The Basic Financial Statements

Budgeting vs. Accounting

If you want to know how an organization connects its money to its mission, read its budget. If the budget calls for more spending in one program and less in another, that tells us much about that organization's priorities. If one of its programs operates at a loss – but another program's profits subsidize that loss – that is also a clear statement about how that organization carries out its mission. We can think of many other ways an organization's money does or does not connect to its mission. A public organization's budget outlines the many unique ways it makes those connections.

But sometimes, we want an "apples-to-apples" comparison. Sometimes, we want to know to what extent an organization's mission-money nexus is the same or different from similar organizations. Sometimes, we want to know how efficiently an organization accomplishes its mission compared to its peers. Sometimes, we want to know if an organization is in comparatively good or bad financial health. To answer these types of questions, you need information found only in financial statements. In this chapter, we walk through the basic financial statements and the essential concepts from accounting you need to understand to interpret the information presented in those statements.

We may need to compare an organization's finances to those of other organizations. If our organization's expenses exceeded revenues, we might consider that to be a failure – unless, of course, we see organizations like it face similar challenges. If it failed to invest in its capital equipment, we might think it was neglecting its service delivery capacity – unless we saw other organizations make that same trade-off. These comparisons demand financial information based on standardized financial information from a broadly shared set of assumptions. As you'll see in Chapters 5 and 6, budgets rarely present information in a standard format.

Fortunately, we can get that information from an organization's financial statements. Financial statements are the main "output" or "deliverable" from the organization's accounting function. Accounting is the process of recording, classifying, and summarizing economic events, which leads to the preparation of financial statements. Unlike budgets, the numbers reported in financial statements are based on generally accepted accounting principles (GAAP) that prescribe when and how an organization should acknowledge economic activity.

GAAP tells us when an organization can say it owns an asset or earned revenue for delivering a service. These are known as principles of accounting recognition. The key point is that GAAP is a shared set of "rules of the game" for summarizing and reporting an organization's financial activities. If an organization offers GAAP-compliant financial information, we can compare its finances to those of other organizations over time.

Standardized rules are not the only difference between budgeting and accounting. Broadly speaking, if budgeting is the story, then accounting is the scorecard. An organization's budget tells us the activities it wants to do, how it plans to pay for those activities, and what it hopes to achieve. Politicians and non-profit board members love to talk about budgets because budgets are full of aspirations. Budgets are how leaders translate their dreams for the organization into a compelling story about what might happen.

Financial statements tell us what happened. Did the organization's revenues exceed its expenses? Did it pay for goods and services it received with cash or on credit? Did its investments gain value or lose value? How much revenue would it need to pay for capital improvements and equipment? Accountants often see themselves as the enforcers of accountability. That is why budget-makers and accountants often don't see eye-to-eye.

These two worldviews are different in many other important ways. As mentioned, budgeting is prospective (i.e., about the future), whereas accounting is retrospective (i.e., focused on the past). Budgets are designed primarily for an internal audience – elected officials, board members, department heads, program managers, etc. In contrast, accounting procedures produce financial reports mostly for an external audience, including taxpayers, investors, regulators, and funders. Budgeting focuses on resources that flow in and out of an organization, also known as the financial resources focus. Accounting focuses on the long-term resources the organization controls and its long-term spending commitments, also known as the economic resources focus. In preparing a budget, the focus is on revenues and spending. In accounting, the focus is on assets and any claims against those assets. We present a summary of these perspectives in the table below.

Who Makes Accounting Standards?

The Financial Accounting Standards Board (FASB) produces GAAP for publicly traded companies and non-profits. The Governmental Accounting Standards Board (GASB) produces GAAP for state and local governments. Both the FASB and the GASB are governed by the Financial Accounting Federation (FAF), a non-profit organization headquartered in Norwalk, CT, just outside of New York City. Both Boards are comprised of experts from their respective groups of stakeholders: accounting, auditing, "preparers" (entities that prepare financial statements, like companies and governments), and academia.

The Securities and Exchange Commission (SEC), the federal government agency that regulates public companies, designates the FASB as the official source of GAAP for public companies. The GASB has not been designated as such. Still, it is the de facto source of GAAP for governments because key stakeholders like municipal bondholders and credit ratings agencies have endorsed its standards. GAAP for federal government entities is produced by the Federal Accounting Standards Advisory Board (FASAB). The FASAB is comprised of accountants and auditors from federal government agencies. Federal government GAAP is still an emerging set of concepts and practices.