Who uses this, and why cash isn't the whole story¶
Nobody builds financial statements just to file them away. Investors, banks, suppliers, tax authorities, and employees all pull the same numbers apart to answer different questions. Who's reading changes what those numbers have to accomplish. Along the way you'll meet the idea that separates accounting from watching a checkbook: earning money and collecting cash for it are two different events, often months apart.
Investors and lenders read the numbers before they act¶
When a public company announces quarterly earnings, its stock price can move within minutes, sometimes by several percent. Investors are deciding whether to buy, hold, or sell shares, and the report, especially revenue and net income compared with what analysts expected, is one of the biggest inputs to that call. On average, a company that beats expectations sees its stock rise, and one that falls short gets punished, even if it's still profitable. Guidance and other details in the report matter too, so the reaction isn't automatic.
Lenders, banks that make loans and investors who buy a company's bonds, ask a narrower question: will this business pay us back? They check the balance sheet for how much debt a company already carries and the income statement for whether it earns enough to cover interest. A company can be a great stock to own and still be a shaky one to lend to, because the two decisions weigh different things.
| Who | Main question |
|---|---|
| Investors | Should I buy, hold, or sell this stock? |
| Lenders | Will this business repay what it borrows? |
Suppliers, customers, regulators, and the people on the payroll¶
A supplier deciding whether to ship inventory on credit wants to know if the buyer can pay in 30 days, so it checks the same balance sheet a bank would. A customer signing a multi-year contract wants assurance the company will still exist to honor it. Both are reading the statements to judge risk, not to admire the business.
Regulators and tax authorities care about compliance, not opportunity. Regulators require public companies to publish their statements so investors have something reliable to compare; you'll meet the referees who enforce that in the next section. Tax authorities, the IRS in the United States, start from a company's records but apply separate rules to compute taxable income, a different number than net income.
Employees and managers read finished statements too. Employees size up job security and raise prospects from the same profit trends investors watch. Managers check whether the business is on track, though the detailed, forward-looking reports they use to set prices and staffing are the managerial accounting you contrasted with financial accounting earlier in this chapter.
Cash now, earned later: the idea behind accrual accounting¶
Go back to the Costco question from the start of this chapter. A member pays $65 in September for a year of shopping access. Costco has the cash, but it hasn't finished earning all of that $65; it still owes eleven more months of membership. If Costco counted the whole $65 as revenue the day the payment arrived, September would look great. The other eleven months would look like the membership earned nothing, even though the warehouses run the same way all year.
Accrual accounting fixes this by recording revenue when it's earned, not when cash shows up. Costco earns roughly $65 divided across twelve months, a little over $5 a month, whether or not a new payment arrives.
Common mistake: assuming revenue is just the cash you collected
It's tempting to think revenue means "cash that came in the door." But revenue is earned when a good or service is delivered. Cash can arrive that day, later, or all at once up front, as with a membership fee. A company can collect a large payment and still report only a small slice of it as revenue this month.
One payment, two ways to count it
Harbor Music Lessons sells an all-lessons annual pass for $1,200. A customer pays the full year up front in September. Here's how that payment shows up under each basis, for September alone:
| Cash basis | Accrual basis | |
|---|---|---|
| Cash collected in September | $1,200 | $1,200 |
| Revenue recognized in September | $1,200 | $100 |
| Owed to the customer at month end | $0 | $1,100 |
Under cash accounting, September looks like Harbor's best month of the year, and the next eleven look empty even though lessons happen every week. Under accrual accounting, September shows $100, one-twelfth of the pass, like any other month once it's divided evenly. The remaining $1,100 sits on the balance sheet as a liability called Deferred Revenue, sometimes called unearned revenue, until Harbor delivers those lessons.
Neither basis changes how much cash sits in Harbor's bank account. What changes is when that cash counts as earned.
Common mistake: treating net income as the cash a company made
Net income is revenues minus expenses on an accrual basis, not a cash total. A company can report solid net income while its cash balance shrinks, if customers haven't paid yet or if it spent cash on things that aren't expenses yet, like new equipment. The statement of cash flows, not the income statement, holds the actual cash story.
Before you go on¶
- Investors decide whether to buy, hold, or sell; lenders decide whether to keep extending credit; they read the same statements differently because they're asking different questions.
- Suppliers and customers use the statements to judge risk before they extend credit or sign a contract.
- Regulators and tax authorities want reliable, rule-following numbers; tax rules can produce a different number than net income.
- Employees and managers read finished statements too, even though they work inside the company.
- Accrual accounting records revenue when it's earned, not when cash arrives, which is why an upfront payment like Costco's membership fee or Harbor's annual pass gets spread across the months it covers. Chapter 3 covers the mechanics; for now, just recognize the difference when you see it.
Next up: who actually writes accounting's rule book, and who checks that companies followed it.