No matter what business or industry you’re in, you would have encountered financial statements at some point. It’s one of the most important things for your business and it’s used for a variety of purposes.

So what is a financial statement? Here’s an introduction to the basics.

Let’s get started!

What is a Financial Statement?

A financial statement tells you the financial status of your company by showing your financial position, how much profit or loss you generated or lost and the flow of cash.

It is typically made up of these three statements: If you haven’t checked out our blogs on these topics, I recommend you check it out at these links below first and then come back to this one.

Balance Sheet

Together with all of the above, you can capture your company’s financial information at a specific point in time and over a period of time.

Types of Financial Statements

Depending on your needs, there are actually four different types of financial statements and each serve a different purpose and it depends on who is looking at it.

Internally Prepared Financial Statements

Compiled Financial Statements
Reviewed Financial Statements
Audited Financial Statements

Let’s go into the differences for each of these! These sections goes from least to most complex and least to most costly. Are you ready?

Internally Prepared Financial Statements

As the heading indicates, these financial statements are internally prepared by someone inside your company without going to an external accounting firm. It could be the owner or someone in the accounting department (preferably a controller or accounting manager level). This type serves as the base for all the other three types of financial statements.

If you use Quickbooks Online or another accounting ERP software, financial statements can be generated with built-in reports which allows you to specify the period you want to run it for. It’s important to have your Controller/Accounting Manager review your software set up to ensure that the financial statements are produced properly.

To continually review your business, it’s important to create interim financial statements which are statements created during the year. It could be monthly, quarterly or some other interval. Why? If you own a business, you want to know how well you did earlier so you can make decisions to adjust this. What’s the point of waiting a whole year to find out how you did?

In what situations would you use this type?

Your external stakeholders don’t require financial information of your company
You want to use it to forecast how you could do by the end of the year
You want to know how much you profit and/or cash you generated
If you need a Review or Audit done, external accounting firms typically require interim financial statements

Shattered sheets of white paper (compilation)

Compiled Financial Statements

These are known as Compilations, formerly widely known as Notice to Readers. These are the most common and are only produced by external accounting firms. This type relies on financial information received from the company in order to generate these. Your accounting firm wouldn’t magically know your financial information unless you provide it to them.

There is typically some validation of numbers between the internally generated financial statements, trial balance, general ledger and source documents. For example, to confirm your cash balance matches, you may need to provide a bank statement. If the balances are different, you might be asked for a bank reconciliation.

External third parties typically require a minimum level of compiled financial statements since information prepared by a third party (ie. An accounting firm) is more reliable than something produced within a company (ie. Risk of management bias).

Note disclosures, which discloses more information about the company and the accounting choices, are usually minimal with this type of engagement.

In what situations would you use this type?

You have borrowed funds for your real estate project and the lender requires this prepared every year
An investor requires this as part of their investment in your company
You have borrowed a loan from a bank and they require this

Person flipping a book and writing notes (reviewing)

Reviewed Financial Statements

Reviewed Financial Statements are prepared by an external accounting firm and the engagement is meant to determine whether or not the financial statements are believable (ie. Plausible) in accordance with the applicable financial reporting standard. Only Licensed Public Accountants can perform this type of engagement (ie. A firm that can specifically do this type of engagement or audits, known as auditors)

The main focus of this engagement for auditors are inquiries to management on the financial information provided and analytical procedures.

Inquiries can include asking about certain transactions shown on the general ledger details, intercompany reconciliations or reconciliations with subledgers. Questions like “show me how you reconciled the intercompany or subledgers”, “what is included as part of this balance?”, etc.

For analytical procedures, auditors look at the trends from year to year or account to account to see if it makes sense. If not, they need to understand from management on the reasons or causes. For example, if your revenue increased 40% YOY and your cost of goods sold increased 30% YOY, and this is in line with prior year then it’s reasonable. However, if your cost of goods sold increased 80% YOY, then something is off.

This engagement is meant to provide something called ‘negative’ assurance or in other words, moderate assurance. The report identifies whether or not the auditor found something in the financial statements that does not represent a true and fair picture of the company. See how the ‘negative’ comes in?

As you can tell, the nature of this engagement is more complex and more expensive than Internally Generated or Compiled Financial Statements. Note disclosures are usually more extensive with this type of engagement.

In what situations would you use this type?

Your CEO, Board of Directors or your Management Team who wants some assurance over the financial information
An investor requires this as part of their investment in your company
You have borrowed a loan from a bank and they require this
If you require it as part of regulations
If you’re a construction company and the surety requires this as part of ongoing reporting

Magnifying glass on a grey laptop (auditing)

Audited Financial Statements

Audited Financial Statements are prepared by an external accounting firm and the engagement is meant to determine whether the financial information provided by the company is accurate in accordance with the applicable financial reporting standard. Only Licensed Public Accountants can perform this type of engagement (ie. A firm that can specifically do this type of engagement or reviews, known as auditors)

The main focus of this engagement for auditors are a full examination of the financial statements and a review of the company’s internal controls.

What does full examination mean? Remember the Balance Sheet, Income Statement and Cash Flow Statement explained in our previous blogs? It’s examining each one of these in detail.

Some examples can include reviewing bank reconciliations, general ledger details, review source documents or reviewing what makes up a balance.

How about internal controls? Before reviewing source documents, the auditors would usually require a process document (or something similar) outlining the different processes and flow of information involved in the preparation of the financial statements. This is meant to give the auditor an understanding that there are the proper controls in place. When they review source documents, they compare to the process document to ensure that it is actually being followed.

Here’s an overly simplified example of an AP process:

AP receives invoices
They match to a purchase order, quote, packing or delivery slip
Invoice gets sent for approval
Invoice gets entered in accounting software
Payment gets prepared after n days
The Controller, Accounting Manager or Owner reviews and signs off

This engagement is meant to provide positive assurance or in other words, high assurance. On the audit report, the auditor will provide an opinion whether the financial statements represent a true and fair picture of the company. It’s important to note that it’s called high assurance, not full assurance.

Full assurance means reviewing every single thing, every single source document and every single entry. Imagine how costly and time intensive this is so that’s why no one wants this done. No one offers full assurance engagements!

As you can tell, the nature of this engagement is the most complex and most expensive than the other type of financial statements. Note disclosures are usually most extensive with this type of engagement.

In what situations would you use this type?

Your CEO, Board of Directors or your Management Team who wants high assurance over the financial information

An investor requires this as part of their investment in your company
You have borrowed a loan from a bank and they require this
If you require it as part of regulations
If you’re a construction company and the surety requires this as part of ongoing reporting
You’re a publicly traded company

Shining light bulb on a post-it on a tack board

The Importance of a Financial Statement

Now that we went through what consists of a financial statement and the different types of it, why is this even important?

Financial statements are prepared for stakeholder needs.

Who is considered a stakeholder?

Company’s management team
Company’s employees (if the management team presents this)
Shareholders
Creditors and Lenders
Government Authorities
Competitors (if you’re a publicly traded company)
Anyone else that has an interest in the financial information

As seen above, certain stakeholders may have different requirements on the type of financial statements they require. If the management team requires reviewed financial statements and the bank requires audited, then you’re going need to get an audit completed. It’s important that you don’t need to get both a review and an audit (there’s no point) as the management team will be even more satisfied with audited statements.

Limitations of a Financial Statement

Stakeholders use the financial statements for decision-making purposes but the statements are only as good as the underlying data. Although an audit is essentially an examination, not every single thing is reviewed.

You might be asking this question: “what do you mean by ‘only as good as the underlying data’?”

Decisions are made with data, but only sound decisions are made with good data.

Here is an example:

You’re on the management team of a construction company. Project 1 shows you are making 40% profit and Project 2 shows you are losing 30%. You are very happy about Project 1 but frustrated about Project 2. Project 2’s loss according to a report indicates labour overrun. This might be the case, but if the timesheets aren’t coded to the correct job, the profitability reports are incorrect, leading to the wrong decisions. By the way, an audit doesn’t review this.

Here is another example:

You’re a real estate developer and recently acquired 2 acres of land for a new subdivision. You have hired a Planning Consultant and Architectural Firm to review the project. A report indicates that the cost for planning is 50% and 20% for architectural so far. This is assuming that the invoices are coded correctly. If not, then these might be overstated or understated which will lead to the wrong decisions. Again, an audit doesn’t review this.

The lesson here? Data needs to be in the correct spot in order to make the most effective decisions.

Your Turn

Do you have a better understanding of what a financial statement is, the different types, why it’s important and some limitations of it? If not, go back and review those sections.

Although our firm doesn’t offer Review or Audit engagements, we can help you streamline your processes so that data is going to the correct buckets, leading to more effective decision making.

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At JTL CPA, we are Ontario’s virtual accounting firm. Our goal is to automate your accounting and bookkeeping processes in a way that increases financial visibility. Pair that with our value-added approach and tailored advisory solutions gives you the ability to make sound decisions from good data. Check out our website here: https://www.jtlaccounting.com.

Thank you for making it to the end of the blog post. If there are topics that you would like to learn more about in the future, please let us know down in the comments.

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