What is an Audit Report?
We have purposefully used the term “Audit Report” in the opening line of this article to bring attention to the fact that people often use the term to describe a financial audit or financial report when in fact many types of business audit reports exist.
So now that we are finished with our little rant, we can move on to describing exact what financial audits and financial reporting are all about.
Where is the money coming from and where is it going?
Most businesses can be broken down into 3 levels of financial reporting, small businesses, mid-sized business and large businesses. If we were to use the IRS definition for business size, we would view any business under $10 million in assets as a small business and any business of $10 million in assets as a large business.
And although the governmental body responsible for collecting taxes defines business size this way, we would be remiss to do the same when considering financial reporting. For the purposes of this article we will use “number of employees” as the basis for defining the size of an organization, where a small business will have 1 to 99 employees, a mid-sized business defined as having 100 to 999 and a large business would have 1000 or more employees.
Financial Reporting for each size of Business
At this point I would like to introduce the term “interested parties”. This is very common term used in business auditing and reporting. The term very much means, just as it reads: Interested Parties can be anyone who has a legitimate reason to be interested in the organizations finances.
For most small businesses, the government (specifically the IRS and likely a local comptroller’s office) will always be interested, there will be an owner or maybe some partners and there may be a bank or some other financial institution, if loans are involved.
As a business grows in size there will inevitably be an increase in the number of interested parties. There will be more owners, perhaps stock holders, maybe a board of directors, more banks, vendor or suppliers, investors and perhpas even the employees.
Small Business Financial Reporting
Before we start discussing specific financial reports, let’s quickly think about what type of business you have. Businesses can be separated into 2 major categories: Product or Service. The distinction is very clear, in that, either you sell a product or you offer a service. For example a company that sells lawn mowers is a product based company and one that prepares taxes for people is a service based company.
Once you have determined whether you are a product business or a service business, you will want to determine your businesses legal status. There are several types of businesses and it is important to know the legal status of your company. Most business owners were deeply involved the creation of their business and are fully aware of its legal status, but if you are unsure, read more in the article linked below:
Now that we a have a firm knowledge of the type of business we are running we can take a look at the many financial reporting we may encounter and how the reporting differs from one type of business to another.
Income Statement or Profit and Loss Report – The Profit and loss statement is one of the more common finacial reports in small business. And in some cases it can be one of the simplistic reports that a business generates.
The statement to the left is an example of a very simple P&L, which may also be referred to as an “Income Statement” or “Earnings Statement”. As you can see the document basically reports the company’s earnings and deducts the expenses to determine whether the company earned a profit.
Of course earnings statements can get much more detailed then the one pictured, for example they often distinguish between various types of income and various types of expenses. But for the most part a P&L lists a company’s income and deducts the expenses.
Also you can immediately see the difference between a product based business and a services based business in the simple profit and loss statement pictured. A service based business will not have a cost of goods sold necessarily, as just one example.
We will discuss preparing a profit and loss statement in much greater detail in a later article, but for now let’s discuss some other common finacial statements.
Balance Sheet – If you are a business owner or perhaps an executive with a larger company, I am sure you are familiar with a balance sheet. Unlike a P&L statement, a balance sheet will include the owner’s equity in a company and will always balance one side with the other.
The balance sheet is typically a formal document and quite often prepared by an accountant. Often referred to as a “snap shot” of the company’s financial position at a given moment in time, the balance sheet might be used by investors, creditors, lenders, auditors and more to evaluate a company’s financial health.
In its simplest form, the balance sheet will list all of the company’s assets. Assets are anything of tangible value that the company owns, that could be cash, inventory, accounts receivable, land or other property. Assets are most commonly listed on the left side of the balance sheet.
The right side of the balance sheet basically shows how the company obtained the assets show on the left side. Either the company purchased things with credit, took out loans or invested money. Investments are known as equity and credit that needs to be paid back are known as liabilities.
In the end the two side of the balance sheet absolutely need to equal one another. Which makes sense, the left side or company assets must have been obtained in some way and the right side shows where the money came from to purchase the asset.
Statement of Changes in Equity or Statement of Retained Earnings – Understanding “equity” as it pertains to business is a valuable piece of knowledge. The Balance-Small Business is a resource website for small business and defines “business equity” in as many as 6 forms, including owner investment, stockholder investment, earnings that are reinvested and perhaps even real estate equity on property owned.
Let’s remember back to our discussion about the Balance Sheet. Both sides of the balance sheet need to remain equal at all times. So if you were to add equity to the company in any way that addition would need to be accounted for if it were not obtained through the normal operation of the business.
Additionally equity can certainly change through the normal operation of business by means of what is called “retained earnings”, so any profit that kept within the business to continue operations is considered as an increase in equity. This increase in equity is very commonly determined by simply subtracting liabilities from assets, remember the balance sheet?
Cash Flow Statement – Financial documentation is critically important for the owners and operators of a business and for those who have a vested interest in the financial health of the organization and a cash flow statement is a very helpful document indeed.
Basically the cash flow document shows how cash or any cash equivalent is obtained and how it is spent. It’s important to remember that “cash” is the most liquid asset that a company can possess (mean that it is the most easily spendable asset).
Cash flows through a business for many reasons, here are just a few:
- Cash received through sales of goods and services
- Interest payments from investments or savings
- Income tax payments (both incoming and paid)
- Payments made to suppliers of goods and services
- Salary and wage payments to employees
- Rent payments
- Any other type of operating expenses
The cash flow statement shows the totals for each of these potential cash flow paths and ultimately gives a picture of how effectively a company handles it’s most important asset.
What is the Financial Health of a Given Organization?
As business progresses through each and every day you will accumulate a wide variety of financial documentation. As discussed above, this doucmentation should be used to generate reports that are intended for those interested in your comanies finances.
A financial audit is the examination of the financial records of an entity by a certified third party examiner. This examination by a knowledgeable outsider is needed to provide credibility to an organization’s financial statements. If an auditor does not find any issues, then he or she releases an audit opinion, which accompanies the certified financial statements when they are issued. Lenders, creditors, and investors want to see an audit opinion, as proof that the financial statements are correct.
An auditor will conduct a variety of tests to verify that the financial records are complete, and fairly represent the financial results and condition of an organization. These tests may include tests of controls, tests of transactions, analytical procedures, and tests of balances. Financial audits are most commonly conducted for the financial statements of a firm, but may be targeted at more specific areas, such as tax records.