The importance of reading between the lines: 7 footnote disclosures you may be missing
Financial statements (e.g., the balance sheet, income/operation statement, equity statement and cash flow statement) are vital in retelling the results in operations for the period noted, but the footnote disclosures fill in the gaps and make the financial statements complete.
Think of financial statements as the storyline to your company’s results — a series of events occurring through time. Footnote disclosures are your company’s plot; they tell the story of your company’s events in a way that creates additional insights to readers. Storylines with strong plots are the cult classics and top performers at the box office because they communicate their story effectively, which is your overall goal in preparing your financial statements.
Stakeholders (equity investors, lenders, and others that rely on your financial statements) aren’t involved in your day-to-day operations, but they are literally invested in your business and thus want to understand its state — where it’s been, where it is, and especially where it’s headed. A hallmark for a trusted business advisor is the ability to answer questions before they are asked, and adequate information within the footnote disclosures can provide just this to the adept reader. The more information you provide to them, the more of their questions you answer and the more peace of mind you give them.
While many footnote disclosures are required by GAAP, your management may decide to include additional information to best describe events and “set the scene.” The plot twist to negative results in the income statement could be the reinvestment in new technology or a new service line, which could create exponential growth. Remove those noncash expenses, and those negative results suddenly look like a forerunner for an academy award.
Additionally, a very large portion of business litigation centers around lack of proper disclosure, so thorough, accurate footnotes can protect a company from unintended losses. This is one example where the “less is more” concept doesn’t apply.
Financial statements and footnote disclosures can also help companies measure themselves against competitors and identify why differences may exist and what they can do to close the gap or gain market share. Footnotes give you not only the “what” of a situation but also the “why.” Take for example the PPP loans in 2020. Two companies of identical size may have received PPP loans in the identical amount. One company may have elected an accounting policy to record the proceeds as a grant, where the other company may have elected to treat the proceeds as a loan. Without the footnotes, these two companies have very different financial results; however, the footnotes will tell the reader how those proceeds were accounted for and the reader will then be able to understand why the results between these two companies differed.
Top financial statement footnotes you may be missing
Since footnotes are so important to potential and current stakeholders, you want to make sure you’re including important disclosures. Here are seven extremely important financial statement footnote disclosures you don’t want to miss:
1. Related parties
Disclosing related parties provides transparency regarding whether the business producing the financial statements is engaging in related-party transactions and whether those transactions are within the normal course of business. We mentioned litigation above, and frankly this is one of the most common situations where litigation occurs – not properly disclosing related party relationships and transactions.
For example, if the owners of Company A also own Company B, and Company B leases office space to Company A, they are related parties. The rent paid by Company A to Company B should be in the normal course of business, meaning it can’t be substantially cheaper than the rent amount Company B would offer an unrelated party. Otherwise, additional information may be asked as to why the concession is granted. Is Company A paying higher market rent and could find a better deal elsewhere? Is Company A not doing so great and Company B is leasing space at a discount as a concession to help them survive or inflate financial results?
This disclosure provides clarity into operations for stakeholders not involved in the day-to-day operations, including reassurance that nothing untoward is going on.
2. Concentration of credit risk
How many times have you seen a company that depends solely on another entity to survive, whether it’s because they are the only customer or because they are a supplier of a key input necessary to produce a company’s most profitable product. Just like investing, things can go great if you put all of your eggs into one basket and that basket is turning the eggs to gold, but what happens if that basket breaks?
Disclosing major customers and suppliers is required by GAAP because it provides insight to stakeholders on other entities that compromise a certain percentage of revenue, accounts receivable or goods/materials to the business. Regardless of whether the stakeholder is risk-tolerant or risk-averse, providing appropriate disclosures (including any plans to increase, decrease, maintain and/or mitigate potential risk) should be enough to pacify stakeholders.
3. Significant Estimates
Not all financial accounting presentation items are cut and dry. Some items presented in the financial statements are subject to management’s best estimate. Wouldn’t you like to know as a reader what those estimates are and what assumptions management used to determine those amounts? That is exactly what GAAP requires; however, some companies fail to properly disclose these significant estimates. Without being able to identify and understand the uncertainty involved in some of these estimates, readers may not be as informed as they thought they were.
4. Debt maturity schedule
Think about two similar companies that each have five million dollars of debt. On the financial statements, they may be identically presented. But if one company has those debt payments spread over the next twenty years and the other company has a balloon payment due in an upcoming year, I would probably want to know that as a reader of the financial statements. This footnote requires management to disclose the terms of each significant debt agreement along with the interest rate, maturity date, payment terms, and collateral pledged against that debt. The required debt footnote provides insight into the liquidity management of the company, which is vital to assisting stakeholders in making informed decisions.
5. Commitments and contingencies
If anyone tells you that they love surprises, it’s probably because nothing bad has ever happened to them. When it is reasonably possible a loss event will occur, the likelihood of the event occurring and the potential amount of the loss should be disclosed as a loss contingency. This includes the results of legal proceedings, product warranties, guarantees and other potential contingent liabilities. Disclosing this information to users of the financial statements now will prevent unintended “surprises” down the road.
6. Going concern
Absent information to the contrary, it is anticipated the company will continue to operate indefinitely as a going concern. A going concern disclosure indicates management has significant doubt about the company’s ability to operate indefinitely. A going concern disclosure can indicate trouble for a business, but it doesn’t necessarily spell the end. The business could be experiencing trouble but has a plan to recover. That’s still important (and required by GAAP) to note in a disclosure, as stakeholders will likely be wary of a business becoming a going concern, what has happened and why, and how long it will continue as one.
7. Subsequent events
Just because something didn’t happen during the year doesn’t mean that we shouldn’t be telling our readers about it. Significant events occurring after the period in the financial statements but before the statements are issued are required to be included as a subsequent event footnote.
For example, the known and unknown interruptions to operations as a result of COVID-19 was a common subsequent event footnote disclosure for financial statements published beginning in March 2020.
Final determination of litigation proceedings, fires or other disasters, merger and acquisition activity, significant changes to the business and other items deemed important to users of the financial statements could become subsequent events requiring disclosure. A statement as to whether these events are accrued and included in the financial results presented provides further information to readers.
Questions about these financial statement disclosures?
Reach out to an accountant at Wipfli. We can help you make your financial statements and footnote disclosures most robust to better tell the story of your company.
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