Annual financial state­ments – an overview of the financial year

Is your company a success or failure? Annual financial state­ments show a company’s financial position over the span of the fiscal year. Es­tab­lish­ing your business’s finances is important for you, and to make sure you are complying with tax laws. A precise as­sess­ment of your financial situation is also important in­for­ma­tion for en­tre­pre­neurs when un­der­tak­ing future planning. Here we explain exactly what the ac­count­ing term means, and what preparing annual financial state­ments should look like.

Annual financial state­ments are regulated by the Internal Revenue System (IRS) and the U.S. Se­cu­ri­ties and Exchange Com­mis­sion (SEC). The aim of creating a financial statement is to compile and process in­for­ma­tion on a company’s economic situation. There are two goals:

1. In­for­ma­tion about the results of op­er­a­tions, financial position, and cash flows of an or­ga­ni­za­tion
2. This in­for­ma­tion is used to estimate the liquidity, funding, and debt position of an entity, and is the basis for a number of liquidity ratios

Annual financial state­ments are required for the public (if you have a publicly traded company) and for taxation au­thor­i­ties, as they may use your financial state­ments in their tax as­sess­ments. Annual financial state­ments show how high a company’s profits or losses are and can be then used to calculate income tax.

The primary aim of a financial statement for publicly traded companies, however, is to inform share­hold­ers and the public. Annual financial state­ments are filed as part of your company’s annual report. Financial state­ments for a public company must be made available to anyone who requests access, and must be filed quarterly with the SEC. You are also required to file an annual report with the Secretary of State in each state in which you operate. In­ter­est­ed parties, like share­hold­ers or potential investors, can use this in­for­ma­tion to assess how secure their in­vest­ments are, or would be, in the company.

Public company owners are required to file annual financial reports in the state where their business was formed, and again in every state in which their company operates. Deadlines are usually based around the date that your company was created; the filing re­quire­ment begins a year after formation and continues until the company is dissolved. However, there are some states that set their own annual deadlines, and things can quickly become confusing if you are a business owner operating in numerous states. Con­sult­ing a tax pro­fes­sion­al is the best way to ensure that you are legally complying with all your state deadlines.

Annual financial state­ments are also important for internal com­mu­ni­ca­tion. An overview of a company’s financial situation means that there is ac­count­abil­i­ty. Man­age­ment is obliged to prove how and to what extent capital has been used. The different groups involved in a company (share­hold­ers, investors, etc.) can measure the success or failure of their man­age­ment by this. That is why the detailed listing of all items in the balance sheet and income statement (the two main com­po­nents of annual financial state­ments) is so important. The result isn’t the only thing that counts: a bad business appraisal does not nec­es­sar­i­ly mean that those re­spon­si­ble have done a bad job. Only an in depth look at the exact figures can reveal where the errors lie.

As pre­vi­ous­ly mentioned, all publicly traded companies are required to prepare and publish annual reports including financial state­ments. Despite there being no legal oblig­a­tions for private companies or sole traders to do so, it is often helpful for their own as­sess­ments to prepare financial state­ments.

As well as publicly traded companies, LLCs and cor­po­ra­tions are required to file annual financial reports to their Secretary of State. It is important to find out what the state reg­u­la­tions are in each state your business operates, as many of these have different rules.

Your profit and loss account reveals the economic successes or failures of your company, which is why this statement is also called an income statement. In this cost estimate, you offset income against expenses but list all items in detail. In this way, it is easy for third parties to trace which com­po­nents have led to profit or loss.

The balance sheet lays out the ending balances in a company's asset, liability, and equity accounts as of the date stated on the report. As such, this statement has both an asset and a liability element. The basis for the balance sheet is the trial balance where all ledger accounts are listed according to closing value. Finally, all quantity in­for­ma­tion is omitted from the balance sheet and only monetary value plays a role. At the end, a balanced equation must be clear, both sides must have the same value i.e. total assets must equal the total li­a­bil­i­ties plus the equity. Equity is composed of capital, ad­di­tion­al paid-in capital, and retained earnings (profit from previous years).

While not a legal oblig­a­tion, it is common practice for companies that submit annual financial state­ments to include ad­di­tion­al notes. These notes provide further in­for­ma­tion on the contents of the balance sheet and income statement, ful­fill­ing four functions:

• In­ter­pre­ta­tion: These notes provide in­for­ma­tion that explains the balance sheet and income statement in more detail. Results can be in­ter­pret­ed better when the methods used are explained clearly.
• Clarity: To ensure that the results of the balance sheet and income statement are not mis­un­der­stood, ad­di­tion­al notes can provide clar­i­fy­ing in­for­ma­tion. A mis­un­der­stand­ing can occur if an in­ac­cu­rate financial picture is painted, and following clear guide­lines can ensure that there is no confusion. This applies to both positive and negative cir­cum­stances.
• Credit: To keep the balance sheet and income statement clear, certain data is sometimes removed or omitted. In order to make sure that in­ter­est­ed parties can still obtain an accurate, com­pre­hen­sive picture of the current economic climate within a company, trans­fer­ring missing in­for­ma­tion to the appendix notes is an option.
• Additions: Ad­di­tion­al notes can also be used if in­for­ma­tion from the balance sheet and income statement is in­suf­fi­cient to present an accurate picture. Dis­clo­sures relating to items not eligible for inclusion in the balance sheet may be moved to the appendix notes.

Balance sheet policies can also be used to present the company. Leg­is­la­tion only has minimum in­for­ma­tion re­quire­ments, but in no way does it prohibit ad­di­tion­al in­for­ma­tion. Any statement that better explains the financial situation of a company is welcomed by the au­thor­i­ties – provided that the prin­ci­ples of clarity and coherence are adhered to.

Although there is no mandatory sequence of entries, certain struc­tures have become es­tab­lished in financial ac­count­ing. Your approach to the balance sheet and income statement should start with general in­for­ma­tion. Which methods did you use? This is followed by ex­pla­na­tions of the annual financial statement’s two main com­po­nents. Entries should, however, appear in the same sequence on both the balance sheet and the income statement. You can then add any other in­for­ma­tion to your notes that is not included in the first two cat­e­gories.

Of­ten­times, companies will include a man­age­ment report with their annual financial state­ments to help better assess a company’s future de­vel­op­ment. This man­age­ment report puts words behind the numbers provided in the income statement and balance sheet. The function of an operation review is ul­ti­mate­ly to provide in­for­ma­tion and ac­count­abil­i­ty.

In contrast to the financial state­ments, which focuses more on pre­sent­ing data and figures, man­age­ment reports are used for analysis and com­men­tary. If your annual report is being published and dis­trib­uted to share­hold­ers, aspects of the op­er­a­tions review will likely be touched on in the initial letter from the Chief Executive Officer (CEO). Man­age­ment reports often include the following aspects:

• Economic report: This section is intended to present the course of business taken during the financial year and the company’s position. Man­age­ment can use this as an op­por­tu­ni­ty to express their view of the year’s financial results and the situation on the reporting date. The market share, as well as in­vest­ment products, pending trans­ac­tions or pro­duc­tiv­i­ty are taken into account.
• Risk and forecast report: This part of the report presents the expected de­vel­op­ment of the company – but not without sub­stan­ti­at­ing it first with un­der­ly­ing as­sump­tions. Planned ini­tia­tives will also be addressed. Third parties should be able to assess the plau­si­bil­i­ty of the in­for­ma­tion and comments. The forecast should cover at least one year.
• Report on financial risks: The report provides in­for­ma­tion on risk man­age­ment measures. Potential financial risks for the company are also discussed here.
• Research and de­vel­op­ment plans: The in­for­ma­tion in this part of the op­er­a­tions report provides an overview of the company’s research and de­vel­op­ment ac­tiv­i­ties. Although this area can be rep­re­sent­ed by the expenses incurred, the expected profit can only be estimated. Planned research ini­tia­tives in the future are also included in this section of the report.
• Branch office report: If your company has multiple branches or offices around the country or abroad, it may be worth including their in­for­ma­tion if they are organized sep­a­rate­ly from head office. Including this in a report can provide an insight into the ge­o­graph­i­cal spread of the company and might include in­for­ma­tion about in­vest­ments and employee numbers in these branches.
• Re­mu­ner­a­tion report: This report is intended to provide trans­paren­cy for share­hold­ers and as a result, is only relevant for publicly traded companies making this in­for­ma­tion public. It provides in­for­ma­tion on the re­mu­ner­a­tion of the Executive Board, the Su­per­vi­so­ry Board, the Advisory Board, and their former members.
• Report on a takeover situation: Publicly listed companies and part­ner­ships limited by shares must provide potential bidders with an overview of any possible takeover. Obstacles like re­stric­tions on voting rights and powers of the Board of Man­age­ment are also addressed.
• Internal control and risk man­age­ment: This section clarifies which methods are used to safeguard ac­count­ing. The report is only relevant for cor­po­ra­tions.
• Directors, Executive Officers and Corporate Gov­er­nance: The text is intended to provide an insight into corporate man­age­ment practices. This consists of a de­scrip­tion of, in­for­ma­tion on practices that go beyond the legal re­quire­ments and – in the case of public limited companies – in­for­ma­tion on diversity in bodies. In contrast to the rest of the man­age­ment report, there is no need to audit a corporate gov­er­nance statement. The auditor just has a critical-reading oblig­a­tion to check the document for in­con­sis­ten­cies.

This statement, also known in­ter­na­tion­al­ly as the statement of changes in equity, is an integral part of the annual financial state­ments for capital market-oriented cor­po­ra­tions that are not required to prepare con­sol­i­dat­ed financial state­ments. The aim of the statement of retained earnings is to reflect changes in equity – and in all its com­po­nents – between two balance sheet dates. All changes (i.e., not just successes) in the company should be listed. State­ments of retained earnings uses the contents of the income statement to provide context for the balance sheet. State­ments of retained earnings are required under the U.S Generally Accepted Ac­count­ing Prin­ci­pals (U.S GAAP) in cases when com­par­a­tive balance sheets and income state­ments are provided together. While there is no reg­u­la­tion under com­mer­cial law for how this document should be struc­tured, they generally include the following items:

• Issued capital
• Capital reserve
• Retained earnings
• Reval­u­a­tion reserves
• Retained earnings
• Annual profit

This in­for­ma­tion is ac­cu­mu­lat­ed on the basis of values from the previous years’ key date and shows all events from there that have led to changes. At the end, the figures of the last key date should be displayed. This results in a clear table that includes all changes in equity.

A complete financial statement also includes a cash flow statement. Even if you, as an en­tre­pre­neur, are not required to prepare a cash flow statement, it is still rec­om­mend­ed that you do so: the aim of the cal­cu­la­tion is to show the cash flows between two reporting dates. For example, a cash flow statement provides in­for­ma­tion on the movements of all funds affecting liquidity and provides more in­for­ma­tion on the flow of money within a company than the annual financial state­ments with the balance sheet, income statement and notes can.

The cash flow statement is divided into three totals:

• Cash flow from operating ac­tiv­i­ties
• Cash flow from investing ac­tiv­i­ties
• Cash flow from financing ac­tiv­i­ties

The cash flow can be cal­cu­lat­ed using two different methods, the direct method and the indirect method.

The original or direct method of cash inflows and outflows is based on the cash flows directly in the re­spec­tive business trans­ac­tions. This means that you can calculate the cash flow statement directly from all incoming and outgoing payments – the balance results in the cash flow statement. In this case, the items are marked according to their purpose:

Using this method, the in­for­ma­tion for the cash flow statement is de­ter­mined from the annual financial state­ments. To do this, you first adjust the income statement for all non-cash business trans­ac­tions (like de­pre­ci­a­tion). Only the first part of the cash flow statement (cash flow from operating ac­tiv­i­ties) changes as a result: cash flows from investing and financing ac­tiv­i­ties are generally de­ter­mined directly.

The aim of segment reporting is to provide in­for­ma­tion on the in­di­vid­ual business segments of a company. This enables third parties to gain a better insight into the areas and therefore better assess the op­por­tu­ni­ties and risks of in­vest­ment than is possible with the data from the income statement and balance sheet alone. Complete segment reporting is only mandatory for publicly traded companies that are required to prepare financial state­ments.

The in­di­vid­ual segments result from the internal or­ga­ni­za­tion­al structure of the company. If there are different internal segments, the company has to choose the one that best rep­re­sents the op­por­tu­ni­ties and risks. The In­ter­na­tion­al Financial Reporting Standards (IFRS) 8 require an entity whose debt or equity se­cu­ri­ties are publicly traded to disclose in­for­ma­tion to enable users of its financial state­ments to evaluate the nature and financial effects of the different business ac­tiv­i­ties in which it engages and the different economic en­vi­ron­ments in which it operates. IFRS 8 requires judgement in its ap­pli­ca­tion. Man­age­ment should consider the key principle as it de­ter­mines its segment dis­clo­sures rather than relying on a set of rules. The key concept is that the entity should provide in­for­ma­tion used by man­age­ment that will allow users to un­der­stand the entity’s main ac­tiv­i­ties, where those ac­tiv­i­ties are located and how well those ac­tiv­i­ties are per­form­ing.

Segments whose op­por­tu­ni­ties and risks behave ho­moge­nous­ly towards each other can be combined. The reason for this is that it is rec­om­mend­ed to only list 10 segments in total in the report. The aim is to keep segment reporting as clear as possible and still provide a com­pre­hen­sive picture of the company. It is easy to dif­fer­en­ti­ate between a primary and secondary reporting format, since segments are created once by a business sector and once re­gion­al­ly. The accrual/deferral type, which better rep­re­sents the op­por­tu­ni­ties and risks, is au­to­mat­i­cal­ly assigned to the primary reporting format. If this cannot be clearly de­ter­mined, business segments are generally primary and regions are generally secondary segments.

• General in­for­ma­tion
• In­for­ma­tion about the re­portable segment; profit or loss, revenue, expenses, assets, li­a­bil­i­ties, and the basis of mea­sure­ment
• Rec­on­cil­i­a­tions
• Entity-wide dis­clo­sures

While there is no set way to present your segment report, one of the most popular ways is in tabular form. You don’t just enter the current values, but also the previous year’s values, so that third parties can get the most com­pre­hen­sive im­pres­sion possible. Following the principle of con­sis­ten­cy, you should choose the same display format in each period. Since you have to ac­com­mo­date for both report formats, choose either the single-level or com­bi­na­to­r­i­al type.

In single level seg­men­ta­tion, the primary and secondary report formats are listed one below the other:

The com­bi­na­to­r­i­al display form, on the other hand, links the two seg­men­ta­tions and displays them in a matrix:

An annual financial statement always consists of at least a balance sheet and a profit and loss statement. In addition, the Generally Accepted Ac­count­ing Prin­ci­ples (GAAP) should be followed. These are generally accepted rules that apply not only when you are preparing annual financial state­ments, but also in general ac­count­ing. It must be possible for an in­de­pen­dent third party to un­der­stand the in­for­ma­tion provided.

Pay attention to these rules when preparing your annual financial state­ments:

• Reliable, ver­i­fi­able, and objective: For example, showing land at its original cost of $10,000 (when it was purchased 50 years ago) is con­sid­ered to be more reliable, ver­i­fi­able, and objective than showing it at its current market value of $250,000. Eight different ac­coun­tants will wholly agree that the original cost of the land was $10,000 – they can read the offer and ac­cep­tance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same eight ac­coun­tants to give you the land's current value, you will likely receive eight different estimates. Because the current value amount is less reliable, less ver­i­fi­able, and less objective than the original cost, the original cost is used.
• Con­sis­ten­cy: You use con­sis­ten­cy to make it easier to compare the financial state­ments of different periods. To do this, you use the same terms and schemas each year when creating financial state­ments. The type, value and quantity de­ter­mi­na­tion for in­di­vid­ual items should also remain the same year after year.
• Com­pa­ra­bil­i­ty: Investors, lenders, and other users of financial state­ments expect that financial state­ments of one company can be compared to the financial state­ments of another company in the same industry.

Miller Cor­po­ra­tion

Miller City

Annual financial state­ments for the financial year from 01.01.2018 to 12.31.2018

Balance

Assets

Li­a­bil­i­ties and owner’s equity

Profit and loss account

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