Why Does a Small Business Need Financial Statements?

A common question we receive from many owners of micro and small businesses is why do they need financial statements if their business is so small.

Another question asked by more in the know business owners is which financial statements should they request from their accountant.

Let us begin by clarifying what the 5 main financial statements are:

1. Statement of Financial Position (also referred to as a Balance Sheet)
2. Detailed income statement (or the Statement of Retained Earnings and Schedule of Expenses)
3. Statement of Changes in Equity or Members Interest
4. Statement of Cash Flows
5. Notes to the Financial Statements

It is a Legal Requirement to Prepare Financial Statements

 Irrespective of how small your business is, if the business is incorporated as a Company or Close Corporation (companies include non-profit companies and personal liability companies), there is a legal obligation to prepare accurate and complete financial statements within 6 months of the entity’s financial year end.  The law goes as far as to making it a criminal offence in terms of both the Companies Act and the Close Corporations Act should either type of these entity’s fail to comply.

The legislation further requires that the financial statements must conform with the prescribed standards, that is, it must satisfy the financial reporting standard required in terms of the Companies Act and Regulations.  The financial framework that must be used is relevant to the Public Interest Score (PIS) of the entity as well as whether the entity is owner managed or not. The legislated financial reporting frameworks are:

• IFRS (International Financial Reporting Standards)
• IFRS for SME’S (International Financial Reporting Standards for Small and Medium Enterprises)
• Tax / historical cost base (own financial reporting framework – framework is not legislated)

Furthermore, directors of Companies are required to prepare a director’s report each year that must accompany the financial statements.  This is not a requirement for Close Corporations’; however, the accounting officer’s report must accompany its financial statements.

Where financial statements are prepared by an external accountant of a Company, there are many compulsory documents that the accountant needs to prepare to support the legitimacy of those financial statements so as to comply with the Companies Act, and in addition, to comply with onerous international professional standards.  Accounting officers of close corporations on the other hand, although also subject to international standards, are not subject to as many burdensome requirements.

At the bare minimum, a Company is required to prepare all 5 financial statements together with extensive disclosure notes thereto in order to comply with the Companies Act and the appropriate financial reporting standard being adopted.

On the other hand, a Close Corporation is required to prepare only 4 of the financial statements as they are not required to report on its cashflows, however, it is highly recommended that they do as this is a useful report for the members.

Financial statements must also be submitted to SARS according to the Income Tax Act and the Tax Administration Act together with the entity’s income tax return.  The figures from the financial statements and the company’s profit disclosed in the income statement is subject to income tax and are used to complete the tax return that is submitted to SARS.

As can be concluded, the size of the business and its turnover is of no relevance, every company and close corporation are obliged to have financial statements prepared annually that must comply with all the provisions of legislation.  Our accountants at Business Accounting Network are proficient in all of the legal requirements for Companies, Close Corporations and income tax as well as with the different financial reporting standards and for that reason, are well placed to assist smaller and medium businesses who do not have a qualified in-house accountant.

Do Sole Proprietors and Partnerships Need to Prepare Financial Statements?

As sole proprietors fall outside of the ream of companies and close corporations’ they are only subject the Income Tax Act and the Tax Administration Act. As such, there is no legal requirement for sole proprietors or partnerships to have a full set of financial statements prepared.

Nonetheless, an income statement and a statement of personal assets and liabilities must be prepared annually which are used to prepare and submit your income tax return to SARS when it becomes due.  There are no financial reporting standards that apply to the income statement and statement of assets and liabilities that sole proprietors are required to prepare, meaning that it is a far less costly and complex task compared to companies.

On the flip side, banks, other finance houses and investors will not provide financing without financial statements.  This would mean that as a sole proprietor, if you do not have financial statements prepared annually, you would encounter difficulty in obtaining financing for say, a mortgage bond if you wish to buy property or financing if you wish to purchase a new motor vehicle.

Financial statements for sole proprietors are simple as there are no legal regulations surrounding them other than they should be accurate and complete and presented in accordance with generally accepted accounting practice, making financial statements far less costly for sole proprietors in business than their company counterparts in a similar or even smaller sized business.

Recommended financial statements for sole proprietors and partnerships are:

• Balance sheet (of the business’s assets and liabilities)
• Income statement (compulsory)
• Notes to the financial statements (minimal)
• Statement of personal assets and liabilities (compulsory)

Do Trusts and Non-Profit Organisations Need to Prepare Financial Statements?

The trustees are obliged to maintain detailed records of the trust’s properties held in their capacity as trustees in terms of the Property Trust Control Act.  The Trust Instrument (commonly known as the Trust Deed) would provide further information as to the extent of financial statements the trustees are obligated to prepare.

Furthermore, the income earned by trusts are subject to the Income Tax Act, and therefore, the trustees are required to prepare an income statement reflecting the profit of the trust as well as the distributions to its beneficiaries.  The income tax law surrounding trusts are quite complex that may require more detail of certain transactions to be disclosed to SARS.

The recommended financials statements that should be prepared for trusts are:

1. The balance sheet (compulsory – trust properties and trust capital or loans from the founder);
2. The income statement (compulsory) and disclosure of distributions to beneficiaries; (compulsory); and
3. Notes to the financial statements to disclose relevant information to the beneficiaries, for example, details of the trust properties held.

The constitution of a non-profit organisation determines the scope of the financial statements that members are obliged to prepare annually. Certain non-profit organisations may qualify to be exempt from paying income tax, whereas others may not.  Whether a non-profit organisation is exempt from paying tax or not, they need to submit an income tax return to SARS, together with an income statement reflecting the detailed nature of the income earned and its expenses on a similar basis to that of a sole proprietor.

To Wrap it Up

Although the level of financial statements that sole proprietors, trusts and non-profit organisations require are far less complex, onerous and time consuming than companies, the presentation of the statements nonetheless should be prepared in accordance with generally accepted accounting practice for both users of the statements as well as for the income tax returns for SARS.

How can BAN Help?

If all of this sounds daunting and overwhelming, look no further! Located nationally, our accountants at Business Accounting Network have the financial and tax expertise to provide these services on your behalf, giving you peace of mind!