Welcome to part two in this series. This part contains an introduction to Financial Reporting, and we will cover three areas. First, we will explain the difference between financial accounting and management accounting and the difference between financial statements and management accounts. Second, we will introduce the three primary financial statements being the income statement, the balance sheet, and the cash cashflow statement, and discuss the various alternative names by which they are referred to. And finally, we will explain the foundational accounting concept of accrual accounting, and the impact of this on financial reporting. 

To begin, as a director, you should expect to receive financial reports and updates from the management team throughout the year. It is helpful for directors to understand the different types of financial reports they will receive and their purpose. We will start by explaining the difference between financial accounting and management accounting, and then the difference between financial statements and management accounts. 

Financial accounting is the process of recording and summarising your organisation's financial transactions and reporting them in financial statements. These financial statements are prepared for external stakeholders, notably regulators such as the ACNC, shareholders or members of your organisation, government or private funding bodies, corporate sponsors, donors, creditors, and the general public. On the other hand, management accounting is the process of analysing and interpreting financial information and reporting them in management accounts. The audience for management accounts are the key internal stakeholders, being the board of directors and the management team. 

The purpose of external financial statements is to provide information about your organisation's financial position and performance in a way that is reliable, consistent, and transparent. The statements must be in a form that facilitates the easy comparison of your organisation's information, with that of other organisations, they're intended to assist external stakeholders to make informed decisions about your organisation. 

By contrast, the purpose of internal management accounts is to assist the directors and management team to monitor the organisation's operational and financial performance and to assist forward planning, decision-making and risk management. While external financial statements are prepared annually, internal management accounts are usually prepared monthly or quarterly, but can be weekly or ad hoc if required. Directors will typically see external financial statements once a year after the close of the organisation's financial year end, allowing time for the management team to prepare them and the auditors to audit them, where applicable. Internal management accounts are typically distributed to the board throughout the year with board papers ahead of scheduled board meetings. 

As we've discussed, a key purpose of external financial statements is to facilitate the easy comparison of information between entities. Consequently, the way the information is presented is standardised and the form and content of external financial statements must strictly follow the legal requirements in the ACNC Act, which includes compliance with Australian accounting standards. No variation from these requirements is permitted. You must follow the rules. 

External financial statements include the three primary financial statements, a statement of changes in equity, notes to the financial statements, and a responsible entity's declaration. We will discuss these further in later parts in this series. As these external financial statements are lodged annually with the ACNC, they are publicly and freely available via the ACNC website, and you can obtain examples of external financial statements from other organisations there. 

By comparison, there are no legal requirements as to the form and content of internal management accounts, and therefore it's up to the board to make clear to the management team the information that they require. Typically, internal management accounts contain a combination of financial and non-financial information, together with commentaries on variances and performance by the chief executive officer, the CEO, or the finance manager. They may include actual performance of the month and year to date, comparison to both the budget and the equivalent period in the previous year. They should also include a balance sheet and a cashflow statement. This is referred to as "look back" information. 

In addition to the "look back" information, they should ideally also include "look forward" information such as a four year forecast for the profit and loss, together with a cash flow forecast. If the organisation has a strategic plan, the internal management accounts may also include a dashboard for tracking key performance indicators such as audience attendance and numbers of donors, et cetera. Internal management accounts are confidential and therefore may contain a lot of granular operational and financial information. Though not lodged with a regulator, some public or private funding bodies may ask for summarised management information periodically as a condition of the funding being provided. 

We now turn to the three primary financial statements. The first of these is the income statement, which is sometimes called the statement of profit and loss, or the statement of profit and loss and other comprehensive income or the P and L for short. This shows the revenue and expenses and surplus or deficit over a specific period, for example, the financial year. The second statement is the balance sheet, which is sometimes called a statement of financial position or statement of assets and liabilities. This shows the organisation's assets, liabilities, and equity at a specific time. For example, the end of the financial year. The final statement is the cash flow statement, sometimes known as the statement of cash flows. This shows the inflows and outflows of cash during a period, for example, the financial year and the cash balance at the end of that period. 

An example of the three primary financial statements of a fictitious entity, Creative Arts Limited can be downloaded from the link in this video, and they will each be discussed in more detail in parts three, four, and five, later in the series. We now turn to a discussion of a key accounting concept: Accrual accounting. 

Accrual accounting is where income or expenses are recognised and recorded when they are earned or incurred, not when the cash is received or paid. For example, Creative Arts Limited has programmes printed and delivered on 29 June. The printer provides their invoice with the delivery, and it is paid by the company's finance team two weeks later. In this example, the expense will be recorded in June in the income statement, even though the payment was not made until July. 

The income statement and balance sheet are prepared on an accruals basis, but the cash flow statement is prepared on a cash basis. In other words, there's a timing difference between when the expense is recorded in the income statement versus when it is recorded in the cashflow statement. In the example we just discussed, as Creative Arts Limited has a 30 June end of financial year, it means that the printing expense would be recorded in the income statement in one financial year and recorded in the following year in the cashflow statement. 

To summarise the key learnings from this part of the series: First, financial statements are prepared annually for regulators and other external stakeholders. The form and content of financial statements must follow the requirements of the ACNC Act, which includes compliance with Australian accounting standards. You must follow the rules. By contrast, management accounts are prepared throughout the year and are used by the board and management to monitor the organisation's operational and financial performance and to assist forward planning, decision making and risk management. It's up to the board what information the management team includes in the management accounts. 

Second, the three primary financial statements are the income statement, the balance sheet, and the cashflow statement, and each of these will be discussed in depth in future parts in this series. Finally, accrual accounting is where income or expenses are recognised and recorded when they are earned or incurred, not when the cash is received or paid. The income statement and balance sheet are prepared on an accruals basis, but the cashflow statement is prepared on a cash basis.