Financial reporting is a themed topic for companies by the end of the fiscal year. Who doesn’t want to see how their businesses did financially for the year?
Nowadays, there are many convenient accounting software for you to easily generate the financial reports. But understanding the logic and process behind the scene is still critical to properly set up your accounting system that fits your business.
This post is all about financial reporting and I will go through the entire process with a hypothesized business as example. In this post you will read:
- Meaning and objective of financial reporting
- Importance of financial reporting
- Financial reporting framework
- Types of financial reports
- Financial reporting example (Ben’s Event.co)
Alert: there are some accounting concepts in this article. You can learn more about the concepts in this post:
- 13 essential financial concepts with examples
Let’s dive in!
1. Meaning and objective of financial reporting
While accounting is to transfer economic activities to financial data, financial reporting is to gather, organize, and present the financial data in a structured written format.
The objective of financial reporting is to communicate the financials of a business to the stakeholders, including owners, investors, regulators, tax authorities, etc..
2. Importance of financial reporting
Accounting is not in center of a business owner’s mind, but it is extremely helpful to have a clean and organized accounting book and financial reports for your business.
Investors and financial analysts rely on the financial reports to evaluate the performance, financial health, and earning potentials of your business and make prediction about the future direction or make investing or financing decisions.
Governments may have benefits applicable to your business. Financial reports can help you obtain those benefits more smoothly.
Financial reporting is the foundation of more in-depth financial analysis that reveals more details about the business performance for management to make decisions.
3. Financial reporting framework
Framework, standards, principles. There are so many names. But all the names refer to the same thing: the accounting principles – the guidance accountants follow to record all transactions happening in the business.
There are 2 major accounting principles in the world: IFRS, standing for international financial reporting standards, and US GAAP, standing for US generally accepted accounting principles. IFRS is more prevalent worldwide, but GAAP is the default accounting principles for business locating or headquartering in the United States.
Those 2 principles share some similarity, but there are also differences. If you like to learn more about the difference, you can check KPMG’s summary.
4. Types of financial reports
The 3 major financial reports are balance sheet, income statement, and cash flow statement. There is another statement called statement of changes in equity, which is considered less important in general.
4.1 Balance Sheet
There are 3 types of accounts included in the balance sheet: assets, liabilities, and equity. And those elements fit into the equation: assets = liabilities + equity.
While many like to start with income statement, I recommend starting with balance sheet to assess the finance of a business. In the balance sheet, you can see what resources the company is controlling on the asset side, and how the business finances the resources on the liability and equity side.
From the retained earnings, you also see how much net profit the company has accumulated over the years and what kinds of financing activities the shareholders are conducting, such as paying dividends, buying back shares, etc..
4.2 Income Statement
There are 2 types of accounts included in the income statement: revenues and expenses. The balance of the income statement is the net profit and will be added to the retained earnings in the balance sheet.
4.3 Cash Flow Statement
The cash flow statement contains 3 sections to record cash flows related to 3 types of business activities: operation, investment, and financing.
Operation means the core business; investment refers to spending in long-term assets such as property, plant, and equity – people consider this spending as a investment to grow the business; financing activities refers to loans, interest payment, injecting capital, or paying dividends.
Cash flow statement becomes increasingly important because cash flows play a critical role, arguably more critical than net income, when it comes to deciding whether to buy a company.
This is because net income is subject to accounting adjustment that may end up with bad debts and the business cannot collect the cash for the transactions – hence, there is no return for the investment. Whereas cash is the source of return on investment.
There are 2 ways to generate cash flow statement. One is to record all cash transactions chronically. But that requires a lot of duplicated work if we already adopt the accrual accounting. That is why accountants use shortcut: start from net income, then adjust for the non-cash transactions and include cash transactions that are not a part of income statement.
4.4 Statement of Changes in Equity
Statement of changes in equity contains all activities that involve equity accounts.
This statement is considered less important but is necessary for companies with complex shareholder structure. Sometimes the owners of the company will have significant impact on the value of the business.
5. Financial reporting example
Finally we come to the part with the most fun – going through the financial reporting with an example!
Ben’s Event.co
Ben is a talented entrepreneur who runs a company to organize fantastic quarterly conferences. The business generates revenues from ticket sales and other event related activities. While the main expenses include spending associated to organizing the events, and some admin costs like maintaining a website.
To generate the financial reports, there are 3 steps in brief:
- Pull the account balances from the general ledger
- Fill the balances to income statement and balance sheet
- Adjust items for cash flow statement and statement of changes in equity
5.1 General Ledger
General ledger is a exhausted list of accounts in the accounting book. It includes accounts in the all five accounting elements: assets, liabilities, equity, revenues, and expenses.
The event business is simple and Ben does not need a factory to deliver the services. Therefore, the accounting accounts (a.k.a. general ledger) are also very simple. Let’s look into the balances of Event.co’s general ledger:
If you wonder why the balances fall into debit or credit for a certain accounts, please read the ‘Dual Aspect’ concept in: 13 essential accounting concepts with examples for beginners
Assets
- Cash: this is the cash and bank account balance of Event.co.
- Accounts Receivable: if Ben has sold the tickets but has not received the payment, or he has obtained a written sponsorship but has not yet received the cash, then the amount will appear here.
- Prepaids: this is the amount Ben paid for the event in the next year. Because of the matching principle, the spending will become expenses in the next year. But since he has issued the payment, Ben needs to record the payment as a prepaid. You can regard prepaids as a ‘loan’ lend to the supplier, thus the prepaid is a type of assets.
- Inventory: this is the goodies Ben has purchased for the next event. Why the goodies are inventory but not prepaid? Because inventory is dedicated to items that Ben will sell to the customers. But the payment recorded in prepaids will only be an expenses next year.
- Long-Term Assets: this account is for the assets that will last more than one year and are not inventory. For instance, Ben purchased a laptop dedicated to company operation, and the laptop will be recorded as a long-term asset.
Liabilities
- Accounts Payable: this is the balance that Ben has purchased from the suppliers, but has not yet paid.
- Long-Term Liabilities: Event.co has no long-term liability. But long-term liabilities normally include long-term debts. Ben did not borrow any debts to run the business.
Equity
- Common Stock: this is the face value of the stocks of the company.
- Contributed Surplus: this is the difference between the face value of the stocks and the actual capital the company received from the shareholder. For example, Ben set up 100 stocks with $1.00 as the face value, then he input $1,000 into the company. The $900 difference is recorded as the contributed surplus.
- Retained Earnings: this is the accumulated net profit from the company’s years of operations.
- Dividend Paid: this is the dividend paid to Ben. He is getting good income from this side hustle!
Revenues
- Ticket Sales: this is the ticket sales Event.co has made for the year.
- Sponsorship: this is the income from sponsorship by companies.
- Other Revenue: this is the income from other miscellaneous sources. For example, Ben will sell some goodies at the events
Expenses
Usually, there are 2 types of expenses: cost of good sold and period expenses. Cost of goods sold are the expenses directly linking to production or service delivery; while period expenses are the spending that you cannot link to production or service delivery.
- Venue rental, facility rental, catering, marketing expenses, and other event expenses: those are expenses directly related to organizing an event, that is said, they are the cost of goods sold. Because the general ledger
- Admin expenses: admin expenses are period expenses. They include spending such as website maintenance, software subscription, etc..
These simple accounts are sufficient for Event.co but may not be applicable to all business models. I will share tips to design your general ledger in another post.
Once the balances of general ledger is ready, you can start to generate financial reports.
5.2 Income Statement and Balance Sheet
While I recommend starting with balance sheet to assess businesses, for financial reporting, I like to start with income statement then balance sheet, because you need the net income to calculate the ending balance of retained earnings.
All you need is to organize the account balances into these 2 reports according to their elements.
You will notice that the retained earnings in the balance sheet is different from the general ledger.
This is because the retained earnings in general ledger is the beginning balance, but the retained earnings in the balance sheet is the ending balance, which equals to beginning balance + net profit of the year from income statement. This is to maintain the balance of the accounting equation.
5.3 Cash Flow Statement
Ben starts with the net income to prepare the cash flow statement.
Here the operation refers to event organization. There is no investment activity in Event.co.
Note that usually, cash transactions for investing and financing are not in the income statement. Therefore, you will need to add them anyways,.
In Event.co’s case, the dividend payment of $20,000 occurred during the year is included in the financing cash flows.
In Event.co’s case, the following adjustments are made:
- Cash transaction not in I/S (I/S stands for income statement): for example, when Ben purchased inventory but has not yet sold, the spending will be recorded to cash and prepaids ($500), not entering the income statement. But the cash flow statement will reflect this spending.
- Cash transaction in I/S but not ops (ops stands for operation): this is the case of interest payment ($100). Interest payment is included in income statement, but it is not operating but financing activity. That is why we take it out from operating cash flows and add it to the financing cash flows.
5.4 Statement of Changes in Equity
This financial report only concerns the equity. It explains what transactions have touched equity accounts, including the changes because of the net income of the year. Event.co has 2 activities concerning equity: making profit and paying dividends.
Summary
With the financial reports, we conclude that Ben’s Event.co has $39,000 total assets and has generated $33,000 income in 2023 for him (ignore the tax in this case). Isn’t event business a good side hustle? You may consider to start organizing events in your school!
Of course, succeeding in the event business requires a lot of connections in the fields that relate to the events and in all related domains such as venues, facilities, performers, keynote speakers, caterers, etc..
This post is all about financial reporting. You now have learned how to generate financial reports from the general ledger. Although accounting software helps you automatically add the balances to the reports, knowing the process will help you feel more comfortable about setting up the software and tackling errors if necessary.
