How To Your Read Financial Statements
For The Home-Based Business Owner

Published February 2009 | Edited June 13, 2024

This is the first article in a series on how to read your financial statements. It is not meant for readers interested in learning about investing.

This series has been written for the small business owner who works from home and does their own bookkeeping ... and wants to know how to use the financial reports to help them make sound business decisions.

If you want to skip the introduction, feel free to go directly to the balance sheet and income statement chats ...

... but you will miss the discussion on whether you need GAAP financial statements if you do.

If you are in a BIG HURRY, you will also find brief overviews of the balance sheet and income statement in "The Road Map" section of this site.

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Learning How To Read Your Internal Financial Reports

Tools for the Home Based Business Owner

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Are you starting to see a picture here?

To run your business efficiently, you need to know how much profit (from the income statement or retained earnings) you are making (that's why you are in business) and determine how much cash you have. (Don't confuse cash flow with net profit.)

To run your business efficiently, you need a method of keeping track of all the people who owe you money (accounts receivable) and who you owe money to (accounts payable and loans). You need a method to keep track of all your business possessions (assets) you have accumulated.

All the items listed above are found on your financial statements using a tried and true system recognized all over the world. It is the language of money and finance.

In this series of articles, you will learn about some basic equations such as:

Assets - Liabilities = Equity ... where ...

Equity = Owner's Equity + Net Income (Loss) ... and ...

Net Income (Loss) = Income - Expense

If you were to go to the bank and apply for a loan for your business, the loans officer would ask to see your Balance Sheet and your Income Statement. (If you don't have a set of financial statements and you are a sole proprietor, the bank will probably accept your T2125 (Canadian) or Schedule C (U.S.) from your most current tax return.) Why?

Because, if you know how to read it, it tells the bank whether you are earning a profit or losing money ... whether you are carrying too much debt. This is important if you are going to be asking them to loan you more money.

Let's get started by looking at the balance sheet and see what it reveals to the banker about your business.

In the coming days, we will also look at the income statement, cash flow statement, and ratio analysis.

Oh and by the way, your banker will probably also want to see a business plan.

Do You Need GAAP or ASPE Financial Statements?

The above discussion on having financial statements for your banker raises the question ...

Do you, as a home-based business owner or small business owner, need to spend money having an accountant prepare a set of financial statements that conform to generally accepted accounting principles (GAAP)?

To answer that, you need to know that GAAP was initially developed for public companies that had to report to third parties. These third parties were usually investors and they needed access to financial information to make good investing decisions ... or the third party could be bankers (or other creditors) who loaned money to the companies.

So if you are a small business owner with little to no debt and are active in your business ... do you really need to have financial statements prepared to meet third party reporting requirements? Your main concern is paying your taxes and having information to run your business.

The answer - No. You can have your financial statements prepared on an income tax basis instead of GAAP. This is an acceptable practice if your financial statements are not widely distributed and mainly for internal use. ... particularly if you do not require review or audited statements for the banker or insurance agent.

Before I discuss what this means to you, I'll bring you up-to-date on this ongoing battle in the accounting world.

On April 29, 2009, the Canadian Accounting Standards Board (AcSB) released a proposal to have a "Made in Canada" GAAP for private companies that would take effect January 2011. This is when Canada switched from GAAP to international financial reporting standards (IFRS) for publicly traded companies or companies who want to raise equity or debt financing on the world stage.

This new standard was approved and released in December 2009. It is called Accounting Standards for Private Enterprises (ASPE) and went into effect on January 1, 2011.

ASPE accounting is generally seen as good bookkeeping practices. If you book your entries properly every day throughout the year, it is fairly easy to prepare your financial statements ... but tax does treat some items differently than ASPE.

As long as your financial statements clearly indicate the standard used for preparation, it is an acceptable practice for small business owners. I believe the practice is actually called 'other comprehensive bases of accounting' (OCBOA) ... at least it is in the U.S. ... I'm not so sure if it applies to Canada as well.

The differences between tax basis and ASPE basis is usually related to measurement issues. So what differences are we talking about here. Here are three of the most common that probably affect you.

1. Amortization is reported at CCA tax rates instead of economic or useful life.
2. Bad debts is reported using the specific write-off method. Doubtful accounts reserves are also done on a specific set of accounts not as a general allowance.
3. No deferred taxes requirement.

Effective for all fiscal periods ending on or after December 14, 2021, a new standard was introduced by the Audit and Assurance Standards Board of Canada for compilation engagements previously referred to as Notice to Reader (NTR) engagements. The NTR is now called the Compilation Engagement Report (CER) and includes a note on the basis of accounting as well as clarifying management's responsibilities and the accountant's responsibilities.

The CER package usually includes:

• A Notice to the Reader ( A Disclosure Statement)
• A Balance Sheet
• An Income Statement
• A Cash Flow Statement (I think this may be optional)
• Notes to the Financial Statements

Small business owners will need to chat with the third party users of their financial statements to determine if they require compilation (no assurance) engagement statements or if internal financial statements with notes are adequate for their purpose. This is an important discussion to have if you are not required to have ASPE financial statements ... or it may mean you need to provide reviewed (limited assurance) or audited (reasonable assurance) statements.

The new compilation engagement statements may only be prepared by licensed public practice CPAs (I.E. external CPA). The report must include additional information not previously disclosed in a Notice to Reader report; which includes management's responsibilities for the information provided, the CPA's responsibilities of what actions were or were not performed, along with the basis of accounting used.

The reasoning behind this restriction is that the CPA must apply professional judgement and consider the reasonability of the information provided by the client.

Why would you need an NTR set of financials? Some examples are:

• Applying for a bank loan
• Possibly for the annual report to owners or shareholders
• Reporting to investors
• Possibly when filing a corporate income tax return
• Selling your business

If none of these apply to your situation, you would likely be able to use your internally prepared financial statements if you can assure a third party of the accuracy and completeness of the financials.

Under the new standard, CPA's can no longer compile and issue financial statements when preparing the corporate tax return. CPA's are now permitted to prepare corporate tax returns based on internally financial statements without the NTR disclosure.

For more information on these changes, please read Grant Thornton's excellent overview titled "Canada's compilation engagement standard is changing: A summary for management" available online.

• Your internally prepared balance sheet, income statement, and cash flow statement.
• Your trial balance
• Your general ledger
• You business's bank and credit card statements
• Your reconciliation reports for each bank and credit card account (this ensures all transactions are captured)
• A list of all expenses paid from your personal funds (and a note as to whether they have been included in your internal financial statements)
• Your accounts receivable aging report (shows who owes the business money)
• Your accounts payable aging report (shows who the business owes money to)
• A fixed asset continuity schedule (this is a schedule that tracks all capital assets acquired by the company and the cumulative depreciation taken for each type of asset)

It is my understanding CPAs would prefer your financial information was prepared by a reliable bookkeeper. It gives them a certain level of confidence that the financial and tax records are in good order.

You may not have a fixed asset continuity schedule. However, if you have booked your assets by CCA class with sub accounts for Original Cost and Accumulated Depreciation, this may suffice. You would need to customize a report to print out the information from the start of your business. Another source for this information would be your past tax returns.

Keeping in mind the new December 14, 2021 standards for compilation engagements, and depending on your situation, there may be more differences. A Compilation Engagement Report and Notes to the Financial Statements, which are an integral part of your statements, can be prepared to explain any accounting policies that differ from ASPE reporting ... if you are going to be presenting the financial statements to a third party.

The notes still need to disclose contingent liabilities, going-concern considerations, risks and uncertainties.

Tax basis statements may include non-taxable revenue and non-deductible expenses.

Tax basis financials do not require a cash flow statement ... and the title of the statements must be modified to show the basis of accounting.

I like to rename the Balance Sheet to Statement of Financial Position - Tax Basis (Unaudited) and ensure there is a footnote saying Notice to Reader - Statement prepared on an income tax basis not ASPE. It could also be called Statement of Assets, Liabilities and Equities - Income Tax Basis.

I like to rename the Income Statement to Statement of Operations - Tax Basis (Unaudited) and ensure there is a footnote saying Notice to Reader - Statement prepared on an income tax basis not ASPE. It could also be called Statement of Revenues and Expenses - Income Tax Basis.

The main benefit to you, besides reduced costs to prepare this type of statement, is that it is easier for you to understand what it is saying.

If you have to submit statements to your banker or insurance agent on a regular basis, check that it's okay to switch to tax basis statements. Also check to see whether they will require a CER or if your internally prepared financial statements are sufficient.

Speaking of bankers ... be aware that the new Accounting Standards for Private Enterprise (ASPE) that came into effect on January 1, 2011 affected your financial ratios ... and therefore your covenants. Grant Thornton (www.grantthornton.ca), in their Catalyst Winter 2010 newsletter recommended "initiating and maintaining communications with your lenders and legal counsel to keep them abreast of issues" that had an impact on your covenants.

See you on the next page ...
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