrual accounting system to treat the entire cost as an expense in one year. The portion
of the asset’s cost treated as an expense in a year is called the depreciation expense of
that asset for that year. Ideally, one would want to base the amount of depreciation
expense each year on the decline in the value of the item being depreciated. That would
make sense from an economic perspective. However, it is difficult in practice to
determine how much the value of each capital asset has declined each year. Accountants
have developed formulas to allocate the cost of capital assets to the years the asset is
expected to provide useful service. However, it should be noted that these formulas are
only rough approximations at best. To the extent that they do not accurately estimate the
decline in value of the asset, the depreciation expense for the year (on the activity
statement) will be inaccurate, and the remaining asset balance (on the balance sheet) will
be inaccurate.
However, the matching principle would hold that if we use up more of an asset in
the early years of its life than in the later years, it would be appropriate to assign more
expense to those early years. Suppose that equipment and buildings need more
maintenance as they age. If we could charge more depreciation in the early years of an
asset’s life and less in the later years, the total of the depreciation cost and the
maintenance costs would be more stable from year to year. To deal with this problem,
there are several alternative methods of depreciation, referred to as accelerated
depreciation. These accelerated methods charge more depreciation expense in the early
years and less in the later years.
The inventory choice relates to an assumption about the flow of inventory. One
would normally assume that the organization uses its oldest inventory first. However,
during periods of high inflation, the expense reported on the activity statement could
substantially understate the economic impact of the use of inventory. For instance,
suppose that the Hospital for Ordinary Surgery (HOS) used an expensive medical supply
item. At the start of the year, it owns one unit of an item that it paid $50 to acquire.
During the year, it purchases a unit for $60. For the coming year, it expects to acquire a
unit for $70. It uses one unit during the year. What expense should appear on the activity
or operating statement, and what asset value should appear on the balance sheet? (Note
that most not-for-profit organizations use the activity statement title for the financial
statement that reports revenues and expenses. Health organizations, by contrast, refer to
the statement as the operating statement.) Logically, if it uses its oldest inventory first,
the expense on the operating statement will be $50. The balance sheet value of inventory
will show the $60 cost of the unit purchased during the year. This is referred to as a first-
in, first-out (FIFO) approach. However, the operating statement is not reporting the
amount that it will cost HOS to replace the inventory it used. HOS will now have to
replace that unit of inventory at a higher price.
As an alternative to the FIFO choice, organizations are allowed to assume that
their inventory moves on a last-in, first-out (LIFO) basis. Under this method one would
assume that HOS used the last item it had purchased, at a cost of $60, and held on to the
one it had paid $50 to acquire. The operating statement now shows an expense of $60,
and the balance sheet shows an asset value of $50. One can see why it is important to
disclose the choice made in a note. Two different organizations could have bought and
used exactly the same inventory but reported different financial results simply because
they chose to make different assumptions about which inventory was used and which was
kept. Note that financial statements report inventory as an asset on the balance sheet and
as an expense on the operating statement based on an assumption of the order in which
inventory is used. An organization can use its oldest inventory first (a FIFO approach)
but use the LIFO approach to report on the financial statements. This allows the
organization to use its inventory in its usual manner and also have the LIFO benefit of a
more accurate operating statement during times of inflation.
Some would even contend that the operating statement should show a $70
expense because that is the anticipated cost to acquire the unit of inventory that will
replace the unit used. However, such a replacement cost approach is not allowed. In some
cases, there are specific advantages to reporting inventory consumption on a LIFO basis.
If an organization is for-profit, LIFO will lower its taxes during periods of inflation.
Why? Because as inventory prices rise, if you assume that you have used the last units
purchased, they are likely to be the most expensive. Higher expenses result in lower
income and therefore lower taxes. It should be noted that International Financial
Reporting Standards (IFRS) do not allow the use of LIFO. The FASB and the
International Accounting Standards Board (IASB) had been working to converge U.S.
GAAP with IFRS over the past several years. At least in the near term, it is unlikely that
the United States will adopt IFRS. If such a change is adopted in the future, it is likely
that the Internal Revenue Service would no longer allow LIFO for tax reporting as well.
Why would a not-for-profit organization, exempt from income taxes, use LIFO?
In some cases, it may receive payments that reimburse it for the cost of providing
services. Suppose that Middle City pays Meals for the Homeless 75 percent of the cost of
each meal served. If Meals uses LIFO during an inflationary period, it will report a higher
cost per meal and receive higher current reimbursement as a direct result of this decision.
This is the same reason that some not-for-profit organizations prefer to use accelerated
depreciation. In addition to the FIFO and LIFO inventory flow assumptions, there are
several other allowable, less used, methods. They are discussed in Appendix 10-C, along
with a more detailed discussion of inventory valuation calculations.
C. The Dangers of Estimates
One of the principles of GAAP is that the organization should use objective,
verifiable evidence. That is why land is valued on the balance sheet based on its cost
rather than some estimate of current market value. Sometimes, however, there is no
reasonable alternative to making an estimate. Bad debts are one example. Depreciation is
another. Bad debt expense should be exactly the portion of current revenues that we will
be unable to collect. However, we will not know the exact amount for a long time—
perhaps several years. So an estimate is made, even though that estimate must be based
on a subjective analysis. We try to minimize the subjectivity by basing the estimate on
historical experience, the economy, who owes the money, and other factors that might
affect ultimate collectability. Depreciation is also an estimate. We cannot know
objectively how the market value of an asset will change from year to year, so
accountants use formulas to estimate annual depreciation. Even using those formulas, we
cannot be sure how much we will be able to get for the fixed asset when it is sold, so the
salvage value used in the calculation is an estimate. Nor can we be sure how long the
useful life will be, so that is another estimate. These are subjective best guesses.
One danger with subjectivity is that it opens the door to both honest error and
intentional manipulation. Estimates are likely to be imperfect and should be considered
carefully, even when they are reasonable. Furthermore, if we want to look poor to
encourage donations, we might be tempted to overstate bad debt expense or to
underestimate the salvage value for a piece of equipment. Both of those actions would
tend to lower the current increase in net assets, making us look poorer now. Conversely,
if we planned to borrow a large amount of money in the future, we might want to
overstate the increase in net assets to make the organization look more financially solvent
to potential lenders. We might underestimate bad debts or overestimate the salvage value
of equipment. The use of a reasonable estimate can improve the information reported in
financial statements considerably. Although one should be aware of the danger of
information manipulation, this is not meant to say that we would be better off without
reasonable estimates. Rather, one should carefully consider information based on
estimates, much as one must be careful when interpreting most financial information.
When is revenue not really revenue at all? When it is deferred revenue. Deferred
revenue is a liability. It is sometimes called unearned revenue. At times, an organization
will receive payments for services that have not yet been provided. This is very much like
the asset prepaid expenses, except that we have received payment rather than made
payment. In fact, it is a mirror image. The prepaid expense on the financial records of one
organization will be a deferred revenue on the financial records of the other organization
involved. If HOS pays for fire insurance in advance, it will have a prepaid insurance asset
and the fire insurance company will have deferred revenue liability in the same amount.
At some future point, the organization with the deferred revenue liability must either
provide the services or refund the money. Until then, the deferred revenue represents a
liability rather than a revenue. When service is provided, the deferred revenue is
converted from a liability to a revenue.
For example, suppose that a magazine publisher received $120 for a 1-year
subscription. At the time the money is received, the publisher has not yet provided its
service to its customer. Therefore it must show a liability. However, it never expects to
actually pay the customer in cash. It expects the $120 to become revenue when it
provides the monthly issues of the magazine. Therefore, the liability is called unearned or
deferred revenue because the point at which it can be recognized as revenue has been
pushed off or deferred to the future. What if the magazine publisher expects it to cost $60
to fulfill its obligation to provide the monthly issues of the magazine? Should the
deferred revenue liability be the $120 that was received or the $60 that it will cost to
provide the magazine to the customer? The answer is the full $120. Suppose that for
some reason the publisher was unable to provide the magazine. How much would the
customer be entitled to as a refund? The $120 paid, or the $60 that it would have cost the
publisher? Clearly the customer is entitled to a refund of the $120, so that is the amount
of the recorded liability.
Imagine that a person is trying to decide whether to buy shares of stock in Prisons
R Us or its main competitor, We Lock M Up. Prisons R Us had net income of $200,000
this year. We Lock M Up had $1,000,000 of net income. It might appear that the latter
company is much more profitable and therefore a better buy. However, Prisons R Us has
100,000 shares of stock outstanding. Therefore, each owner of one share of stock owns
$2 of earnings ($200,000 earnings ÷ 100,000 shares = $2). We Lock M Up has 1,000,000
shares of stock outstanding. Therefore, its earnings per share are only $1 ($1,000,000
earnings ÷ 1,000,000 shares = $1). Since owners only own their pro rata (proportional)
share of the company and its profits, one can see that the earnings per share information
may be more relevant than simply total profits.
The activity statement opens a wealth of opportunity for analysis. We noted
earlier that foundation grants rose dramatically. Was that a one-shot increase? Can it be
sustained in coming years? Will it likely increase even more in coming years? Why did
administrative costs rise so steeply this year? Which changes from year to year make
sense? Which changes do not make sense? What can we conclude from the income
statement about the overall results of operations? Activity statements provide information
that can be analyzed to better understand the overall financial health of an organization.
For most managers, even more important than being able to generate financial
information is development of a critical eye for evaluating financial information. The
purpose of becoming comfortable with financial reports such as balance sheets and
activity statements is that it allows the manager to examine results and to get an
understanding about what is going right and what is going wrong with the organization
from a financial perspective. One cannot always get answers from the statements; but if
review of the statements allows the manager to ask perceptive questions, the statements
can aid enormously in the management of the organization.
D. The Statement of Cash Flows
The activity statement focuses on the revenues and expenses of the organization.
If we used a cash basis of accounting for reporting, the activity statement would provide a
wealth of information about the organization’s cash. However, most organizations use
some form of accrual accounting. They do this to better represent how the organization
did for the year by matching the revenues it earned (whether collected or not) to the
expenses it incurred (whether paid for or not). Cash, however, is also vitally important.
The statement of cash flows focuses on financial rather than operating aspects of the
organization. Where did the money come from, and how was it spent? While the major
concern of the activity or operating statement may be profitability, the statement of cash
flows focuses to a great extent on viability. Viability relates to whether the organization
is generating and will generate enough cash to meet both short-term and long-term
obligations and therefore will be able to continue in existence.
There have been a number of instances of profitable businesses that have fallen
into desperate financial crises, at times even leading to bankruptcy. How could this
happen? During profitable periods, many organizations expand. Since they are making
profits on current services, expanding services should lead to even greater profits.
However, profitability alone does not ensure that such expansion is financially feasible.
Expanding the quantity of services offered tends to require additional physical facilities.
More employees must be hired and more supplies purchased. What is the problem if all
of these additional expenses result in even more additional revenues? The problem relates
to delays or lags between paying for expenses and collecting revenues. In many cases,
organizations must acquire the resources of production (e.g., buildings, equipment,
supplies, employees) and start paying for them before they start collecting revenues for
those services. In other words, there may be a profit on an accrual basis, but we have paid
more in cash for our expenses this year than the amount of money collected in cash from
our revenues. Eventually cash collections should catch up, but by that time we may have
failed to pay some obligations when they were due.
This problem is discussed in the planning section of this book. We cannot plan
solely based on an accrualbased operating budget. Cash budgets are required as well.
Similarly, we cannot judge how well things are turning out based only on a report of
actual profitability. We also need to report on what has happened with respect to cash
during the period of time being examined. Did we have a net gain in cash or decrease in
cash during the time period? Where did we get our cash from and what did we spend our
cash on? Suppose that the Millbridge Blood Bank is having difficulty meeting its
obligations as they come due. As a result, during the past year it sold its land for $75,000.
That land was purchased by the blood bank a number of years ago for $40,000. The
activity statement will include a $35,000 gain from the sale of the land. Even with that
gain, however, the organization showed a net income of only $10,000 because of a loss of
$25,000 on its other activities. Between the loss of $25,000 on other activities and lags in
collection of receivables, at year-end the blood bank’s cash balance had increased by just
$15,000.
One way to view what has transpired is that the organization made a profit of
$10,000 and cash increased by $15,000. Both of those numbers are correct. However, this
does not really convey what happened. By themselves, they imply an organization that is
both profitable and generating cash surpluses. However, when we examine the sources
and uses of cash we learn a different story. Although cash increased by $15,000, the sale
of land generated $75,000 of cash. Without that sale, the cash balance would have gone
down by $60,000. The organization had only that one piece of land. Can it go on
indefinitely selling off its assets to get the cash needed to provide its current services?
Probably not. By looking at the sources of cash, we find that, rather than a rosy picture,
there are serious financial problems that must be addressed if the organization is to be
able to continue providing services. Consider another example. Suppose that HOS had a
cash decrease of $2,000,000 for the year. That might cause great concern. Looking at a
detailed statement of cash flows, however, we find that the routine ongoing activities of
the organization generated a cash surplus of $3,000,000. Then how did the cash balance
decline? The organization is so profitable and generating so much cash that it decided to
purchase $5,000,000 of new equipment to expand services offered. It used the full
$3,000,000 of cash generated this year and took $2,000,000 of cash out of its bank
account. It anticipates that with the new equipment, next year it will generate even more
than this year’s $3,000,000 increase in cash from ongoing activities.
In this second example, cash fell, but there really is no problem. In the first
example, cash rose, but there was nothing to celebrate. In each case, managers could not
really interpret the financial situation of the organization without some detailed analysis
of the sources and uses of cash. Cash flow statements are divided into three main
categories: cash from operating activities, cash from investing activities, and cash from
financing activities. Operating activities are those activities related to accomplishing the
organization’s primary mission. They include the day-in and day-out operations of the
organization. Investing activities are related to buying and selling long-term fixed assets
(property, plant, and equipment) and investments such as shares of stock. Financing
activities are those related to borrowing and repaying loans.
The cash flow statement has links to both the activity statement and balance sheet.
The first number on the cash flow statement is the change in net assets or net income,
taken directly from the activity statement. The ending balance on the cash flow statement
is also the cash balance from the balance sheet. In fact, there are additional links as well.
The cash flow statement begins with the organization’s change in net assets, or net
income, and then lists the changes in liabilities and the changes in all other assets. The
changes in liabilities and changes in all other assets appear on the cash flow statement in
the section that best represents whether they result from routine operating activities,
investing activities, or financing activities. It is easier to derive the various components of
the cash flow statement if one thinks of the statement in terms of this equation. For
example, if we borrow money, it increases a liability (the right side of the equation) and
increases cash (the left side).
If we repay a loan, it reduces the liability and also reduces the cash available.
Note that the All Other Assets part of the equation has a negative sign in front of it. If we
buy a building, assets go up, but the right side of the equation goes down because of the
negative sign in front of Δ All Other Assets. But that makes sense because when one buys
a building one uses cash, so both sides of this equation decrease. Each type of financial
statement is independent and provides different, valuable information. Yet all of the
statements are derived from the same fundamental equation, and all of the statements are
interdependent and should be taken together as a whole.
The first section of cash flow statements is Cash Flows From Operating
Activities. This is considered to be a critical element. The ability of an organization to
continue operations over a long time period often depends on whether its normal daily
operating activities generate more cash than they consume. An organization that
generates more cash than it uses for operations is, ceteris paribus, more financially stable
and viable. A rapidly expanding profitable organization may suffer cash shortfalls as
inventories and receivables increase. This need not create a crisis if management is aware
of it and plans to handle the cash shortage. The cash flow statement focuses
management’s attention on the cash shortfall and its causes. It creates a warning flag.
With sufficient lead time, other sources of cash, such as long-term debt, may be arranged
to avoid a serious problem.
The first adjustment made is for expense items that do not consume any cash. In
nearly all cash flow statements, the first item listed after change in net assets is
depreciation. In 2017, Meals for the Homeless had $10,000 of depreciation. The cash
payment to acquire a capital asset would show up as a use of cash in the section of the
statement called Cash Flows From Investing Activities. This would occur in the year the
asset is acquired. In each year that we own the asset, a portion is charged as depreciation
expense. However, there is no cash receipt or payment related to that annual depreciation
charge. Consider, for example, that Meals for the Homeless purchased a delivery van in
2016. In 2017, no equipment was purchased or paid for. However, the delivery van
purchased in 2016 and the kitchen oven equipment purchased in earlier years are being
depreciated during 2017. Since Meals used those assets in 2017 to provide meals, it is
appropriate to charge some of their original cost as an expense in 2017. However, Meals
is not paying cash for them in 2017. They were already paid for in earlier years.
Depreciation is only an allocation of cost; it is not a cash payment.
This creates a minor problem. The change in net assets was used as an
approximation of cash flow on the first line of the cash flow statement. One would
therefore assume that revenues had been received in cash and all expenses paid in cash.
However, if there is an expense such as depreciation that is not paid in cash, we must
make an adjustment. Since expenses are subtracted to arrive at the change in net assets on
the activity statement and since depreciation expense is not paid in cash, we must add
depreciation back to changes in net assets to approximate cash flow better. This creates
some confusion. Many people assume that depreciation generates cash since they see
depreciation as a positive number on the cash flow statement. It is important to realize
that depreciation is not being added because it generates cash. It does not. It is being
added to adjust for the fact that it was subtracted to arrive at the change in net assets but
did not consume cash. In addition to depreciation, there are other expense items, such as
amortization, that reflect a current-year expense but do not consume cash. For example, a
patent is not a tangible asset. As such, it cannot be depreciated. Depreciation is just used
for tangible assets. But the patent does get used up over a period of time, and its cost is
allocated each year as an amortization expense. Meals for the Homeless did not have any
amortization for 2016 or 2017.
The activity statement assumes that the full $17,000 of food used must have been
paid for in cash. However, we see from the preceding calculation that we purchased only
$15,000 of food. The activity statement assumes that more cash was used than was
actually the case. So we need to add back the difference between the $17,000 and the
$15,000. This is equivalent to adding back the decrease in the inventory balance. By
contrast, what if we had purchased more inventory than we had used? Our inventory
balance would have increased. Our expense for the use of inventory would show only the
inventory used. It would not show the amount paid to acquire inventory that we still
owned at the end of the year. It would be necessary to make an adjustment in which we
subtracted the year-to-year increase in inventory from the change in net assets. That
subtraction would adjust for the fact that we not only paid cash for the inventory we used,
but also paid cash to acquire more inventory that we still have at the end of the year.
Changes in current assets are part of the change in all other assets in the equation.
Increases in current assets are subtracted, for example, because we spend money to
acquire those assets, causing both sides of the equation to decline. Notice the negative
sign in front of Δ All Other Assets in the equation. Following this equation, Meals must
also subtract the decrease in wages payable. If wages payable decline, it is because we
have paid employees more than they earned this year. That means that payments to
employees exceeded the amount treated as an expense in the activity statement. So a
subtraction is required. Looking at the equation, a reduction in a liability reduces both
sides of the equation.
Another common adjustment relates to unrealized gains and losses on
investments. For example, suppose that an organization owns shares of stock with a value
of $30 per share at the beginning of the year. During the year the value of the stock rose,
and at the end of the year it is worth $40 per share. On the operating statement, a gain of
$10 per share will be shown to reflect this increase in the value of our investments. Since
we have not yet sold the stock, this gain is considered to be “unrealized.” Although that
change has resulted in an increase in net assets, there has been no cash flow. We didn’t
actually sell the stock, so we didn’t receive cash. Therefore, we need an adjustment on
the cash flow statement. We will subtract the unrealized gain on investments. Similarly, if
there were an unrealized loss on investments, that would have lowered net assets on the
operating statement, even though cash is not paid to anyone when an unrealized loss
occurs. So unrealized losses are added back in the operating section of the cash flow
statement.
These adjustments can be complicated, and they make preparation of a cash flow
statement difficult. The vast majority of managers, however, will not have to prepare the
statement. So it is more important to focus on interpretation of the numbers. Managers
should be able to answer questions such as “What are the implications of an increase in
accounts receivable on the cash generated by operations? Does the increase in accounts
receivable imply that we are not making an adequate effort to collect money owed to us?
Does the lag in collection of money owed to us affect cash flow to a great enough extent
to create a dangerous financial position for the organization?” Meals for the Homeless
has had decreases in cash from operating activities for both 2016 and 2017. The decrease
in 2017 was smaller than in 2016, but given Meals’s profit in 2017, it might still be
considered surprising. The cash decrease in 2017 is not extremely large. And it might be
caused by expansion in services and lags in collections of receivables. It does, however,
raise a note of caution, and it will be important for managers to keep their eyes on their
cash flows during the coming year.
The second part of the statement of cash flows is cash from investing activities.
This section focuses on two very different types of investment activities. First is the
purchase and sale of investments not directly related to the production of the
organization’s goods and services. This would include, for example, the purchase and
sale of shares of stock. The second type of activity relates to the purchase or sale of the
capital assets the organization needs to provide its goods and services, such as buildings
and equipment. In either case, the investing activities section of the cash flow statement
shows the total purchase amount for purchases and the total sales amount for sales. If we
buy a building for $1,000,000, in the investing activities section of the cash flow
statement we would show that we used $1,000,000 of cash. What if we pay only
$200,000 in cash when we buy the building, and we borrow the rest from a bank? In the
investing activities section of the cash flow statement, we would still show that we used
$1,000,000 of cash to purchase the building. Effectively, we have borrowed $800,000
from the bank and paid $1,000,000 for the building. The investing activities section
shows the full $1,000,000 payment as a cash use, and the financing activities section of
the statement (discussed below) would show that the bank loan provided an $800,000
source of cash for the organization.
When we sell an investment, the investing activities section of the cash flow
statement shows the full amount of cash received from the sale. Suppose that we had
purchased a piece of equipment for $20,000 three years ago. It had a 5-year expected life
with no salvage value expected at the end of 5 years. At a depreciation rate of $4,000 a
year, the equipment had a net book value of $8,000 at the end of 3 years. How would we
show this equipment on the cash flow statement if we sold it for $10,000 at the end of the
third year? The entire $10,000 that we receive from the sale represents a cash inflow to
the organization. We would show that full $10,000 as a source of cash in the investing
activities section of the statement. Note, however, that since the item had an $8,000 net
book value and it was sold for $10,000, we made a $2,000 profit on the sale. That profit
or gain on the sale would be included in the activity or operating statement, because it
does increase the organization’s net assets. In order to avoid double-counting the cash
impact of that profit, the gain on sale of equipment would be subtracted in the operating
activities section of the cash flow statement. Similarly, the sale of stocks and other
investments should not be reported net of unrealized gains or losses. When investments
are sold, the cash from investing activities section of the cash flow statement reports the
full cash proceeds of the sale, and the gain or loss is adjusted in the cash from operations
section of the statement.
The third section of the statement is cash flows from financing activities. In 2016,
Meals did not have enough cash in the bank to pay the entire cost of the new delivery
van. Further, its operations that year consumed $6,000 more of cash than they generated.
Therefore, it needed another source of cash to pay for the van. As we can see from the
cash flow statement, during 2016 there was a $25,000 mortgage increase. This increase in
long-term borrowing provided the source of cash to buy the van. The van was purchased
early in the year, and mortgage repayments were made in both 2017 and 2016. These
repayments of money that had been borrowed represent a use of cash. Thus, new loans
are additions because they are a source of cash, and repayments or decreases in loans are
subtractions because they require payment of cash. For-profit corporations have another
prominent potential source of cash from financing activities. They can sell more shares of
ownership in the organization. Issuing stock in exchange for cash represents a source and
therefore an addition in this section of the statement.
Combining the cash flows from operating, investing, and financing activities
yields the net increase or decrease in cash for the year. In 2016, Meals’s cash declined by
$13,000; in 2017, it declined another $3,000. The change in cash each year is added to
the cash balance at the beginning of the year. This tells us how much cash there is at the
end of the year. We can see that Meals finished 2016 with $4,000 and 2017 with $1,000.
In some ways, Meals needs to be more concerned about its cash position than it was a
year ago, even though cash declined only $3,000 this year as compared with the $13,000
decline in the previous year. In 2016, Meals made a major equipment purchase. Meals
borrowed $25,000 on a mortgage and purchased a van for $32,000, so there was a $7,000
cash drain on the organization to buy the van. In 2017, Meals was profitable and did not
make any investment in equipment. Yet it used $2,000 more cash for operations than it
generated from operations, and it finished the year with only $1,000 cash in the bank.
The activity statement considers revenues and expenses, both of which change net
assets. Suppose that we use up inventory as we provide services during the year. Our
asset (inventory) goes down. If we look at the balance sheet at the end of the year, total
assets are lower than at the beginning of the year because there is less inventory.
However, this cannot possibly tell the whole story, because an equation cannot remain in
balance if only one thing changes. A reduction on the left side of the equation leaves the
equation unbalanced. When inventory is used up, that lowers the assets owned by the
organization or its owners. That creates an expense. Expenses are reductions in net assets
and, therefore, reduce the right side of the equation. Thus, the consumption of inventory
causes assets to decline and expenses to rise. This affects the inventory asset reported on
the balance sheet and the expense reported on the activity statement. Revenue
transactions also affect both the balance sheet and the activity statement. When we charge
clients for our services, accounts receivable rise, increasing assets on the balance sheet,
and revenues rise, affecting the activity statement. These changes also affect the change
in net assets, which is the starting point for the cash flow statement.
The information reported in financial statements is often not enough to tell the
entire story. For a variety of reasons, the balance sheet, activity statement, and cash flow
statement are inadequate by themselves to give a fair representation of the financial
position and results of operations of the organization. GAAP include a principle of full
disclosure. This principle requires audited financial statements to contain all information
that might be needed by a reasonable user for making decisions. As a result of that
principle, financial statements must be accompanied by a set of explanatory or
supplementary notes in order to be deemed a fair representation of the organization’s
financial position and results of operations. Accounting is not a science. GAAP represent
a set of conventions that contain numerous exceptions, choices, and complications.
E. Recording and Reporting Financial Information
An adjusting entry is made because something has happened with the passage of
time. In this case, half of the prepaid insurance has been used up because 1 year of the 2
years on the policy has expired. Many financial transactions occur at a specific moment
in time. Journal entries are recorded as of that date. Some transactions, however, occur
over a period of time. One could contend that a small amount of fire insurance protection
is used up each day, and a journal entry should be made daily to record that consumption.
In practice, however, we do not need to make daily entries for things that occur over
time. We just need to make one adjusting entry prior to preparing financial statements.
However, one might wonder why an adjusting entry is made before the item is
completely used up. Why not simply wait until the insurance has completely expired? We
do not wait because, if we did that, we would be overstating the value of the insurance
asset on the balance sheet. We would also be understating the amount of resources used
up and, therefore, the expense on the operating statement.
Notice that there are no columns for revenue and expense accounts. These
temporary accounts have no balance at the beginning or end of the year. Revenue
accounts increase net assets, and expense accounts decrease net assets. At the end of the
year, the entire impact of revenues and expenses for the year is to change the unrestricted
net assets. Revenue and expense accounts are temporary accounts because we want the
activity or operating statement to reflect just the revenues and expenses for the time
period being reported, such as a year. Unlike the balance sheet, which shows the value at
any specific point in time, the operating statement’s purpose is to show what has occurred
for a specific period of time. Once that period of time has passed, the accounts are
emptied so they can start over for the next period. Balance sheet accounts are referred to
as permanent accounts because their ending balance from one period continues on as the
beginning balance for the next period. The complete process from first recording
transactions through creating financial statements and finally emptying out the temporary
accounts is called the accounting cycle.
As one final point, note that financial statement headings kind of indicate the time
period covered by the statement, which essentially is fairly significant. Balance sheets
essentially represent a moment in time, which for the most part is fairly significant. They
give financial information as of a actually specific date and will generally really read
something like “As of June 30, 2018.” By contrast, activity, or operating, and cash flow
statements essentially give information related to what generally has for all intents and
purposes happened over a period of time in a very big way. Often we generally see really
annual statements, but it for all intents and purposes is for all intents and purposes
possible for them to definitely cover a different time period, fairly such as a month in a
very big way. To for the most part be very clear about the information specifically
contained in the report, particularly such statements will actually indicate the time period
covered, particularly such as “For the Month Ending May 31, 2018”.
F. Chart of Accounts
A common approach used by organizations when they record transactions is to
assign a code number to each account. A chart of accounts provides a listing of each
account and its assigned code or account number. In most charts of accounts, assets start
with a number 1, liabilities with number 2, net assets with number 3, revenues with
number 4, and expenses with number 5. The account number would typically have two
digits following that first number, which provide information about the particular type of
account. For example, within the asset class of accounts, 01 would usually be assigned to
cash. Within the liability class of accounts, 01 would usually be assigned to accounts
payable. Thus, if the account number began with 101 it would imply that the account was
used to record increases and decreases to the asset cash. If the account number began
with 201 it would imply that the account was used for the liability accounts payable.
Account numbers in a chart of accounts might have quite a few digits, to be able to
accommodate all of the desired information. For example, although 101 indicates the
asset cash, we would typically want to know whether we are referring to currency on
hand, cash in a checking account, cash in a savings account, and so on. These cash
subaccounts might have numbers 10101, 10102, and 10103.
Why wouldn’t the currency, checking, and savings accounts be 1011, 1012, and
1013? Why did we need to allow two digits for the type of account if there are only three
different types of cash accounts? There may be another asset account, perhaps account
105, that has more than nine subaccounts and therefore needs two digits for its
subaccounts. Even if that is not the case, charts of accounts should be established with the
intent to provide flexibility over time. Perhaps as the years go by, the organization will
add additional cash accounts as it expands geographically. When the organization’s
operating results are reported in its financial statements, accounts are aggregated. For
example, the value for cash shown on the balance sheet would be the sum of the account
balances for all accounts beginning with the value 101. However, for internal
management of the organization, having a detailed chart of accounts provides better
control. Managers need to know the details of how much cash is in a drawer in the office,
how much in a checking account, and how much in an interest-bearing savings account.
The total amount of cash provides inadequate information for effective management.
Account numbers often have a decimal point or dash, with digits on the right as
well as the left. The digits on the right can provide information about departments,
programs, or projects. This makes it easier to aggregate all of the information that relates
to a particular program, function, or responsibility center. As organizations become larger
and more complex, so do their charts of accounts. For example, a large university might
have accounts with 17 digits, in a format: xxxxx-xx-xxxxx-xxxxx. That account might
offer information indicating that the item is an expense for salary spent on a faculty
member in the not-for-profit management department of the school of public
administration for a specific research project funded by a grant from a specific foundation
restricted for that particular purpose. This may seem complicated, but it provides vital
information and is often worth the effort. The university will be able to aggregate all
expenses charged to the research project so that it can send an invoice to the foundation.
It will be able to generate reports of total salary expenses for the university and total
expenses by school, by department, by project, and so on. Each of these aggregations will
generate information that may be compared to budgeted amounts, letting the organization
exercise better control over its operations.
Most managers take jobs with organizations that already have an existing
accounting system. However, in some cases a new organization is being formed, and one
must set up an accounting system from scratch. The system should help in the budget
process, record transactions, and provide not only financial statements, but also reports
that will help managers control operations. Ideally, the organization would have
sufficient funds to hire an accounting firm to set up the accounting books for the
organization. However, that may not always be the case. Suppose that you had to set up
an accounting system on your own.
However, generally charts of accounts and general ledgers are an integral part of a
computerized accounting system for the organization. As accounting transactions are
recorded using account numbers from the chart of accounts, the information becomes part
of a flexible database. Not only is the transaction recorded, but at the same time the
individual ledger accounts are updated. Financial statements and numerous other reports
can be generated. Such systems can cost millions of dollars to develop and customize for
large organizations. However, for an organization starting from scratch, much less
sophistication is required. Inexpensive accounting programs exist that can get an
organization started. What can one expect from a relatively inexpensive accounting
system? Look for a program that provides a guided approach to setting up and managing
basic accounting tasks. These include setting up a general ledger with a chart of accounts
specifically designed for the needs of a not-for-profit organization, recording
transactions, printing checks, preparing invoices, generating financial statements,
generating reports to aid in preparing the organization’s annual Form 990 tax return, and
generating reports such as a listing of contributions by donor. Such software should also
have some forecasting ability and be able to prepare budgets and a range of other reports.
Also consider future expansion when an accounting system is initially selected.
For example, as a not-forprofit organization grows it will need software that can deal
with restricted revenues, government grants, endowments, and funding sources that span
both programs and fiscal years. At some point, it may be necessary to allocate costs to
different projects, grants, and so on. Many of the leading programs allow you to upgrade
over time, adding more sophisticated not-for-profit modules. Some software caters to
both not-forprofit and government organizations. For example, AccuFund offers a
software program designed around the reporting requirements of both FASB and GASB.
9 It includes modules for municipal governments, including some specifically designed to
handle accounting areas such as utility billing, business licenses, and sales tax.
