By / Ron Coleman
This is part one of a two-part series on understanding and interpreting financial statements. Part two will appear in the Winter 2022 issue of TIAC Times.
More than 32% of business failures are related to poor management of the financial affairs of the business. If we can’t manage the numbers, we can’t manage the business effectively.
Filing tax returns and meeting the requirements of your financial institutions are the two primary reasons most companies prepare financial statements. That’s compliance. The real reason you should prepare annual financial statements is to provide you with management information. Why not combine the two functions? To do this, you must decide on the key items of information. In addition, your monthly financial reporting will be a lot more valuable to you.
Your two primary financial statement documents are your Income Statement (Profit and Loss Statement) and Balance Sheet.
It is critical that you have a clear understanding of what goes where. All bookkeeping entries are “double entry”. Every debit has a corresponding credit. Often, one entry will be recorded in the income statement and one in the balance sheet.
Revenue and expenses are recorded in the income statement. The income statement shows what happened over a period of time. The balance sheet is a “snapshot” of what we have at a specific date. When you sell something on credit, you credit sales (income statement) and debit accounts receivable (balance sheet). Your sales ledger will show the sales for the period, while the accounts receivable list how much you are owed at that particular date.
Capital asset purchases are recorded on the balance sheet. Adjustments for depreciation are made by debiting depreciation expense (income statement) and crediting accumulated depreciation (balance sheet). That way, the balance sheet reflects the net book value of the assets.
Income Statement (Profit and Loss Statement)
This is where you record all the activities—both income and expenses—that relate to making a profit. The income statement includes sales, job costs, and overhead for the period. All other transactions are recorded in the balance sheet.
Expenses are divided into categories—direct cost and overhead.
Direct cost includes all the costs you incur completing a project. If in doubt, ask yourself this question: “Did I allow for this cost in my estimate before my markup for overhead and profit?” If yes, then it is a direct cost; if no, it is overhead. It is essential to break payroll costs down into direct payroll for jobs and overhead payroll. Also, include related payroll burden, such as benefits and workers’ compensation premiums.
Unless you get the allocation correct, you won’t know what profits you are making on your jobs, what your true overhead is or how to calculate your break-even sales.
Balance Sheet
The balance sheet should be laid out to provide information in the most favourable light. Are you better off showing items as current assets or long term-assets? How about liabilities, current or long-term?
Current assets are those that are cash or expected to become cash within 12 months.
Capital assets are those the business will use on an ongoing basis, such as vehicles and equipment.
Current liabilities are the mirror image of current assets; debts you expect to pay within 12 months.
Long-term liabilities are the mirror image of capital assets; they are expected to exist beyond 12 months.
When it comes to preparing your year-end financial statements you have three options. Most of you will skip option 3 and decide between option 1 and 2.
1. Notice to reader (NTR)
In an NTR, the accountants are not verifying many, if any, of your transactions. They are compiling your numbers, primarily for tax purposes, based on information you provide. This is your least expensive option, and many contractors go with this provided their financial institutions and boding companies are okay with that. Mistakes are sometimes found. Misrepresentation or fraud will definitely not be detected. Just read the Notice to Reader page on your year-end financial statements and you will see how little work has been undertaken. That and the engagement letter you sign will show you how much they rely on the information you provide.
2. Review engagement report (RER)
The RER is used where a more comprehensive report is required. The accountants verify bank balances, check other relevant accounts and some external matters. Comprehensive notes are prepared and attached to the financial statements. Misrepresentation or fraud may or may not be detected.
3. Audit
Larger contracting companies are often asked to provide audits. These are very expensive and should be avoided unless necessary.
Having a clear understanding of why you are preparing your statements will help you decide which level of accounting services you need. Accounting firms are not all the same. Get references and use a firm you have confidence in. The RER is around three times more expensive than the NTR.
Tax Advice
You may think that tax advice is part of your year-end accounting procedure, but this is not normally so. If you want tax advice, ask for it.
Many people ask the question, “Why have I no cash when I know I made a profit?” The answer to that question will be in part 2 of this article.
You share your financial statements with the Canada Revenue Agency and with your financial institutions. Maybe also with bonding companies, insurers, and suppliers. They are all quite expert at analyzing them. Rarely will your external accountants comment on the management information provide within your statements. However, with a few tweaks, you can make your numbers look at lot more attractive to those who analyze your statements. Staying in control of your numbers puts you in the driver’s seat. You can’t drive from the back of the bus. ▪
