Accounting is the language of business. The financial statements are an important element of accounting. All businesses need to track their performance and understand how well they’re doing over time. Financial reporting is used to communicate information about a company’s financial performance to stakeholders, investors, and others who might be interested in the company. Financial reporting refers to the process of collecting and analyzing accounting data for external users and communicating that information through various reporting mechanisms such as annual reports or quarterly statements.
Internal financial reporting refers to measures used by managers within a company for planning, budgeting, and monitoring performance. External financial reporting refers to measures used by investors, lenders, suppliers, or other parties outside the organization. This article explains the difference between internal and external financial reporting so you can understand which one is most applicable for your organization.
What is Internal Financial Reporting?
Internal financial reporting refers to the accounting metrics and financial performance analysis used within a company to track performance, forecast future activities, and make strategic decisions. Internal financial reporting is used primarily by business decision makers (BDMs) such as managers or executives rather than investors. It’s critical for internal financial reporting to be consistent with the external financial reporting so that investors can understand how a company’s performance compares to previous years.
Internal financial reporting helps inform the decision-making process within a company, including annual or multi-year plans, budgeting, and resource allocation processes. Decision-makers can use financial information to make strategic decisions related to a company’s long-term plans or short-term actions. These types of financial reporting are typically based on accounting data that is summarized or projected from the books and records. In some cases, the data is compared to previous periods or forecasts to determine if the results are in line with expectations.
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What is External Financial Reporting?
External financial reporting refers to the accounting metrics and financial performance analysis used by a company and its investors to analyze financial performance and make decisions. Investors and other external stakeholders use financial statements to evaluate the financial health of a company and determine whether they want to invest in it. A company may have many investors, and each one may have different expectations of the information they want to see in a financial report. In general, investors want to see a comprehensive view of a company’s financial health, including the following:
- Statement of Financial Position: A balance sheet or statement of financial position summarizes a company’s assets, liabilities, and equity. This is a critical metric for investors who want to understand the company’s financial risk and overall financial health.
- Statement of Operations: The income statement or profit and loss (P&L) statement summarizes a company’s revenue, expenses, and net profit over a period of time, typically one year. The P&L is also known as a profit and loss statement (P&L).
- Comparative Financial Analysis: Investors want to see the financial results for a company compared to previous periods. They often look at the most recent results and compare them to the same period in the previous year.
Differences Between Internal and External Financial Reporting
- Timing: One of the main differences between internal and external financial reporting is the timing of when these calculations are made. Internal financial reporting is done at the end of every period, such as a month or quarter. Investors want to see financial results as soon as possible, so businesses report financial results each period. Depending on the length of a period, financial reporting may be required quarterly or annually. External financial reporting is done at the end of the fiscal year.
- Use of Estimates: Another key difference between internal and external financial reporting is the use of estimates. Businesses can’t perfectly predict the results at the end of a period, so they make forecasts or use various estimates to predict results. Investors, on the other hand, want to see actual results and don’t use estimates to arrive at results.
- Type of Analysis: Internal financial reporting uses a different type of analysis than external financial reporting. Internal financial reporting may look at different metrics than external financial reporting, use different financial analysis, or compare results against a different metric than external financial reporting.
When Should You Use Internal Financial Reporting?
Internal financial reporting is used primarily in business planning and budgeting. Managers need to understand the performance of their organization and forecast future results to make the best use of their resources. These metrics are used to evaluate the effectiveness of a business unit or product line and are helpful in making adjustments to improve results. Internal financial reporting is used to forecast sales, expenses, and profit or loss for the short term, usually one year or less.
While internal financial reporting is not intended for external audiences, it must be consistent with the company’s external financial reporting. That’s why it’s important to use the same financial statements and metrics as those used in external financial reporting, with a few exceptions. For example, while the external financial statements might include detailed information on each revenue source, the internal financial statements may not.
When Should You Use External Financial Reporting?
External financial reporting is used by a company to communicate its financial results to external parties such as investors, lenders, and suppliers. These parties need accurate financial information to make decisions about the company and how to work with them. Financial statements are a critical part of the decision-making process, and investors and other stakeholders want to see the same financial statements companies use internally.
Depending on the industry and the type of investor, there are several financial statements and ratios they may want to see. For example, banks and other lenders are likely to use the balance sheet, cash flow statement, and other financial ratios while investors and stock analysts may want to see the income statement, cash flow statement, balance sheet, and other metrics. Financial statements include the balance sheet, income statement, cash flow statement, and statements of shareholder equity.
Benefits of Internal and External Financial Reporting
- Insight Into Operations – By tracking sales and expenses, managers can better understand how their operations are performing. This insight into operations is especially helpful in adjusting for seasonal fluctuations or other changes in the business that impact results.
- Strategic Decision Making – The financial reporting metrics used in internal financial reporting are helpful in making strategic decisions about the long-term operations of a company. Managers can look at the trends in sales, expenses, or other metrics to understand how their organization is performing and make adjustments to improve results.
- Financial Planning – The financial reporting metrics used in long-term planning are helpful in making financial projections for the future. Budgeting is a critical part of financial planning, and managers can use their financial information to forecast future expenses, sales, and profit or loss.
Limitations of Internal and External Accounting Reporting
- Accuracy: While internal financial reporting is consistent with the company’s external financial reporting, it’s based on calculations that are estimates rather than actual figures. This means the results may not be as accurate as actual financial numbers reported on the financial statements. Actual financial results reported on the financial statements are actual numbers while estimates used in internal financial reporting are forecasts or calculated values.
- Timing: Internal financial reporting is done at the end of every period, such as a month or quarter. It takes time for a business to collect data from various departments and forecast results for the short term. The short period of time between the end of the period and the date of the forecast means the results may be inaccurate, especially for projections.
- Internal Financial Reporting vs. External Financial Reporting: The short-term financial reporting metrics used for internal financial reporting may not match the metrics used for external financial reporting. If a business uses a different set of figures for internal and external financial reporting, the results may be inaccurate or confusing for both parties involved.
- The financial reporting used by business managers internally and the financial reporting used by investors externally are two different things.
- Internal financial reporting refers to the accounting metrics and financial ratios used within a company to track performance, forecast future activities, and make strategic decisions.
- External financial reporting refers to the accounting metrics and financial statement analysis used by a company and its investors to analyze financial performance and make decisions.
- Internal financial reporting is used primarily in business planning and budgeting while external financial reporting is used by investors.