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.
Tools for the Home Based Business Owner
Basic Sample Financial Statements
How To Read Your
How To Read Your
How To Read Your
Do you prepare financial statements monthly?
Do you review them once they are prepared?
Do you understand what they are saying about your business?
Are you sure they are accurate and make sense?
Warm-up your tea. How about cinnamon tea and apple today?
Let's begin learning how to read your financial reports and
evaluate the information. Together we will uncover your business's
financial health, problems, and potential outlook.
The goal is to enable you to apply sound accounting and bookkeeping principles to improve your operations. It's time to remove that dark cloud that seems to hover over your head every time you pick up a financial report.
Reading financial statements is not that difficult, once you understand the layout of the reports and the language being used.
Following is a brief "story" that relates your every day tasks of running a business into "financial statement language" ... kind of like a foreign language dictionary.
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
Have you been wondering, "What business decisions could be made using the income statement or balance sheet?" or ...
"What are some of the critical pieces of business information for you to keep track of to help you run your business? "
To get an idea of the answers to those questions, take this quick quiz. See if you can match a business question asked in column A with where you find the correct financial statement information in column B.
Where to Find the Answer
|Who owes your business money?
|Indirect Expenses on the Income Statement
|What does your business own?
|Accounts Payable on the Balance Sheet
|How much is the business spending?
|Office Furniture and Equipment (or Assets) on the Balance Sheet
|What have you invested in the business?
|Accounts Receivable on the balance Sheet
|What are your sales? How much are you bringing in?
|Owner's Equity on the Balance Sheet
|What is your business overhead ... the money you have to spend even if you don't make a sale ?
|Revenue on the Income Statement
|What cash do you have on hand?
|Liabilities on the Balance Sheet
|Is your business making or losing money?
|Net Profit / Net Loss on the Income Statement
|How much is the business in debt?
|Bank Balance on the Balance Sheet
|Who does your business owe money to?
|Expenses on the Income Statement
The answers are found on the Balance Sheet Essentials page. Na, uh, uh ... no clicking until you've tried to come up with your own answers! ;-)
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.
Oh and by the way, your banker will probably also want to see a business plan.
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, is called Accounting Standards for Private Enterprises (ASPE). It did in fact go 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.
Effective for all fiscal periods ending on or after December 14, 2021, a new standard was introduced by the Audit and Assurance Standards Board for compilation engagements previously referred to as Notice to Reader engagements.
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 as 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. 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.
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.
Keeping in mind the new December 14, 2021 standards for compilation engagements, and depending on your situation, there may be more differences. A Notice to Reader 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 its okay to switch to tax basis statements.
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.
You can find information on CICA's recommendations for the ASPE Notice to Reader or ASPE compilation report in the bookkeeping forum.