Financial Accounting: What It Records and Who Reads It

Financial accounting is the system that records every transaction a business enters into and turns those records into a small set of statements, prepared under common rules, for people outside the business who cannot look inside it. Its purpose is not to help the owner run the business day to day. Its purpose is to let a lender, a tax office, a buyer or an investor read the same business the same way.

Here is the idea underneath. Anyone standing outside a business is looking at it through a keyhole. An outsider cannot walk the floor, open the drawers, count the stock or ask the staff what the month felt like. And yet that outsider still has to decide something: whether to lend, whether to supply, whether to buy in, what to assess. A decision like that needs a description of the business, and it needs a description that was not written to flatter it. Financial accounting exists to produce that description, in a shape that looks the same whichever business produced it.

Four facts run under the whole subject: one question decides whether an event gets recorded; five different people open the same statements and each turns to a different line first; the rules cannot be left to the person being described; and a business can have its best year yet and end it with less in the bank, without either figure lying.

What is financial accounting, and what is it actually for?

Start with an ordinary street. A vegetable seller keeps a notebook. Money in on the left, money out on the right, and at the end of the day the notebook tells her whether the day went well. The notebook works perfectly, and it works for exactly one reader: the person who wrote it. She knows which entries were unusual, which customer still has to pay, and which crate of tomatoes she will have to throw away tomorrow. None of it needs to be written down, so none of it is. She is standing inside the business.

Financial accounting is what has to be built once somebody who is not standing inside the business needs to understand it. The moment a bank is asked for a loan, or a tax office asks what was earned, or a cousin is asked to put money in, the notebook stops being enough. Not because it is dishonest, but because it is private shorthand. Private shorthand has no rules a stranger could learn, it leaves out everything the writer already knew, and it cannot be set beside another seller's notebook to see which of the two is doing better. Financial accounting fixes all three problems at once by insisting the record follows rules that were not written by the person being described.

So the system has three moving parts, each with its own name. Every transactionAn exchange the business actually entered into: goods or a service moving one way, and money or a firm promise to pay moving the other. the business enters into is recorded as it happens. The records accumulate in the booksThe complete running record a business keeps of everything it has bought, sold, paid and been paid, from which the summary statements are later drawn. through the year. At the end of the period the records are summarised into a short set of financial statementsThe small set of summary documents drawn from the records at the end of a period, setting out what the business earned and what it holds and owes., and those statements go out to people who were never in the room. Recording, accumulating, summarising, publishing: that is the whole shape of the system.

What counts as something worth recording?

Here is the test, and it is a single question. Did an exchange actually take place? If goods moved one way and money or a firm promise to pay moved the other, there is a transaction and it goes in. If nothing moved in either direction, there is nothing yet to record, however certain everybody feels about what is coming.

Anjani Stationers, an invented business, prints school notebooks in one city, out of one small printing unit, with one delivery van. In year one it delivered notebooks to schools and billed them Rs 2,40,00,000. On the day the notebooks left the unit, paper and printing left the business and a right to be paid arrived in its place, so every one of those deliveries goes into the books on that day. No money changed hands, but something did: a claim on the school.

The line between what is recorded and what is not is drawn at the moment of exchange, not at the moment of confidence. A school signs an order for Rs 5,00,000 of notebooks for next term. Anjani Kulkarni has been supplying that school for years and is completely certain it will go ahead. Nothing goes into the books. Nothing has moved. If a signature alone were enough, then any business could report whatever revenue it liked simply by collecting signatures, and every set of accounts in the country would become worthless in a season.

What does the system deliberately leave out?

The hardest part of the system to accept is that the things it leaves out are often the things that matter most. Meera Rao, the accountant who comes in three days a week, is unusually good at her job. Her skill appears nowhere. The fifteen years of trust between Anjani Kulkarni and the head of the Sunrise Public School group is why the orders keep arriving. The trust appears nowhere. A competitor is about to open two streets away. Nowhere. Anjani Kulkarni has not put her own house into the business, so the house is not in the accounts either, and neither is the loan she took personally to pay for it.

Everything left out is left out for the same reason: no exchange took place between the business and anyone else, so there is nothing to write down that a stranger could check. Leaving them out is not a flaw the system is trying to fix; it is the price of the system being checkable at all. The moment a business is allowed to record the value of its relationships, it has been allowed to record a number that nobody outside can verify, and the whole point of the exercise collapses. So the accounts always describe less than the whole business, and a good reader knows to go looking for the rest elsewhere.

Who reads a set of accounts, and what is each one hunting for?

Ask this question of any other document and the answer is boring. Ask it of a set of accounts and it turns out to be the whole design. A set of statements is not written for a reader but for five readers at once, who want different things, and who would each design a completely different document if left to themselves. The compromise holds because every one of them is a stakeholderAnyone whose money, job, supply or tax take depends on how the business does, whether or not they have any say in how it is run. with something real at risk, and each one goes straight to the figure that measures their own exposure.

Each reader opens the same statements and turns first to the line that measures what they personally stand to lose. The lender stands to lose the money it advanced, so it goes to what the business owes and what it can pay with. The tax office is assessing a year that was earned, so it goes to profit. A school placing next term's order stands to lose next term's books, so it goes to whether the printer can keep operating. A possible investor stands to lose the money put in, so it compares what the business earned against what is already tied up in it. And Anjani Kulkarni stands to lose the business itself, so she goes to the bank balance and to what the schools have not paid.

Here are the five readings in plain words. At the lender's seat, Anjani Stationers owes Rs 18,00,000 to its paper mill and other suppliers and Rs 3,00,000 to its staff, Rs 21,00,000 in all, and it holds Rs 7,00,000 of cash. Cash covers what is owed 0.33 times. Move to the tax office and the first stop is profit of Rs 38,00,000. Move to the school group and it is Rs 22,00,000 of stock against Rs 18,00,000 owed to suppliers, cover of 1.22 times. Move to a possible investor and it is Rs 38,00,000 of profit against a stake of Rs 1,12,00,000, a return of 33.9 per cent. Move to Anjani Kulkarni and it is Rs 7,00,000 in the bank against Rs 78,00,000 the schools have not paid, 11.1 times the bank balance. Five readings, five verdicts, and not one figure moved.

Why must the accounts follow common rules rather than the owner's preference?

A reference letter works on the same principle. If every employer wrote references in their own private format, using their own private scale, a glowing letter could not be told apart from a lukewarm one written by someone who is simply enthusiastic, and a reference would tell a stranger nothing. The value of the letter comes from the convention. Accounts are the same, only with more money attached.

Common rules exist so that two businesses can be laid side by side and the difference between them means something. If Anjani Kulkarni decided herself what counts as revenue and when, and the printer down the road decided differently, a lender comparing the two would be comparing two private languages rather than two businesses. So the rules are written by someone other than the businesses being described. In India the accounting standards are issued through the Institute of Chartered Accountants of India, and companies are required by the Companies Act to keep proper books of account in the first place. Both halves matter: one says a record must be kept, the other says what the record has to look like.

The rules also do something less obvious: they set out what must be explained as well as what must be counted. A figure on its own can be perfectly true and still mislead, so the standards require a business to attach an explanation of the choices behind its numbers. The explanation is called disclosureThe written explanation attached to the statements, saying which choices were made and what sits behind a figure, so a reader is not left to guess at it., and a careful reader spends more time on it than on the numbers themselves. Anjani Stationers set aside Rs 3,00,000 against the Rs 6,00,000 the Sunrise Public School group has left overdue: a judgement about how much of that will never arrive. The Rs 3,00,000 is the number. Why she chose half is the disclosure, and it is the half a lender actually argues with.

How is this different from the cash book a small shop keeps?

A cash book answers one question with great precision: did money come in or go out, and how much is left. Nothing wrong with the question. A great many businesses have been run for decades on nothing else, and for a shop that sells for cash and buys for cash, the cash book and the accounts would say almost exactly the same thing.

The cash book and the accounts describe the same year and can disagree completely. One of them records money moving and the other records trade happening. Anjani Stationers is the clean case. Money in during the year was Rs 1,92,00,000 and money out was Rs 1,93,00,000, so the bank balance went backwards by Rs 1,00,000, from Rs 8,00,000 at the start of the year to Rs 7,00,000 at the end. The cash book records exactly that, and every rupee of it is correct. The accounts for the same twelve months show Rs 2,40,00,000 billed to schools, Rs 2,02,00,000 of costs and a profit of Rs 38,00,000. Every rupee of that is correct too.

The reason the two records point in opposite directions is not a mystery, and it is not an error. Anjani Stationers sells on credit to schools that pay in sixty to ninety days, so a great deal of the year's trade had not turned into money by 31 March. Rs 78,00,000 of school bills were still unpaid on that date, against Rs 30,00,000 unpaid a year earlier. The trade happened. The money had not arrived yet. A bill nobody has paid never appears in a cash book at all, so a cash book has no line for the gap and cannot show it. Missing the gap is not a weakness of the shopkeeper; it is a limit of the instrument. Exactly which year each cost and each sale belongs to, and the rule that decides it, is covered under accrual and cash accounting.

What did Anjani Stationers' first year actually look like, line by line?

Everything above comes down to one year of figures. The year runs 1 April to 31 March. Schools do not pay on delivery and never have, so when Anjani Stationers printed and delivered notebooks to schools across one city and billed them Rs 2,40,00,000, every rupee of it was on credit. Against that billing sit six costs, and the ladder from the top line down to profit is the whole of the year in eight lines.

Anjani Stationers had the best trading year it has ever had and ended that year with less money in the bank than it started with, and both of those sentences are simply true. Cash went from Rs 8,00,000 on 1 April to Rs 7,00,000 on 31 March. The reason sits in one line of the closing position: Rs 78,00,000 of school bills unpaid at the year end, against Rs 30,00,000 unpaid at the start. Of the Rs 2,40,00,000 billed during the year, roughly Rs 1,62,00,000 came in as money and Rs 78,00,000 did not, taking the oldest bills as paid first. The profit is real. The money is sitting in the schools' hands rather than in the bank, and not having collected it is a completely different problem from not having earned it.

How does a lender actually work through a set of accounts like this?

Knowing how the system works is not the same skill as using it on a working Monday.

A credit officer reading Anjani Stationers for the first time makes three passes, and the order of the passes is the whole skill. The first pass is arithmetic and takes two minutes: what is owed out, what is available to pay it, and how far apart the two are. Rs 21,00,000 owed against Rs 7,00,000 of cash. The first pass never ends in a decision; it ends in a question. The second pass goes looking for the answer to that question and lands on the Rs 75,00,000 of school bills, money that is still coming. A bill from December behaves very differently from a bill from March, so the second pass immediately asks how old those bills are. The third pass is the disclosures, where the officer finds that Rs 3,00,000 has been set aside against the Sunrise Public School group and starts asking why half and not all of it.

Notice that the officer never once treats a single number as an answer; that refusal is the practical difference between someone who can read accounts and someone who can only look at them. An analyst does the same three passes for a different purpose, and a buyer does them for a third. The recognitionThe decision that something has become certain enough and measurable enough to be written into the records as a number, rather than only described in words. choices and the explanations behind them are where the room for judgement lives, and that is where all three of them spend their real time.

What can financial accounting not tell, however well it is done?

A set of accounts prepared to the highest standard by the most careful accountant still cannot answer some of the questions a reader most wants answered, and knowing which ones is a large part of reading them intelligently.

Financial accounting describes exchanges that have already happened, so it is silent about capability, about relationships, and about everything that is going to happen next. The accounts cannot tell whether Meera Rao is good at her job or whether the press operator is about to leave. The accounts cannot tell that the Sunrise Public School group has a new purchase head who prefers a different supplier, or that a bigger printer is opening two streets away with a machine three times faster. The accounts cannot tell whether Anjani Kulkarni, who is the only person who has ever signed a cheque here, is well. Every one of those will show up in the accounts eventually, as a fall in billing or a rise in unpaid bills, but only after the fact, and after the fact is exactly when the information is worth least.

There is a second and quieter limit. Some numbers in the accounts are not measurements at all; they are estimates, and they are estimates made by the business being measured. The Rs 3,00,000 set aside against the overdue school group is a judgement. The Rs 5,00,000 of wear charged on the van and the machine rests on somebody's view of how long each will last. Both estimates are made honestly, are disclosed, and are still judgements. Financial accounting is not management accountingRecords and reports prepared for the people running the business, in whatever shape helps them decide, with no obligation to follow common rules or to be shown to anyone outside., where a business can define anything it likes for its own use, but even inside the common rules there is real room to choose. How much room, and what two equally honest businesses can do with it, is covered under accounting policies, estimates and errors.

Anjani Stationers Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.