The Basic Financial Statements

The Basic Financial Statements

Organizations that follow GAAP produce three basic financial statements:

1. A Balance Sheet summarizes the organization's assets, liabilities, and net assets at the end of the fiscal period (e.g., as of December 31, 20XX).
   
   
2. An Income Statement presents a summary of the organization's revenues, expenses, and changes in net assets for the fiscal year (e.g., for the year ending December 31, 20XX).
   
   
3. A Cash Flow Statement shows how the organization receives and uses cash to carry out its mission (e.g., for the year ending December 31, 20XX).

In the discussion that follows, you will see more detail about each statement and how the information it contains can inform key management and policy decisions.

When considering an organization's financial statements, keep one central point in mind: Net assets are the focal point. Regardless of the organization's structure or mission or changes in assets, liabilities, revenues, expenses, and cash flows will affect net assets. While the content of each financial statement differs, the focus is on net assets.

Additionally, each statement's presentation style and terminology vary depending on the sector. The table below summarizes these differences.

Many of the labeling differences are intended to contrast the mission orientation of non-profits and governments with the profit orientation of for-profits. We see this most clearly in the income statement. For-profit organizations often refer to the income statement as the "profit/loss statement," given that its purpose is to distinguish its profitable products and services from its non-profitable products and services. For governments and non-profits, the focus is on "activities". The question here is not whether the organization's activities are profitable but how those activities advance its mission. To be sustainable, every organization must generate more income than it incurs in expenses. That said, profitability is not a primary objective for public sector organizations, as it is in the private sector.

You will also note several differences in what governments call these statements. We have already discussed how financial statements illuminate operational accountability or how efficiently and effectively an organization uses financial resources to advance its mission. Taxpayers want to know that their government delivers services efficiently and effectively. To that end, state and local governments prepare "government-wide" financial statements. These statements present the government's overall financial position. These statements offer some insights into the government's ability to continue to deliver services in the future. With a few modifications, these government-wide statements are conceptually like the basic financial statements for a non-profit or for-profit.

The government-wide balance sheet is called the Statement of Net Position, and the government-wide income statement is called the Statement of Activities. By referring to the income statement as the Statement of Activities, standard setters have sent a clear message: governments exist not to generate income but to produce activities. This also explains why there is no government-wide cash flow statement. Information about how a government generates and uses cash does not necessarily help us understand if it is achieving its mission.

But with governments, operational accountability is only part of the story. Taxpayers also want to know if their government did what they told it to do. They want to know if services were delivered with revenues collected. That's fiscal accountability.

When we think of fiscal accountability in government, we usually think of the budget. A government's budget is not just a plan – it is the law. Most governments' constitutions or charters require them to lay out their planned revenues and spending in a special law called an appropriations ordinance. They must pass legislation that makes their budget intentions clear. If they spend more than their budget allows or if monies are spent in ways not specified in their budget ordinance, they are breaking the law.

Budgets are enshrined in law because they are one of our most effective tools to ensure inter-period equity. Inter-period equity is the idea that if a government presents and approves a balanced budget, it is living within its means and not passing costs onto future generations.

Fiscal accountability and inter-period equity are so important that they are built not just into a government's budget but also its financial statements. For instance, imagine a school district levies a property tax to pay for school buildings. Taxpayers want to see how much revenue that tax generated, how much money the school district borrowed for capital improvements, how much of that revenue is being used to repay those borrowed funds, and so on. They want fiscal accountability on that special tax. To assess this, taxpayers need to see those revenues, expenditures, assets, and liabilities presented separately from all other operations. To do that, the school district must present those finances in a stand-alone special revenue fund.

A fund is a stand-alone, self-balancing set of accounts with a specific purpose. The General Fund has every government account for services paid for through general revenue sources. It is where local governments account for police, fire, public health, and other essential services paid for using locally adopted property and sales taxes. It is where state governments account for funding for education (K-12, public universities, and community colleges), public health, public safety, and other essential services paid for using state-wide income and sales tax revenues.

For most governments, the General Fund is the largest and most carefully watched. According to GAAP, a government's General Fund, special revenue funds, debt service funds, capital projects funds, and permanent funds are collectively called governmental funds. The governmental funds account for the government's core operations and services.

Like budgets, governmental funds focus on near-term revenues and spending (also known as current financial measurement focus). For that reason, the information you see in governmental funds statements is prepared using a different set of accounting principles. Those principles are known as modified accrual accounting (or "fund accounting"). Modified accrual basis of accounting measures the current financial resources available. To that end, revenues are recognized when they are both measurable (i.e., revenues can reasonably be estimated) and available (i.e., revenues are available within 60 days). Expenditures are recognized when the costs have been incurred to acquire goods or services in the current period.

Funds are so important to governments that governments are required to present a separate set of fund financial statements prepared using the modified accrual basis of accounting. The balance sheet in the governmental funds is called the Balance Sheet, and the income statement is called the Statement of Revenues, Expenditures, and Changes in Fund Balance.

Governments also deliver goods and services whose operations are similar to what we would find in the private sector. Examples include water and electric utilities, golf courses, swimming pools, and waste disposal facilities, to name a few. These are known as business-type or proprietary activities. In concept, business-type activities should cover their expenses with the revenue they generate through charges for services. Many governments operate business-type activities because they are profitable and can subsidize other services that cannot pay for themselves. Since business-type activities pay for themselves, we account for them on an accrual basis and prepare a separate set of fund statements referred to as proprietary fund statements. The accrual basis of accounting reports on a transaction when it has an economic impact, regardless of whether it spends or receives cash. Governments reporting business-type activities will prepare a Statement of Net Position, a Statement of Revenues, Expenses, and Changes in Net Position, and a Statement of Cash Flows in the proprietary fund statements.