If you're not an accountant, financial recording might not be what you do best. As a result, it might be the last thing on your list of to-dos. More likely than not, you’d rather be spending your time working on your product or service.
However, accounting and financial recording is a key business process. Having accurate, timely and sufficient financial information is crucial to running a successful business. There are countless reasons to keep good financial records, here are some of them:
It is no secret that poor decisions are made with poor information. If you don’t have the appropriate records or financial information available, it makes it very difficult to make sound business decisions.
Tracking your business’ successes (or failures)
If you don’t keep track of your financial performance it is difficult to understand how well your business is performing. Are you making money? Are sales increasing, or decreasing? How is your new service line doing? If you’re not tracking the financial performance of your business, it becomes impossible to identify the risks and opportunities that your business is presented.
Accurate records can help translate into strong budgeting. All businesses small and large should have some sort of budget in place. Are you assuring that you will have sufficient cash flows in the future? Without an accurate picture of the past, how will you plan for the future?
Obtaining financing and capital
At some point in time your business may need to obtain additional financing. Whether this is from private investors or bank loans, they will want to see how your business is doing. Accurate and reliable financial information is a prerequisite to obtaining financing. Without reliable records, no one will be willing to lend or invest their money in your business.
Preparing your income tax return
Every year, you will have to file an income tax return, whether it is business income, partnership income or corporate income, you will need financial records to support your income tax return. If you are carrying on a business or engaged in a commercial activity in Canada, you are required by law to keep adequate records. Your records should provide enough details to determine your tax obligations and entitlements. Having sound financial records can make filing your tax return on time, painless (imagine that).
CRA record Keeping
For all of us who fell asleep in our accounting class, here is a high level overview of the most common elements in a set of financial statement. Generally speaking, a set of financial statements is comprised of:
- an income statement,
- a statement of retained earnings,
- a balance sheet,
- and a statement of cash flows.
The income statement summarizes the income for the year; the statement of retained earnings shows the reconciliation of opening and ending retained earnings; the balance sheet summarizes the assets, liabilities and equity at the end of the year; the cash flow reconciles opening and ending cash balances, summarizing operating, investing and financing cash flow activities throughout the year.
An income statement is a summary of a business’s operations for a given year. It summarizes the revenues, cost of sales and expenses to determine the income earned during the particular year.
Revenue – represents cash inflows, (or asset betterments) during the period, typically from delivering goods or services relating to the business’s principal operations.
Cost of goods sold – represents cash outflows (or incurred liabilities) directly attributable to the creation of revenues. Typically cost of goods sold are accumulated from direct materials, direct labour and overhead costs. Overhead costs represent the allocation of absorbed costs directly related to producing goods or services.
Gross profit – represents the total income earned from the principal operations, usually calculated as revenue minus cost of goods sold. Gross profit is an indication of the business’ ability to create income from its principal operation before deducting operating costs such as selling, administrative or research & development costs.
Operating costs or expenses – represents additional cash outflows (or incurred liabilities) that are not directly attributable to the creation of revenues.
Net income – represents the total income earned from operations over the period after deducting all expenses. The income is closed off, or moved to retained earnings on the balance sheet for future years.
A balance sheet is a summary of all of the items that a business owns (known as assets) and the items a business owes (known as liabilities). The difference between assets and liabilities, or net assets, is known as equity. A business’ total equity be must equal to the assets minus the liabilities, which gives us the name, balance sheet.
Current assets - are any assets the business owns which it expects to be sold, consumed or mature in normal operations in the current fiscal year. Typical current assets include cash, cash equivalents, inventory, prepaid expenses and accounts receivable.
Capital assets –are any assets that the business owns which it uses in principal operations to generate revenues or profit. Generally speaking, these assets are not directly sold to a customer, but rather are utilized to generate profit over a long term period through lasting use. Given this, capital assets must be depreciated. Depreciation represents pro-longing the cost of the assets and recognizing it as an expense over the useful life of such assets. Typical capital assets might include land, buildings, vehicles, equipment, furniture, computers, fixtures and machinery.
Long-term Assets –are any assets that the business owns which it does not use in principal operations. Typically these assets are not easily converted into cash, and are not expected to be sold, consumed or mature in the current period. Typical long term assets might include investments or intangible assets (such as trademarks or goodwill).
Current Liabilities – are any liabilities that the business owes which it expects to settle or pay in normal operations in the current fiscal year. Typical current assets include accounts payable, deferred or unearned revenue or customer deposits.
Long term Debt –are any loans, debt or liabilities which the company has attained to finance the business. Long term debt is not expected to be repaid in normal operations in the current fiscal year, however often a current portion or amount to be paid in the coming fiscal period is shown separate. Typically long term debt is held by banks, financial institutions, credit facilities or shareholders.
Long-term liabilities – are any liabilities that the business owes which it does not expect to settle or pay in normal operations in the current fiscal year. Typical long-term liabilities might include warranty provisions, asset retirement obligations or pension and employee benefit obligations.
Share Capital – are shares or issued capital representing the company’s liabilities to owners. Typically this represents the liability for cash or capital provided by shareholders to the business.
Retained Earnings – are the accumulated earnings, or profit earned each year, over the life of the business. Typically the retained earnings are maintained to continue the operations of the business, unless they are paid out to the shareholders in the form of dividends.
Financial statements and reports offer an excellent opportunity to evaluate the performance of a business by comparing to industry standards, competitors or even historical results within the business itself. Financial analytics is the science of transforming financial data into meaningful insights to enable management to make informed strategic decisions.
It should be noted that although financial analysis can offer insight into potential strengths and weaknesses, they do not represent the “end all, be all” of the business’ performance. There are many additional factors which are not captured in the financial statements which must be considered with any financial statement analysis. A deep understanding of the industry, processes and operating environment are crucial and need to be harmonized into any financial analysis.
If you can incorporate financial analysis with other business evaluation techniques, they can offer invaluable insights into the business’ risks and opportunities.
Gross Margin Ratio(Revenue less cost of goods sold)/Revenue Gross margin ratio is used to determine the margin earned as a percentage of revenues. It represents the total income earned after deducting the costs of creating those revenues. The higher the percentage, the more profit the business retains on each dollar of revenue earned.
Current ratioCurrent assets / Current liabilities Current ratio is used to compare the total current assets to total current liabilities. The ratio is often used to show the business’s ability to repay current liabilities using current assets. The higher the percentage, the more able the business is to repay current liabilities.
Inventory Turn-overCost of goods sold / Average inventory Inventory turn-over is used to determine the number of times per year that inventory is sold and replaced. The higher the inventory turn-over the lower the risk of inventory obsolescence, however inventory turn-over should be compared to industry or historical averages.
Return on Equity (ROE)Net Income / Shareholders’ Equity Return on Equity is used to determine the total return or income earned on the equity contributed by a shareholder. The higher the return on equity the more profitable the business is for its shareholders.
Return on Assets (ROA)Net Income / Assets Return on Assets is used to determine the total return or income earned on the assets owned by a business. The higher the return on assets the better managed the assets are to produce profit. The measure is often used to determine the profitability of the assets regardless of the financing methods.
Receivable TurnoverSales / Average accounts receivable Receivable turn-over is used to determine the number of times per year that sales are collected. A lower receivable turn-over may indicate a risk of uncollectible sales, however should be compared to industry or historical averages.
Average Collecting Period365 days / Receivable Turnover The average collecting period (an extension of the receivable turnover) represents the average number of days it takes for the business to collect. Again a higher average collecting period may indicate a risk of uncollectible sales.
Although reliable internal financial information is very important, for many businesses, there is a need for external financial reporting. Generally speaking, external reporting must be produced to a set of rules or standards usually referred to as Canadian generally accepted accounting principles. In order to maintain comparability and consistency amongst financial statements, the Canadian Institute of Charted Accountants (CICA) has the CPA Canada Handbook.
The handbook contains the standards set by the Accounting Standards Board for entities that wish to prepare financial statements in accordance with Canadian generally accepted accounting principles (GAAP). GAAP are the accepted set of rules which must be followed in preparing financial statements. Depending on the nature of the entity, and the needs of the users of the financial statements, the entity will prepare their financial statements in accordance with one of the following set of standards:
- International Financial Reporting Standards (IFRS),
- Accounting Standards for Private Enterprises (ASPE),
- Accounting Standards for Not-for-Profit Organizations,
- or Accounting Standards for Pension Plans.
The choice of reporting framework can be a complex one, some considerations would be reporting requirements from shareholders, debtors and parent companies, stakeholders and other user needs, and accounting competences and capacities.
International Financial Reporting Standards (IFRS)
IFRS is a common international set of standards for reporting that is used around the globe to create comparable financial statements on the global scale. The standards allow two companies preparing statements in separate countries to use an identical set of standards to create consistencies and comparability between financial statements.
Given its mass application, there are considerable complexities in the standards used in IFRS. It is often only adapted by larger, international entities. Although Canadian private companies have the choice to adopt IFRS, all publicly traded companies in Canada are required to report in IFRS.
Accounting Standards for Private Enterprises (ASPE)
ASPE is a set of standards released by the Canadian Accounting Standards Board (AcSB) that can be adopted by private enterprises. A private enterprise is defined as a profit-orientated enterprise that is neither publicly accountable nor an entity in the public sector.
Generally speaking the requirements are less stringent and complicated in comparison to IFRS making them more easily applied by smaller enterprises.
Accounting Standards for Not-for-Profit Organizations (ASNFPO)
ASNFPO is a set of standards released by the AcSB that can be adopted by not-for-profit-organizations (NFPO). Again NFPO’s can adopt IFRS, but ASNFPO allows a less complicated set of standards tailored specifically for NFPO.
Accounting Standards for Pension Plans
Accounting Standards for Pension Plans is a set of standards released by the AcSB specifically established for pension plans, and benefit plans that have characteristic similar to pension plans
Canadian Institute of Chartered Accountants
Assurance is a broad term used to define services offered typically by a Chartered Professional Accounting Firm to reduce the risk of inaccurate financial statements. For all types of organizations, from the small to the large global companies, making sound business decisions requires reliable financial reporting information. Assurance services help business leaders and stakeholders in all industries to communicate a fair picture of their financial performance.
It is important to understand which service your business needs based on the needs of management, debtors, shareholders and other stakeholders.
Notice to Reader/Compilation (NTR)
Simply put, a notice to reader involves creating a set of financial statements from the information provided by a client or business, no additional work is performed. That is why there is a ‘notice’ to the reader, indicating that the statements are not audited or reviewed.
Some organizations do not need financial statements containing all disclosures normally required for general purpose use, nor do they need the assurance that can be provided by an audit or a review. In a notice to reader the financial statements are compiled using information supplied by management or proprietor. No assurance is offered in compiling the statements. Compiled financial statements are often prepared to prepare and accompany an organization’s tax returns.
The scope of a review is less than that of an audit and therefore the level of assurance provided is lower, usually negative assurance, or that nothing unusual was noted. During a review, the professional will assess whether the information being reported on appears to be plausible, primarily through inquiry, analytical procedures and discussion. A review of financial statements is often performed for banks, creditors and potential purchasers.
The purpose of an audit is to enhance the degree of confidence in the financial statements. This is achieved by the expression of an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. An Audit is generally performed when outside third parties (such as regulators, banks, creditors, potential purchasers and outside investors) require an auditor’s opinion on the financial statements.
Deloitte Assurance & Advisory
Broadly speaking, internal controls are methods, processes or procedures that an organization puts into place in order to:
- ensure that financial information is accurate, timely and reliable,
- ensure compliance with regulatory, financial and operational requirements,
- achieve or implement business objectives,
- prevent, mitigate and detect fraud,
- and safeguard assets.
The control environment should be as specific as the business itself, and there is no one formula for creating reliable controls. The business needs to spend time thinking about what are the risks, and design and implement controls that will appropriately address the risks. The following are some examples of common controls for small businesses:
Dual Cheque Signing
Having two signees on cheques provides a safeguard against misappropriation of cash through fraudulent cheques. In conjuction with signing the cheques, all expenses should be reviewed to ensure that they are genuine expenses for the business.
Bank reconciliations involve reconciling between the balance per the bank and the general ledger. Typically performed monthly, bank reconciliations will ensure that all items per the bank statement have been appropriately recorded in the general ledger.
Counting inventory can help to reduce both the risk of potential misappropriation of assets or theft as well as inaccurate inventory levels. Cyclical inventory counts reconciled back to perpetual inventory systems can uncover discrepancies between what the inventory system shows and what is actually on hand.
Access/Safeguards for assets
It might sound old fashion, but simple controls such as locking cheques, reducing access to warehouses, password protecting systems can go a long way. Restricting the access can safeguard both your tangible assets and information from theft and damage.
Segregation of duties
Segregation of duties is not so much a control, but rather a principle in designing controls. Dividing processes between people can be very effective in reducing misappropriation of assets and other fraud risks as well as detecting errors in processes and inaccurate information.
For example, different people should approve invoices, prepare cheques to pay the invoices, sign checks and reconcile the bank account. Not only does this reduce the risk of fraud, but it also places a series of checks and balances to ensure that all processes are being completed correctly.
Deloitte Information & Controls Assurance :
Having a financial plan can be one the most important functions for financial success. If you don’t have a financial plan of how your business will achieve success? A financial plan and budget will help you determine how much cash you have, how much you expect to spend, and how much you will need to bring in to ensure that you are meeting your business goals. Not only will it help you determine where you need to be, but often sitting down to actually create a budget will force you to examine your current situation, and identify unseen business insights, or risks before they sneak up and surprise you.
Setting a budget
There is no perfected method to forming a budget, depending on the business you’re in, the budgeting process and final budget might look very different. If your business is already in operation, one of the best resources for budgeting can be the historical information, which reiterates the important of accurate financial records. A good start might be to look at the revenues and expenses that your business is currently incurring. Are there any trends? What are the industry projections? Are you expecting to gain or lose any major customers?
Once you have determined your projected revenues you should be able to budget your cost of goods sold based on the cost of production/services. Consider if there will be increases in inputs such as materials or labour.
It is very important that you do not forget to consider other expenses. Be sure to be comprehensive, your budget should include all expenses: rent and other occupancy costs, administrative payroll and employment costs, interest on debt, income tax expenses. Which expenses you expect to continue? Are there expenses you expect to increase? Are there any expenses that you can cut?
If you are starting up a new business, you’ll obviously be forced to make more assumptions, but do your research. If you will need an office, find out how much that will cost per month. Research other local business. Are there similar products that you can use as a price point for determining revenues? Are there any specific expenses that you can observe that might provide additional insight into your costs? Use industry statistics as available, although no two businesses are the same, the environment they operate in might be identical. Research traffic patterns, perform customer surveys, do whatever you can to obtain as much information as possible.
Plans for growth
Upon setting an expected budget for the year, it is time to consider growth. This might be on an annual basis, but it might be over a much longer period. Regardless of the timeline, you should be considering your five year plan in the current budget. What capital expenditures might you have? Will you need to buy new equipment to facilitate the growth? Will you need any new computers, software, systems? Will you need to hire on additional staff? It is important that you plan for the costs related to growth or expansion. If you plan to grow revenue by 10% you should have a plan to ensure you will be able to finance and facilitate the growth.
Another important long term consideration is maintenance. Have you considered the costs of maintaining your current operation? Is there old machinery that will need to be replaced? Will you have the cash flows to purchase these assets? Have a plan for replacing key assets, at least the large ones, being crippled by the sudden loss of key equipment can sink a business very quickly.
Remember that despite you best estimate there will always be unforeseen circumstances. You should include some breathing room. Even though you may estimate that your business will maintain a certain growth, or that certain expenses may be contained or reduced, these numbers are not definite. Setting aside extra cash or being conservative in your estimates can save you when the unexpected occurs. Be careful not to be too aggressive with growth, be sure that you can maintain your business before you go buying new equipment, or hiring on new employees.
Reviewing budget throughout the year
Lastly, there is no point in setting a budget if just sits in a folder on your computer. Reference the budget throughout the year, communicate it to employees, and compare it to your actual results as often as possible. Although lots of large companies only set one budget a year, it may be very useful for you to revise your budget quarterly, or even monthly. As more facts present themselves, and your estimates turn to actuals, you may need to revise your strategy or goals for the year.