Financial accounting involves the preparation of a detailed report that outlines and summarizes a company’s performance to show to outside parties, such as investors, lenders, and creditors.
Accounting is also one of the most common business operations that small businesses have trouble outsourcing.
The critical issue with this situation is that an accurate financial report is a necessity for small businesses—from securing funding to successfully tracking its own expenses—and, if the reporting isn’t done correctly, all of these bricks fall.
Inaccurate financial reporting is unfortunately a commonality, as a recent poll performed by BlackLine, Inc., a financial controls and automation software company, found that one in four respondents indicated they were worried about data errors that can’t be detected but which they know must exist.
The four basic financial statements
Good financial accounting leads to good financial reporting, and those reports commonly come in the form of four key financial documents:
- an income/profit and loss statement
- a balance sheet
- a stockholders’ equity statement
- a cash flow statement
“We are used to watching for signs that indicate if something is healthy or needs our intervention—such as wilted plants, crying children, or the check engine light in your car,” said Beth Melcher, founder and owner of MoneyFit. “Likewise, these four documents reveal the health of your small business. Businesses talk to their owners and stakeholders through well-prepared financial statements.”
Income statement
According to Robert Duron, PhD, CPA, CFE, associate professor of accounting at Husson University, an income statement provides information on the results of your operations on an accrual accounting basis for a specific period of time—usually one year. It reveals the revenues earned and expenses incurred (including cost of goods sold if you’re a retailer) and the net income or loss for the period.
“When people refer to the ‘bottom line’ of a business, they are referring to the income statement. It also has to be prepared before any of the other statements can be prepared,” Duron said.
Balance sheet
A balance sheet, on the other hand, gives a snapshot financial view of your company at a particular point in time, often on the last day of the fiscal year (December 31 for most businesses).
It lists all of your business’ assets, beginning with the most liquid (cash) and then moving in descending order of liquidity to items like receivables (amounts owed), inventory, prepayments for items like insurance and rent, and non-current assets including land, buildings and equipment.
Additionally, the balance sheet displays liabilities (claims against assets), which represent amounts owed to others and long-term debt. [Read our full article on how to create a balance sheet.]
Stockholders’ equity statement
A stockholders’ (or owners’) equity statement indicates the change in equity (assets minus liabilities) for the year.
“The difference between assets and liabilities is called stockholders’ equity if you are a corporation or owners’ equity if you’re a proprietorship, and it represents the stockholders’ claim against your assets,” Duron said.
In addition to extra investments by stockholders or owners during the year, stockholders’ equity rises based on net income earned.
Consequently, it serves as a link between the balance sheet and income statement. Stockholders equity is decreased by dividends paid (or owner withdrawals), and the balance sheet reports the ending balance of stockholders’ equity. [Read our full article on how to create a stockholders' equity statement.]
Cash flow statement
A cash flow statement reveals your change in cash and cash equivalents over the current year. It uses the cash basis of accounting and classifies cash flows into three major categories: operating, investing, and financing.
Investors appreciate this statement, since accrual-based net income does not fully provide this information.
“In addition to these four basic statements, you can and should include a document called notes to the financial statements, which expand upon and provide additional information and details on the amounts reported on the actual statements,” said Duron.
Less is typically more in a financial report, as many people find rows and columns of numbers intimidating or overwhelming.
Robert Duron, PhD, CPA, CFE, associate professor of accounting at Husson University
How to design a financial report
The four aforementioned reports comprise the heart of a financial report—a complete set of your financial records, usually prepared once a year, that can be given to investors, lenders or other third parties.
When creating an annual financial report, “it’s necessary to ensure that the data that went into creating it is complete and accurate. That’s why they should be audited or reviewed by a licensed independent accountant,” said Marilyn Pendergast, CPA and managing director of UHY Advisors.
However, you shouldn’t simply compile these documents and call it your company's financial report.
“Your financial report should also include a narrative about what happened in your business during the year,” said Allec. It should answer questions like:
- Why was revenue lower this year than last year?
- Were there any extraordinary items of revenue or expense included in this year's books that couldn't reasonably be expected in future years?
- Are there any major asset purchases planned for next year?
Duron’s rule of thumb for an effective financial report is simple.
“Less is typically more in a financial report, as many people find rows and columns of numbers intimidating or overwhelming,” Duron said. “Summarize data in reports, but have the details either on hand or in an appendix for those who may wish to see the details. Use color, shading, bolding, underlining, commas and dollar signs to greatly enhance readability. Don’t hesitate to employ graphs and charts instead of just the dry numbers.”
Why a financial accounting report is necessary for your business
“Implementing an effective financial accounting and reporting system should not be seen as a necessary evil,” said Logan Allec, CPA and owner of Money Done Right. “In fact, it is an extremely important part of your company, as it will help you become a well-informed business owner. Furthermore, a proper set of books and financial statements will make your company more appealing to important third parties such as investors and lenders,” he said.
More importantly, even small businesses don’t get a pass for failing to file necessary financial reports and tax returns with local, state and federal agencies.
“The penalties can be steep, and there are typically no waivers,” Duron said. Also, “sloppy or no financial records is a recipe for inviting theft or fraud from employees, customers, or vendors, as errors and irregularities are much more likely to go unnoticed until it’s too late.”
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