Real estate accounting: A clear and

simple guide for 2022

Written by Jeff Rohde

Last updated on December 15, 2021

Real estate accounting is an essential part of owning and operating rental property.
While accounting is probably one of the least favorite tasks that most investors want
to do, good accounting can help keep property profits higher by accurately tracking
income, expenses, and tax deductions.

 
Key takeaways
  Bookkeeping and accounting in real estate describe two different things.
 Benefits of good real estate accounting include improved cash flow, accurate
tracking of income and expenses, and being prepared for a tax audit.
 Basic steps in setting up a real estate accounting system include creating a chart
of accounts, separating business transactions from personal funds, and keeping
documents and receipts organized.

 
 

Bookkeeping vs. accounting

Although many people use the words bookkeeping and accounting to describe the
same thing, there’s actually a big difference between the two:
Bookkeeping

 Setting up a chart of accounts

 Creating a process for invoicing tenants for rent and posting receipts
 Accurately tracking payments made to vendors and charging to the right
account
 Monitoring automatic recurring payments made to business credit and debit
cards
 Reconciling bank statements and vendor invoices to ensure a paper trail is
being created

Accounting

 Understanding property income and expenses, profits and losses, and gains in
asset value
  Learning how to manage money smartly to help maximize profits
 Knowing what to look for when performing a financial audit or analysis
 Making sure business regulations and tax collection and remittance
requirements are met
 Correctly preparing reports for quarterly and year-end tax filing and meeting
tax due dates

Many real estate investors are pleasantly surprised to learn that bookkeeping and
accounting tasks can often be automated.
Rental property owners can sign up for a free account with Stessa to automatically
track income and expenses, receive personalized recommendations for maximizing
revenue, and access the Stessa Tax Center.
 

Benefits of good real estate accounting

Often, when people hear the word “accounting” their eyes glaze over and they quickly
try to change the subject. But as unexciting as accounting might be, there are several
big benefits to understanding how good real estate accounting works:
Improve cash flow
Sending out rent statements as quickly as possible, getting tenants to pay on time, and
waiting until the due date to pay vendors are three ways that real estate investors can
improve cash flow.
A good real estate accounting system simplifies keeping track of accounts payable so
that vendors are paid on time or early, to take advantage of an early payment discount.
(Online rent payment services such as RentTrack report rent payments to all three
credit bureaus, providing tenants with an incentive to pay the rent on time.)
Control income and expenses
A rental property accounting system like Stessa automatically tracks income and
expenses and helps real estate investors to maximize revenue with personalized
recommendations.
Using Stessa is easy and free. Simply sign up for a free account, enter your rental
property address, connect your bank accounts quickly and securely, and see your real
estate portfolio stats come to life.
When a tenant rent payment hits your bank account, Stessa updates your income
statement. To track expenses on the go, just download the mobile app for iOS or
Android, scan a receipt, and Stessa will parse the receipt data to create a new expense
entry that is automatically categorized for you.
Reduce outside expenses
While an automated real estate accounting system may never completely replace your
accountant, it can help to reduce outside expenses paid to a bookkeeper or CPA.
A CPA will tell you that come January 1st when tax season rolls around, they begin
working seven days a week preparing tax returns. By providing your tax professional
with tax-ready financial statements, you’ll make their job much easier and reduce the
number of billable hours they charge to you.
Backup for a tax audit
Although there is a chance that a real estate investor may never be audited, an ounce
of prevention is worth a pound of cure. There are three types of IRS tax audits a rental
property owner could face:

1. Correspondence audit with an IRS request for additional documentation.

2. Field audits conducted face-to-face, typically in a taxpayer’s home or business.
3. Office examinations conducted in IRS offices.

A good real estate accounting system automatically creates a paper trail to back up
every income and expense item claimed. Instead of having to dig for information the
IRS requests, documents are neatly organized if you are ever audited. An accounting
system for real estate will help you keep track of documentary evidence like invoices
and receipts, to help you defend each deduction.
Monitor property and portfolio performance
Detailed record keeping also can make it easier to monitor financial performance at
both the property and portfolio level. By comparing past rental property performance
to the current year, investors are able to form strategies to maximize revenues and
increase net cash flow:

 Spotlight rental properties that are performing well.

 Identify underperforming properties to help decide to hold or sell.
 Compare year-over-year financial metrics such as cash on cash return.
 Create historical property performance data to help make refinancing a rental
property easier.

Basic steps of real estate accounting

There are seven main steps to follow when setting up a real estate accounting system:
1. Choose accounting method
The most common types of accounting methods are cash and accrual. Transactions are
recorded differently, depending on which accounting method you use.
Under the cash method, income is reported in the tax year it is received, and expenses
are deducted in the tax year the expenses are paid.
Under the accrual method of accounting, income is generally reported in the tax year
it is earned, regardless of when the payment is received. For example, if you send the
tenant an invoice for the January rent in December, income is credited in December
and recorded as receivable from the tenant.
Expenses under the accrual accounting method work in a similar way. If you receive
an invoice for landscaping service in December, the invoice is recorded as an expense
in December, even if the bill is not paid until January.
There are pros and cons to each method. In general, most individuals and many small
businesses use the cash method of accounting, according to IRS Publication 538.
2. Separate business and personal funds
Business and personal income and expenses should not be commingled with one
another. That’s why most real estate investors open a business checking account for
deposits and expenses, along with a debit card or card.
Business funds are kept in one place, making it much easier to review your business
bank statement to locate a transaction. Having a business account for a rental property
can also help to:

 Keep books organized

 Avoid inaccurate tax returns
 Improve cash flow management
 Identify opportunities to increase income and reduce expenses

Depending on your state landlord-tenant laws, a landlord may also be required to hold

tenant security deposits in a separate bank trust account.
3. Create a chart of accounts
A chart of accounts is used to separate income from expenses. A chart of accounts for
a rental property usually contains categories for assets, liabilities, equity, revenue, and
expenses.
Accounts are created within each category for different transactions. For example, in
the revenue category, a landlord may have individual accounts for rental income, late
fees, and other rent (such as pet or roommate rent).
The chart of accounts for a rental property can be customized based on the property
type and an investor’s specific needs. Many real estate investors model their chart of
accounts based on Schedule E (Form 1040):
You can learn more about income and expense categories by reading this recent
article from Stessa.
4. Track and itemize income and expenses
Money that flows into and out of your real estate business should be categorized and
posted to the property account. Rental property financial management software such
as Stessa automatically tracks income and expenses and auto-categorizes them for
easy reporting.
Each time a transaction occurs, the income or expense is recorded under the
appropriate category and account. A good real estate accounting system also allows
details for each transaction to be entered, so that it is easy to understand what the
transaction is for.
5. Reconcile accounts
The reconciliation process ensures that the bank account balance in your real estate
accounting system is the same as what the bank shows.
The beginning and ending balance shown by your bank should match what your
accounting system shows. When accounts are reconciled, there may be gaps in the
transactions due to time delays in posting, accounting mistakes, or an error by the
bank.
6. Keep documents organized
Each income and expense transaction recorded on the chart of accounts should have a
backup or supporting document.
Common rental property documents a landlord needs to keep track of can include:

 Purchase and lease agreements

 Mortgage-related documents
 Vendor contracts
 Bank statements
 Invoices and receipts
 Credit card statements
 Insurance information
 Property tax statements
 HOA rules, regulations, and declarations
 Tax returns

While some investors keep hard copies, many other rental property owners scan and
upload each document to a secure, cloud-based storage system on the internet. Storing
real estate receipts, invoices, and documents digitally may allow you to find
paperwork in minutes rather than hours.
7. Generate accurate reports
The best real estate accounting software allows investors to get performance
dashboards at the portfolio and property level online and generates informative reports
at the click of a button.
Three of the most common financial reports for rental property are:

 Income statement (also known as a profit and loss statement) focuses on

revenues and expenses.
 Net cash flow reports the cash moving in and out of your account over a given
period of time.
 Capital expense report tracks money used to improve or add value to a property
beyond normal maintenance and repairs.

 
Real estate accounting software
There are a wide variety of accounting systems available, including real estate account
software that is absolutely free. Some of the top rental property accounting platforms
include:

 Appfolio: Good for beginning real estate investors. Minimum monthly fee of
$280.
 FreshBooks: Helps investors grow revenues and boost ROI. Billing starts at
$108 per year.
 Landlord Studio: Over 15 customized reports designed for landlords. Pricing
begins at $5.99 per month.
 Quicken Rental Property Manager: Owner dashboard helps simplify rental
property management. Pricing begins at $93.59 per year.
 Rentec Direct: Designed for landlords who want to do their own property
management. Pricing begins at $35 per month.
 Stessa: Created by real estate investors for real estate investors seeking to
maximize profits through smart money management. Pricing is free.

Creating an Income Statement for an

Investment Property
This video on how to create an income statement to aid in analyzing the
financial performance of an investment property. Creating an accurate
profit and loss statement for an income property is a critical step in the
due diligence process of analyzing any investment property.

In this video I’m going to describe the basic steps required to create an
income statement. Otherwise known as a profit and loss statement for an
investment property one might be interested in purchasing. In any
investment, it is critical to properly analyze that investment’s financials in
order to see if it’s worth investing in in the first place. In order to
understand the returns that an investment property will provide us, we
need to create an income statement for the property. The income
statement is comprised of two sections: The income section and the
expense section. With single-family home investments, the income
section is typically comprised solely of the rents we can expect from the
property. Our gross or overall income is called our gross scheduled
income or GSI. The GSI assumes perfection. In other words, the GSI
assumes our tenants pay on time and never leave the property.

Expected Income
Since we know this isn’t going to be the case, we need to create an
expected income. A realistic income we can count on. In order to do that,
we need to apply a vacancy rate to our gross scheduled income. They
can see this typically measured as a percentage of the total annual
income. In this example, we are using a 5% vacancy rate; which means
in a given year where we expect to receive $11,400 in rent. We anticipate
that on average our investment home will be vacant 5% of the year.
Translated into dollars, 5% vacancy equals 5% of our $11,400 in rental
income or $570. By subtracting the expected vacancy from our gross
scheduled income, we get our ‘real expected’ annual income on the
property – $10,830. Which we call our gross operating income or GOI.
The GOI is the income we expect to see in a given year after accounting
for vacancy loss on our property.

Property Expenses
Now we need to create the expense section of our income statement.
Investment property expenses come in all shapes and sizes but most
typically comprise of property management fees, property taxes,
insurance, maintenance, and in some cases owner paid utilities and HOA
fees. It is very important that you spend time and do adequate due
diligence on the expenses you expect to have on your investment home.
As this is often the area where investors tend to take an optimistic
approach to things. Remember like the home you live in, things will go
wrong. Items will need to be repaired and in general, tenants will be
harder on the property than you, as an owner, will be. That doesn’t mean
you should shy away from investing. It just means that you need to
analyze a property knowing these things will probably occur and budget
accordingly. Most property expenses are expressed as a flat annual
dollar expense such as insurance and property taxes; which are typically
paid annually and have a set known value.

Property Management
Other expenses are expressed as a percentage of gross operating
income such as property management and maintenance expenses. Note
that these are a percentage of gross operating income and not gross
scheduled income. This is an important distinction. Property management
fees are earned when a property is tenanted and are expressed as a
percentage of rents collected. Management fees are generally not
collected when the property is vacant. Thus, our property management
expenses are calculated as a percentage of gross operating income or
income after our vacancy reduction has been calculated. In this case,
$1,080 – 10% of our GOI.

Property Taxes
We then want to add a line for our property tax expense. It is important to
research what your property tax rate will be as an investor. Remember, in
most areas, the property is taxed at a higher rate for investors, especially
out-of-state investors. It pays to call the County in which you are planning
to invest to determine what your tax rate will be as an out-of-state
investor.

These rates can be in some cases two to three times the homeowner tax
rate on a property. Thus, if you are purchasing your home from a current
homeowner and are looking at what they paid in property taxes, you may
be seriously misleading yourself. Some states such as California, tie their
property tax rate to the purchase price of the property. Thus, if you’re
buying a property for $300,000 from someone who paid $150,000 for the
property 10 years ago, you’ll be paying twice the taxes they paid. To
ensure accuracy, call the County, let them know what you’re doing and
they will let you know how you’ll be taxed.

Homeowners Insurance
Insurance is an easier item to address. The key here is to get a variety of
quotes and let the agent know that you are purchasing the property for
investment purposes. Insurance rates are truly all over the map and it
pays to shop around. Investment property insurance typically includes
specialty items such as liability and coverage and rent loss coverage that
help protect you as the owner.

Additionally, be sure to check and see if your property requires flood

insurance or other mandatory coverages such as windstorm insurance.
These additional coverages are not typically disclosed by the seller and
can be an unwelcome surprise at closing.

Maintenance
The next expense item we need to account for is our maintenance
expense. This item can be tricky, as the rate we use will depend on a
number of factors. A general rule of thumb for single-family homes is to
use 5% of our GOI for our maintenance beginner. This assumes a typical
home 10 to 20 years old in good shape. If the property you were looking
at has been recently renovated, your number might be lower than this.
On the other hand, if you’re looking at a property with considerable
deferred maintenance, you’d likely want to increase that number. In most
markets, your tenant will be required to give a security deposit prior to
attending a home. This security deposit will help offset many of the day-
to-day maintenance expenses associated with getting the unit rent ready
for the next tenant. Another factor to consider with respect to
maintenance costs is the cost of the repair relative to the rents received.
For example, assume we have two properties. One is a $75,000 home
with $750 in rent. And the other’s $150,000 home with $1,500 in rent.

Both have been recently renovated and we decided to use 5% as a

maintenance factor for both. In the case of the $75,000 home, our
maintenance costs are anticipated to be 5% of our annual GOI or $427.
In the case of our $150,000 home or maintenance costs are similarly
anticipated to be 5% of the GOI or $855. Note the difference. In one
case, we’re setting aside $427 per year for repairs and the other, we’re
setting aside $855. Now you’ve got to ask yourself, does a water heater
in the $75,000 home costs 50% of the one you’d put into $150,000
home? Will replacing the roof costs 50% less? One of the biggest
mistakes I see investors make is using a maintenance percentage factor
without considering the actual dollar amount they’re setting aside.
Granted more expensive homes require more expensive maintenance.
You might use nicer carpet or put a nicer roof on a more expensive
home. But in the end, the costs of those upgrades aren’t twice the cost of
what you’d put into the $75,000 home.

Additional Fees and Expenses

Our last expense category is somewhat of a catchall. In some homes, the
owner might be responsible for the utilities and other areas an HOA fee
might be an expense born by the owner. If these expenses are something
you, the owner, will be paying be sure to enter them into your expense
section. Once done, we can add our operating expenses to determine our
total annual expense outlay. We can then subtract the total operating
expenses from our gross operating income to get our net operating
income or NOI. As this is the cashflow we will have coming at us that can
be used to pay our debt service or mortgage on the property.

If we have a positive balance left after paying our debt service, the
property is considered to be positively cash flowing. If the debt service
exceeds our NOI the property would negatively cash flow and would
require outside funds in order to maintain. In most cases, negative cash
flow is something most investors want to avoid.

In Closing
Well, we’ve done it. We created our income statement. By accurately
determining our rental income. We then applied a vacancy factor to
determine the income we can actually depend on creating our gross
operating income. We then analyze our expenses, accounting for
property management and insurance. We also called the County to
determine what our property taxes would be as an investor. And lastly,
we estimated our anticipated maintenance costs and accounted for any
miscellaneous costs that might be associated with the property. We then
calculated our net operating income by subtracting our maintenance
costs from our GOI and then deducted our debt service to determine
what the performer cash flow is on the subject property.

How to Find Your Return on Investment

(ROI) in Real Estate
Here are two ways to calculate your profits

By 
MARC DAVIS
 

Updated September 20, 2022

Reviewed by JULIUS MANSA
Return on investment (ROI) is a measurement of how much money, or profit,
you have earned on an investment as a percentage of its total cost.

This article looks at two ways to calculate the ROI for real estate investments.

KEY TAKEAWAYS

 Return on investment (ROI) measures the profit you have made (or
could make if you were to sell) on an investment.
 ROI is calculated by comparing the amount you have invested in the
property, including the initial purchase price plus any further costs, to its
current value.
 Two common ways of calculating the ROI on a real estate investment
are the cost method and the out-of-pocket method.
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How to Calculate ROI For Real Estate Investments

2 Ways to Calculate Your Return on Investment (ROI)

There are two primary methods for calculating ROI: the cost method and the
out-of-pocket method. Following are simplified examples of each method.
Note that neither example accounts for any rental income your property might
produce or any ongoing costs, such as property taxes.

The Cost Method 

The cost method calculates ROI by dividing the investment gain in a property
by that property's initial costs.

As an example, assume you bought a property for $100,000 in all cash. After
repairs and improvements, which cost you an additional $50,000, the
property is valued at $200,000.

This makes your gain in the property $50,000 (i.e., $100,00 gain in market
value less $50,000 spent on costs).

To use the cost method, divide the gain by all the costs related to the
purchase, repairs, and rehabilitation of the property.

Your ROI, in this instance, is:

$50,000 ÷ $150,000 = 0.33, or 33%.
The Out-of-Pocket Method 
The out-of-pocket method is preferred by many real estate investors because
it results in a higher ROI. It takes the current equity of the home divided by
the current market value. Note that this differs from the above calculation
where the cost method divides the investment gain (not the equity) by the
initial total costs (not the market value).

Using the numbers from the example above, assume you bought the same
property for the same price, but this time, you financed the purchase with a
loan and a down payment of $20,000.

Your out-of-pocket expense is $20,000 plus the $50,000 for repairs and
rehab, for a total of $70,000. With the value of the property at $200,000, your
equity position, or potential profit, is $130,000.

Your ROI in this case is:

$130,000 ÷ $200,000 = 0.65, or 65%.

This is almost double the first example's ROI. The difference, of course, is
attributable to the loan: leverage as a means of increasing ROI. 

What Is a Good Return on Investment for Real Estate

Investors?
What one investor considers a "good" ROI may be unacceptable to another.
A good ROI on real estate varies by risk tolerance—the more risk you're
willing to take, the higher ROI you might expect. Conversely, risk-averse
investors may happily settle for lower ROIs in exchange for more certainty.

In general, however, to make real estate investing worthwhile, many investors

aim for returns that match or exceed the average returns on a major stock
market index such as the S&P 500. Historically, the average annual return on
the S&P 500 is about 10%.1

Of course, you don't have to buy physical property to invest in real

estate. Real estate investment trusts (REITs) trade like stocks on an
exchange, and they can provide diversification without the need to own and
manage any property. In general, REIT returns are more volatile than
physical property (they trade on an exchange, after all). In the U.S., equity
REITs delivered an average annual return of 10.7% for the five-year period
ending March 31, 2022, as measured by the FTSE Nareit All Equity REITs
index.2 You can also invest in REITs through mutual funds that specialize in
them.

 
Mortgage lending discrimination is illegal. If you think you've been
discriminated against based on race, religion, sex, marital status, use of
public assistance, national origin, disability, or age, there are steps you can
take. One such step is to file a report with the Consumer Financial Protection
Bureau or the U.S. Department of Housing and Urban Development .

Costs That Can Reduce Your Return on Investment

In order to realize your ROI in actual cash profits, you have to sell the
property. Often, a property will not sell at its market value, which will reduce
your expected ROI if that was the number you based your calculations on.

In addition, there are costs associated with selling real estate, such as
repairs, painting, and landscaping. The cost of advertising the property
should also be added in, along with appraisal costs and the commission to
any real estate agent or broker that's involved. And, of course, if there's a
mortgage on the property it must be paid off.

How Is Investment Real Estate Taxed When You Sell the

Property?
When you sell investment property, any profit you make over your adjusted
cost basis is considered a capital gain for tax purposes. If you held the
property for a year or more it will be taxed at capital gains rates. If you held it
for less than a year it will be taxed as ordinary income, which will generally
mean a higher tax rate, depending on how much other income you have.3

How Is Income From a Real Estate Investment Trust

(REIT) Taxed?
Real estate investment trusts, or REITs, can pay income to their investors in
three forms: dividends, which are taxable at the same rate as ordinary
income; capital gains distributions, which are taxed at the usually lower rate
for capital gains; and returns of capital, which are not taxable.4
How Is Rental Income Taxed?
If you have rental income from a property you own, you have to report that
income when you file your taxes for the year, generally on IRS Schedule E.
You can also subtract your related expenses to arrive at your total income or
loss on that property for the year. Losses are deductible up to certain limits.5

The Bottom Line

Calculating your ROI is a way to determine how much profit (if any) you have
made on a real estate investment. You can also use it to compare the return
on real estate to other potential investments, such as stocks. The examples
above are simplified for the purposes of illustration, and, depending on all of
the costs involved and any potential cash flow you receive from your real
estate investment, getting a precise ROI may be more complicated. For tax
purposes, in particular, you will most likely want to consult an accountant or
other tax professional who is familiar with the rules as they apply to real
estate.

Real Estate Chart of Accounts and

Bookkeeping Strategies
Chart of accounts and bookkeeping are important for real estate companies as they are
prerequisites for financial budgeting. In addition, the real estate business involves complex
operations, from buying and selling to property management. So keeping a record of financial
transactions is essential. In this article, we will discuss a real estate chart of accounts and
bookkeeping strategies. 

A well-prepared chart of accounts allows real estate agents to safeguard their financial well-being
and maintain an organization for crucial tax compliance and collection tasks. The real estate chart of
accounts will enable you to categorize and simplify the complicated financial data of your company.
It helps to categorize data into understandable, logical account categories. It also aids in
establishing real estate financial models.

What is a Chart of Accounts?

A chart of accounts for a real estate company represents all the accounts of your business gathered
in one location. It gives you a birds-eye overview of every financial transaction of your company. The
real estate chart of accounts will be different from other businesses because of the different nature
of the business and distinct accounts. 
A chart of accounts enables you to categorize all of your company’s transactions during a given
time. In addition, it allows you to obtain insight into the success of different sections of your
organization by separating your revenue, liabilities, assets, equity, and business expenses. Finally,
by detailing all the accounts implicated in your business’s daily activities, the chart of accounts aids
in financial budgeting and planning.

Bookkeeping and chart of accounts are crucial for more than merely recording and storing financial
data. They allow you to:

 Assess your business health easily

 Predict its future performance
 Provide information to your banker and accountant

A solid business structure is because of your chart of accounts. Thus, it’s worthwhile to devote the
time (or hire professional support) to create one that fulfills your specific needs.

Overview of the Real Estate Industry

The real estate industry includes land improvement and modifications, including constructions,
furnishings, roads, buildings, and oil and gas pipelines. This industry can fluctuate depending on the
national and local economies. Still, it remains somewhat consistent since people always need
homes and businesses always need office space.

As cities developed, the need for real estate transactions increased. And to manage these growing
transactions, accountants and bookkeepers are equally important in this industry. In addition, we
must know the importance of bookkeeping and a chart of accounts for real estate agents.

The real estate industry has evolved rapidly in the past decades. Let’s examine the industry’s
operations and the primary vocations and careers inside it. The real estate sector comprises several
categories:
Development
Purchases of undeveloped land, redevelopment, construction projects, rehabilitation, and sale or
rental of the project to end users are all steps in the real estate development process. In addition,
developers can benefit by enhancing the worth of the land (by adding structures or upgrades,
redistricting, etc.) and accepting the risk of financing a project. 

Sales and Marketing 

Developments collaborate with sales and marketing companies to sell the structures and apartments
they produce. These businesses create all promotional material and use their sales representatives
to sell the finished goods inventory, earning a percentage. These businesses usually concentrate on
new units.

Brokerage
When we talk about brokerage, we talk about a company that employs a group of real estate agents,
also known as brokers. These agents help facilitate a financial transaction between property
purchasers and sellers. Their responsibility is to represent both parties. Also, to work with them to
negotiate the most favorable conditions for a sale or purchase.

Property Management
The property management companies help building owners in renting out the apartments within their
structures. They also manage renters, show apartments, correct defects, execute maintenance, and
charge interest. They demand payment from property owners, usually in the form of a portion of the
rent.
Lending
Since almost all assets and projects rely on power and influence (debt) to subsidize their operations,
lenders play a significant role in the real estate industry. Banks, credit unions, individual lenders, and
governmental organizations can act as real estate lenders. And this is where accounting and
bookkeeping also play a critical role in this industry. 

Professional Services
The real estate industry has the support of some experts who work in it. Other than those already
mentioned, the most frequent examples are those of accountants, attorneys, design professionals,
remodelers, general contractors, consultants, and artisans.

Real Estate Chart of Accounts –

Accounting and Bookkeeping
Accounting and bookkeeping are crucial for the real estate industry as they help in the financial
analysis of a company. Even though most investors certainly don’t enjoy accounting, excellent
accounting and bookkeeping help increase real estate companies’ profits by precisely tracking
income, costs, and tax deductions. Like other companies, a real estate chart of accounts is also
prepared after the bookkeeping of financial transactions.

Even though bookkeeping and accounting are sometimes known interchangeably, there is a

significant distinction between the two:

Bookkeeping
It includes setting up a chart of accounts for a real estate company, establishing a system
for financial reporting receipts, sending rent invoices to tenants, and correctly tracking and billing the
appropriate account. Also, it keeps track of regular corporate credit and debit card payments. Finally,
it compares sales invoices and bank statements to ensure a clear legal document.

These are some typical bookkeeping tasks involved in the real estate industry:

 Recording financial transactions

 Posting debits and credits
 Producing invoices
 Managing payroll
 Maintaining and balancing ledgers, accounts, and subsidiaries
Accounting
Accounting is more subjective, providing business owners with financial insights based on
information gleaned from their bookkeeping data. A key part of the accounting process is
analyzing financial reports to help you make business decisions. The result is a better understanding
of actual profitability and awareness of cash flow in your real estate business. 

These are some typical accounting tasks: 

 Verifying and analyzing data

 Generating reports, performing audits, and preparing financial reporting records like tax
returns, income statements, and balance sheets
 Providing information for forecasts, business trends, and opportunities for growth
 Helping the business owners understand the impact of financial decisions
 Adjusting entries

Real Estate Chart of Accounts

A real estate chart of accounts depicts the collection of accounts that support all of its journal entries.
However, contrary to popular belief, the most crucial aspect of a chart of accounts is a clear,
preferably full, description of the nature of each ledger account. An ideal chart of accounts for a real
estate company gives a detailed financial analysis of its operations.

In a chart of accounts for a real estate company, private finances must be kept separate from the
business finances. 

For a real estate industry, a chart of accounts might include these sub-accounts under the assets
account:

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Asset Accounts
 Land 
  Building
 Vehicles
 Tenant Improvement
 Telephone Equipment
 Account Receivables
 Cash

Liabilities account may have sub-accounts, such as:

Liability Accounts
 Mortgages
 Loans
 Lines of credit
 Payroll liability
 Credit cards
 Business credit 
 Security deposits

Shareholders’ equity can be broken down into the following accounts:

Equity Accounts
 Shareholder Equity
 Initial Equity
 Capital Contribution equity
 Equity draws
 Allocation of earning
 Capital Stock

Expenses account may include the following accounts:

Expense Accounts
 Advertising
 Auto and travel
 Cleaning and maintenance
  Commissions
 Insurance
 Legal and other professional fees
 Management fees
 The mortgage interest paid to banks
 Other interest
 Repairs
 Supplies
 Taxes
 Utilities
 Depreciation expense or depletion

Revenues account may have sub-accounts, such as:

Revenue Accounts
 Utility payments (pass-through)
 Security deposits
 Parking fees
 Pet rent
 Training Income
 Interest income
 Referral fee
 Real Estate Commissions 

Following is the real estate chart of accounts example:

Advantages of Real Estate Chart of
Accounts & Bookkeeping 
A real estate chart of accounts helps prepare financial statements, such as balance sheets and
income statements. Then, various other accounts, such as capital or equity, debt, liability fees, and
other expenses, can also be added to the chart of accounts as needed by the real estate company.

Here are the benefits of creating a real estate chart of accounts:

Better Cash Flow

With the chart of accounts, real estate investors can increase cash flow by bringing out rent
statements as soon as workable, encouraging renters to make payments on time, and delaying
paying contractors until the deadline. In addition, a solid real estate chart of accounts makes it easier
to keep control of payables, ensuring that contractors are delivered on time or early to benefit from
an early settlement discount.

Controlling Income and Expenses

A real estate chart of accounts usually records income and expenses and provides individualized
advice to real estate investors to help them maximize profits. By setting up your chart of accounts,
your real estate investment statistics become a reality, providing the position of your rental property
and safely and swiftly connecting your bank accounts.

Track the Performance of Your Investment’s

Properties.
Maintaining thorough records might also make it simpler to watch the portfolio’s and individual
properties’ financial performance. Investors can develop plans to enhance revenues and boost net
cash flow by comparing historical rental property statistics to the current year. Tracking the
performance can help:

 Highlight the best-performing rental properties.

 Decide whether to hold or sell substandard assets by identifying them.
 Compare financial parameters such as the revenue of interest earned year after year.
 Facilitate the refinancing of a rental property and generate historical property performance
data.

Basic Real Estate Accounting Procedures

When establishing a real estate accounting procedures, there are seven essential stages to take:

Choose Accounting Method

Before preparing a real estate chart of accounts, you must choose between accrual and cash
accounting methods for bookkeeping. The cash method enables the financial reporting of revenue in
the taxation year it is received and the deduction of costs in the tax year it is paid.

In the accrual method of accounting, real estate businesses report their income tax for the year in
which they recognize the revenue, regardless of when they receive payment. And they deduct their
expenses in the tax year they incur them, regardless of when they make payments.

Differentiate your Personal and Business Finances

Like other industries, the real estate industry also follows the business entity concept while
complying with accounting and bookkeeping procedures. While doing this, the owner’s personal
transactions are kept separate from business transactions. The business entity concept allows real
estate companies to hold separate business accounts. It also allows them to:

 Hold books in order

 Keep your tax returns accurately
 Enhance your cash flow management
 Determine ways to boost revenue and decrease costs

Create a Chart of Accounts 

Income and costs are separated using a chart of accounts for a real estate company. Assets,
liabilities, equity, revenue, and expenses are typically under several divisions in a chart of accounts
for a real estate company. Within each area, accounts are for various operations. For instance, a
landlord might have multiple ones for rental income, late fees, and other rent in the revenue column.
According to the type of property and the investor’s demands, the chart of accounts changes for real
estate.

Follow Up on and List your Expenses and Income

You must classify and record to the property account any money that comes into or leaves your real
estate business. The operating system for managing the finances of rental properties automatically
tracks revenues and expenditures and classifies them for simple reporting.

The relevant category and account help record the income or expense when a financial transaction
occurs. An agile real estate bookkeeping system also enables the entry of transaction-specific
information, making it simple to comprehend the purpose of each transaction.
Account balancing
The procedure of balancing makes sure the balance of your bank account in your real estate chart of
accounts matches the balance of the bank statement. Your financial reporting system must ensure
that all accounts in the trial balance must balance. When finances are reconciling, there could be
voids in financial transactions because of posting delays, bookkeeping faults, or a bank error.

Document Management is Key

We should include a backup or supporting document listing every income and expense activity on
the real estate chart of accounts. Typical rental property records that a real estate agent should keep
track of include:

 Purchase and lease agreements

 Mortgage-related documents
 Vendor contracts
 Bank statements
 Invoices and receipts
 Credit card statements
 Insurance information
 Property tax statements
 Tax returns

Many real estate companies scan and submit each document to a safe, cloud-based backup system
on the internet, though some investors preserve paper copies. 

Wrapping Up
A real estate chart of accounts is essential in every aspect, from financial budgeting to financial
modeling. Managing properties involves many financial concerns. Also, it’s crucial to handle
essential elements accurately, like measuring profits and losses, managing expenses, and
assessing a property’s profitability. Therefore, investment company managers, real estate agents,
housing associations, and construction enterprises are some major industries that need to
implement real estate accounting to grow and make more revenue.

Real estate companies can determine their bookkeeping technique according to their flow of
transactions. Bookkeeping and chart of accounts are prerequisites for financial planning. 

Your business’s success depends on your business’s finances and creating a model that works for
you. And if you have no idea where to start all this, OAK Business Consultant provides full-fledged
support in all financial aspects of your business.
 8 Essential Bookkeeping
Tips for New Real Estate
Investors

January 24, 2023 by Blake Bobit

Disclosure: Our content is reader-supported, which means that if you click on some of our links that we
may earn a commission.
As a new real estate investor, it is crucial to know if your investments make
sense. Bookkeeping is the process that tracks all the money coming in and
going out of your business. By following these simple tips, you will be able to
rely on your bookkeeping system to make educated decisions and know
exactly how your real estate investments are performing.

Key benefits of maintaining an organized accounting system:

 See how much cash flow your real estate is generating

 Know which rentals are performing best
 Make educated decisions to buy or hold properties
 Track your NOI and CAP rate to benchmark your performance
 Use historical performance data to measure new strategies
 Recognize all expenses to maximize your deductions
  Avoid stress and IRS penalties for miscategorized or undocumented
expenses

Real Estate Bookkeeping Tips

1. Business Bank Account
2. Keep Personal Expenses Separate
3. Keep Receipts
4. Categorize Expenses
5. Reconcile Monthly
6. Review Financial Statements
7. Find a CPA With RE Experience
8. Use the Latest Software

1. Open a Business Bank Account

Many new investors wonder if they need a separate bank account for their
rental property. The answer is a resounding, YES!

There are many reasons a business account is necessary. It will help you
save time and money. A business account will help protect your personal
assets (if you follow Tip #2). And it will help you maintain better books and run
a better business.

5 PROPERTIES, 5 ACCOUNTS?
Long ago, separate accounts made it easier to keep track of transactions for
different properties, but could become unmanageable as the portfolio grew.
Nowadays, accounting software can accurately track the expenses for
multiple properties all within a single bank account.

So, do you need a separate bank account for every property? It’s probably
unnecessary, unless you’re holding your properties in separate LLCs (in which
case you should have a bank account for each LLC). Talk to your lawyer or
CPA if you’re unsure.
One caveat exists with security deposits. Check your local laws as they may
require you to hold security deposits in separate accounts.
Using a business bank account creates a solid foundation for your real estate
business. It reduces your risk, makes bookkeeping easier and more accurate,
and helps ensure you keep all your personal and business finances separate.

2. Keep Personal Expenses Separate

This is important: Keep your personal and real estate
expenses completely separate. We’re talking separate bank accounts, credit
cards, and debit cards.
If you’ve never owned a business, you might wonder, “Why is this such a big
deal?” There are two primary reasons:

 Tax Liability
 Asset Protection
Using a single account for business and personal transactions is known as
commingling funds. Blurred lines between business and personal finances are
a red flag for the IRS, which could cause an audit.

An LLC is meant to safeguard your personal assets (limiting your liability) if

your property gets sued. Liability protections don’t exist for commingled
accounts. If you are being sued and your account is frozen, your personal
funds will be considered part of the business.

A track record of strict separation should prevent creditors from seeking your
personal assets, also known as piercing the corporate veil. It’s best to talk with
your lawyer about how to maximize the protection of your LLC.
Having separate personal and business accounts provides protection. It also
makes it easier to claim every possible deduction, which will reduce your tax
burden – saving you money.

3. Keep Copies of All Receipts

This is easier than it sounds since you’re not required to keep hard copies.
We recommend photos or scans of receipts since they are much easier to
work with.
Most accounting software can scan receipts, making them searchable. The
software can also link receipts to your bank and credit card transactions,
helping you stay totally organized and ready to defend your expenses.

Related: Best Receipt Scanning Apps

Make note of which property the receipt is for and what the purpose of the
expense is. This will make categorization much easier.

The IRS requires you to keep all receipts over $75 as documentation for your
expenses. While it’s best to scan all your receipts, pay particular attention to
meals and travel, since they usually get the most scrutiny by the IRS in
reviews and audits.

4. Categorize Expenses
Ok, so you’ve got a business bank account and are keeping all your personal
finances separate. Great!

You’re keeping digital copies of all your receipts and staying organized. Good
job!

Expense categorization should be relatively straightforward, especially if you

are keeping all of your receipts.

Go
ogle Sheets or Excel can be used to categorize expenses, but better tools are
available
If you’ve only got a few units, you could manage your bookkeeping using a
simple spreadsheet. But there’s a ton of great software that can help you
manage your finances (and your properties).
The point of documenting income and itemizing expenses for your real estate
is so you can determine your taxable income. The lower your taxable income,
the less you pay in taxes.

Rent (plus any additional income) is your revenue. Subtract relevant expenses
from your revenue, and the result is your taxable income. This is all reflected
on the Schedule E that you file with the IRS.

To maximize your allowable deductions, organize your expenses using the

same categories the IRS lists on the Schedule E:

 Advertising
 Auto and travel
 Cleaning and maintenance
 Commissions
 Insurance
  Legal and other professional fees
 Management fees
 Mortgage interest paid to banks, etc.
 Other interest
 Repairs
 Supplies
 Taxes
 Utilities
 Depreciation expense or depletion (capital improvements)
 Other
You might consider waiting to categorize expenses, but this increases the
chance for errors. If you are categorizing expenses manually, it’s best to
update your records as you pay bills.

5. Reconcile Accounts Monthly

Reconciling your accounts is the process that double checks that the recorded
transactions match your actual. When everything aligns the accounts are
balanced. If you are using technology, this should be a relatively quick
process and might happen automatically.
Not long ago, when every transaction needed to be entered manually in a
paper ledger, there was a much higher chance of errors. Still, reconciliation
remains a fundamental practice of bookkeeping because ongoing accuracy is
so important.

Most of the bookkeeping software we’ve recommended can reconcile your

accounts in real-time using the connection with your bank account. Although a
direct connection should eliminate most data entry errors, it’s still
recommended to double check.

Balancing your books monthly will help you discover problems near to when a
transaction took place, so the circumstances should still be fresh in your mind.
This makes it much easier to resolve any issues that come up. 

Aim to reconcile your accounts at least every month. An organized approach

to your bookkeeping tasks will help you understand how each of your
properties is performing.

6. Review Financial Statements

Reviewing your financial statements will help you make better decisions. They
will also show you exactly how your real estate investments are performing.

A Profit and Loss (P&L) statement gives you a summary of your revenue and
expenses. It’s important because it shows you how much profit you made.

A Balance Sheet is a snapshot of the assets your business owns and what
you owe to others. It shows you how much equity you (and any partners or
investors) have invested in your business.
If you’re like Robert Kiyosaki and most real estate investors, you’ll also want
to focus on the Cash Flow report. Similar to the P&L statement, a Cash Flow
report shows all the cash coming in and going out, but also includes payments
for loans and taxes. The Cash Flow report shows your current operating
profitability.

KEY PERFORMANCE METRICS

Tracking key performance metrics with your bookkeeping system can help
you optimize your performance and make better decisions. Other metrics you
should track for each of your properties:

 Net Operating Income (NOI): Total income for the year minus

expenses. Note that NOI does not include mortgage or taxes. Net
operating income is used to compare the performance and profitability
of properties.
 Capitalization Rate (Cap Rate): Divide annual NOI by the cost of the
property (or its current value). A higher cap rate shows an investment is
risky. A low cap rate shows high value and strong demand for
properties.
  Cash-on-Cash Return (CCR): Calculated by looking at the annual pre-
tax cash flow divided by the total cash invested. The CCR measures the
investment’s performance.
Real estate accounting and property management software can calculate
these metrics for you. They will be displayed on your dashboard so you get a
continuous overview of your performance.

7. Find a CPA With Real Estate

Experience
Tax is one area where it’s not recommended to go it alone. A tax professional
with real estate experience can offer advice and strategies that could save
you thousands of dollars and help you optimize your bookkeeping workflow.

Working with an experienced tax professional ensures your return is accurate

and that you’re claiming every allowable deduction. As your real estate
business grows, a CPA that understands your business can offer advice on
future investments. Most importantly, they can help you structure your
investments in a tax efficient manner. 

OUR TOP PICK

Try 1-800 Accountant

When looking to retain a CPA, be sure to check their qualifications first and
ask them how long they have been practicing. Determine how much
experience they have with real estate and ask if you can speak to any
references. 

8. Use The Latest Technology

The latest tools make it easier than ever to manage your finances and your
real estate investments. They can automate repetitive tasks like data entry,
saving you time while improving accuracy.

There are a few types of technology to help you manage various aspects of
your real estate bookkeeping.

 Business Accounting Software

 Rental Property Accounting Software
 Property Management Software

BUSINESS ACCOUNTING SOFTWARE

The most obvious tool to assist you is accounting software. It will help you
stay organized and store your receipts and supporting documents.

The key features to look for are:

 Connects to your bank account and automatically imports transactions

 Automatic expense categorization (you still need to check it)
 Receipt management
 Late payment notifications

Popular Accounting Software

Quickbooks is the most popular small business accounting software,
and Xero is known for its ease of use. Both come loaded with features, like
automatic import and categorization of transactions.
Unfortunately, neither can track multiple projects (or properties) on the basic
plan. Quickbooks gains project tracking on their Plus plan for $70 per month.
The Established plan from Xero has project tracking for $60 per month.

Free Accounting Software

There is free accounting software that works for real estate
bookkeeping. Wave is great to help you track basic financial
data. Akaunting is better if you have multiple units. 
Related: Best Free Bookkeeping Software
While the price might seem right with free accounting software, there are
some limitations. Wave can’t tag transactions by property, and Akaunting
doesn’t have automatic bank account reconciliation.

Accounting software is primarily targeted at small businesses. It can work for

real estate, but specialized software has additional features – and could cost
less.

RENTAL PROPERTY ACCOUNTING SOFTWARE

Rental property accounting software is the best bet for residential or multi-
family investors. All the features and workflows are designed with real estate
in mind. This also makes learning and using the software easier, since there
will be fewer distractions.

Additional features to look for:

 Reporting by portfolio, legal entity, property, and unit

 Simple workflow for creating your Schedule E
 Automated mortgage accounting
 Lease tracking

With REI Hub, long-term rentals, short term or vacation rentals, and flips are
all supported. The software links to all your financial accounts and
automatically imports transactions. Integrated document storage and lease
tracking are just a few of the features that set REI Hub apart from standard
accounting software.
REI Hub is easy to set up. Just add your properties, then link your bank and
credit card accounts. That’s it.

Since it’s usually best to try before you buy, they offer a 30-day free trial to
help you figure out if the software is right for you.

REI Hub Plan Units Cost

Essentials 1 to 5 $10

Investor 1 to 20 $25

Professional unlimited $75

*REI Hub Investor and Professional plans include multi-entity reporting.

Stessa is 100% free rental property accounting software for single-family,

residential multifamily, and short-term rentals. They offer optional fee-based
services for rent analysis, mortgage financing, and market research.
Stessa was built from the ground-up with real estate investors in mind.
Thoughtful dashboards make it easy to monitor and analyze the details. You
won’t have to search through pages of reports to find the information you need
to make decisions.

Features that make Stessa a good choice:

 It’s free
 Track unlimited properties
 See performance at the portfolio and property level
 Automate expense categorization
 Organize and store all your real estate documents
 Export tax-ready financials
Stessa also offers iOS and Android apps to help you track expenses on the
go.
PROPERTY MANAGEMENT SOFTWARE
Property management software can help with accounting, but it’s really
designed for property managers and landlords. It could be the right solution
for you if you own and manage your properties.

Property management software introduces many features like community

association management, leasing tools, and maintenance tracking.

Buildium is a full-featured property management platform that could work just

as well with five or 5,000 units. You’ll have the tools you need to keep your
property-level bookkeeping complete and accurate. Their wide array of
automated features are more tailored for property managers than investors,
but with pricing starting as low as $50 per month, Buildium is worth checking
out.
All accounts include financial reporting including:

 Balance sheets
 Income statements
 Cash flow statements
 Budget vs actual
 General ledger
Features that make Buildium an excellent choice for real estate bookkeeping:

 Automated bank account importing

 Task management
 Detailed maintenance management and reporting
 eLeases (sign and store leases online, no printing)
 Document and store property inspections
 Tenant screening (basic or premium options)
 Renters insurance
 1099 eFiling

Cozy offers their core service for free to landlords with 20 units or less. They
can offer the service free to landlords by charging renters for screening
reports, credit card payments, and renters insurance. Cozy will become part of
Apartments.com in mid-2021.
Cozy provides a portal to manage many common real estate activities. It also
allows you to:

 Track multiple properties

 Collect rent payments
 Organize scans of important documents, like applications and leases
 Find renters
 Screen applicants
 Sign leases online
 Run monthly performance reports and cash flow statements
 Streamline communication with tenants about maintenance and rent
collection
Regardless of which technology solution you choose and how automated it is,
remember that you need to check on it from time to time. Log in and verify that
transactions are being categorized correctly. Also, make sure your records
match what’s in your bank account.
Final Thoughts on Real Estate
Bookkeeping
You made it this far, so be sure to take the next step and put all you’ve
learned into action. Treat your real estate like the business it is.

Keep copies of receipts and categorize your expenses. Link your bank and
credit card accounts with accounting or property management software.
Automate as much of the bookkeeping process as possible.

Reconcile your accounts monthly to ensure your books are balanced. At the
same time, review your financial statements so you’re aware of your cash flow
and can foresee any problems coming up.

A good CPA with real estate experience cannot be replaced by software (at
least not yet). Find one, and use them to make sure you’ve structured your
assets as efficiently as possible. You could realize huge savings.
Finally, be sure to open a business bank account and always keep your
personal expenses separate. 

Be good to yourself and others. I hope you have a great day!

Pro forma in real estate and

how to calculate
“Pro forma” is Latin in origin, and its literal translation is “as a matter of

form or formality.” In law, pro forma refers to the formal proceedings in

place to move the legal process forward. In business applications, it

describes both the pro forma process or a pro forma financial document
(sometimes called a pro forma invoice), which predicts future income and

expenses.

In real estate, pro forma analysis can help guide your decision whether or

not to invest in a property by projecting how the property will perform

financially for the long term. Here’s an easy way to remember how pro

forma calculations apply to real estate investment  decisions: pro forma =

performance. 

Table of contents
Pro forma definitionPro forma in real estateHow to calculate pro formaOther
calculations

Pro forma definition

Pro forma is both a method of analysis and the resulting financial statement.

A pro forma statement lists actual income and expenses in one column and

estimated income and expenses in another column. 

 Business. A pro forma financial statement, like a budget or balance sheet,

calculates projected financial results, which can help business owners

evaluate a company’s outlook and make informed business decisions about

the future.

 Real estate. Pro forma in real estate can help investors determine the

property's potential. Much like how a company uses pro forma to make

predictions about the business, a real estate investor can determine if the

initial investment—and efforts if they decide to manage the property

themselves—are worth the long term profit.

One important thing to note about pro forma is that it typically focuses on

consistent cash flow and costs, excluding one-time or out-of-the-ordinary

costs. But by looking at estimated income and expenses, you can predict

how a business or investment will perform over time. 

Pro forma in real estate

In real estate, pro forma is a document that helps investors evaluate a

property’s potential profit. It combines real-world information about a

property (such as past or current rental income) and projections (such as

how much repairs might cost and how often you’ll need to make them) to

provide an assessment of the property’s potential future financials (see

below for more calculation specifics). 

A real estate pro forma report details a property’s projected net operating

income (NOI) and cash flow projections using its current and potential

rental income and operating expenses. It will forecast how a property would

perform with certain fluctuations in mind—for example, if you raised rents,

shrunk the vacancy rate, made improvements, or hired a property

manager and incurred property management fees .

How to calculate pro forma

The first step in calculating pro forma is to estimate the following line

items:

 Projected gross rental income (GRI). This is the income the property would

bring in if it was completely filled all the time at market rent.

  Vacancy rate. Takes into account how many vacant units your property

would have at any given time, and how often vacancies might occur.

 Repair expenses. An estimate of how much repairs to the property would

cost over a year. It is best to set aside a portion of the monthly gross income

for potential repairs.

 Property management fees. This includes what you’ll pay to a property

manager, property management company, or a  building super.

 Mortgage payment. If you have a mortgage, how much will it cost you per

month?

 Other expenses. This includes tax fees, insurance costs, leasing costs, and

legal fees.

Once you’ve made the estimations above, total your expenses and use the

equation to calculate pro forma: 

Pro Forma NOI = GRI – Vacancy expenses (Vacancy rate x GRI) – All

other expenses
Other calculations

Remember, the pro forma calculation is an estimate based on assumptions

and projections that are calculated using market research, history, and

financial know-how. It’s a vital piece of real estate investment decisions

best used alongside other projection tools to paint the fullest picture of risk

and return.

A thorough pro forma document will include other calculations that are

helpful in making investment decisions.

Cap rate

In real estate, the capitalization rate, or cap rate, is used to show the

expected rate of return on an investment property. It is expressed as a

percentage of the initial purchase price and indicates its net gain or loss over

a one-year time frame. To calculate:

Capitalization rate = Net operating income / Current market value x 100% 

Return on investment (ROI)

ROI tells you how much profit you can expect to make in rental income

over the long term. It’s expressed as a percentage of the cost of the

investment, and you can figure it out by using a fairly straightforward

formula. To calculate:

ROI = (Gain on investment - Cost of investment) / Cost of investment 

Cash-on-cash return

Cash-on-cash return, sometimes abbreviated as CoC return and also referred

to as cash yield or the equity dividend rate, is an annual measure of a real

estate investor’s earnings on a property compared to the amount the investor

initially spent to purchase it and make it operational. To calculate: 

Cash-on-cash return = Annual cash flow (pre-tax) / Total cash

Bungalow is the best way to invest and manage your real estate portfolio.

We work with you to identify, purchase, fill, and manage residential

properties—so that you can enjoy up to 20% more in rental income with a

lot less stress. Learn more about Bungalow.

Financial Statements Dos

and Don’ts for Real Estate
Funds
OCTOBER 6, 2021

Financial statements are a tool that investors, creditors and

management use as a financial dashboard of the business or fund. It is
important that financial statements are designed in a manner that is
easy to understand by these users. In financial reporting, it is strongly
advised that the financial statements be prepared in accordance with
the standards, and present information in a clear and simple manner
without omitting useful information.

In order to provide the most transparent financial information to the

users, a real estate fund’s management, administration firm, and audit
firm should foster a collaborative environment. Identifying proper
financial reporting requirements, as well as useful financial statement
 information in a timely manner, will be critical to the overall
presentation of a fund’s audited financial statements.

During the planning phase of your audit, discuss the draft financial
statements with your auditors in order to avoid unexpected surprises,
such as new or required disclosures as a result of new accounting
standards updates (ASUs) that may affect your fund. Being proactive
could alleviate delays when you are trying to finalize your audited
financial statements.

Let’s review some “Dos and Don’ts” that go into the preparation of the
financial statements of real estate funds.

CHOOSE THE RIGHT BASIS OF ACCOUNTING FOR

YOUR FUND
Cash, Accrual or Tax Basis – which basis of accounting is best for
your fund? Users rely on the financial statements to gain an
understanding of your fund’s financial position and the results of its
operations. Regulatory requirements surrounding your fund, following
an established framework (generally accepted accounting principles or
GAAP), or provisions in your organizational documents are just some
of the factors to consider when making a choice.
 Do: seek out the advice of your attorney, administration, or audit
advisor regarding the proper basis. Make sure this is done prior to
finalizing your fund documents. These advisors will be able to guide
you through the advantages and disadvantages of each option and
provide valuable insights on what could be the right fit for your fund.
 Don’t:  choose a methodology solely because of what you have seen
the most, is the most popular, or is the least costly to maintain.
 Don’t: deviate from the basis of reporting outlined in your fund
documents as this can be problematic.  Unless necessary and
 beneficial, don’t contemplate changing your basis at a later date as the
process could be costly and time consuming.
BE CONSISTENT IN APPLYING VALUATION
METHODOLOGIES
When it comes to the financial statements of a real estate fund, one of
the most critical disclosures relates to the valuation of the fund’s
underlying investments. There must be adequate disclosures which
should include the valuation techniques, methods and inputs used by
the fund to measure fair value of the real estate, including any
judgments and assumptions.

 Do: make sure your financial statement disclosures align with the

policies and procedures the fund has written in the fund agreements.
 Do: make sure you are following those procedures in practice and not
just in documentation alone. The accounting policy on valuation
methodologies should be included and discussed in depth in the fund
agreement and consistently applied to all of the real estate
investments made by the fund.
 Don’t:  choose a policy that is too vague or too complex as this will
make it difficult to follow in practice. Your valuation policies should be
based on industry practices and should follow Generally Acceptable
Accounting Principles.
WRITING THE FINANCIAL STATEMENTS
Once you have determined the basis of accounting for your fund and
you have created and implemented your valuation policy, you can now
begin preparing the actual financial statements and disclosures.

 Do: make sure to have a knowledgeable person in-house who can

prepare the statements and the disclosures that comprise the financial
report. Alternatively, if you have engaged an administration firm to
 prepare your books and records, make sure they will be able to
prepare the financial statement and related support to compliment
your accounting and administrative needs. It is also important that you
have someone in-house who can review and approve those financial
statements.
 Do: look to your advisors for industry guidance and standard financial
statement reporting. Most audit firms have a financial statement guide
and disclosure checklists where you can find valuable information and
samples for both the overall presentation as well as disclosures.
 Don’t:  expect your audit firm to prepare your financial statements.
GETTING THE BASICS RIGHT
When preparing your annual financial statements, there is significant
information that must be included, both from a financial perspective
as well as a disclosure perspective. Often, it is the basics that are
overlooked.

 Do: make sure that significant financial accounts that are being

presented in the financial statements have corresponding required
disclosures. In addition, make sure the disclosures agree to the
financial statement line items they relate to.
 Don’t: assume everything is correct, even if you have engaged an
outside service provider to prepare your financial statements. Take
your time and thoroughly review the financial statements, making
certain they present the fund’s records fairly and accurately.
As the fund manager, you have the responsibility of reviewing and
ultimately approving the financial statements that will be issued. Take
the time to understand the required disclosures and how these
disclosures best fit your fund. Make sure that all disclosures accurately
and fairly represent the fund’s performance. To conclude, work with
your advisors, ask questions, and seek out guidance.
For more information on best practices for preparing your financial
statements, please contact ANCHIN’S EMERGING MANAGER
PLATFORM TEAM  or your Anchin Relationship Partner.

HOW TO DRAW-UP 3-PART FINANCIAL

STATEMENTS FROM YOUR CRE
FINANCIAL MODEL
Sometimes, your investors will want to see financial statements. Though this is usually
something left to accounting, it’s not a difficult thing for you to draft up on your own. It
actually just takes the simple steps of familiarizing yourself with the broad framework of
financial statements, learning the basic rules of accounting, and creating formats in
Excel. To give you all the information you need to succeed, this article will talk about the
two approaches to financial modeling, the need for financial statements, creating
financial statements, the types of assets in your balance sheet, and the accounting
basics.

Note from Spencer and Michael: This is another post in a growing series that we call
‘International CRE’. Written by CRE professionals based outside of the United States,
this series is a collection of deep dives into various CRE topics relevant to real estate
professionals all over the world. One of the reasons we love the International CRE
series is that things are not done the same in one country to the next, and this series
highlights those differing perspectives.

This particular post is written by our friend Padmaa Iyer. Padmaa is an India-based Real
Estate Fundraising Strategist and Chartered Accountant. She is also a long-time A.CRE
reader and graduate of our Accelerator Program. A huge thank you to Padmaa for
sharing her knowledge with the A.CRE community!
Picture it. You’re feeling upbeat, and rightfully so. Your meeting is going exactly the way
you wanted it to. You just made a solid pitch for your deal. And to back up your
convictions, you now lay out your A.CRE-style financial model on the table. The
numbers have made your story come alive. The input assumptions and the timing of
various events reveal your meticulous planning and foresight.

Your investor audience is already sold on you. They have never seen a financial model
like this one before – neat and well structured, great flow, easy-to-understand formulas,
comprehensive, sharp. Simple yet elegant.

Still, one of them asks: “But where’s the depreciation? Where’s the tax amount?”

You’re like, “How will depreciation ever feature in a financial model that’s driven by the
cashflows?”

You would be right in thinking that. Depreciation doesn’t belong in a cash-based

financial model. It’s an accounting thing. An expense item is charged to the P/L account.
Even tax for that matter is payable out of the profits recorded in the books of account.

So how do you tackle this confusion?

Definitely not by stringing half-hearted tweaks into the model triggered by the knee-jerk
demands of the other side.

It’s better to first draw up basic 3-part financial statements (viz, the Balance Sheet,
Profit/Loss account, and the Cashflow Statement) from the financial model and then add
accounting adjustments as necessary. This will set things straight.

The good part is even if you’ve never had to do accounting before, drawing up the
forecast financials from the financial model is a fairly simple job.

First, you should familiarize yourself with the broad framework of financial statements
and how they apply to your business. Next, pick up (or refresh) the basic accounting
rules as well as any specific guidance available for accounting your CRE asset. Lastly,
create formats in Excel (that has your financial model), fill them up and you’re done!

In this article we’ll go over 5 concepts about financial statements:

 THE 2 APPROACHES TO FINANCIAL MODELING
 NEED FOR THE FORECAST FINANCIAL STATEMENTS
 FINANCIAL STATEMENTS: PRIMER
 3 TYPES OF RE ASSETS IN THE BALANCE SHEET
 SOME QUICK ACCOUNTING 101

Let’s start.

6 EASY STEPS TO DRAW UP THE FINANCIAL

STATEMENTS
THE 2 APPROACHES TO FINANCIAL MODELING
The  Pure Cashflow Approach  The Balance Sheet Approach

Data from past years’ Balance Sheets is extrapolated with

estimates for the future to understand the impact of new
Investment is purely analyzed in terms of CASH. investments.

Meaning: Meaning:

The Financial Model documents the entire lifecycle of the The Financial Model strives to show how the new Investmen
Investment Proposition. Proposition adds value to the existing business situation.

Best suited for: Best suited for:

Project Finance. Corporate Finance.

E.g., most CRE deals, Cash cow investment opportunities. E.g., M&A deals, Expansion plans of a growing corporation

Goal:

Does the Investment make sense and deliver the investor’s

expected returns? Goal:
The investor would want to know only 2 things – What synergies (e.g.: (2+2) > 4) will the merger offer?
 What cash is required to be invested? How will the increased investment add to the bottom line of
 What cash will they reap out of the investment? Firm?
 And of course, the timing of the various cashflows.

Process:

Cash is analyzed through a simple and logic-driven layout –

1.      Investment Cashflows – (Outflows) Process:

2.      Operating Cashflows – (Net Inflows) Fresh inputs, as well as past insights, are channeled through
Balance Sheet and P/L Statement so as to see what the future
3.      Exit Cashflows – (Net Inflows) periods in the investment analysis period will look like.

What is left out?

The non-cash item of depreciation, income tax expenses, and credit

is given for sales/ incomes and received for purchases/expenses
don’t get calculated. What is left out?

However, discounts for any bad debts and necessary expense In order to calculate return and valuations metrics such
provisions are duly considered in calculating the net cashflow as NPV/ IRR/ Enterprise Value/ Equity Value, we have to pu
estimates. back into pure Cashflow Analysis formats.
THE NEED FOR FORECAST FINANCIAL
STATEMENTS

Based on the premise of a Project Finance Structure, we always follow the clean and
sharp “Pure Cashflow Approach” to prepare our CRE financial model.

If needed, a projected balance sheet will still have to be drawn out from the financial
model.

Here are a few good reasons that might be the case:

1. Legal and regulatory requirements
Many times, we may be required to annex a projected balance sheet as part of the legal
documents forming part of the fundraiser. The formal channels such as bank lenders
often ask for projected 3-part financial statements.
2. After-tax analysis

Having a projected set of financial statements enables us to calculate the tax impact
more easily.

Tax is payable out of income. To know the income, we must have the P/L account that
is part of the Balance Sheet.
3. Investors’ expectations

Investors may want to see what the modeled numbers look like on the Balance sheet.
4. Planning your working capital requirements

A projected Balance sheet can help you better understand our working capital needs
and arrange for short-term funds accordingly.

FINANCIAL STATEMENTS: PRIMER

Really, the crux of the article is this:
The 3-part Financial Statements consist of –
1. The Statement of Financial Position a.k.a. Balance Sheet

Shows the financial health of a business at any point in time.

2. The Statement of Income a.k.a. Profit and Loss Account

Net profit or loss earned during the period. This balance rolls into the Equity that further
rolls into the Balance Sheet.
3. The Cashflow Statement

The schedule that shows cash transactions are broken down into 3 main activities.
 Operating activities
  Investing activities
 Financing activities

For our modeling purposes: The closing cash balance from this Cashflow Statement will
roll into the Balance Sheet.

This means we won’t create a separate schedule for cash.

But remember! In practice as with any other item, there is a ledger account for cash
also. This will find its way into the period-end trial balance. From the trial balance are
prepared the Balance Sheet & P/L account. And lastly, a Cashflow Statement is drawn
out of the Balance Sheet and P/L. Call this a rough summary of the accounting process,
if you will.

We have 2 more segments that will form part of our projected financials.
4. Statement of Changes in Equity, a.k.a. The Equity Schedule

This is the break-up of the Equity Capital balances. It rolls into the Balance Sheet.
5. Supporting Schedules

This is to show the movement in the balances of assets and liabilities.

3 TYPES OF REAL ESTATE ASSETS IN THE

BALANCE SHEET
The main hero of your financials is your CRE asset.

But, how do you know under which asset category the CRE you are dealing with falls?

Well, there are definitions and guidelines laid out by the various accounting standard
boards of the world such as the IFRS to help us with this.
(IFRS is the most preferred set of accounting standards because they seek to unify the financial
reporting practices across the world, and are widely followed by most multinational businesses).
For additional reference, please refer to this technical resource from EY.

From the accounting perspective, there are 3 types of Real Estate Assets:

 Investment Property  Property, Plant & Equipment  Inventory Property

When you build/acquire the CRE property    

with the sole purpose of earning rents and
later selling it off down the line at an
opportune time and price.
Accounting points to remember:
You own the CRE property, but use it You develop a CRE property so as to sel
for the purposes of running your main immediately. This is also a recurring bus
business. for you.
It’s a long-term asset that will appear Accounting points to remember:
 in your books as long as you use the
asset.

Accounting points to remember:

The CRE asset enables you to run

The investment (until it is sold off) should
be restated at its fair values (FV) in the
Balance Sheet at each period end.
And any resulting FV gain or loss will get
booked in the P/L account.
There’s no question of depreciation here!
Examples:
A multifamily apartment building meant for
renting.
An industrial warehouse that comprises
several units meant for leasing out to
eCommerce retailers, manufacturing firms,
etc.
your business smoothly. Although
you may not directly earn income
(such as rent) from it.
As the property is consumed in the
business, it will entail some wear and
tear over its useful years. Only in
such a case, you will provide for a
depreciation expense in your books.
Examples:
A tech company owns an office
building that is occupied by its own
staff.
A hotel company that uses its
premises to provide various
hospitality services.
A retailer firm that owns all of its
mall premises for own business.
Building and selling are the 2 main busin
activities for you. You build – not for ea
rents, not for consumption in your own
business, but for immediate sale.
All the costs incurred in the developmen
process will get capitalized under ‘Inven
Property’, an item of current assets in the
Balance Sheet until it is sold off.
Once the sale is effected, the proportiona
costs move into the P/L from the balance
sheet.
Examples:
Apartments/condominiums/single-family
homes and even commercial premises
developed for immediate sale.

SOME QUICK ACCOUNTING 101

(Skip this segment if you know the basics of accounting)

All the points enumerated in this section are ones you learn in the basics of accounting.
But if you’ve never done any accounting, this handful of basic rules will help drive your
thought process when you sit down to draw up your projected financials.

WHAT ARE THE DEBITS AND CREDITS?

In the Balance Sheet:  All asset balances are debit balances and all liability balances are
credit balances.
In the P/L account:  All income items are credits and all expense items are debits.

Remember, whenever there is a cash outflow, it’s mainly to acquire an asset or pay off
a liability or incur an expense.

Whenever there is a cash inflow, we have either disposed of an asset, raised an item of
debt or other liability, or realized an income.

FOR EVERY DEBIT, THERE IS A CORRESPONDING CREDIT

This is the essence of the Double Entry system. It lends completeness to
accounting. The Zero-sum equation.
ACCOUNTING SANCTITY/ENTITY CONCEPT
If I invest my own equity in my business, the business still has an obligation to return
back my money at the end of its lifecycle.

MATCHING CONCEPT
All the revenues and related expenses are recognized in the same reporting period.

THE 3 GOLDEN RULES OF ACCOUNTING

 Debit the receiver, credit the giver.
 Debit what comes in, credit what goes out.
 Debit all expenses and losses, credit all incomes and gains

Examples:
1.
 When an Investment Property is purchased

1.
 When Partners contribute Equity Capital to the business

1.
 When a Financing Fee is paid to the Lender
 1.
 When a rental income is received

1.
 To Capitalise or not to Capitalise?

This is a frequent question you will encounter in the process of accounting. Of course, it
calls for prudence and reference to any accounting guidance available from the
regulatory authorities.
Capitalizing on an item of the cost will lead to a higher Net-worth versus a write-off in the
P/L.

Example:

In the Books of one SPE, the break-up of a CRE Investment Property Cost is as follows:
Scenario 1:  If these XYZ fees are capitalized –

Scenario 2:  If these XYZ fees are not capitalized –

Now, here comes the main part…

6 STEPS TO THE FORECAST FINANCIAL

STATEMENTS
EXAMPLE #1: WHERE THE CRE ASSET IS AN INVESTMENT
PROPERTY
When the CRE asset is an investment property you raise capital for, buy/build, lease out
for some years and then exit at an opportune time.

Let’s look at the 6 steps in detail and a short video walkthrough inside Excel.
 Link to the PDF
 Link to the Excel sheet
VIDEO WALKTHROUGH
EXAMPLE #2: WHERE THE CRE ASSET IS A PROPERTY, PLANT,
AND EQUIPMENT
Coming soon.

EXAMPLE #3: WHERE THE CRE ASSET IS AN INVENTORY

PROPERTY
Coming soon.

WORDS OF CAUTION!!
We are not doing elaborate accounting here. The limited purpose of such forecast
financial statements is to understand broadly what the balance sheet will look like,
assess the need for any short-term funding, or provide a basis for calculating the likely
tax impact on the proposed investment.

By nature, books of account are maintained post events. If your investor audience
wants a great deal of accuracy, ask them to first get invested in your project and ride the
investment in real time. And see firsthand how things turn out. :)
HOW TO DRAW-UP 3-PART FINANCIAL
STATEMENTS FROM YOUR CRE
FINANCIAL MODEL
Sometimes, your investors will want to see financial statements. Though this is usually
something left to accounting, it’s not a difficult thing for you to draft up on your own. It
actually just takes the simple steps of familiarizing yourself with the broad framework of
financial statements, learning the basic rules of accounting, and creating formats in
Excel. To give you all the information you need to succeed, this article will talk about the
two approaches to financial modeling, the need for financial statements, creating
financial statements, the types of assets in your balance sheet, and the accounting
basics.

Note from Spencer and Michael: This is another post in a growing series that we call
‘International CRE’. Written by CRE professionals based outside of the United States,
this series is a collection of deep dives into various CRE topics relevant to real estate
professionals all over the world. One of the reasons we love the International CRE
series is that things are not done the same in one country to the next, and this series
highlights those differing perspectives.

This particular post is written by our friend Padmaa Iyer. Padmaa is an India-based Real
Estate Fundraising Strategist and Chartered Accountant. She is also a long-time A.CRE
reader and graduate of our Accelerator Program. A huge thank you to Padmaa for
sharing her knowledge with the A.CRE community!

Picture it. You’re feeling upbeat, and rightfully so. Your meeting is going exactly the way
you wanted it to. You just made a solid pitch for your deal. And to back up your
convictions, you now lay out your A.CRE-style financial model on the table. The
numbers have made your story come alive. The input assumptions and the timing of
various events reveal your meticulous planning and foresight.
Your investor audience is already sold on you. They have never seen a financial model
like this one before – neat and well structured, great flow, easy-to-understand formulas,
comprehensive, sharp. Simple yet elegant.

Still, one of them asks: “But where’s the depreciation? Where’s the tax amount?”

You’re like, “How will depreciation ever feature in a financial model that’s driven by the
cashflows?”

You would be right in thinking that. Depreciation doesn’t belong in a cash-based

financial model. It’s an accounting thing. An expense item is charged to the P/L account.
Even tax for that matter is payable out of the profits recorded in the books of account.

So how do you tackle this confusion?

Definitely not by stringing half-hearted tweaks into the model triggered by the knee-jerk
demands of the other side.

It’s better to first draw up basic 3-part financial statements (viz, the Balance Sheet,
Profit/Loss account, and the Cashflow Statement) from the financial model and then add
accounting adjustments as necessary. This will set things straight.

The good part is even if you’ve never had to do accounting before, drawing up the
forecast financials from the financial model is a fairly simple job.

First, you should familiarize yourself with the broad framework of financial statements
and how they apply to your business. Next, pick up (or refresh) the basic accounting
rules as well as any specific guidance available for accounting your CRE asset. Lastly,
create formats in Excel (that has your financial model), fill them up and you’re done!

In this article we’ll go over 5 concepts about financial statements:

 THE 2 APPROACHES TO FINANCIAL MODELING
 NEED FOR THE FORECAST FINANCIAL STATEMENTS
 FINANCIAL STATEMENTS: PRIMER
 3 TYPES OF RE ASSETS IN THE BALANCE SHEET
 SOME QUICK ACCOUNTING 101

Let’s start.

6 EASY STEPS TO DRAW UP THE FINANCIAL

STATEMENTS
THE 2 APPROACHES TO FINANCIAL MODELING
The  Pure Cashflow Approach  The Balance Sheet Approach
 Data from past years’ Balance Sheets is extrapolated with
estimates for the future to understand the impact of new
Investment is purely analyzed in terms of CASH. investments.

Meaning: Meaning:

The Financial Model documents the entire lifecycle of the The Financial Model strives to show how the new Investmen
Investment Proposition. Proposition adds value to the existing business situation.

Best suited for: Best suited for:

Project Finance. Corporate Finance.

E.g., most CRE deals, Cash cow investment opportunities. E.g., M&A deals, Expansion plans of a growing corporation

Goal:

Does the Investment make sense and deliver the investor’s

expected returns? Goal:
The investor would want to know only 2 things – What synergies (e.g.: (2+2) > 4) will the merger offer?
 What cash is required to be invested? How will the increased investment add to the bottom line of
 What cash will they reap out of the investment? Firm?
 And of course, the timing of the various cashflows.

Process:

Cash is analyzed through a simple and logic-driven layout –

1.      Investment Cashflows – (Outflows) Process:

2.      Operating Cashflows – (Net Inflows) Fresh inputs, as well as past insights, are channeled through
Balance Sheet and P/L Statement so as to see what the future
3.      Exit Cashflows – (Net Inflows) periods in the investment analysis period will look like.

What is left out?

The non-cash item of depreciation, income tax expenses, and credit

is given for sales/ incomes and received for purchases/expenses
don’t get calculated.
What is left out?
However, discounts for any bad debts and necessary expense
provisions are duly considered in calculating the net cashflow In order to calculate return and valuations metrics such
estimates. as NPV/ IRR/ Enterprise Value/ Equity Value, we have to pu
back into pure Cashflow Analysis formats.

THE NEED FOR FORECAST FINANCIAL

STATEMENTS
Based on the premise of a Project Finance Structure, we always follow the clean and
sharp “Pure Cashflow Approach” to prepare our CRE financial model.

If needed, a projected balance sheet will still have to be drawn out from the financial
model.

Here are a few good reasons that might be the case:

1. Legal and regulatory requirements

Many times, we may be required to annex a projected balance sheet as part of the legal
documents forming part of the fundraiser. The formal channels such as bank lenders
often ask for projected 3-part financial statements.
2. After-tax analysis

Having a projected set of financial statements enables us to calculate the tax impact
more easily.

Tax is payable out of income. To know the income, we must have the P/L account that
is part of the Balance Sheet.
3. Investors’ expectations

Investors may want to see what the modeled numbers look like on the Balance sheet.
4. Planning your working capital requirements
A projected Balance sheet can help you better understand our working capital needs
and arrange for short-term funds accordingly.

FINANCIAL STATEMENTS: PRIMER

Really, the crux of the article is this:

The 3-part Financial Statements consist of –

1. The Statement of Financial Position a.k.a. Balance Sheet

Shows the financial health of a business at any point in time.

2. The Statement of Income a.k.a. Profit and Loss Account

Net profit or loss earned during the period. This balance rolls into the Equity that further
rolls into the Balance Sheet.
3. The Cashflow Statement

The schedule that shows cash transactions are broken down into 3 main activities.
 Operating activities
 Investing activities
 Financing activities

For our modeling purposes: The closing cash balance from this Cashflow Statement will
roll into the Balance Sheet.
This means we won’t create a separate schedule for cash.

But remember! In practice as with any other item, there is a ledger account for cash
also. This will find its way into the period-end trial balance. From the trial balance are
prepared the Balance Sheet & P/L account. And lastly, a Cashflow Statement is drawn
out of the Balance Sheet and P/L. Call this a rough summary of the accounting process,
if you will.

We have 2 more segments that will form part of our projected financials.
4. Statement of Changes in Equity, a.k.a. The Equity Schedule

This is the break-up of the Equity Capital balances. It rolls into the Balance Sheet.
5. Supporting Schedules

This is to show the movement in the balances of assets and liabilities.

3 TYPES OF REAL ESTATE ASSETS IN THE

BALANCE SHEET
The main hero of your financials is your CRE asset.

But, how do you know under which asset category the CRE you are dealing with falls?

Well, there are definitions and guidelines laid out by the various accounting standard
boards of the world such as the IFRS to help us with this.
(IFRS is the most preferred set of accounting standards because they seek to unify the financial
reporting practices across the world, and are widely followed by most multinational businesses).
For additional reference, please refer to this technical resource from EY.

From the accounting perspective, there are 3 types of Real Estate Assets:

 Investment Property  Property, Plant & Equipment  Inventory Property

When you build/acquire the CRE property    

with the sole purpose of earning rents and
later selling it off down the line at an
opportune time and price.
Accounting points to remember:
The investment (until it is sold off) should
be restated at its fair values (FV) in the
Balance Sheet at each period end.
And any resulting FV gain or loss will get
booked in the P/L account.
You own the CRE property, but use it
for the purposes of running your main
business.
It’s a long-term asset that will appear
in your books as long as you use the
asset.
Accounting points to remember:
The CRE asset enables you to run
your business smoothly. Although
You develop a CRE property so as to sel
immediately. This is also a recurring bus
for you.
Accounting points to remember:
Building and selling are the 2 main busin
activities for you. You build – not for ea
rents, not for consumption in your own
business, but for immediate sale.
All the costs incurred in the developmen
 you may not directly earn income
(such as rent) from it.

As the property is consumed in the

There’s no question of depreciation here!
Examples:
A multifamily apartment building meant for
renting.
An industrial warehouse that comprises
several units meant for leasing out to
eCommerce retailers, manufacturing firms,
etc.
business, it will entail some wear and
tear over its useful years. Only in
such a case, you will provide for a
depreciation expense in your books.
Examples:
A tech company owns an office
building that is occupied by its own
staff.
A hotel company that uses its
premises to provide various
hospitality services.
A retailer firm that owns all of its
mall premises for own business.
process will get capitalized under ‘Inven
Property’, an item of current assets in the
Balance Sheet until it is sold off.
Once the sale is effected, the proportiona
costs move into the P/L from the balance
sheet.
Examples:
Apartments/condominiums/single-family
homes and even commercial premises
developed for immediate sale.

SOME QUICK ACCOUNTING 101

(Skip this segment if you know the basics of accounting)

All the points enumerated in this section are ones you learn in the basics of accounting.
But if you’ve never done any accounting, this handful of basic rules will help drive your
thought process when you sit down to draw up your projected financials.

WHAT ARE THE DEBITS AND CREDITS?

In the Balance Sheet:  All asset balances are debit balances and all liability balances are
credit balances.
In the P/L account:  All income items are credits and all expense items are debits.

Remember, whenever there is a cash outflow, it’s mainly to acquire an asset or pay off
a liability or incur an expense.

Whenever there is a cash inflow, we have either disposed of an asset, raised an item of
debt or other liability, or realized an income.

FOR EVERY DEBIT, THERE IS A CORRESPONDING CREDIT

This is the essence of the Double Entry system. It lends completeness to
accounting. The Zero-sum equation.
ACCOUNTING SANCTITY/ENTITY CONCEPT
If I invest my own equity in my business, the business still has an obligation to return
back my money at the end of its lifecycle.
MATCHING CONCEPT
All the revenues and related expenses are recognized in the same reporting period.

THE 3 GOLDEN RULES OF ACCOUNTING

 Debit the receiver, credit the giver.
 Debit what comes in, credit what goes out.
 Debit all expenses and losses, credit all incomes and gains

Examples:
1.
 When an Investment Property is purchased

1.
 When Partners contribute Equity Capital to the business

1.
 When a Financing Fee is paid to the Lender

1.
 When a rental income is received
 1.
 To Capitalise or not to Capitalise?

This is a frequent question you will encounter in the process of accounting. Of course, it
calls for prudence and reference to any accounting guidance available from the
regulatory authorities.
Capitalizing on an item of the cost will lead to a higher Net-worth versus a write-off in the
P/L.

Example:

In the Books of one SPE, the break-up of a CRE Investment Property Cost is as follows:

Scenario 1:  If these XYZ fees are capitalized –

Scenario 2:  If these XYZ fees are not capitalized –

Now, here comes the main part…

6 STEPS TO THE FORECAST FINANCIAL

STATEMENTS

EXAMPLE #1: WHERE THE CRE ASSET IS AN INVESTMENT

PROPERTY
When the CRE asset is an investment property you raise capital for, buy/build, lease out
for some years and then exit at an opportune time.

Let’s look at the 6 steps in detail and a short video walkthrough inside Excel.
 Link to the PDF
 Link to the Excel sheet
VIDEO WALKTHROUGH
EXAMPLE #2: WHERE THE CRE ASSET IS A PROPERTY, PLANT,
AND EQUIPMENT
Coming soon.
EXAMPLE #3: WHERE THE CRE ASSET IS AN INVENTORY
PROPERTY
Coming soon.

WORDS OF CAUTION!!
We are not doing elaborate accounting here. The limited purpose of such forecast
financial statements is to understand broadly what the balance sheet will look like,
assess the need for any short-term funding, or provide a basis for calculating the likely
tax impact on the proposed investment.

By nature, books of account are maintained post events. If your investor audience
wants a great deal of accuracy, ask them to first get invested in your project and ride the
investment in real time. And see firsthand how things turn out. :)


What is financial forecasting?
 Why is it important?
 4 common types of financial forecasting
 How to do financial forecasting in 7 steps
 Financial forecasting FAQs
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Uncertainty is one of the constant aspects of doing business. Many factors beyond your control
can potentially influence the market in ways you didn't expect. For example, new technologies
are constantly changing operations across almost all industries at a fundamental level. 

It pays to know what to expect in the near future and plan ahead, hence the need for financial
forecasting. Every business (including monopolies) could benefit incredibly from
regular financial forecasting. Here is a comprehensive guide on the importance of financial
forecasting for your business model and how to do it.
Failure to conduct regular financial forecasting leaves you flying blind.
What is financial forecasting? 
Financial forecasting refers to financial projections performed to facilitate any decision-making
relevant for determining future business performance. The financial forecasting process includes
the analysis of past business performance, current business trends, and other relevant factors.
However, some aspects of financial forecasting may change depending on the type and purpose
of the forecast, as will be discussed later. 
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Importance of financial forecasting 

Hypothetically speaking, failure to conduct regular financial forecasting leaves you flying blind.
Regular forecasting has extensive benefits for some of your business' fundamental operations,
including: 

Annual budget planning 

A budget represents your business' cash flow, financial positions, and future goals and
expectations for a set fiscal period. Financial forecasting and planning work in tandem, as
forecasting essentially offers an insight into your business' future—these insights help make
budgeting accurate.  
Establishing realistic business goals 

Accurate forecasting will help predict whether (and by how much) your business will grow or
decline. As such, you can set realistic and achievable goals—and manage your expectations. 

Identifying problem areas 

Financial forecasting can help you identify ongoing problems by analyzing the business' past
performance. Additionally, you can identify potential problems by getting an insight into what
the future holds. 
Reduction of financial risk 

You risk overspending by creating a budget without financial forecasting. In fact, most of your
financial decisions would be ill-informed without the input of a financial forecast's results. 
Greater company appeal to attract investors 

Investors use a company's financial forecast to predict its future performance—and the potential
ROIs on their investments. Additionally, regular forecasting shows your investors that you are in
control and have a solid business plan prepared for the future.

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4 common types of financial forecasting 

Businesses conduct financial forecasting for varying purposes. Consequently, forecasting
practices are categorized into four types: 

1. Sales forecasting 

Sales forecasting entails predicting the amounts of products/services you expect to sell within a
projected fiscal period. There are two sales forecasting methodologies: top-down forecasting and
bottom-up forecasting. 

Sales forecasting has many uses and benefits, including budgeting and planning production
cycles. It also helps companies manage and allocate resources more efficiently. 

2. Cash flow forecasting 

Cash flow forecasting entails estimating the flow of cash in and out of the company over a set
fiscal period. It's based on factors such as income and expenses. It has many uses and benefits,
including identifying immediate funding needs and budgeting. However, it is worth noting that
cash flow financial forecasting is more accurate over a short term. 
3. Budget forecasting 

As a financial guide for your business' future, a budget creates certain expectations about your
company's performance. Budget forecasting aims to determine the ideal outcome of the budget,
assuming that everything proceeds as planned. It relies on the budget's data, which relies on
financial forecasting data. 

4. Income forecasting 
Income forecasting entails analyzing the company's past revenue performance and current
growth rate to estimate future income. It is integral to doing cash flow and balance sheet
forecasting. Additionally, the company's investors, suppliers, and other concerned third parties
use this data to make crucial decisions. For example, suppliers use it when determining how
much to credit the company in supplies. 
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How to do financial forecasting in 7 steps 

Many integral aspects of your company's current and future operations hinge on the results of
your financial forecasts. For example, forecasting results will influence investors' decisions,
determine how much your company can get in credit, and more. 

As such, accuracy cannot be overemphasized. Here is a step-by-step guide to ensure that you do
it right: 

1. Define the purpose of a financial forecast 

What do you hope to learn from the financial forecast? Do you hope to estimate how many units
of your products or services you will sell? Or perhaps you wish to see how the company's current
budget will shape its future? Defining your financial forecast's purpose is essential to
determining which metrics and factors to consider when doing it. 

2. Gather past financial statements and historical data 

One of the components of financial forecasting involves analyzing past financial data, as
explained. As such, it is important to gather all relevant historical data and records, including: 

 Revenue 
 Losses 
 Liabilities 
 Investments 
 Equity 
 Expenditures 
 Comprehensive income 
 Earnings per share 
 Fixed costs

It's important to ensure that you gather all required information as your financial forecast's
results will be inaccurate if you exclude relevant data.

3. Choose a time frame for your forecast 

Financial forecasts are designed to give business owners an insight into the company's future.
You get to decide how far into the future to look, and it can range from several weeks to several
years. However, most companies do forecasts for one fiscal year. 

Financial forecasts change over time as factors such as business and market trends change.
Consequently, it is worth noting that financial forecasting is more accurate in the short term than
in the long term.

4. Choose a financial forecast method 

There are two financial forecasting methods: 

 Quantitative forecasting uses historical information and data to identify trends, reliable
patterns, and trends. 
 Qualitative forecasting analyzes experts' opinions and sentiments about the company and
market as a whole. 

Each method is suitable for different uses and has its strengths and shortcomings. However,
qualitative forecasting is more suitable for startups without past data to which they can refer. 

5. Document and monitor results 

Financial forecasts are never 100% accurate and tend to change over time. As such, it is
important to document and monitor your forecast's results over time, especially after major
internal and external developments. It is also important to update your forecasts to reflect the
latest developments. Using forecasting software to automate related tasks may help too.
6. Analyze financial data 

Regularly analyzing financial data is the best way to tell whether your financial forecasts are
accurate. Additionally, continuous financial management and analysis helps you prepare better
for the next financial forecast and gives you crucial insights into the company's current financial
performance. 

7. Repeat based on the previously defined time frame 

Smart companies conduct regular financial forecasting to stay in the know and in control. As
such, it is advisable to repeat the process once the time period set for the current financial
forecast elapses. It's also prudent to keep collecting, recording, and analyzing data to improve
your financial forecasts' accuracy.

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We’ve acquired ProfitWell. Together, we’ll help run and grow subscription businesses automatically.

Christian Owens

Get accurate metrics for financial forecasting—absolutely

free 
An efficient system of collecting, storing, and analyzing data is necessary for accurate financial
forecasting. ProfitWell Metrics is a subscription analytics software designed to do all of this on
one platform. Some of the metrics that you can get using this program include: 

 Monthly and annual recurring revenues 

 Market and customer segments 
  Customer acquisition and retention 
 Customer lifetime value 
 Churn rate 
 The average revenue per user 

ProfitWell Metrics collects and records all important metrics, giving you enough data to work
with when conducting a financial forecast. Additionally, the data collected in real-time offers
crucial insights to help you update your forecasts and other projects accordingly. 
ProfitWell Metrics also integrates seamlessly with other popular data analytics programs,
including Google Sheets and Stripe. More importantly, it's 100% free and secure. 
Financial forecasting FAQs 
Some of the most frequently asked questions regarding financial forecasting include: 

What is the role of forecasting in financial planning? 

Financial forecasting estimates important financial metrics such as sales, income, and future
revenue. These metrics are crucial for finance-related operations such as budgeting and financial
planning as a whole. Consequently, forecasting functions as a guiding tool (or marking scheme)
for financial planning. 

What is the difference between financial forecasting and modeling? 

On the one hand, financial forecasting entails predicting the business' future performance. On the
other hand, financial modeling entails simulating how financial forecasts and other data may
affect the company's future if everything goes according to plan. Financial modeling is done for
very specific and often discrete purposes. 

What is the difference between financial forecasting and budgeting? 

Financial forecasting and budgeting work in tandem and are often misinterpreted as meaning the
same thing. However, financial forecasting entails estimating and predicting the company's
future performance (financially and in other aspects). On the other hand, budgeting is the
company's financial expectations for the future (expectations based on financial forecasts and
other data). 

What are the three pro forma statements needed for financial forecasting? 

Pro forma statements are financial reports designed to give insights into how different scenarios
would play out based on hypothetical circumstances. There are three pro forma statements: 

 Pro forma statements of income 

 Pro forma cash flow statements 
 Pro forma balance sheets 
Pro forma statements may be hypothetical, but they help companies prepare for an uncertain
future. Consequently, they're useful when conducting financial forecasts. 

6 steps to making financial projections

for your new business
3-minute read

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A business plan is one of the key building blocks of any new company. One of its main
components should be financial projections for your first two years.

These projections are forecasts of your cash inflows and outlays, income and balance
sheet. They show bankers and investors how you will repay loans, what you intend to
do with your money and how you will grow. They also help you identify financing needs,
optimize your pricing, plan production, time major expenditures and monitor your cash
flow.

It’s normal for some of your initial numbers to be rough guesses since sales will usually
be hard to predict. Here are the steps to create your financial projections for your start-
up.

1. Project your spending and sales

As you develop your business plan, list the key expenditures you will need to make to
get your company off the ground and your subsequent costs to operate. Be sure to
include recurring expenses—salaries, rent, gas, insurance, marketing, raw materials,
maintenance and the like—and one-time purchases, such as machinery, website design
and vehicles. Research industry spending to get a better idea of the numbers.

Also, create a sales forecast and use it to project anticipated monthly revenues. A
careful study of your potential market will help you arrive at realistic numbers.

2. Create financial projections

Plug your expenses and revenues into a cash flow projection that shows monthly
inflows and outflows of money for the first 12 months of operations. For the second
year, you can make quarterly or yearly projections.

To create the projections, you can use an Excel spreadsheet or tools available in your
accounting software. Don’t assume sales equal cash in the bank right away. Enter them
as cash only when you expect to get paid based on industry averages and any prior
experiences of your team.

Use your cash flow projections to prepare annual projected income (profit and loss)
statements and balance sheet projections.

3. Determine your financial needs

Your financial projections will help you see if your business plans are realistic, whether
you’ll have any shortfalls and what financing you may need. The documents will also be
vital for building a case for business loans.
4. Use the projections for planning
It can be useful to include various scenarios—most likely, optimistic and pessimistic—
for each projection in order to help you foresee the financial impacts of each one.

Your projections can also help you analyze the impacts of different strategies for your
new business. What if you charged a different price? Or were able to collect bills more
quickly? Or opted for more efficient equipment? Plugging in various numbers shows
how such decisions would affect your finances.
5. Plan for contingencies
What would you do if an unexpected event threw off your projections? It’s a good idea
to do some contingency planning ahead of time. Also consider setting aside a cash
reserve, just in case. Many entrepreneurs like to have enough cash for 90 days of
operations (including cash in the bank and/or room on their line of credit).

6. Monitor
As your business starts operations, compare your projections against actual results to
check if you’re on target or need to make changes. Monitoring helps you learn about
your company’s cash flow cycle and spot looming shortfalls early on, when they’re
usually easier to address.

Plus, if you ever go looking for more funding, you’ll need financial forecasts to prove
that your business is on track for growth.

Here’s everything you need on hand, and the steps you can take, to produce a reliable
financial forecast.

What is a financial forecast?

A financial forecast tries to predict what your business will look like (financially) in
the future. Pro forma financial statements are how you make those predictions
somewhat concrete.

Pro forma statements are just like the financial statements you use each month to see
how your business is performing. The only difference is that you prepare pro forma
statements in advance, for future months and years.

There are three key pro forma statements you should be familiar with:

 The Income Statement

 The Cash Flow Statement

 The Balance Sheet

Helpful resource: How to Read and Analyze Financial Statements

Depending on your goals, these statements will cover different time spans. If you’re
creating a financial forecast for your planning purposes, you should create pro forma
statements covering six months to one year in the future.

If you’re presenting your forecast to a lender or investor, though, you should create
pro forma statements covering the next one to three years.

Financial forecasting vs. budgeting

When you create a budget for your business, you plan to set aside money for certain
costs, taking into account your income and expenses. The budget you make may be
based on info from your financial forecast, but it’s distinct from the forecast itself.

Think of financial forecasting as a prediction, and budgeting as a plan. When you

make a financial forecast, you see what direction your business is headed in, based on
past performance and other factors, and use that to anticipate the future.

When you make a budget, you plan how you’re going to spend money based on what
you expect your finances to look like in the future (your forecast).

For instance, if your financial forecast for next year says you’ll have an extra $5,000
in revenue, you might create a budget to decide how it will be spent—$2,000 for a
new website, $1,000 for Facebook ads, and so on.
How do you usually handle your bookkeeping tasks?
 

Three steps to creating your financial forecast

Ready to peer into the crystal ball and see the future of your business? There are three
steps you need to follow:

1. Gather your past financial statements. You’ll need to look at your past

finances in order to project your income, cash flow, and balance.

2. Decide how you’ll make projections. Besides past records, there’s other data
you can draw on to make your projections more accurate.

3. Prepare your pro forma statements. Pour a coffee and get ready to crunch
some numbers.

Step one: Gather your records

If you’re not looking into the past to see how your business has grown, you’re not
really forecasting—you’re just guessing.

You’ll need to gather past financial statements so you can see how your business has
developed over time, and then project that development into the future.

Your bookkeeper or bookkeeping software should generate financial statements for

you. If you don’t have either, and you don’t have financial statements, you’ll need to
take care of that before you can start forecasting. You need complete bookkeeping in
order to get the transaction history you base your financial statements on.

Put aside the task for financial forecasting for the moment, and learn how to catch up
on your bookkeeping.

Once your books and financial statements are up to date, you’ll have everything you
need to start planning for the future.

Step two: Decide how you’ll make your forecast

Depending what resources you choose to use, the type of forecast you create will fall
between two poles—historical and researched-based.
Almost every financial forecast includes a little bit of historical forecasting, and a
little bit that’s research-based. The blend you choose will depend on your needs and
the resources at your disposal.

Remember, the goal is to create a realistic, useful forecast—without breaking the bank
or eating up all your time.

Historical forecasting

When you use your financial history to plot the future, it’s historical forecasting.
You’re looking at your last few annual Income Statements, Cash Flow Statements,
and Balance Sheets to see how fast you’ve grown in the past. From there, you can
make a guess about how fast you’ll grow this year.

The benefit of this is that it’s relatively easy to do and doesn’t take a lot of time,
money, or expertise. The drawback is that you’re only using info about your own
business, and not looking at broader market trends—like what your competition has
been up to.

Historical forecasting is a good bet if you’re forecasting for modest growth, or else
creating a quick-and-dirty forecast for your own use—not putting together a
presentation for potential investors.

Research-based forecasting

When you do research about broader market trends, you’re using research-based

forecasting. You may look at how your industry has performed over the past ten
years, investigate new technologies and consumer trends, or try to measure the
progress of your competitors. You might look at how companies similar to yours have
planned their own growth.

The benefit of research-based forecasting is that you get a detailed, nuanced view of
how your business could grow, taking into account a lot of different factors. And it’s
the kind of forecast that investors and lenders want to see.

The drawback is that researched-based forecasting can be expensive. You may find
you need to hire outside consultants and researchers to handle the heavy lifting.

Research-based forecasting is a good choice if you’re courting investors, or planning

on rapid, aggressive growth. It’s also good if your company is brand new, and doesn’t
have a lot of financial history to draw on for making projections
See what running a business is like with Bench on your side.

Try us for free—we'll do one prior month of your bookkeeping and prepare a set of
financial statements for you to keep.

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Step three: Create pro forma statements

Once you’ve collected the information you need to build your forecast, you can create
pro forma statements.

We’ll cover the three key financial statements here. Whether you use all of them is up
to you.

If you’re creating a quick forecast for your own planning, you may only need to create
pro forma Income Statements. If you’re presenting to lenders or investors, you’ll want
to use all three.

Rule of thumb: Any form you’d use in the month-to-month operation of your business
should be created pro forma. For instance, if you move a lot of cash around every
month, and you rely on Cash Flow Statements to make sure you’ve got enough money
on hand to pay your vendors, then it’s wise to create pro forma Cash Flow Statements
as part of your forecast.
Creating the pro forma Income Statement

First, set a goal—a projection—for sales in the period you’re looking at.

Let’s say you made $30,000 in sales this year. Next year, you want to make $60,000.
So, your total sales will increase by $30,000.

Set a production schedule that will let you reach that goal, and map it out over the
time period you’re covering. In our example, there will be 12 Income Statements in
the year to come (one each month). Map out that $30,000 increase in sales over the 12
statements.

You could do this by increasing sales a fixed amount every month, or gradually
increasing the amount of sales you make per month. It’s up to your instincts and
experience as a business owner.

Then, it’s time for the “loss” part of “profit and loss.” Calculate the cost of goods
sold for each month, and deduct it from your sales. Deduct any other operating
expenses you have, as well.

It’s important to take every expense into account so you get an accurate projection. If
part of your plan is quadrupling your online advertising, be sure to include an expense
that reflects that.

Once you’re done, your pro Forma Income Statements show you how much you can
expect to earn and how much you can expect to spend in the time ahead.

Example Pro Forma Income Statement:

Karen’s Falafel Warehouse

2022 (current) $ 2023 $ 2024 $

Sales Revenue 15,000 19,000 23,000

Cost of Sales (6,000) (9,000) (11,000)

Gross Profit 9,000 10,000 12,000

Operating Expenses

Rent 1,000 1,000 1,000

Web hosting 600 600 600

Advertising 3,000 3,000 3,000

 2022 (current) $ 2023 $ 2024 $

Total Operating Expenses (4,600) (4,600) (4,600)

Operating Income 4,400 5,400 7,400

Net Income 4,400 5,400 7,400

Creating the pro forma Cash Flow Statement

You create a pro forma Cash Flow Statement a lot like the way you’d create a regular
Cash Flow Statement. That means taking info from the Income Statement, and using
the Cash Flow Statement format to plot out where your money is going, and how
much you’ll have on hand at any one time.

Your projected cash flow can tell you a few things. If it’s in the negative, it means
you’re not going to have enough cash on-hand to run your business, according to your
current trajectory. You’ll need to make plans to borrow money and pay it off.

If your net cash flow is positive, you can plan on having enough surplus cash on hand
to pay off loans, or save for a big investment.

Example Pro Forma Cash Flow Statement:

Ruth’s Raccoon Rescue and Rehabilitation Center

2022 (current) $ 2023 $ 2024 $

OPENING BALANCE 15,000 16,000 18,000

CASH RECEIVED FROM

Donors 86,000 88,000 93,000

Souvenir Shop 1,000 900 800

Total Cash Received 87,000 88,900 93,800

CASH PAID FOR

Supplies 33,000 35,000 36,000

Rent 24,000 24,000 24,000

Income Tax 8,000 8,600 8,800

Total Cash Paid 64,000 67,600 68,800

 2022 (current) $ 2023 $ 2024 $

Net Cash Flow Operations 23,000 22,300 25,000

Creating the pro forma Balance Sheet

Drawing on info from the Income Statement and the Cash Flow Statement lets you
create pro forma Balance Sheets. But you’ll also need previous Balance Sheets to
make this useful—so you can follow the story of how your business got from
“Balance A” to “Balance B.”

The Balance Sheet will project changes in your business accounts over time. That
way, you can plan where to move money, when.

Example Pro Forma Balance Sheet:

Big Bill’s Budget Wedding Videos

2022 (current) $ 2023 $ 2024 $

ASSETS

Current Assets

Checking Acct. 12,000 15,000 18,000

Savings Acct. 34,000 40,000 44,000

Accounts Receivable 3,000 1,000 2,000

Inventory 14,000 17,000 21,000

Total Current Assets 63,000 73,000 86,000

NON-CURRENT ASSETS

Video Equipment 13,000 13,000 13,000

Car 7,000 7,000 7,000

Total Non-Current Assets 20,000 20,000 20,000

Total Assets 83,000 93,000 106,000

LIABILITIES & EQUITY

Current Liabilities

Accounts Payable 10,000 9,000 11,000

Line of Credit 23,000 20,000 19,000

 2022 (current) $ 2023 $ 2024 $

Total Current Liabilities 50,000 45,000 43,000

Non-current Liabilities

Loan 40,000 36,000 32,000

Total Liabilities 90,000 81,000 75,000

EQUITY

Owner’s Capital 30,000 30,000 30,000

Retained Earnings 45,000 56,000 65,000

Total Equity 75,000 86,000 95,000

Total Liabilities & Equity 165,000 167,000 170,000

Forecast vs. actuals

Once you’ve created a financial forecast, your work isn’t done. The vital second stage
is to go back and record what your actual financials were in comparison to your
forecast once the month or year is over.

Why is this so vital?

It helps you learn to forecast better next year, and when your forecast is way off, you
can take notes for yourself on why that was.

For example:

 March revenue was much higher than I forecasted for. I didn’t realize there
would be a seasonal boost over spring break.
 Sales were lower than I forecasted in the June. There was a miscommunication
with the supplier and I didn’t have all the inventory I needed.

These mundane notes to yourself accumulate into invaluable business knowledge that
help make every year more successful than the last.
Best, worst, and normal case projections

Whether you’re the kind of person who always sees the glass half full, or the kind
who always sees it half empty, it’s a good idea to take into account different possible
outcomes for your business.

Humans aren’t very good at predicting the future. Consider creating three different
forecasts: One for the best case scenario, one for the worst, and one for the middle or
“regular” scenario.

 Maybe the t-shirts you buy wholesale for your online store go up in price, like
they did last year. Factor that into your worst case scenario.

 Maybe t-shirt prices stay the same, plus your new advertising plan takes off,
and you get more business. Consider that the best case.

 Maybe everything more or less stays the same. Let’s call that the regular case.

The best/worst/regular trifecta is also useful when you’re making a budget for your
business. For example, in January you might budget for a regular scenario. In this
case, that means monthly sales revenue of $8,000.

However, in February say your revenue hits $10,000, and in March it’s $11,000. At
that point, you may want to adjust your budget to the best case to scenario—since
you’ll now have more money to reinvest in your business.

At the end of the day, the more robust your forecast, the better you’ll be able to plan
the future of your business, and think on your feet. Plus, you’ll impress investors and
lenders, by proving you’ve considered (almost) every possible outcome.

The better you understand how financial statements work, the easier you’ll find it to
create financial forecasts. Before you start forecasting, take a look at our other helpful
resources for understanding your small business financials:

To make informed financial decisions in your company, you first

have to be, well, informed.
Understanding the financial activity of your company sets the
foundation for identifying good business opportunities and making
the right decisions to ensure future growth.

By tracking, organizing, and analyzing financial performances, you

will have a clearer picture of where the money is going and where
it’s coming from. No wonder finance is one of the most monitored
and reported operations, according to Databox’s State of Business
Reporting .

To stay on top of numbers, companies use financial reports.

Financial reports are formal documents that capture all the

significant financial activities within a business in a specific period.

While these reports are extremely useful for you and your key
stakeholders, you won’t be the only one reaping the fruits. Financial
statements are also examined by potential investors and banks since
they provide them with enough insight to determine whether they
want to invest in your business.

In this article, we are going to walk you through what financial

reports are, why they are significant and show you a step-by-step
guide that will take your financial reports and business reporting  as
a whole, to the next level.

 What Is a Financial Report?

 What Is the Purpose of Financial Reporting?
 What Are the Types of Financial Reporting?
 How to Write a Financial Report?
 Finance Report Examples
 Improve Financial Reporting with Databox
What Is a Financial Report?
Financial reports are official company documents that showcase all
the financial activities and performances of your business over a
specific period. Usually, they are created on a quarterly or yearly
basis.

Every business is legally obliged to use financial reporting to

display its current financial status and organize financial data.

The documents are available for public view which means that
potential banks and investors will most likely analyze them before
they decide to work with you and invest in your business.

They are also important for tracking future profitability estimates,

business growth, and overall financial health.

At bottom, financial reports provide you with insight into how much
money you have, how much did you spend, and where it is coming
from. Based on the data within the report, you can make informed
business decisions and create plans for future spending.

The key things a financial report should include are:

  Cash flow data
 Asset and liability evaluation
 Shareholder equity analysis
 Profitability measurements
Related: Quarterly Business Review: How to Write One and How to
Present It Successfully

What Is the Purpose of Financial Reporting?

Financial reports are used to track, analyze, and display your
company’s cash flow .

Understanding how your business is performing from a financial

standpoint can seem like an impossible task without these reports.

However, financial reports aren’t used only because they are

practical; you are legally required to include them.

Here are some of the main ways in which financial reports can help
your business:

 Communicate essential data

 Monitors income and expenses
 Supports financial analysis and decision-making
 Compliance
 Simplify your taxes
Communicate essential data
Having an insight into the current financial situation of your
business is important to each high-ranking member of the company
(stakeholders, executives, investors, and partners).

You will use this financial data to create budget plans and monitor
the company’s overall performance. When you establish an open
communication and transparency policy within your business, you
are more likely to attract new investors and enhance funding.

The information communicated in financial statements is what

investors rely on when they are assessing risks, profitability, and
future returns.

One way to gain the trust of investors is to showcase how your

financial performance stacks up against your peers. For example,
by joining this benchmark group , you can better understand your
gross profit margin performance and see how metrics like income,
gross profit, net income, net operating increase, etc compare against
businesses like yours.

For example, you can discover that the median gross profit a month
for B2B, B2C, SaaS and eCommerce is 73.79K. If you perform
better than the median, this might be a good incentive for your
investors to increase your funding.
*Important note: Databox Benchmark Groups show median values.
The median is calculated by taking the “middle” value, the value for
which half of the observations are larger and half are smaller. The
average is calculated by adding up all of the individual values and
dividing this total by the number of observations. While both are
measures of central tendency, when there is a possibility of extreme
values, the median is generally the better measure to use.

Benchmark Your Performance Against

Hundreds of Companies Just Like Yours
Viewing benchmark data can be enlightening, but seeing where your
company’s efforts rank against those benchmarks can be game-
changing. 
Browse Databox’s open Benchmark Groups and join ones relevant
to your business to get free and instant performance benchmarks. 
BROWSE BENCHMARK GROUPS

Monitors income and expenses

Financial reporting involves tracking incomes and expenses for a
specific time period. To establish efficient debt management and
budget allocation, you will need an insight into the most
important spending areas .

By tracking income and expenses , you will also understand current

liabilities and assets. Analyzing financial documentation will
provide you with a bigger picture regarding the key metrics such as
debt-to-asset ratios that investors use to calculate potential
profitability.

All of this is information is crucial for staying ahead of your

competitors.

Related: How to Write a Great Business Expense Report: A Step-

By-Step Guide with Examples

Supports financial analysis and decision-making

The performance analysis in financial reports is what you rely on to
make better business decisions.
Considering the different data that financial reports include, you can
check out real-time information regarding historical performances,
key spending areas, and use them to create accurate financial
forecasts.

Implementing detailed financial analysis and using developed data

models can help any business better evaluate current activities and
make future business growth decisions.

You will be able to recognize trends, potential problems, and stay on

top of your financial performances in real-time. This sets the
foundation for quick and accurate economic decisions.

Compliance
The main purpose of financial reports is to make sure your business
is in compliance with the law and regulations of government
agencies.

Regulatory institutions examine every document that evaluates the

financial activities of your company. This is why making accurate
financial documentation is crucial for the well-being of your
business.

Aside from accuracy, you will also have to follow certain deadlines
that these institutions set. This sometimes causes pressure in
accounting departments to create complex financial reports quickly
and accurately, which is why regular bookkeeping is immensely
important.

In the US, private and public companies have to be compliant with

the GAAP (Generally Accepted Accounting Principles), while
international companies mostly report under the IRFS (International
Reporting Financial Standards).
Both of these organizations provide some standard guidelines but
there are a few differences you will have to pay attention to when
creating your financial statements.

Simplify your taxes 
No matter how big or small your business is, doing taxes can be a
stressful task.

By creating accurate financial reports, you can make tax calculation

a lot easier since you will minimize any chances of error and save
time by including all financial data in one document.

Not only that, since financial reports are a legal requirement, the
IRS uses them to evaluate the tax income of each individual
company. 

Additionally, with the introduction of Making Tax Digital  (MTD) in

many countries, including the UK, it is now mandatory for
businesses to maintain digital records and submit tax returns
digitally. This means that accurate financial reports are more
important than ever, as they will be used to populate the required
digital tax submissions.

What Are the Types of Financial Reporting?

While financial reports all have the same goal, there are a few
different types that you should know about.

This isn’t only a matter of compliance or best practice, these reports

are key for understanding the different segments of cash flow.

Here are the main types of financial reporting:

  Balance Sheet
 Cash Flow Statement
 Income Statement
 Shareholder Equity Statement

Balance Sheet
A balance sheet  is a financial statement that tracks the total amount
of assets, liabilities, and shareholder equities within your company.
They also provide you with a real-time evaluation of asset liquidity
and debt coverage.

Most companies create balance sheets on a quarterly basis and

include the data from each quarter in the annual report.

When creating a balance sheet, there is an asset page (includes

available cash, equipment value, inventory value, etc.) and a
liability page (includes accounts payable, credit card balances, bank
loans, etc.) that you need to fulfill.

Once you total these assets and liabilities, you will subtract
liabilities from the assets. The amount you get is what is called
‘owner’s equity’.

Cash Flow Statement

This is a financial statement that records all the different cash flow
activities in the company.

Cash flow statements track cash generated and cash spent amounts
in a specific time period. This report is crucial for measuring
whether companies generate enough cash to cover their debts. Also,
it provides insight into fund operations, investments, and the overall
activities that are generating revenue.

This statement is helpful for investors since they can use it to

determine whether your business presents a good investment
opportunity .

While balance sheets incorporate certain calculations to determine

financial values, cash flow statements are consisted of three main
elements:

 Operational activities – inventories, wages, tax income,

accounts receivable, accounts payable, and cash receipts
 Investment activities – investment earnings use, investment
earnings generation, asset sales, issued loans, payments from
mergers
 Financing activities – payable dividends, debt payments, debt
issuance, cash from investors, and stock repurchases

Income Statement
The income statement records the company’s expenses, revenue, and
net loss/income over a specific time period.

Balance sheets focus on the current activities and performances

while income sheets track them over a longer period. Businesses
tend to track income statements each quarter to gain better insight
into the different financial processes that occur.

Income statements include profits and losses , which is why they are

also called P&L statements (Profits & Losses).
The main elements included on the income statement are:

 Operating revenue – financial data regarding sales of

products or services
 Net and gross revenue – includes the total sales revenue and
remaining revenue (after the cost subtraction)
 Primary expenses – these include general costs,
administrative costs, depreciation and selling, and COGS
(cost of goods sold)
 Secondary expenses – capital loss, asset loss, debt interest,
and loan interest
 Nonoperating revenue – this is revenue that comes from
accrued interest, it includes investment returns, capital gains,
and royalty payments

Shareholder Equity Statement

Even though shareholder’s equity is usually included on the balance
sheet, larger companies tend to report these activities on a separate
statement.

This statement tracks the amount of money key stakeholders invest

in the business. The investments most commonly include company
stocks and securities. After dividends are released to stockholders,
the retained earnings in the company change.

Stakeholder equity statement includes these key components:

 Retained earnings after dividends and losses have been

subtracted
 Common/preferred stock sales
  Purchased treasury stock
 Generated income (including the income that comes from
unrealized capital gains)

Pro Tip: How to Stay on Top of the Financial

Health of Your Business
Do you own and manage a small business? Then you know how
much of a struggle it can be to stay on top of the financial health of
your business on a daily basis. Now you can pull data from
QuickBooks and HubSpot’s CRM to track your key business metrics
in one convenient dashboard, including:

1. Open deals and deal amounts by pipeline stage. Get sales

data directly from your HubSpot CRM and track deals, deal
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2. Key financial data. Track gross profit margin, open
invoices by amount and by customer, paid invoices,
expenses, and income from QuickBooks.
Now you can benefit from the experience of our HubSpot CRM and
QuickBooks experts, who have put together a plug-and-play
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To set up the dashboard, follow these 3 simple steps:
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How to Write a Financial Report?

Financial reports help you understand your company’s financial
performance, attract potential investors, and are legally required.
This is why you have to make sure that they are as accurate as
possible.
You want your financial reports to be comprehensive,
understandable, and precise.

Even though creating a good financial report can be very complex,

we are going to show you a step-by-step guide that will make the
whole process much easier.

Follow these steps to create a great financial report:

 Step 1 – Make a Sales Forecast

 Step 2 – Create a Budget for Expenses
 Step 3 – Create a Cash Flow Statement
 Step 4 – Estimate Net Profit
 Step 5 – Manage Assets and Liabilities
 Step 6 – Find the Breakeven Point

Step 1 – Make a Sales Forecast

When making a sales forecast, the first thing you should do is create
a spreadsheet that includes your sales performance from the last
three years.

Use a specific section for each line of sales and organize columns
for each month of year one. For years two and three, organize
columns on a quarterly basis.

Create three different blocks – one for pricing, one for unit sales,
and the third one for multiplying units by unit cost (to calculate the
cost of sales).
Cost of sales is important because it helps you calculate a precise
gross margin.

Once you do the math, you can make an accurate sales forecast that
is backed up by historic financial data.

PRO TIP: If you are using HubSpot CRM to visualize your sales
data, watch the video below to learn how to set up and track your
HubSpot CRM data in order to more accurately forecast your
sales  this month, quarter, and beyond.

10:00

Step 2 – Create a Budget for Expenses

Once you have made a sales forecast, you will want to calculate how
much it will cost you.

When creating an expense budget, you should include both fixed

costs (rent, payroll, etc.) and variable costs (marketing and
promotional expenses). Costs such as interest and taxes can’t be
completely accurate, so you are going to have to make rough
estimates.

For taxes, you can multiply the estimated debt balance by your
estimated tax percentage rate.
To estimate interest, multiply your estimated debt balance by an
estimated interest rate.

Step 3 – Create a Cash Flow Statement

We already mentioned what cash flow statements are and why they
are so important for your business. They are typically created based
on the sales forecast, balance sheet components, and other estimates.

To make cash flow estimates, companies should use historical

financial statements. If your business is relatively new, you should
project cash flow statements by breaking them down into 12 months.

Your way of invoicing  is also linked to cash flow estimates.

For example, if a customer has the right to pay for your services
after 30 days, the cash flow statement will show that you only
collected 80% of your invoices within the month (while you need
100% to cover the expenses).

Step 4 – Estimate Net Profit

To estimate net profit, you should use the numbers from your sales
forecast, expense estimates, and cash flow statement.

You can calculate the net profit by subtracting expenses, interests,

and taxes from the gross margin .

This step is extremely important since it serves as a profit and loss

statement that helps you create a detailed business forecast for the
next three years.
Step 5 – Manage Assets and Liabilities
In order to estimate your business’s net worth  at the end of a fiscal
year, you have to be able to manage assets and liabilities that won’t
be shown in the profits and loss statement.

Come up with a rough estimate of how much money you expect to

have on hand each month and include accounts receivable,
inventory, land, and equipment.

After that, calculate liabilities, debts from outstanding loans, and

accounts payable.

Step 6 – Find the Breakeven Point

You know that you have found a breakeven point if your business
expenses  are in line with the sales volume.

The three-year income estimation should help you acquire this

analysis. In viable businesses, the total revenue should exceed total
expenses.

For potential investors, this kind of information is crucial since they

want to be reassured that they are investing in a company with
steady growth.

How To Make a Financial Statement:

Definition and Benefits
Rachel Rotich
Updated February 4, 2023
Producing regular financial statements is an integral part of basic business operations.
They provide essential information you can use to track a company's financial activities
and attract potential investors. When you know how to make financial statements, you
can prepare these crucial reports to summarize your company's financial results and
understand its financial position and cash flows.

In this article, we explain a financial statement, discuss how to create one and highlight
the benefits of producing them.

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What is a financial statement?

A financial statement is a report that shows a business's financial activities and
performance for a certain period. The reports show the company's assets and liabilities,
sources of revenue, expenditures and cash flow management. Often, businesses
undergo auditing from accountants, government agencies or other companies to verify
their accuracy for various purposes, including taxation, financing and investing.
Maintaining reliable, accurate, comparable and understandable financial statements is
important since interested parties use them to make critical decisions affecting
operations and funding.

Related: Learn About Being an Accountant

How to make a financial statement

The following are steps you can take to make a financial statement:

1. Determine the time frame and information required

The first step to making a financial statement is determining the time frame and
information required since these statements use specific data corresponding to a
particular accounting period. You may make statements quarterly, semiannually or
annually, depending on your company's needs. For example, you can choose to
determine the amount of money entering and leaving the business every three months,
your net income in six months or your total debts.
2. Choose the type of financial statement

You can choose the type of financial statement depending on the required information
about the company's financial position. Here are the main types of financial statements:

Balance sheet

A balance sheet shows detailed information on a company's assets, liabilities and

shareholders' equity for the duration, often at the end of a fiscal year. It helps you know
the company's worth or equity at the stated time. Here are the components of a balance
sheet:

 Assets: Assets are anything that a company owns and has value.

Examples of assets include a company's savings account, inventory,
cash and cash equivalents, property and equipment.
 Liabilities: Liabilities are anything a company owes. Examples include
loans, wages, dividends payable, rent and government taxes.
 Shareholders' equity: A company's equity, or total liabilities subtracted
from total assets, shows its worth. Shareholders' equity includes
retained earnings.
Related: Nonprofit Balance Sheet vs. A For-Profit Balance Sheet
Income statement

An income statement, also called a profit-and-loss statement, shows the amount of

income, profits, expenses and earnings per share of a business. Using this financial
statement, you can determine the amount gained or lost and the shareholder's amount
in earnings if distributed during that accounting period. Some components of the income
statement include:

 Gross profit: The gross profit of a business is the amount of profit it

makes after deducting any of its costs. You get gross profit by
subtracting the cost of goods sold from total sales.
 Operating expenses: These are expenses that allow the business to
stay functional. Operating expenses include loans, insurance, rent and
inventory costs.
 Non-operating expenses: Any expense that's not related to the core
functions of the business is non-operating. Common types of non-
operating expenses are interest on loans, currency fluctuations and
inventory write-downs.
 Net income: The net income is the amount earned during a specific
period after deducting expenses, interest and taxes for the same period.
It shows the company's profitability.
Read more: How To Prepare an Income Statement: With Examples
Cash flow statement

A cash flow statement shows the money that moves in and out of a company from cash
and cash equivalents. Cash flow statements generate data from the balance sheets and
income statements to show net increases or reductions in cash. You can assess a cash
flow statement to gain insight into a company's liquidity and solvency, operating
performance and future cash flow changes. Here are the sections of a cash flow
statement:

 Operating activities: In this section, you reconcile actual cash from

operating activities, both received and used, and the net income derived
from the income statement to show cash movement from net gains and
losses. Operating activities include deferred tax, salaries, changes in
depreciation, amortization, cash receipts for clients, profits or losses
from the sale of long-term assets and accounts receivables and
payables.
 Investing activities: This section shows cash flows from investing
activities, such as return on investments. It also includes cash inflows
and outflows from dividends, investment securities and the sale of
assets.
 Financing activities: This section details cash flows from financing
activities. Examples include loans, dividends, cash borrowed from
banks, equity, debt issuance and debt repayment.
Related: Step-by-Step Guide on How To Create a Cash Flow Statement
Shareholders' equity statement

The statement of shareholders' equity uses data in the balance sheet to provide more
information about changes in the value of shareholders' equity during a specific period.
After paying out stockholders and investors, you can determine shareholders' equity by
deducting the total liabilities from total sales and the company's value. If the value is
positive, it implies the assets can cover liabilities. If it's negative, the liabilities exceed
assets. This type of financial statement includes:

 Common stock: This is the standard stock of the business.

 Treasury stocks: These are stocks that the issuing company buys
back.
 Preferred stock: This has higher assets than common stock.
 Retained earnings: This refers to the amount of income a business has
after it's paid its shareholders.
Related: What Is Stockholder's Equity? Definition and Formula
3. Collect basic data and documents

Once you determine the type of financial statement to make, collect all basic and
relevant financial documents. Check for transactions in the ledgers, receipts and other
departments and record or make necessary adjustments. You may require previous
financial statements to make potential adjustments necessary in making current
statements, including opening and closing balances. Ensure that
you countercheck records for accuracy to avoid accounting errors.

Related: What Is Basic Accounting?

4. Format your financial statement

Financial statements follow specific formats and methods. You may use software to
compile the financial statement elements to ensure proper formatting, reduce errors and
save time. Using a program to track the business' spending and profits can help
automate creating financial statements. Whether you're using software or a manual
process in making financial statements, learning to read and interpret them is
essential. Here are some ways to format different financial statements:

 Balance sheet: List assets in the order of liquidity and liabilities

according to their due dates. You may list items from top to bottom,
starting with assets, or post assets on the left and liabilities and
shareholders' equity on the right.
 Income statements: You list total revenue or sales before subtracting
total expenses and the cost of business operations. Consider including
a header above each section and totals at the end of each section.
 Cash flow statements: A financial statement usually displays the cash
flow with net spending in parentheses and net income without
parentheses. Add a decrease in income to net earnings, subtract its
increase and vice versa for expenses.
Read more: Guide to Income Statement vs. Balance Sheet vs. Cash Flow
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Benefits of producing financial statements

Here are some advantages of creating and using financial statements:

 Helps interested parties track financial results and identify profitability

concerns
 Tracks spending by determining how the company generates cash,
where the money comes from and how it uses the money
  Shows the company's ability to repay its debts
 Helps make informed decisions useful for annual reports, which are
crucial to investors and lenders
 Highlights areas that the business can improve

12 Things You Need to Know About

Financial Statements
Quick tips to help you master the art of reading a financial statement

By 
RICHARD LOTH
 

Updated April 13, 2023

Reviewed by 
MARGUERITA CHENG
Fact checked by 
KATHARINE BEER
Knowing how to work with the numbers in a company's financial statements is
an essential skill for stock investors. The meaningful interpretation and
analysis of balance sheets, income statements, and cash flow statements to
discern a company's investment qualities is the basis for smart investment
choices.

However, the diversity of financial reporting requires that we first become

familiar with certain financial statement characteristics before focusing on
individual corporate financials. In this article, we'll show you what the financial
statements have to offer and how to use them to your advantage.

0 seconds of 1 minute, 48 secondsVolume 75%

 

1:47
Financial Statements
KEY TAKEAWAYS

 Understanding how to read a company's financial statements is a key

skill for any investor wanting to make smart investment choices.
 There are four sections to a company's financial statements: the
balance sheet, the income statement, the cash flow statement, and the
explanatory notes.
 Prudent investors might also want to review a company's 10-K, which is
the detailed financial report the company files with the U.S. Securities
and Exchange Commission (SEC).
 An investor should also review non-financial information that could
impact a company's return, such as the state of the economy, the
quality of the company's management, and the company's competitors.
Practice trading with virtual money
Find out what a hypothetical investment would be worth today.
SELECT A STOCK
TSLA
TESLA INC

AAPL
APPLE INC

NKE
NIKE INC

AMZN
AMAZON.COM, INC

WMT
WALMART INC

SELECT INVESTMENT AMOUNT

$
SELECT A PURCHASE DATE

 CALCULATE

1. Financial Statement = Scorecard

There are millions of individual investors worldwide, and while a large
percentage of these investors have chosen mutual funds as the vehicle of
choice for their investing activities, many others are also investing directly in
stocks. Prudent investing practices dictate that we seek out quality
companies with strong balance sheets, solid earnings, and positive cash
flows.

Whether you're a do-it-yourself investor or rely on guidance from an

investment professional, learning certain fundamental financial statement
analysis skills can be very useful. Almost 30 years ago, businessman Robert
Follett wrote a book entitled How To Keep Score In Business. His principal
point was that in business you keep score with dollars, and the scorecard is a
financial statement. He recognized that "a lot of people don't understand
keeping score in business. They get mixed up about profits, assets, cash
flow, and return on investment."1

The same thing could be said today about a large portion of the investing
public, especially when it comes to identifying investment values in financial
statements. But don't let this intimidate you; it can be done.

2. Financial Statements to Use

The financial statements used in investment analysis are the balance sheet,
the income statement, and the cash flow statement with additional analysis of
a company's shareholders' equity and retained earnings. Although the
income statement and the balance sheet typically receive the majority of the
attention from investors and analysts, it's important to include in your analysis
the often overlooked cash flow statement.

3. What's Behind the Numbers?

The numbers in a company's financial statements reflect the company's
business, products, services, and macro-fundamental events. These
numbers and the financial ratios or indicators derived from them are easier to
understand if you can visualize the underlying realities of the fundamentals
driving the quantitative information. For example, before you start crunching
numbers, it's critical to develop an understanding of what the company does,
its products and/or services, and the industry in which it operates.

4. Diversity of Reporting
Don't expect financial statements to fit into a single mold. Many articles and
books on financial statement analysis take a one-size-fits-all approach. Less-
experienced investors might get lost when they encounter a presentation of
accounts that falls outside the mainstream of a so-called "typical" company.
Please remember that the diverse nature of business activities results in a
diverse set of financial statement presentations. This is particularly true of the
balance sheet; the income statement and cash flow statement are less
susceptible to this phenomenon.

5. Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology
complicates the understanding of many financial statement account entries.
This circumstance can be confusing for the beginning investor. There's little
hope that things will change on this issue in the foreseeable future, but a
good financial dictionary can help considerably.

 
Investopedia's Glossary of Terms provides you with thousands of definitions
and detailed explanations to help you understand terms related to finance,
investing, and economics.

6. Accounting: Art, Not Science

The presentation of a company's financial position, as portrayed in its
financial statements, is influenced by management's estimates and
judgments. In the best of circumstances, management is scrupulously honest
and candid, while the outside auditors are demanding, strict, and
uncompromising. Whatever the case, the imprecision that can be inherently
found in the accounting process means that the prudent investor should take
an inquiring and skeptical approach toward financial statement analysis. 

7. Key Accounting Conventions

Generally accepted accounting principles  (GAAP) or International Financial
Reporting Standards (IFRS) are used to prepare financial statements. Both
methods are legal in the United States, although GAAP is most commonly
used. The main difference between the two methods is that GAAP is more
"rules-based," while IFRS is more "principles-based." Both have different
ways of reporting asset values, depreciation, and inventory, to name a few.2
8. Non-Financial Information
Information on the state of the economy, the industry, competitive
considerations, market forces, technological change, the quality of
management and the workforce are not directly reflected in a company's
financial statements. Investors need to recognize that financial statement
insights are but one piece, albeit an important one, of the larger investment
puzzle.

9. Financial Ratios and Indicators

The absolute numbers in financial statements are of little value for investment
analysis unless these numbers are transformed into meaningful relationships
to judge a company's financial performance and gauge its financial health.
The resulting ratios and indicators must be viewed over extended periods to
spot trends. Please beware that evaluative financial metrics can differ
significantly by industry, company size, and stage of development.

10. Notes to Financial Statements

The financial statement numbers don't provide all of the disclosure required
by regulatory authorities. Analysts and investors alike universally agree that a
thorough understanding of the notes to financial statements  is essential to
properly evaluate a company's financial condition and performance. As noted
by auditors on financial statements "the accompanying notes are an integral
part of these financial statements." Please include a thorough review of
the noted comments in your investment analysis.

11. The Annual Report/10-K

Prudent investors should only consider investing in companies with audited
financial statements, which are a requirement for all publicly-traded
companies. Perhaps even before digging into a company's financials, an
investor should look at the company's annual report and the 10-K. Much of
the annual report is based on the 10-K, but contains less information and is
presented in a marketable document intended for an audience of
shareholders. The 10-K is reported directly to the U.S. Securities
and Exchange Commission or SEC and tends to contain more details than
other reports.3
Included in the annual report is the auditor's report, which gives an auditor's
opinion on how the accounting principles have been applied. A "clean
opinion" provides you with a green light to proceed. Qualifying remarks may
be benign or serious; in the case of the latter, you may not want to proceed.

12. Consolidated Statements

Typically, the word "consolidated" appears in the title of a financial statement,
as in a consolidated balance sheet. A consolidation of a parent company and
its majority-owned (more than 50% ownership or "effective
control") subsidiaries means that the combined activities of separate legal
entities are expressed as one economic unit. The presumption is
that consolidation as one entity is more meaningful than separate statements
for different entities.

Why are Financial Statements Important?

Financial statements provide investors with information about a company's
financial position, helping to ensure corporate transparency and
accountability. Understanding how to interpret key financial reports, such as a
balance sheet and cash flow statement, helps investors assess a company’s
financial health before making an investment. Investors can also use
information disclosed in the financial statements to calculate ratios for making
comparisons against previous periods and competitors.

What Key Financial Statements Should I Understand

When Analyzing a Company?
Investors should start by learning how to interpret key figures on a company's
balance sheet, income statement, and statement of cash flows. Those
wanting to dig a little deeper may want to consider learning how to analyze
reports, such as shareholder’s equity and retained earnings. Investors can
find a publicly traded company’s financial statements in its annual report or a
10-K filed with the SEC.  
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THE BALANCE / GETTY IMAGES

It's not the flashiest part of running a small business, but analyzing the
financial data from your small business on a regular basis is vital to the health
of your company. Maintaining the proper financial statements helps you
determine your business’ financial position at a specific point in time and over
a specified period.

Information from your accounting journal and your general ledger is used in
the preparation of your business’s financial statement. The income statement,
the statement of retained earnings, the balance sheet, and the statement of
cash flows all make up your financial statements. Also, information from the
previous statement is used to develop the next one.  

Key Takeaways

 Financial statements must be prepared at the end of the company's tax

year, but some companies update them as frequently as each month.
 A financial statement is made up of four main documents: the income
statement, statement of retained earnings, balance sheet, and
statement of cash flows.
 Keeping financial statements updated on a regular clip helps
businesses develop, prepare for the future, and better identify their
capital needs.

Income Statement
The income statement, also known as a profit and loss statement, is important
because it shows the overall profitability of your company for the time period
in question. Information on sales revenue and expenses from both
your accounting journals and the general ledger are used to prepare the
income statement. It shows revenue from primary income sources, such as
sales of the company's products, and secondary sources, like if the company
sublets a portion of its business premises.

Note

The income statement also shows any revenue during the time period in
question from assets, such as gains on sales of equipment or interest income.
The income statement also shows the business's expenses for the time
period, including its primary expenses, expenses from secondary activities,
and, finally, losses from any activity, including current depreciation. One thing
to note about the depreciation shown on the income statement is that it only
accounts for depreciation over the time period in question, not the total
depreciation of an item from the time the asset was acquired.  

The bottom line of the income statement is net income or profit. Net income is
either retained by the firm for growth or paid out as dividends to the firm's
owners and investors, depending on the company's dividend policy. 

Statement of Retained Earnings

The statement of retained earnings is the second financial statement you must
prepare in the accounting cycle. Net profit or loss must be calculated before
the statement of retained earnings can be prepared.

After you arrive at your profit or loss figure from the income statement, you
can prepare this statement to see what your total retained earnings are to
date and how much you’ll pay out to your investors in dividends, if any. This
statement shows the distribution of profits that are retained by the company
and which are distributed as dividends. 

As the name suggests, the amount of retained earnings is the profit retained
by the firm for growth, as distinguished from earnings that are distributed to
shareholders as dividends or to other investors as the distributed share of
profits.   

Balance Sheet
No financial statement would be possible without the balance sheet. The
balance sheet is the financial statement that tracks the firm's financial position
at a given point in time, typically the last day of the accounting cycle. It’s a
statement showing what your business owns (assets) and what it owes
(liabilities). Your assets must equal your liabilities plus your equity or owner's
investment. You have used your liabilities and equity to purchase your assets.
The balance sheet shows your firm's financial position with regard to assets
and liabilities/equity at a set point in time. 
Entries on a balance sheet come from the general ledger, and the format
mirrors the accounting equation. Assets, liabilities, and owners' equity on the
last day of the accounting cycle are stated.  

Note
The general ledger is the centerpiece of your accounting system—every
financial transaction your firm undertakes is recorded in chronological order
via debits and credits,

Entries on a balance sheet come from the general ledger, and the format
mirrors the accounting equation. Assets, liabilities, and owners' equity on the
last day of the accounting cycle are stated.  

A note about depreciation: In contrast to the depreciation shown on the

income statement, the depreciation shown on the balance sheet -- which is a
snapshot of the company at the end of the accounting cycle -- is the total
accumulated depreciation from the day the item was acquired to the present. 

Statement of Cash Flows

Even if your company is turning a profit, it may be falling short because you
don't have adequate cash flow. The cash flow statement compares two time
periods of financial data and shows how cash has changed in the revenue,
expense, asset, liability, and equity accounts during these time periods. 

The statement of cash flows must be prepared last because it takes

information from all three previously prepared financial statements. The
statement divides the cash flows into operating cash flows, investment cash
flows, and financing cash flows. The final result is the net change in cash
flows for a particular time period and gives the owner a very comprehensive
picture of the cash position of the firm. 

The statement of cash flows shows the firm’s financial position on a cash
basis rather than an accrual basis. The cash basis provides a record of
revenue actually received, from the firm's customers in most cases. The
accrual basis shows and records the revenue when it was earned. If a firm
has extended billing terms, such as 30 days net, 60 days 1 percent, these two
methods can produce substantially different results.

Frequently Asked Questions (FAQs)

What are retained earnings?
Retained earnings refers to the net profit of a company after it makes its
dividend and other shareholder payments—earnings which are, therefore,
"retained" by the company.

What goes into a financial statement?

Financial statements are summary-level documents that provide details about
a company's financial position at a given point in time. Typically a balance
sheet, cash-flow statement, and income or profit and loss statement are
included.