Understanding The Basics of Financials & When To Use Them. Financial statements help you quantify how your business is performing. They identify trends and tendencies in your operations such as the time it takes for your inventory or accounts receivable to turnover, enabling you to quickly react to the situation. Financial statements also help you monitor cash flow requirements on a timely basis and identify how the business both acquired and used it’s operating funds. The statements can also monitor your performance comparing actual results with your business plan or budget. There are four basic financial statements starting with the Income Statement or P & L, the profit and loss statement. The income statement shows the revenue generated for a specific time period with the related business expenses from the same period of time. For those companies manufacturing or producing a product, the P & L identifies the revenue generated and the related cost of goods sold which combine to give you the gross profit, which after applying the operating expenses, produces the profit or loss for that specific period. The Balance Sheet shows the clients assets and liabilities classified as current or long term (maturing in more than one year). The difference between the asset value and the liabilities is identified as the owners’ equity or stockholders’ equity section of the Balance Sheet. The third statement is the cash flow analysis referred to as the Statement of Changes in Financial Position, or Statements of Cash Flows. Also referred to as a source and application of funds statement, it explains how the business acquired its operating funds and how those funds were spent. You can refer to Tom Nunnally’s article on Financing a Business on this website. The final statement, the Statement of Changes in Owners’ Equity, or Stockholders’ Equity shows the equity balance at the beginning of the period and at the end of that specific period. The differences being the operating results (P & L) adjusted for any additional capital contributed or additional stock sold and for any distributions taken or dividends declared and paid by the Company. TYPES OF CPA PREPARED FINANCIAL STATEMENT Financial Statements are essential in evaluating an entity’s performance and debt paying ability. When required by a financial institution, leasing company or insurance bonding company the financial statements requested could be audited or unaudited which refers to both compiled and reviewed financial statements. The difference in the type of financial statement wanted is based on the degree of involvement that the independent CPA is required to perform during the audit engagement and the degree of assurance required by the users of the statements. Financial Statement Audits – provide the highest degree of assurance for users. The independent CPA firm expresses an opinion on the fairness of the financial statements and provides assurance that the data has been tested. Financial Statement Reviews – provide a significantly lower degree of assurance than audits. In a review the CPA firm makes inquiries and performs analytical procedures which enable the firm to express limited assurance that it is not aware of any material changes needed for the financial statements to conform with generally accepted accounting procedures (GAAP). Financial Statement Compilations – provide no assurance by the CPA firm. The firm assists in preparing the financial statements but is not obligated to make inquiries. Thus the firm gives no assurance regarding the financial statements meeting any of the professional standards. Audited Financial Statements – are certified by the CPA firm and an opinion is made on the quality and accuracy of the financial statements. In the course of the audit the firm will observe and test the client’s internal controls and perform various tests of financial transactions. In auditing accounts receivables the firm independently communicates with customers to verify that amounts shown are correct and performs tests to determine that the receivables are reasonably collectable. In auditing inventories the CPA firm visually inspects and verifies the physical existence and condition of the inventory. The firm will also test the inventory pricing and its salability. Other tests are also done to assure the CPA firm that significant assets are properly recorded, are the property of the Company and are reflected in the proper account classification on the financial statements. Also the firm wants to assure itself that all material obligations of the Company are reflected in the Company’s liabilities. Accounting firms engaged to prepare Complied Financial Statements should obtain a working knowledge of the nature of the entities business operations, the basics of the accounting system and the basis on which the financial statements are presented. The firm may assist in the preparation of the financial statement but is not obligated to make any inquiries to third parties such as accounts receivable confirmations. Accounting firms engaged to prepare Reviewed Financial Statements should obtain a reasonable basis for expressing limited assurance that the financial statements are in conformity with GAAP. The reviewed statements reflect a higher level of assurance than do compiled financial statements. Since reviewed statements are not audits they do not follow generally accepted auditing standards. Reviewed statements do not require the firm to evaluate internal controls or to correspond with third parties to confirm specific balances and transactions. A review is performed through a combination of inquiries similar to those made during a compilation but in greater detail with more analytical reviews. Accompanying the financial statements, additional pertinent information can be supplied using footnotes to the financial statements or by including the data in a supplemental schedule format. Lending institutions, leasing companies and bonding agencies rely on the information provided by the financial statements in assessing their degree of risk in a lending or insuring transaction. The type of financial statement required will depend on the size, complexity and materiality of the transaction. For small business, a set of compiled financial statements with full disclosure footnote information may suffice. For a basic real estate transaction it might be sufficient to have a CPA prepared tax return, rent rolls and internally prepared financial statement in lieu of a compiled financial statement. Having an ongoing working relationship with your lender, supplying accurate and timely internal financial information, adhering to a well thought out business plan and having an outstanding credit history with the lender may mitigate ongoing financial statement requirements as the loan matures and the lender has sufficient collateral supporting the outstanding balance of the loan.
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