Laws to Understand for Financial Reporting

Jun. 23, 2022

Business owners need to stay on top of everything, including sales, marketing, staff management, and funding. The ultimate goal is to ensure your company becomes profitable. 

It can be challenging to assess the financial health of your business even if you have masterful organizational skills. Financial reporting is extremely useful because it gives you clear insight into your financial position. More importantly, these reports are necessary to show the government, investors, or banks how the business is doing. 

Financial reporting takes time and requires an understanding of specific laws. We’ll talk about these regulations and standards, the purpose of these reports, and what to include in each. 

Financial Reporting: a Quick Overview 

Financial reporting is a documentation practice that communicates a company’s economic activities over a certain period. Most businesses issue these reports annually or quarterly and share them with stakeholders and financial institutions. Financial reports deliver organized accounting data and the company’s current financial status. 

Consider the following laws and standards before starting your company’s financial reporting.

Understanding Financial Reporting Standards

Unlike larger publicly traded companies, small businesses of any size are not legally required to abide by financial reporting laws. However, most creditors and investors still expect these reports.

Business owners should understand two financial reporting standards. These are the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).

Generally Accepted Accounting Principles (GAAP)

These accounting principles track the financial reports of public companies. The GAAP applies to companies based in the U.S. 

Nearly all financial institutions in the U.S. require businesses to submit GAAP-compliant accounting documents to reach debt agreements. It’s vital to understand GAAP if you plan to file for a business loan.

The Financial Accounting Standards Board (FASB), an independent non-profit organization established in 1973, created these accounting principles. The Securities and Exchange Commission (SEC) recognizes the board which has the authority to develop these standardized principles.

The FASB designed the GAAP to ensure a company’s financial statements are consistent, comparable, and complete. These rules allow investors to take away helpful information and make decisions based on these reports. Overall, there are ten principles of GAAP:

  • Principle of regularity
  • Principle of consistency
  • Principle of sincerity 
  • Principle of permanence of methods
  • Principle of non-compensation 
  • Principle of prudence
  • Principle of continuity 
  • Principle of materiality 
  • Principle of utmost good faith

Each principle covers a critical element of GAAP, but they all imply accuracy and full disclosure of data. 

The International Financial Reporting Standards (IFRS)

While the GAAP reporting standard only applies to companies located in the U.S., the IFRS offers a set of accounting rules for 166 worldwide jurisdictions. Essentially, the IFRS is an international equivalent to the GAAP, though there are some differences. 

It’s essential to understand this set of reporting standards as the FASB is working on converging the GAAP and IFRS. 

In 2007, the requirements changed for non-U.S. companies trading on the U.S. exchange. Up to that point, these companies had to reconcile their financial reports to reflect GAAP rules, but they can now rely on the IFRS. 

The General Data Protection Regulation (GDPR)

The GDPR came into effect in 2018 to protect the personal information of people named in a financial report. The financial data of investors, clients, and partners are considered highly sensitive information and need to be protected. Businesses are required to take steps to ensure compliance with the GDPR.

What is the Sarbanes-Oxley Act?

In 2002, the U.S. Congress passed the Sarbanes-Oxley Act to protect investors from fraud. This act bans corporations from issuing fraudulent financial reports and imposes strict regulations and penalties on companies that break the law. 

This legal reform was a direct response to the many instances of financial fraud involving publicly traded companies in the early 2000s. It aims to maximize corporate responsibility and deter fraudulent accounting under the threat of penalty. 

Types of Financial Reporting 

Business owners need to prepare financial reports to understand how their business performed over the past year or several months. If you’ve never had to create a financial report, you might not know what the process entails. There are four major components of every financial report; balance sheet, income statement, cash flow statement, and statement of changes in equity. 

Balance Sheet

The best way to understand a balance sheet is to view it as a snapshot of your company’s current worth. This statement combines liabilities and equity to create a comprehensive layout of the company’s assets. 

As the name implies, this document should be balanced, meaning that it’s vital to differentiate between long-term and short-term liabilities. Learning how to classify the assets in the balance sheet can save you future headaches. 

For example, suppose you list a long-term liability as a short-term liability. In that case, the balance sheet may indicate that the company needs to pay out a particular debt sooner than it actually needs to. That might suggest to your investors that the business is in a much worse state than it is. 

You’ll usually issue a balance sheet at the end of every fiscal year. It’s also crucial to lock in the balance sheet once you enter all the relevant data. This will help you avoid accidental entries that can cause problems. 

Income Statement

Another term for an income statement is the Profit and Loss statement. This report shows how much money you’ve earned and spent over a period. The income statement should contain every sale and operational expense domestically and abroad. 

The income statement aims to make profit numbers clear as day and allow room for potential adjustments. The content should be 100% accurate, as even the tiniest error can throw off the profitability outcomes. Same as other financial reports, an income statement can impact the process of filing for a loan or finding investors for your business. 

Cash Flow Statement

This report shows how much cash came in and out of a business over the fiscal year. The cash flow statement indicates whether a company has enough cash to make a payroll. 

Its structure is similar to the income statement, but it doesn’t include non-cash profits and losses. This portrays an accurate image of your company’s overall solvency and liquidity. 

When looking for new investors, a cash flow statement plays a significant role in guaranteeing that you can cover upcoming expenses and pay your staff. 

Statement of Changes in Equity

You’ll need to create a statement of changes in equity and a report that outlines any changes in the business owners’ equity. If there were no changes during the fiscal year, you’re not obligated to prepare this report. However, even the most minor differences should be noted, such as changes in dividends, withdrawal of capital, net loss, and the like. 

Why is Financial Reporting so Important?

Creating financial reports might not be exciting, but it’s a crucial aspect of every business. We’re not exaggerating the emphasis on accuracy, as a company’s future depends on these reports.

Here are a few reasons to consider and understand why financial reporting is vital for a business. 

Taxation Purposes 

Business taxes might be cumbersome, but they’re necessary. You can provide the Internal Revenue Service (IRS) with the information they need by issuing accurate financial statements. 

The IRS will determine how much you should be paying in taxes based on your business’s financial reports. If you ever start doubting how important business financial reporting is to the IRS, consider the emergence of auditing firms such as Deloitte and KPMG. 

Shareholders and Investors 

We’ve touched on this matter already, but it’s essential to reiterate it. Imagine wanting to invest in a company. You’re very unlikely to do so blindly. Instead, you’d want to see a complete financial report before deciding. This logical approach applies even if you’re on the other side — looking for investors. 

Credit vendors will ask for financial reports and make their decisions based on your information. The company’s shareholders also need regular updates, and these reports help fill in the blanks.

It’s easy to see why accuracy is so vital for financial reporting. Even minor embellishments can provide an unrealistic picture of a company’s well-being. It’s also precisely why the FASB created the financial reporting standards. They protect the shareholders and investors and force you to create reports that reflect reality. 

In-house Decision Making

Accurate financial reporting is the bedrock of any business. Without thorough balance sheets, income statements, cash flow statements, and statements of changes in equity, many companies run into trouble. 

These reports offer a solid foundation for management decisions as they provide all the relevant details and improve the internal company vision. These statements offer cohesive and detailed access to the company’s financial situation, and you can share them with management and employees when necessary.

Accurate Projection and Future Business Strategies 

It’s crucial to point out the predictive abilities of financial reports. You can notice trends and patterns by looking at comprehensive insight into a company’s overall financial health.

These metrics can help business owners and managers spot unexpectedly accurate projections and take specific actions. For example, a financial report can tell you if your company has been spending too much money on items that you aren’t utilizing or show you that there’s a historically underfunded department. Financial reporting can also give you a better idea of whether you should hire more employees or make cuts to save money.

Who is Responsible for Financial Reporting?

In most cases, managers handle the task of financial reporting. All the work involving generating accurate information and complying with legal standards falls on their shoulders. However, hiring a certified accounting firm is also an option if the task is too complex.

Financial Reports and Common Challenges

Yearly financial reports can turn into a daunting task for small business owners. Building these reports takes time — a resource many business owners don’t have. 

Business owners often choose to handle the financial reports by themselves as hiring an outside accounting firm can be pricey. But even if they can afford to do so, it takes time to find someone with the right experience and skills. 

Another problem is following legal standards and ensuring the statements comply with the law. If you’re unfamiliar with the principles governing these rules, you might accidentally make a mistake that can cost you later or get penalized. 

Tips for Making Exceptional Financial Reports

The financial reporting requirements can seem overwhelming if you’ve just started building your business. However, you’re likely to get the hang of it, especially if you consider these tips to help along the way:

  • Use one type of software or a single spreadsheet to avoid irregularities. 
  • Make detailed logs on purchases and cash inflow because every dollar counts.
  • Keep personal and business finances separate. 
  • Save a record of invoices you issue and receive.
  • Create a separate bank account for depositing your personal earnings from the company.

Building Your Business With Accurate Financial Reporting

Running your own business comes with many benefits, but you also have to deal with the mundane stuff. Creating financial reports should be a priority, not just a nuisance. 

It can be easier to see the big picture when you lay out all the relevant financial data. But don’t forget that it’s crucial to stay compliant with GAAP or IFRS. You also need to protect the individuals mentioned in the financial report to comply with the GDPR.

You can make financial reporting much easier by relying on Swyft Books, a robust financial reporting tool. Start a free trial today and upgrade your business in no time.