External accounting reports are created by companies in order to show the outside world business information that is important to shareholders, investors and other financial institutions. Depending on the size of the company and industry the external reports may look similar to the internal accounting reports or they could be a night and day difference. Really the only thing that matters for external financial statements is that they are understandable, complete and give an accurate overview of the businesses financial condition.
Internal Accounting Reports
Business owners and directors have the flexibility to handle their internal accounting the best way they seem fit. Internal financial statements are created for managers to be able to successfully run the business. Internal reports will use cash-basis accounting so revenue would be marked only when cash comes in and expenses are only calculated when cash goes out.
External Accounting Reports
Investors and shareholders do not need to know about late payments or backdated expenses so that is where the external accounting report comes in. These reports are created with a specific set of rules so any outsider with a basic understanding of business will be able follow. External reports will use accrual-basis accounting so revenue would be marked the exactly when it was earned and expenses are calculated as soon as they are incurred, not when they are paid.
How to Create External Accounting Reports
Generally Accepted Accounting Principles (GAAP) are the collective rules that govern the external financial statement reporting for companies in the United States. The Financial Accounting Standards Board (FASB) is the industry body designated by the U.S. government that sets and controls these rules.
By having companies all adhere to the same common standard reporting, the GAAP ensures that investors are able to see an accurate picture of a company’s finances. Outside observers only see external accounting reports which do not contain too many details about a company’s internal operations. GAAP compliant financial statements are needed anytime a business solicits investors, potential business partners or looks for business loans from banks.
Five General Purpose External Financial Statements
- Balance Sheet. This is the critical statement that covers everything a company owns and what it owes. This represents the company’s assets like cash, equipment and accounts receivable. Also included is the liabilities like loans and the account payables. Once these two numbers are calculated then the remaining difference is the company’s equity. The balance sheet presents a picture of where the company is at that point in time using these three things: assets, liabilities and equity.
- Income Statements. Also known as profit and loss statement this will contain a summary of the revenues, gains, expenses, losses, and net income or net loss. This shows a moving picture of what a company is doing and how they performed during that period of time.
- Cash Flow Statements. Used for informing investors and shareholders about the solvency of the business and what cash is being spent on along with where cash is being received from. The cash flow statement shows all the sources and uses of cash during that period of time.
- Statement of Changes in Shareholder Equity. The financial statement that shows the changes in owners or shareholders equity during that period of time. Using the businesses total assets minus the liabilities, this statement shows how the company’s total net assets translate into each owner’s stake.
- Statement of Retained Earnings. This report measures the amount of assets that were generated by profitable activities and retained in the business. These are the assets that were not paid out to shareholders as dividends and have been reinvested into the company. This number is usually negative for startup or companies in the early stages since it takes time to build a business and become profitable.
Bottom Line
The net profit or loss (income statement) is usually the bottom line of any financial statement and receives the most attention. If shareholders do not understand the other reports and line items then net profit or loss will mean very little to them. No experienced investor or financial advisor is going to make a major decision on whether a company is a good investment solely based off of their net profit or loss statement.
These external accounting reports are key to analyzing the company’s performance and financial condition. To track the bottom line accurately owners and investors will need to fully understand the five general external financial statements: balance sheets, income statements, cash flow statements, change in equity statement and retained earnings statements.