Understanding Financial Statements

By Ron Coleman

More than 32 per cent of business failures are related to poor management of the business’s financial affairs. 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 why most companies prepare financial statements—that’s compliance. However, the real reason you should prepare annual financial statements is to provide your business with management information. So 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.

You must have a clear understanding of what goes where. All bookkeeping entries are double entries; 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. For example, 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 in 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 statements

This is where you record all the activities that relate to making a profit; both income and expenses are shown on this statement. The income statement shows what happened over a period of time—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 costs include all the costs you incur, for example, when you are 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 burdens such as benefits and workers’ compensation premiums. If you are using Quick Books or Sage 50, you will have to do manual journals to allocate these costs.

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. More on this in part two of this article.

Balance sheet

The balance sheet should be laid out to provide information in the most favourable light. For example, are you better off showing items as current assets or long-term assets? How about liabilities—current or long-term?

Current assets are those assets 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. Finally, 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 three and decide between options one and two.

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 the 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 not be detected. Just read the NTR 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 that 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 always the case. So if you want tax advice, ask for it.

Many people ask the question, “Why don’t I have cash when I know I made a profit?” The answer to that question will be in part two of this article.

You share your financial statements with the Canada Revenue Agency, your financial institutions, bonding companies, insurers and suppliers—they are all experts at analyzing them. Rarely will your external accountants comment on the management information provided within your statements; however, with a few tweaks, you can make your numbers look a lot more attractive to those who analyze your statements. Staying in control of your money puts you in the driver’s seat. Please don’t take the back seat when it comes to your finances.

Make sure you read part two in the next edition of Plumbing & HVAC magazine, which will focus on interpreting financial statements.