Financial reporting is unglamorous. But it’s one of the most important business processes for accounting, compliance and financial planning and analysis.
Financial reporting helps businesses track where their money is coming from and where it has been spent. From an accurate record of financial transactions and key financial KPIs, like cash flow, businesses can conduct better long term strategic planning.
Financial reporting is also a valuable tool for investors and other external stakeholders because it gives them a clearer picture of a company’s financial health.
In this article we’ll take a look at how financial reporting works, and explain why it’s so important for the smooth running of a business.
What is financial reporting?
First let’s start off with the definition of financial reporting:
Financial reporting is the documentation of a business’s financial status through a core group of financial statements. This includes top-level financial information like revenue and operating costs, as well as non-financial assessments of other key business areas known as footnote disclosures.
In general, financial reporting is essential for three main groups of stakeholders:
- Internal teams (leadership, accounting, operations, etc.)
Internal teams look to financial reporting when conducting strategic planning and reviewing financial performance.
Investors look to financial reporting when assessing a business’s investability and general health.
- Regulatory bodies
Regulatory bodies, including auditors and tax authorities, use financial reports to ensure that businesses are declaring their finances in accordance with regulatory requirements.
Financial reporting takes place periodically at the end of each quarter and each financial year. Internal financial reporting happens more frequently, usually at the end of each month. Sticking to the same reporting periods allows for more accurate comparisons of financial performance over time.
Why is financial reporting important?
Financial reporting is essential for a number of different reasons.
Financial reporting is strictly regulated by central authorities in different countries around the world. Strict regulations ensure that businesses remain compliant with financial and legal regulations, and helps combat financial fraud. Failure to comply with accounting procedures can result in harsh penalties for businesses, auditors, and even individual executives.
Being able to understand, in detail, what is going on in a company in financial terms is essential for a variety of different internal teams. Companies can evaluate their real financial performance against their financial forecasts, and use the results to tune their strategy going forward. Financial reporting also helps businesses assess the performance of individual business units, and make alterations to budgets to improve excess spending, etc.
Financial reporting is essential for investors and other business partners. Financial reports are made public, which helps maintain a level of transparency in general financial conduct. Having ready access to detailed financial information helps investors hold businesses accountable, and helps uphold corporate responsibility.
Financial statements used in financial reporting
When companies release their financial reports, they contain four key documents. These documents are always prepared in the same order:
Profit and loss (P&L) statement
The profit and loss statement, also known as the income statement, is a summary of a company’s revenues, expenses and other costs over a reporting period. Using the P&L statement, companies can calculate their net profit.
P&L statements can be compiled using two different methods, the accrual method and the cash method. The difference between these methods is how and when revenue and expenses are accounted for. The cash method, which is typically used by smaller companies, only accounts for revenue and expenses when they have been paid. By comparison, the accrual method accounts for revenues and expenses when they are earned or incurred, e.g. when a contract is signed. In this sense the accrual method gives a more accurate representation of a company’s finances because it accounts for the cash a business expects to receive or pay out in the future.
Statement of retained earnings
After completing the P&L statement, businesses prepare a statement of retained earnings. It outlines how much money the business has retained, after shareholder dividends, for reinvestment and to cover various financial obligations.
Businesses may also issue a statement of owners’ equity, which outlines capital contributions or withdrawals by the business owner. Investors use these statements to assess how much money the business has retained for growth, and to understand the behaviour of the business owner.
Next businesses prepare a balance sheet. The balance sheet provides a snapshot of the company’s financial position at a specific point in time.
The balance sheet comprises three main components:
Assets are things that businesses own that hold value. They come in many different forms, including cash, property, copyrights, etc.
Liabilities are debts that businesses owe. They also come in many different forms, including mortgages, salaries, payroll tax etc.
- Shareholders’ equity
Shareholders’ equity includes a business’s retained earnings and any money that has been invested in the business by the owner.
These different components are balances by the following accounting equation:
Assets = Liabilities + Shareholders’ Equity
Cash flow statement
The final core financial reporting statement is the cash flow statement. It outlines cash flows into and out of the business, i.e. where a business is getting its money from, and where it is spending it.
In addition to the four documents listed above, businesses typically release a number of additional documents as part of their financial reporting:
Companies with different operating segments also issue segment reports which outline the financial performance of each segment. Business segments are classified as units within a company which generate revenue and incur costs separately from the business’s standard operations. Business segments are usually based in different countries or around different product lines.
Unlike most of the other statements included in financial reporting, footnote disclosures provide vital contextual information and commentary outside of pure numbers. This includes explanations for specific transactions or items on the company’s books, evaluations of risk, accounting policies, etc.
Management’s discussion and analysis (MD&A)
Management’s discussion and analysis is another important section of financial reporting. It provides commentary from top executives, like the CFO, about the results of the financial reports, as well as contextual information about business strategy.
Financial reporting requirements and regulations
Financial reporting relies on transparency and accuracy. Without regulations to uphold these principles, it’s easier for companies to ‘cook the books’ and lie about their finances. The most famous example of fraudulent financial reporting is Enron, a US energy giant which became the largest ever fraud-related bankruptcy back in 2001.
The Enron scandal was so damaging that it spurred congress to enact the Sarbanes-Oxley Act in 2002. This legislation introduced strict new regulation to combat fraudulent accounting practices, including:
- More detailed financial reporting requirements
- New conflict of interest rules for auditing companies and their clients
- Increased financial responsibility for top executives
- Stricter penalties for financial fraud, including larger corporate fines and longer maximum prison sentences
In the UK, financial reporting standards are promoted and regulated by the Financial Reporting Council.
All UK companies are required to adhere to certain guidelines when conducting their financial reporting. Smaller companies are legally obliged to comply with UK Generally Accepted Accounting Principles (UK GAAP). Meanwhile, any company listed on a public exchange must use the International Financial Reporting Standards (IFRS).
While UK GAAP is based upon the US GAAP standards, most countries and regulatory bodies are working to converge their local standards with IFRS in the future.
Managing finances with Moss
Moss’s spend management platform allows businesses to understand flows of money into and out of their business in great detail. Moss Insights draws data from all connected business accounts to build reports that allow businesses to understand how they spend their money.
Moss smart corporate cards allow businesses to delegate company funds easily and securely to anyone within their organisation. Moss’s virtual credit cards are fully software-controlled, meaning you can issue them with individual spend and usage limits. You can create an unlimited number of Moss virtual cards and then monitor each and every one in real-time through the Moss app.
Full integrations with popular accounting software like Xero and DATEV also allow you make use of better spend visibility throughout the entire accounting process.
Financial is the creation of periodical financial reports to summarise a business’s financial health.
Businesses release financial statements for compliance, transparency, investor relations, and to aid internal planning and strategy.
The key financial reporting statements are the profit and loss statement, the statement of retained earnings, the balance sheet and the cash flow statement.
Financial reporting is regulated by national regulatory bodies in each country. In the UK financial reporting is regulated by the Financial Reporting Council, and companies are required to adhere to UK GAAP or IFRS accounting standards.