Understanding the Different Types of Financial Statements
The accounting profession in the US works by several standards of rules or standards. One of them is called, “Generally Accepted Accounting Principles,” or (GAAP) for short. These rules are agreed upon by a governing organization made up of CPAs and accounting scholars. The purpose is so that all financial statements and accounting treatment follow the same set of rules. It is critical that your financial statements reflect GAAP standards and while there are thousands of esoteric rules in the list of (GAAP) rules, there are only about 20 or so that the average small business owner needs to worry about.
Today I am going to discuss the various “levels” of financial statement quality a company may use.
Internally Prepared: A company that does its own books and prepares its interim and annual financial statements itself may accurately follow most (GAAP) rules. The internal member of management preparing the financial statements may even be a CPA, but because these financial statements are internally prepared they are considered the “lowest” quality of financial statements in the hierarchy of (GAAP). For small businesses, and businesses with sophisticated internal accounting professionals, this may be the highest grade of financial statement a company needs.
Compiled: Compiled financial statements are prepared by a Certified Public Accountant (CPA). The CPA prepares these statements with information provided to them by the business client. They prepare them mostly in accordance with (GAAP), but not all (GAAP) rules are precisely followed. For example, a compilation doesn’t normally include footnotes explaining deviations from (GAAP), but it is still a very good idea to do so. Because the accountant isn’t examining every transaction, they cannot provide an assurance that the statements are accurate and complying with the rules of (GAAP). Banks and other lenders generally consider compiled statements of greater value than internally prepared statements, but not by much.
Reviewed: Reviewed financial statements are one step up from compilations. In addition to the steps performed in a compilation, a CPA performing a review will seek a more in depth understanding of the client’s business and financial information through inquiries and analytical procedures. These added procedures are performed in an effort to obtain a basis for reporting whether or not the statements are free from any material modifications that need to be made in order for the statements to be in compliance with generally accepted accounting principles (GAAP). Since the accounting firm does more work in examining the financial condition of the company, reviewed statements are more expensive than compiled statements. Lenders generally feel substantially more comfortable with a review than a compilation.
Audited Statements: An audited financial statement is the highest level of financial statement an accountant can prepare. All publically held companies are required to have audited statements by the Securities and Exchange Commission. Many private companies with numerous shareholders often obtain audited statements and if your business is of decent size and you are thinking about selling it during the next 3 or so years, having an a set of audited financial statements might make sense (and actually increase the value of the enterprise). Audited financial statements are also required by some third parties whom your business works with. For example, the Small Business Administration (SBA) requires audited financial statements from participants in its 8 (a) program when the company gets a certain size. For private companies taking their stock public, the various stock exchanges require at least 3 years of audited financial statements.
An audit provides assurance, through the expression of an “opinion” in the “Auditor’s Report,” as to whether or not the financial statements are presented in accordance with generally accepted accounting principles (GAAP). Audits require considerable time and work on the part of the auditor and can be quite expensive. Not all accounting firms do audits and those that do must be peer reviewed annually, to insure that the quality of the audit meets accounting standards.
Occasionally, a lender will require a loan covenant that the business borrower begins preparing reviewed or audited financial statements. Nearly all lenders will allow internally prepared interim financial statements.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
You may contact Sam directly at: sam@lesliethacker.com
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