Why Do Small Businesses Need Financial Statements?

There are few questions more shocking to an accountant than “Why do we need financial statements?” Years of specialization and familiarity lead most accountants to take the answer to this question for granted. Indeed, when asked this question, many accountants can only give a cursory answer that usually begins with muttering the phrase “performance measurement” and concludes with declaring small businesses need financial statements “because … well … they do.”

In our view “why does our small business need financial statements?” or in other words “why does our small business need your accounting services?” is the most basic and important question a prospective client can ask. We wanted to provide a more than cursory answer so here goes.

There are three reasons your small business needs financial statements:

The first reason your small business needs financial statements is the original: financial statements are the scorecard by which a business is measured. Since Venetian merchants first invented double entry bookkeeping in the 15th century, financial statements have been the means businesses use to gauge their own performance and communicate their past, present, and future prospects to stakeholders.

Investors and potential investors look to the financial statements to assess management’s stewardship of the company, the viability of the business, and as a starting point in forecasting future performance. Lenders and potential lenders look to the financial statements to assess a business’s ability to repay debt.

In the article “Information and the Cost of Capital” (pdf), David Easley and Maureen O’Hara found that accurate accounting information decreases the cost businesses have to pay for capital. In the case of capital from investors, the lower cost of capital would be in terms of expected return (investors willing to accept a lower return can afford to invest more money in your business). In the case of capital from lenders, the lower cost of capital would be in terms of lower interest.

This result is easy to understand. Outside parties can never understand your business on the same level you do. As such – to them – your business is riskier than it actually is, and they seek compensation for this risk by charging you higher rates for the use of their capital. While accurate, timely, financial statements can’t completely reduce this information risk, a proper scorecard can help bridge the gap and lower your cost of capital.

The second reason your small business needs financial statements is that you are expected to have financial statements. Due to the role that financial statements play in bridging the information gap, many lenders will not even consider a loan application without up to date financials.

Many of our clients have expressed the shock and anxiety they felt when their banker first asked for up to date financials. Getting a business off the ground is an overwhelming experience in and of itself without piling on reporting responsibilities, so this sense of shock is not unwarranted.

Unfortunately bankers are notoriously unsympathetic to the stresses put on entrepreneurs.

The third reason your small business needs financial statements is that, in order to file corporate tax returns, Canadian corporations are required to produce financial statements. If a T2 corporate tax return isn’t filed within three months of a corporation’s year end (assuming perfect compliance in the past, otherwise two months), interest on taxes owed begins to accrue. If the corporate tax return isn’t filed within six months of the year end, significant late filing penalties are also charged. In order to avoid these fees it is important to have financial statements prepared on, at least, a yearly basis.

Hopefully we’ve addressed the question about the need for financial statements in a more cogent manner than the theoretical accountant in the introduction to this post. To be fair to him, our answer isn’t that different from his, just a bit more fleshed out:

Performance measurement – The value of financial statements as a scorecard is two fold:

1. Financial statements provide an important gauge of performance that you can use to review the success of your small business.
2. Financial statements bridge the knowledge gap between you and the outside world, which in turn reduces your small business’s cost of capital.

Because … they … do – Two factors compel businesses to produce financial statements:

1. Potential investors and lenders expect financial statements.
2. Canadian corporations have to produce financial statements in order to file a corporate tax return.