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Abstract: Overview of Accounting Systems

Most educational institutions are not-for-profit organizations (NPOs), as defined by Generally Accepted Accounting Principles (GAAP). NPOs must earn profits to replace assets and grow. For-profit firms exist primarily to enrich owners, while NPOs exist mainly to serve a worthwhile social good.

Accounting Equation

First documented by Pacioli in 1494, the accounting equation (i.e., balance sheet or statement of financial position) is anchored in describing a business in two different but equivalent ways, by the things a business uses (assets, including cash) and by ownerships in those things, represented by liabilities (to nonowners) and equity shares (of owners). The basic equation (often referenced by left or right side in this chapter) is: Assets = Liabilities + New Assets.

Sports Analogy

If the accounting equation is a ball game, the left side is the game itself (e.g., stadium, players, ball, action) while the right side is the scoreboard, with the visiting team score as liabilities (expenses) and the home team score as net assets (revenues). Nonetheless, both sides describe a single game.

Coin Analogy

Both sides of a coin must be discussed to fully describe the coin; regardless of whether a discussion addresses heads, tails, or both, a single coin is described; and the two sides must be perfectly balanced to stand the coin on its edge. Understanding accounting requires the ability to split something apart and talk about the two sides separately while understanding that they still form a single whole.

Double Entry

The accounting standard for more than 500 years has been that every transaction requires at least two entries to keep the accounting equation balanced (an addition to one side and equal subtraction to the other or an equal addition and subtraction on one side).

Truth about the Right Side

The accounting equation describes real things on the left side (usually including cash), but the right side represents ideas, including ownership (net assets for NPOs) and budgets. Moreover, net income (profit) is practically never cash, and the equation places revenues and expenses on the right side; if revenues minus expenses equals net income, it also is on the right side. As an analogy, elements on the right side are more like dashboard gauges that indicate remaining gas but are not actually gas, so net income is a right-side gauge, but actual asset growth occurs on the left side.

Truth about Debits and Credits

Despite 500 years of experience, debit and credit rules can still be difficult to understand, in large measure because debit is usually considered a negative while credit is generally a positive. The truest one-word definition of debit is left while credit is right, giving rise to specific rules on  how each operates for specific accounts (asset, liability, revenue, expense, net assets. Basically, a debit (or credit) can either add or subtract to an account, depending on the side of the equation (and occasionally the role of the account), confusing most people who are unfamiliar with accounting (see Figure 1.15).

Figure 1.15. How Debit and Credit Entries Affect the Balances of Accounts (for a Not-for-Profit Organization)
Account Type Debit (DR) Credit (CR)
Assets ++
Liabilities ++
Net Assets ++
Revenues ++
Expenses ++

 

Slightly Different Accounting and Reporting Rules

NPOs with government support are subject to slightly different GAAP measures when compared to privately supported NPOs, but this chapter focuses on similarities.

Net Asset Classifications

Previously common in facilities management, fund accounting has been replaced by new rules using the term net assets (rather than fund balance). Net assets are divided into classifications for each type of NPO, as noted in table 1.16 and defined in comparable pairs (private support, government support).

Permanently Restricted; Restricted-Nonexpendable. By donor mandate (e.g., endowments), these assets (less liabilities) cannot be spent, but income earned by investing the basic gift (principal, corpus) can be.

Temporarily Restricted; Restricted-Expendable.  By donor mandate (e.g., grants), both principal and any income (less related liabilities) can be spent, but only for specified purposes or under specified conditions.

Unrestricted; Unrestricted. Both principal and any income (less related liabilities) can be spent, with no restrictions or conditions as long as the funds are used for the institutional mission. Examples include general appropriations, sales of products and services, and unrestricted donor gifts.

Invested in Capital Assets; Net of Related Debt. These typically cash assets (less related liabilities) are used for acquisition of capital assets (property, plant, equipment), defined by GAAP as probable future economic benefits resulting from past transactions or events by a particular entity. Inventory is an asset, but typically not a capital asset because it is bought and sold quickly; a building usually is a capital asset.

Financial Statements

The final accounting system deliverable is a set of financial statements (called financials). Typical small businesses produce two financials, a balance sheet and an income statement, and thus do not strictly comply with GAAP. Most NPOs must be audited annually, so their financials must comply with GAAP, as noted in the table below and defined in comparable pairs (private support NPOs, government support NPOs.) (See Figure 1.16.)

Figure 1.16. Financials Required by Generally Accepted Accounting Principles
Privately Supported Not-For-Profit Institutions Governmentally Supported Not-for-Profit Institutions
Statement of Financial Positions Statement of Net Assets
Statement of Activities Statement of Revenues, Expenses, and Changes in Net Assets
Cash Flow Statement Statement of Cash Flows
Notes Notes

 

Statement of Financial Position; Statement of Net Assets. Known as a balance sheet in for-profits, these statements simply demonstrate the accounting equation, but with NPO language.

Statement of Activities; Statement of Revenues, Expenses, and Changes in Net Assets. In for-profits, these statements combine income (daily growth or loss of equity) and owner equity (e.g., growth or loss from capital contributions, dividends) statements. With no owners, NPOs use one financial statement to show revenues, expenses, and other net asset changes.

Cash Flow Statement; Statement of  Cash  Flows. These statements report the same information, divided into three basic sections (cash flows from operating,

investing, and financing activities). For NPOs with government support, investing is broken down by cash flows from capital versus noncapital financing activities. The difference between income and cash flow statements is the timing of the measurement and recording of revenues and expenses.

Notes. Sometimes called Explanatory Notes or Footnotes, these are not technically a financial statement, but they are required by GAAP to explain certain captions and amounts in more detail. Notes often are the first reference for experienced financial statement reviewers.

Accrual-Basis Accounting

Accrual-basis accounting overcomes the shortcomings of cash-basis accounting in satisfying GAAP by recording revenues when they are earned, no matter when the related cash is received, and recording expenses when they are incurred, regardless of the timing of cash payout. Thus, accrual-basis accounting enables a proper match and comparison of revenues and expenses within a given reporting period.

Chart of Accounts

This type of chart lists the accounts that an institution needs to record financial transactions and satisfy financial reporting responsibilities. There is no rule on the number of needed accounts; they are set up primarily to record, accumulate, and provide useful information. The account chart provides structural information on each account, including (1) account number, a unique account identifier for journal recording and ledger posting; (2) account name (sometimes called description), a plain-language account label; (3) account type, specifying the major financial class (asset, liability, net assets, revenue, expense) of an account, which is not always clear from account number and name but is especially important in distinguishing accounts shown on the Statement of Financial Position versus Statement of Activities; and (4) normal balance, which indicates whether an account should normally carry a debit balance or credit balance and whether it is a contra- account (with a normal balance opposite of its type).

Auxiliary  Enterprises;  Service Departments

Most NPO departments are mission funded and do not typically earn budgets in a business sense. The institution collects revenues and holds them centrally to pay for expenses as departments use up their budgets.

Auxiliary departments (e.g., food services, athletics, and bookstore) and service departments (e.g., physical plant, parking, information technology, and printing) usually are self-funded to avoid overuse of services under a mission model versus a supply-and-demand fee or sales model.

Accounting Cycle and Audit Trail

Effective facilities managers  fully  understand  the depicted accounting cycle (transaction path and related financials path) and audit trail (accounting cycle in reverse), vital for  internal  control.  Accounting  cycle steps include the transaction and source document; journal entry recording (with debit and credit legs); general ledger posting (and account balance  updates); trial balance at end of period (usually the month) to reconcile debit and credit balances and find unusual account balances; and distribution  of  financials (corrected trial balance) to managers and executive officers. A record is more informal than a post; to  preserve the audit trail for managers and auditors, a post must not be erased, and so, incorrect posts require a correcting entry and complete accounting cycle.

Transaction information can be sorted or presented differently in the accounting cycle but does not change. Auditors work in reverse, starting with the financials, looking for supporting information in the trial balance, tracking those balances to the general ledger posts, tracing those to the journal entries, and then reviewing source documentation for accuracy (see Figure 1.17).

Figure 1.17. The Accounting Cycle

THE ACCOUNTING CYCLE

Transaction
generates

Evidence
(source document: e.g., requisition, purchase order, invoice, etc.) recorded in a

Journal
(transaction is recorded using Debits and Credits)

POSTED
to the

General Ledger
(the book of accounts and balances) reformatted into the

Financial Statements
(The Financials)
Statement of Financial Position
Statement of Net Assets
Statement of Activities
Statement of Revenues, Expenses and Changes in Net Assets
Cash Flow Statement
Notes 

THE AUDIT TRAIL

 

Capitalizing Versus Expensing Off

When an institution makes an expenditure, the credit entry is made to the Cash account. If the debit is for an asset as defined by GAAP, it is capitalized; if the expenditure does not purchase an asset, pay a debt, or return revenue, the debit is placed in an expense   account (expensed off).

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