Bit by bit
Putting it together
Piece by piece
Only way to make a work of art
—Stephen Sondheim, “Putting it Together,” Sunday in the Park with George
It’s easy to glaze over when looking at financial statements. Lots of numbers. Lots of line items. But at the heart of it, financial accounting is a way to write, read, interpret, and share a particular kind of story. According to The Joy of Accounting:
“Accounting is a storytelling system that describes the position a business is in with its assets and obligations. It also describes how the business has been performing” (Frampton, Robilliard, and York 2020).
That story has two primary subplots: position and performance. “Position” is a snapshot of a point in time. “Performance” is a rolling narrative across periods of time.
And that story and its subplots are assembled from only five elements: assets, liabilities, revenues, expenses, and equity.1
ASSETS are economically valuable resources the organization owns or controls. Assets include money and physical things of economic value.
LIABILITIES are obligations the organization must satisfy by transferring assets or providing services. Liabilities are not money, they are obligations.
REVENUES are value-generating activities (that is, activity that increases assets or decreases liabilities). Revenues are not money, they are activities.
EXPENSES are value-consuming activities (activities that decrease assets or increase liabilities). Expenses are also not money, they are activities.
EQUITY is a calculation of the residual economic value of the business after liabilities are subtracted from assets. From the perspective of the business, equity is also not money. It describes a duty and commitment to owners and shareholders (nonprofits, stay tuned).
The Joy of Accounting, which inspired and informed the definitions above, offers a clever and calming mnemonic for these five elements, RELAX: Revenue, Equity, Liabilities, Assets, and eXpenses (I know, but it makes the word work).
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A few clarifying insights flow from these definitions. For example, assets are the only element that contains money or objects of economic value (from the firm’s perspective). Revenue is not money, it is an activity that results in money. Liabilities are not money, they are obligations to outside entities that require assets or activity to release them. Sure, your business’ liabilities show up as assets for other businesses (your bank loan, for example). But that’s from their perspective, not yours.
Equity, of course, is problematic for nonprofits. In a for-profit organization, equity is another flavor of obligation. It calculates residual economic value after subtracting all liabilities. That residual value represents a duty and commitment to the owners (to animate assets for owner benefit, for example). If the business went bust, that’s the asset value owners would get.
Nonprofits don’t have owners or shareholders. So instead of “equity” we use the term “net assets.” Both equity and net assets represent the value of all assets net (after accounting for) all liabilities. Same calculation, different consequence.
So, what exactly are net assets? The best answer I’ve come up with is that net assets represent residual financial power, the accumulated financial capacity of the nonprofit. The nature of that power is shaped by the portfolio of assets (more on that in another post).
So the next time you are staring at an income statement, balance sheet, or budget, remember that behind all those rows and columns are only two essential narratives (position and performance) and five essential elements (RELAX).2
Those five elements serve to tell clear and compelling stories about an organization, and to help you and your community write a better story over time.
From the ArtsManaged Field Guide
Function of the Week: Accounting
Accounting involves recording, summarizing, analyzing, and reporting financial states and actions.
Framework of the Week: Statement of Financial Position (Balance Sheet)
The Statement of Financial Position (also known as the Balance Sheet) is one of the three primary financial statements used by (and required for) formally organized business entities in the United States. The Balance Sheet reports a company’s Assets, Liabilities, and Net Assets at a specific point in time. It offers a “snapshot” of what a company owns and what it owes to lenders and investors.
Photo by Mourizal Zativa on Unsplash
Sources
Frampton, Peter, Mark Robilliard, and Toby York. 2020. The Joy of Accounting: A Game-Changing Approach That Makes Accounting Easy. Wealthvox Limited.
These definitions are informed and inspired by The Joy of Accounting, but modified for my teaching.
“RELAX” is still useful to nonprofits (since RNALAX makes no sense), as long as you place a little mental asterisk by the “E”.