The notes to the financial statements provide explanations of the principles of accounting applied, and the methods used to determine the amounts reported in the financial statements. The notes also provide breakdowns and analyses of certain accounts, and in that sense are a source of more detailed information. And there are also disclosures in the notes that are not in the financial statements. This makes it worthwhile to take the time to get some insights into the company’s financial status, and the potential consequences or effects of certain events.
While there is no standard format for the notes to the financial statements, there are some general categories of information and disclosures that we can find generally. The form and content of the records will vary from one company to the next, and if you are looking at financial statements of a non-U.S. company, you may find disclosures that apply in that particular company’s circumstances. For example, Many countries use inflation accounting, tax regulations will vary between countries, and there may be required disclosures in one country that are not applicable in another.
Much work has been done to make financial reporting comparable across international borders. International accounting standards are not much different from generally accepted accounting principles (GAAP) and reporting standards in the U.S., and in many cases, foreign companies may provide pro forma statements presented by U.S. GAAP or may provide additional disclosures in the notes to point out the differences. It will be especially true with multinational companies with operations throughout the world.
The following are the examples of some of the types of explanations, information, and disclosures you can expect to find in the notes to the financial statements. It is not intended to be a comprehensive listing, but rather a sample of the types of information you could look for in the notes.
The annual report is where you can find more textual information about the company and its activities during the year. The notes to the financial statements will typically include at least a paragraph about the company, possibly indicating the foundation date, the location of its headquarters, where it operates, and a brief description of its line of business, or purpose.
This note should clarify the company’s legal status (corporation, limited liability company, not-for-profit organization, etc.). It may also indicate whether the company is subject to any specific regulatory agency requirements. It should also be clear from this note whether any subsidiary companies have been consolidated in the financial statements. And, while you report the economic periods on are shown in the financial statements, they may be clarified here, especially is there were any significant acquisitions or divestitures during the period.
Summary of Significant Accounting Policies
This section of the notes will indicate the accounting principles and policies applied in preparing the financial statements, and will generally include mention of valuation and other methods applied in determining the amounts to be reported for certain accounts or classes of accounts.
The Basis of Accounting and Presentation
This note generally indicates that you have prepared the financial statements by generally accepted accounting principles (GAAP). It may be GAAP in the United States or in the country in which your companies headquarter is. Reference may also be made to international accounting standards, if these are the basis of accounting and reporting. If you present the financial statements by any specific governmental, regulatory, or other reporting requirements, you should also mention it here.
Basis of Consolidation
If the financial statements include a subsidiary or affiliated companies that have been consolidated, this is reported here, with a specific identification of the companies. The percentage of ownership that the parent company has in each subsidiary and an indication of who exercises administrative and you should also indicate managerial control over each subsidiary. And there will probably be a phrase meaning that significant intercompany transactions and balances are not there in the consolidation and that you removed the unrealized results of those transactions., which is a standard accounting practice for consolidated reporting.
In a company with operations in different countries, or in consolidated financial statements that include subsidiaries in other countries, the basis upon which you converted foreign currencies to the reporting currency. Reference is generally made here to the local currency and functional currency, the rates of exchange used to translate assets and liabilities at year-end, and the prices used to convert results of operations. There should also be an indication of how the gains and losses from these currency translations are reported in the financial statements (as a separate component of stockholders’ equity, for example).
Use of Estimates
The preparation of financial statements by generally accepted accounting principles requires the use of individual estimates and assumptions. These may include an assessment of the allowance for doubtful accounts, accrued expenses, and the valuation of specific accounts, such as marketable securities and inventories. It is standard accounting practice, and if any significant difference were to arise between previously estimated amounts and actual results, this should be the subject of a separate note with full disclosure of the effects.
It is generally an explanation of what constitutes cash equivalents for purposes of the cash flow statement. The note may indicate which types of financial instruments you are including in its definition of cash equivalents, or may consist of a phrase such as, “For purposes of the statements of cash flows, the company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents.”
Allowance for Doubtful Accounts
You should indicate the method the company uses to account for the risk of uncollectible accounts receivable from customers here. It may be an expression that this allowance is based on historical experience, mentioned as a percentage of gross sales, or that some other method is used. An analysis of the allowance account may be presented, such as:
- Allowance for doubtful accounts at beginning of year
- Additions charged to bad debt expense
- Write-downs charged against the allowance
- Recoveries of amounts previously charged-off
- Allowance for doubtful accounts at end of year
Any compensation for impaired notes (notes that may not be collected in full) should be noted here. You may also record the method of measuring the amount of the impairment, such as the present value of expected future cash flows discounted at the note’s effective interest rate.
Debt and equity securities are generally classified in one of three categories: trading, available-for-sale, or held-to-maturity. This note will probably explain these categories and identify the types of securities the company holds, and the valuation method it uses (lower of cost or market value, for instance). If the company uses derivative financial instruments as hedges, you may also explain this here.
This note will primarily describe the inventory valuation method (lower of cost or market value) and the method used to determine cost (first-in-first-out, last-in-last-out). If the company has set up an allowance for obsolete or damaged merchandise, you may indicate this, and there could be a phrase meaning that the valuation assigned to inventories does not exceed their net realizable value. A more detailed note on the breakdown of lists is in a separate record.
Property, Plant, and Equipment
The valuation method used for fixed assets (generally acquisition or construction cost), and the depreciation method (straight-line over the estimated useful life, for instance) will be noted here. There may also be a note about the valuation of property, plant, and equipment held under capital leases and leasehold improvements (stated at the present value of minimum lease payments) and their amortization (straight line over the shorter of the lease term or the estimated useful life of the asset).
Here there will be a general indication of the types of intangible assets the company is reporting (patents, trademarks, deferred business development costs, pre-opening expenses), how they are valued, and how they are being amortized. There may be a reference that how the company spends research and development costs as incurred if they are not capitalized as an intangible asset.
Investments in Affiliated Companies
The method the company uses to account for and report its finances in affiliated companies is noted here. These are generally affiliates in which the company has an equity interest, but does not consolidate them as subsidiaries. The equity method is commonly used to account for these investments – the company reports its percentage share of the affiliate’s earnings in its results. There may also be an indication of goodwill, as the excess of the cost of the stock of those affiliates over the company’s share of their net assets at the acquisition date, and over what period the goodwill is being amortized.
This note may indicate that the company is accruing income tax on income as the company earned it, and will make a reference to any deferred taxes, or will indicate that the company does not recognize deferred taxes on its books since the timing differences are of a recurring nature and set in the short term. Deferred taxes generally arise as a result of temporary differences in the bases of assets and liabilities as reported for book purposes and income tax purposes. If you are reporting deferred taxes, this note will provide a general explanation of how they were determined, or there will be a separate note providing more disclosure on income taxes.
This will probably be a general statement such as. “For a better presentation of the financial statements, some figures for the year …… have been reclassified”. If there were any significant changes, they should be fully disclosed in a separate note.
After the section “Summary of Significant Accounting Policies,” there will generally be a series of other notes. Some of these provide breakdowns and analyses of some of the individual line items reported on the balance sheet and income statement. Other notes provide additional disclosures, not shown on the financial statements themselves.
The financial statements reflect any changes in the accounting methods, but this note serves to bring attention to these changes, explain the reason for them, and indicate the effect of the changes. If the changes are material, the financial statements for the prior period may have been restated to reflect the impact of the change and to facilitate comparison. In other cases, the change may have resulted in an entry to retained earnings, and this too should be disclosed.
A note on leases would disclose the amount of non-cancelable operating leases, renewal options, and future minimum lease payments under non-cancelable operating leases, showing the present value of these net minimum capital lease payments.
Transactions with Related Entities
This disclosure would identify each related entity or person, the type of relationship, the volume and effect of the transactions on the results for the period, and balances payable to, or receivable from related entities.
If the company has a pension plan, you should use this note to disclose information regarding the pension plan fund, the fund method of the plan, and the assumptions used in determining the amount charged to expense for the period. This information may include the actuarial present value of benefit obligations, vested benefit obligations, accumulated benefit obligations, projected benefit obligations, plan assets at fair value, projected benefit obligations less than (in excess of) plan assets, unrecognized net gain, prior service cost not yet recognized in net periodic pension cost, unacknowledged net debt, and prepaid pension cost (pension liability) included in the balance sheet.
It may be a separate note, in addition to the note under Significant Accounting Policies, to more fully disclose the accounting for income taxes. This note may further explain how deferred tax assets and liabilities are recognized, and there may be a breakdown of income taxes that correspond to income from continuing operations and extraordinary items.
A public enterprise must disclose a reconciliation using percentages of dollar amounts of (a) the reported amount of income tax expense attributable to continuing operations for the year to (b) the amount of income tax expense that would result from applying domestic federal statutory rates to pretax income from continuing operations. Tax loss carryforwards, if any, would also be reported
There could be an analysis of the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities. And an assessment of the how you realize deferred tax assets will and how deferred tax liabilities is going to reverse, and the projected future taxable income, and tax planning strategies used in making this assessment.
Contingencies and Commitments
This note may contain a listing and the amounts of any guaranties granted (mortgages, securities, endorsements, etc.), and details of any commitments for investments in assets and their financing.
There may be a phrase such as, “Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties, and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated.” Another phrase commonly used is, “The company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the company’s consolidated financial position, results of operations or liquidity”. In this case, there probably are not any significant amounts to be disclosed. But if the company is involved in legal proceedings that could have a material effect on its results, there should be full disclosure of the pending lawsuits, the amounts required, and management’s opinion as to the expected outcome, based on the best information available as of the reporting date.
If applicable, the notes should contain an explanation of environmental remediation costs. Include it among contingencies, or you may report it separately.
Impairment of Long-lived Assets
Any actual impairments (losses or reductions of value) related to long-lived assets should be reflected in the financial statements and should be explained here.
Business and Credit Concentrations
If the company has a significant proportion of its accounts receivable concentrated in a small percentage of customers, this fact will be disclosed here. There may also be a mention of how management is managing its credit, to mitigate its risk of loss.
This note would include details of purchases and sales of stock by the President, Directors, Administrators or trustees, account inspectors, and majority stockholders.
Stock Option Plan
Disclosure here could include the vesting period for employees or officers, exercise price, terms, date of grant, and the number of options granted, exercised, forfeited, and expired.
Earnings per Share
Net income per share should be reported before dilution, and fully diluted, taking into account the shares from stock options and warrants, calculated using the treasury stock or another method.
Extraordinary items include any material event that is not part of a company’s ongoing line of business and can include sales of assets, lines of business, investments, or subsidiaries. Casualty losses and the results of pending litigation could also be extraordinary events. Extraordinary items can have a significant effect on the financial statements and need to be taken into account for any comparisons or analyses. These items and their effects should be fully disclosed here, and if necessary, you should present pro forma statements of results before extraordinary items.
Subsequent events are events that occur after the accounting period has been closed out and the financial statements have been prepared, but before they are issued. If any subsequent events could have a material effect on the figures reported for the company’s economic and financial position, they should be disclosed here. If no following material events occurred, you should also indicate this.
Notes with Breakdowns or Analyses
There are generally a series of notes that provide additional information on various accounts reported in the financial statements. The information presented in these notes can be valuable for analysis purposes.
Here, inventories, net of allowances, valued as indicated under Significant Accounting Policies, are broken down into finished products, work in progress, by-products, raw materials, supplies, and merchandise in transit. Inventories may be reported by location, by type of product or according to other applicable criteria.
Property, Plant, and Equipment
This note provides a detailed breakdown of the principal assets included in the general classification, including land, buildings and infrastructure, remodeling, machinery and equipment, vehicles, furniture and fixtures, and any other applicable category. The accumulated depreciation associated with each class of assets would also be reported. If there are leased assets, you should report them usually at the present value of future payments, including the purchase option, discounted at the interest rate defined in the corresponding contract.
Here, a breakdown would be shown of increased utilities, taxes, bonuses, commissions, profit-sharing, other employee benefits, employee vacations, severance pay, and others.
This note would include a breakdown by type of debt (first mortgages, convertible subordinated debentures, unsecured notes payable, borrowings under financing agreements), showing interest rates, amortization or sinking fund requirements, maturity dates, debt collateralized, and assets pledged, and any financial restrictive covenants such as restrictions on working capital, acquisition of treasury stock, and payment of cash dividends.
It could be a separate statement included in the notes. It shows the changes in stockholder’s equity for the reporting period, including opening balances, common and preferred stock issued; stock splits, conversion of debentures, exercises of stock options, net income, preferred and ordinary stock dividends declared, acquisition of common shares, unrealized loss on investment securities, and ending balances.