THE IMPORTANCE OF ANNUAL FINANCIAL STATEMENTS
This article is mainly aimed at directors of SME’s who require guidance in respect of Annual Financial Statements and accounting requirements for their company, as well as direction to achieve compliance in respect of the accounting regulations in South Africa.
Whilst assisting many clients we have noted that many small business owners only tend to finalize their Annual Financial Statements (AFS) when they require funding from banks, obtaining tenders or attaining clearance certificates from SARS. Furthermore, there seems to be some difficulty experienced by small business owners in applying certain provisions of the accounting regulations in respect of drawing up their Annual Financial Statements (AFS) either from the Company’s Act or the accounting framework being IFRS for SMEs.
This article will therefore explore these key issues in respect of Annual Financial Statements (AFS), as well as some of the key statutory & regulatory accounting requirements for SMEs.
The above-mentioned reasons finalizing your Annual Financial Statements should not be the only drivers for motivating owners to draw up their annual financial statements for their business. The reason being is that there are various statutory provisions which makes it mandatory for owners to draft their financial statements annually, as well as positive managerial decisions & benefits that could possibly stem from the result of deep analysis of the Annual Financial Statements. Provided that this can only be performed if the financial statements are comparable, understandable, timely, verifiable, faithfully represented & relevant in terms of the framework.
The Objective of Financial Statements in respect of Financial Reporting
In terms of the Conceptual Framework, the objective of Financial Statements is to provide financial information about the reporting entity that is useful to users of financial statements in making decisions about providing resources to the entity.
This should be one of the key drivers that should motivate owners to draw up their financial statements. This statement also elaborates on the fact that financial statements can be used to provide useful financial reporting information which will be used for decision making of the company.
The following are more common instances where Annual Financial Statements will be required:
- Applying for financing from banks (Banks usually review the solvency & liquidity position of the business amongst other factors) - Determining your normal tax liability for SARS - Applying for tenders & contracts (Businesses would want to evaluate your company before granting you a possible contract or tender) - Mergers & Acquisitions (Businesses would evaluate your financial performance & position before attempting to merge with you, a possible due diligence could arise from these scenarios) - NPO’s (To possibly apply for funding from investors) - Complying with CIPC and the Companies Act of South Africa. - Conversion to iXBRL Annual Financial Statements - Making critical managerial decisions regarding the future growth of the company.
Overall there are more positives in respect of drawing up Annual Financial. So, the question arises, why are businesses not drawing up their Annual Financial Statements on time? Is it due to limited benefits (which seems to be unlikely as highlighted above) or is there another reason perhaps? For most small business owners, this possible reason seems to be the potential cost that’s involved that ultimately affects this decision.
Preparation of Financial Statements
In respect of bookkeeping costs, there has been multiple technological updates in recent times which has streamlined the accounting process from the days when everything had to be drawn up manually to now, where there are cloud based systems which are being utilized, where you can monitor your business in real time. These accounting advances are continuously changing the spectrum of general bookkeeping and being introduced at relatively affordable rates, which may serve useful to a small business owner who is new to the market and wants to get to grips with accounting. However, there are limitations with most accounting bookkeeping software’s such as the inability to generate a ‘’Full Set’’ of Annual Financial Statements. It is possible to probably generate a standard income statement & balance sheet for decision making purposes, but this is not a full set of Annual Financial Statements as defined per the accounting framework or the Company’s Act. Ideally the financial statements should be prepared using a specialised software or tool in respect of applying the appropriate accounting framework for your company. A business owner could ideally outsource the preparation of the Annual Financial Statements to a 3rd party for independence, the fees of which are determined based on the level of skill and time required to complete the Annual Financial Statements.
Documents required for the preparation of the Annual Financial Statements
For most SME’s the main documents required would be the following below, as well as other financial reporting schedules for the entire accounting period (Financial Year):
1. Customer Invoices & Statements 2. Supplier Invoices & Statements 3. Bank Statements 4. Any other useful financial reporting information that’s relevant example Fixed Asset Schedules
These documents should be the key documents used when preparing your accounting records which is used to draw up your trial balance at year end for preparation of the Financial Statements. Per the Companies Act Section 30, a company’s financial statements has to be prepared 6 months after the year end, therefore for each financial year since the company was incorporated, there should be a set of Annual Financial Statements (AFS).
A situation could arise where a regulatory entity may request the latest set of financial statements, but the business has not prepared financial statements say for the last 5 Years but you only require the latest year. In this situation, unfortunately there is no shortcut and 5 Years’ worth of financial statements would need to be prepared. This is due to the effect of opening retained earnings on each of the ensuing years as well as correctly bringing forward all prior year balances for each of the financial years to ensure each financial year is stated correctly as well as the previous years have been closed off.
In addition, there is a compounding tax effect which has to be considered for the prior years which will have an effect on the current year which has to be brought forward correctly. Therefore, it is extremely imperative to ensure your Annual Financial Statements are prepared timeously to ensure financial statements are readily available when necessary.
Companies Act Requirements
In terms of the Companies Act of South Africa, there are three major sections dealing with Annual Financial Statements, which are sections 28,29 & 30.
These are some of the key points highlighted below which have been extracted from these sections:
In terms of Section 29, the financial statements must satisfy the reporting standards, not be false, misleading or incomplete. This is vital as small business owners need to ensure the correct financial reporting framework is applied and a full set of financial statements are presented in line with IFRS for SMEs.
The Companies Act assists with implementation thereof and states in regulation 27 the types of frameworks that your business will qualify for depending on the entity and its public interest score. Now for most small business owners, this should essentially be IFRS For SMEs unless the contrary applies per regulation 27.
In terms of Section 30, the Companies Act also provides further information on the various types of companies that are required to be audited and certain information which must be disclosed on the Financial Statements (E.g. Directors Remuneration), which is also in line with IAS24.
It is also important to note the companies ‘’public interest score’’ will need to be calculated in order to determine if your Financial Statements follow the appropriate framework as well as if the Financial Statements has to be audited. This will depend on the type of entity and whether the Annual Financial Statements were internally or externally compiled. Regulation 26 & 28 should be read in conjunction with Section 30 for more understanding.
We have noticed some difficulty in interpreting these provisions from certain business owners and due to this some owners have been unsure whether their financials are in accordance with the relevant framework or in line with the Companies Act. It should be noted that this is also a CIPC requirement. As CIPC requires that your Annual Financial Statements must be prepared within 6 months after the financial year end which is in line with Section 30(1) of the Companies Act.
For some small business owners there is also a possibility of the business being insolvent and running the risk of reckless trading as envisioned in section 22 of the Company’s Act. Per section 22 the solvency and liquidity should be continuously monitored. If the Annual Financial Statements are not up to date or there is not up to date record of the assets and liabilities, there is a possibility that the company could be trading recklessly and be in contravention of the Companies Act. Common situations like this can occur when the directors incurs too much of their own funds for business purposes thus creating a liability which the business owes to the directors, which in turn causes the business to possibly be in a net liability position.
Deferred Tax Effects in respect of Assessed Losses
During the early years of a company’s lifespan, it is also probable the business would have incurred start-up losses in order to get a foothold in the market. I have highlighted this due to the assessed loss that could possibly arise from each of those years which would possibly reduce your normal tax liability in the future once you have generated enough taxable earnings. Further, this also has a deferred tax effect in terms of IAS12 which allows a corresponding Deferred Tax asset to be recognized if it is considered probable that the entity will generate taxable income in the future which the deferred tax asset (Assessed Loss) can be applied against. This has an important effect on the Financial Statements. There appears to be several small business owners either do not know how to account for this or are unsure in the timing of the recognition hence this is not considered for the financial statements.
The Annual Financial statements are also required for conversion to the new iXBRL format provided your company qualifies for the XBRL requirements as determined by CIPC. Find out more about Extensible Business Reporting Language (XBRL).