The Basic Financial Statements

The Fundamental Equation of Accounting

Everything we do in accounting is organized around the fundamental accounting equation. That equation is

Assets = Liabilities + Net Assets

An asset is anything of value that the organization owns. There are two types of assets:

1. Short-term assets, known more generally as current assets and
   
   
2. Long-term or non-current assets. A current asset is any asset that the organization will likely sell, use, or convert to cash within a year.

When someone outside the organization owes money, and the organization expects to collect that money within the year, that obligation is known as a receivable. If it's due within the year, it is classified as a current asset. An organization recognizes an account receivable or A/R when it delivers a service to a client and that client or customer agrees to pay within the current fiscal year.

Organizations will report inventory or supplies if they expect to use these resources as they carry out routine operations. These are also current assets.

Most public organizations own buildings, vehicles, equipment, and other assets they use to deliver their services. These are long-term assets, as the organization expects to use them over multiple years (frequently referred to as useful life). Organizations are not likely to sell these assets, as doing so would diminish their capacity to deliver services. State and local governments build and maintain roads, bridges, sewer systems, and other infrastructure assets. These are among the most expensive and essential long-term assets in the public sector.

By contrast, a liability is anything the organization owes to others. To put it in more favorable terms, liabilities are how an organization acquires its assets. Here, the short-term (or current) vs. long-term distinction also applies. Current liabilities are liabilities that the organization expects to pay within the next fiscal year. The most common are accounts payable for goods or services the organization has received but not yet paid for and wages payable for services delivered by employees but not yet paid for.

Long-term liabilities are money the organization will pay at some point beyond the current fiscal year. When an organization borrows money and agrees to pay it back over several years, it recognizes a loan payable or bonds payable. Many public sector employees earn a pension while they work for the government, and they expect to collect that pension once they retire. If the government has not set aside enough money to cover those future pension payments, it must report a pension liability (sometimes referenced as net pension liability).

What's left is called net assets. Technically speaking, net assets represent the difference between assets and liabilities. For private sector entities, this difference is known as the owner's equity. Public organizations do not have “owners". Instead, they have stakeholders, or anyone interested, financial or otherwise, in how well the organization achieves its mission. For governments, taxpayers are a rough analog to owners. However, unlike shareholders, taxpayers do not have a legal claim to the government's assets. Their priorities also differ. Taxpayers want to see their governments deliver the services.

Similarly, donors expect contributions to be used to provide services. They do not expect to get their money back if the organization fails. However, they care about the organization's financial position and frequently focus on whether its operations are sustainable and will continue serving the public for generations to come. For these reasons, net assets are an important part of government and non-profit finances, but they do not have quite the same meaning as owners' equity for a for-profit entity.

That said, irrespective of sector, we should consider net assets as an indicator of the organization's financial strength. If its net assets are growing, that suggests its assets are growing faster than its liabilities, and in turn, so is its capacity to deliver services. If its net assets are shrinking, its service-delivery capacity is also shrinking.

We also have to think about the restrictions on net assets. The new accounting rules require non-profits to report net assets “without donor restrictions" and net assets “with donor restrictions." Before the FASB Accounting Standards Update 2016-14, unrestricted net assets were now reported as net assets without donor restrictions. Net assets reported as temporarily restricted (i.e., net assets with time or use restrictions) or permanently restricted (i.e., net assets with restrictions that do not expire) are now reported as net assets with donor restrictions. While ASU 2016-14 is a significant change in how non-profits present financial information in their audited financial statements, how they account for these resources in day-to-day operations remains unchanged. Put differently, changes in GAAP do not alter or amend donor intent. Non-profits will need to continue to track gifts – but report in the financial statements in aggregated categories.

Governments use separate classification schemes, but these are a bit more detailed. We describe that scheme later in this chapter.