Basic Financial Statements

At some point, every business will need a set of financial statements.  Maybe you need to obtain a loan from the bank and they want to see a set of statements prepared by your accountant or you need them to give to a new investor.  Most people don’t know what “financial statements” are, so let’s take a look.

The most common set of financial statements include a Balance Sheet, Income Statement and Statement of Cash Flow.  The statements will include a report written and signed by the accountants (more on this later) and may include footnotes (these are optional).

The Balance Sheet shows the company’s assets, liabilities and equity.  Assets are things that the company owns, like bank accounts, equipment and inventory.  Liabilities are what the company owes to others, such as bank loans and credit card balances.  The Equity section shows how much stock or capital has been put into the company and is what makes the Balance Sheet balance.

The Income Statement shows the company’s revenue or sales and subtracts out the Cost Of Goods Sold (if applicable) and all of the other expenses.  The result is the Net Income (or loss).  It’s usually the last number on the income statement, which is where the phrase “the bottom line” comes from.  This is the report that most business people care about the most because it shows how much money the company has made (or lost).

The Statement of Cash Flow is a report that shows the sources and uses of cash.  If the other two statements are prepared on the accrual basis, this report converts the information to the cash basis so it becomes more apparent what areas of the business produced or used the most cash.  It is the most difficult statement for people to understand, and it requires it’s own long-winded explanation.  I’ll cover it in more detail in a later post.

Remember that signed report from the accountant that I mentioned earlier?  That’s the most important part of the whole set of financial statements.  The business owner can produce their own set of financial statements, but the bank (or whoever else needs the statements) usually wants them to be prepared by a third party.  This in theory makes the statements more reliable since the business owner could easily create misleading statements since they aren’t checked over by anyone else.

There are 3 different levels of service that an accounting firm can provide for financial statements.  A compilation provides the lowest level of assurance on the statements.  This means that the accountant takes account balances and figures that the management of the business gives them and they put them in proper financial statement format without auditing or examining them in any way.  If something looks obviously out of sorts, the accountants will question it, but with a compilation the accounting firm assumes almost no responsibility for the accuracy of the information.

The next step up is a set of reviewed financial statements.  This is basically just like a compilation but the accountants ask a lot of questions, compare the account balances from one year to the next and “poke around” to see if anything sticks out as a problem.  The accountant’s report in this case will state something like “On the basis of our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles”.  This type of report provides limited assurance as to the accuracy of the financial information.

The highest level of assurance is obtained by audited financial statements.  This is a very involved process where the accounting firm determines areas of risk, test the company’s internal controls, asks a lot of questions and examines account balances in much more detail.  It is the most expensive option, but at the end of it all the accounting firm will issue a report that states that the financial statements are in conformity with GAAP standards.

So there you have it!  I hope that you find this information useful and that you now understand what financial statements are a little bit better.  Please leave a comment below if you have any questions or what to say anything at all about this post or the site in general.  There is much more to come!