4.03 – Reviewing Common Explanatory Notes

Reviewing Common Explanatory Notes

One aspect of corporate self-governance is giving financial-statement users all information they need to gauge the company’s performance and financial health accurately. Some of that information comes in the form of explanatory notes.

Levelling the playing field among financial statements

Explanatory notes are discussions of items accompanying the financial statements; they contain important disclosures that aren’t presented in the financial statements themselves. The financial statements are the income statement (see Book 4, Chapter 1), balance sheet (see Book 4, chapters 2, 3, and 4, and Book 5, Chapter 1), and statement of cash flows (see Book 5, Chapter 2).

Notes are essential to fulfil the needs of the external users of the financial statements: people like you who may be interested in investing in the business, banks that might loan the company money, or government agencies that need to make sure the company complies with reporting or taxation issues. External users don’t work for the company, so they aren’t privy to the day-to-day accounting transactions taking place within the business.

Information that can’t easily be gleaned from reviewing the financial statements has to be spelled out in notes and disclosures, which explain how or why a company handles a transaction a certain way. Full disclosure allows external users to understand what’s going on at the company and creates a level playing field so an external user can compare the financial statements of one company with those of another company.

Such notes are part of the corporate annual report, which provides shareholders both financial and nonfinancial information about the company’s operations in past years. (See Book 5, Chapter 5 for more on annual reports.)

The notes come after the financial statements in the corporate annual report and are ordered to mirror the presentation of the financial statements. In other words, notes for income statement accounts come first, followed by balance sheet notes and then items reflecting on the statement of cash flows.

The U.S. Securities and Exchange Commission (SEC) requires certain explanatory notes specifically for publicly traded companies. As a best practice, however, many preparers of financial statements for private companies follow SEC guidelines.

Explaining significant accounting policies

This section explains the explanatory notes commonly addressed in financial accounting textbooks. Most of these subjects are presented elsewhere in this course in more detail, so you get a brief overview here and references to let you know where you can find more info.

Each explanatory note is a light-bite (truncated) version. Depending on the company and the complexity of the underlying accounting transaction, explanatory notes can be long and boring to wade through for all but the most diligent and experienced investors. Each type of note is accompanied by a simple version of what you see in real life.

The first order of business when a company prepares its explanatory notes is to describe in general the business and its significant accounting policies. Some businesses break the two broad topics into different notes; the first could be called Basis for Presentation and the second Accounting Policies. Alternatively, the company could have one note called Summary of Business and Accounting Policies. Taking this first step creates a fairer presentation of the financial statements.

Information about accounting policies helps financial readers interpret the statements. A footnote is required for each significant accounting choice the company makes.

Each accounting policy must be applied consistently, because using the same policies each year makes the financial statements easy to compare. The principle of consistency is explained in Book 1, Chapter 4.

If a company decides to change an accounting policy, the financial impact of the change must be explained to readers of its financial statements. You can find out more in “Looking for important event disclosures” later in this chapter.

At the very least, the explanatory notes should include what depreciation methods the company uses, how the company values its ending inventory, what it uses as its basis of consolidation, how it accounts for income taxes, information about employee benefits, and how it accounts for intangible assets. The following sections touch on these subjects.

Note: Explanatory notes may explain the time period and payments due on a capital lease. Leases aren’t covered in detail in this book, but you may see leases in the notes section.

Reviewing depreciation and inventory valuation methods

Depreciation (see Book 3, Chapter 1) consists of spreading the cost of a long-term asset over its useful life, which may be years after the purchase. Inventory valuation methods detail how a business may value its ending inventory (see Book 8, Chapter 2).

The methods a company opts to use for both depreciation expense and inventory valuation can cause wild fluctuations in the amount of assets shown on the balance sheet and the amount of net income (or loss) shown on the income statement. Because of this fluctuation, the financial-statement user needs to know which methods the company uses to compare one company’s financial-statement figures fairly with another company’s. Differences in net income could merely be a function of depreciation or valuation methodology – a fact the user would be unaware of without the footnote.

Assuming that depreciation and inventory are addressed in note 1, here’s a truncated example of such a note:

NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES

We compute inventory on a first-in, first-out basis. The valuation of inventory

requires us to estimate the value of obsolete or damaged inventory.

We compute depreciation for financial reporting purposes using the straight-line

method, generally using a useful life of 2 to 5 years for all machinery and

equipment.

Consolidating financial statements

Consolidation is what happens when companies merge or when a larger company (called a parent company) acquires one or more smaller ones (subsidiaries). In the context of generally accepted accounting principles (GAAP), consolidation refers to the aggregation of financial statements of two or more companies so those statements can be presented as a whole.

The parent company and the subsidiaries continue to operate separately and produce separate sets of financial statements. A consolidation is simply a “what-if” set of financial statements, assuming that the companies operated as one entity.

In this section of the footnotes, the company confirms the fact that the consolidated financial statements do indeed contain the financial information for all its subsidiaries. Any deviations from including all subsidiaries must be explained.

Here’s a truncated example of a note that addresses consolidation:

NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES

Our consolidated financial statements include our parent account and all wholly

owned subsidiaries. Intercompany transactions have been eliminated, and we use

the equity method, which means we report the value based on our proportionate

ownership, to account for investments in which we own common stock.

Accounting for income taxes

Financial statements prepared by using GAAP and those prepared for tax purposes differ. The former are created by using what’s called book accounting, and the latter are created by using tax accounting. Temporary and permanent differences can exist between the book and tax figures. Keep reading for a brief explanation of each difference.

Here’s an example of a permanent difference: Using book accounting, assume that a business can expense 100 percent of the meal and entertainment costs that it incurs in the normal course of business. For tax purposes, however, it can expense at most 50 percent of the same costs. This difference is permanent because under the Internal Revenue tax code, the business is never able to expense 100 percent. The difference between book and tax expenses is permanent.

The most common temporary difference relates to depreciation. Suppose that a company uses straight-line depreciation for book purposes and a more accelerated method for tax purposes. In the short run, there will be a difference in depreciation expense. Eventually, over time, the amount of depreciation the company expenses for an asset will balance out, so the total amount of depreciation is the same in either method. The difference in depreciation expense is temporary.

The company must address the differences between book and tax, called deferred tax assets and liabilities, in the footnotes to the financial statements. Here’s a truncated example of such a note:

NOTE: TAXES

Income before taxes was $7.68M, and the provision for federal taxes was $2.78M,

an effective tax rate of 36.2 percent. Deferred income taxes reflect the net tax

effects of temporary differences between the carrying amounts of assets and

liabilities for financial reporting versus for tax reporting purposes.

SPELLING OUT EMPLOYEE BENEFITS

Details about the company’s expense and unpaid liability for employees’ retirement and pension plans are also spelled out in the footnotes. The obligation of the business to pay for postretirement health and medical costs of retired employees must also be addressed.

Accounting for employee benefits is a somewhat advanced accounting topic. Just remember that employee benefits require an explanatory note, and you’ll be fine. Here’s a truncated example of such a note:

NOTE: RETIREMENT BENEFIT PLANS

We provide tax-qualified profit sharing retirement plans for the benefit of our

eligible employees, former employees, and retired employees. As of December 31,

2022, approximately 80 percent of our profit sharing fund was invested in equities with the rest in fixed-income funds. We have independent external investment managers.

Walking through intangibles

Intangible assets aren’t physical in nature, as desks and computers are. Two common examples of intangibles are patents, which licence inventions or other unique processes and designs, and trademarks, which are unique signs, symbols, or names that the company uses. (See Book 4, Chapter 3 for more information about intangibles.) Besides explaining the different intangible assets the company owns via an explanatory note, the business needs to explain how it determined the intangible asset’s value posted to the balance sheet. Here’s a truncated example of such a note:

NOTE: INTANGIBLE ASSETS

We classify intangible assets with other long-term assets. As of December 31, 2022,

our intangible assets consisted of the following: patents, copyrights, and goodwill.

They are generally amortised on a straight-line basis. We perform a yearly review

to determine whether useful life is properly estimated, and to determine whether

the value of the intangible asset has been impaired.

Looking for important-event disclosures

A company must also provide information in its annual report explaining the following topics: accounting changes, business combinations, contingencies, events that occurred after the balance sheet date, and segment reporting.

The topic of event disclosure is usually discussed separately from the topic of explanatory notes that accompany financial statements. But keep in mind that event disclosure information goes in the footnotes to the financial statements right along with the accounting method information described in the preceding section.

Accounting changes

A company may have up to three types of accounting changes to report: a change in accounting principle, a change in an accounting estimate, or a change in a reporting entity. Narrative descriptions of accounting changes go in the explanatory notes to the financial statements early in the game – usually, in the first or second note.

Following is an explanation of each type of accounting change:

» Accounting principles guide the way the company records its accounting transactions. Under GAAP, a company is usually allowed different ways to account for transactions. GAAP allows companies to use different depreciation methods to expense the cost of long-lived assets, for example.

For financial statements, changes in accounting principles have to be shown by retrospective application to all affected previous periods (unless doing so isn’t practical). This process involves three steps:

• Adjust the carrying amounts of affected assets and liability accounts for the cumulative effect of the change.

• Take any offset (difference in amounts) to beginning retained earnings. In other words, the difference in carrying amounts increases or decreases beginning retained earnings.

• If the financial report shows multiple years for comparison, show the effect of the new accounting principle in each of the reported years.

» Accounting estimates are numbers that a company enters into the financial records to reflect its best guesses as to how certain transactions will shake out. Going back to the depreciation example, consider the estimate for salvage value, which is how much a company assumes that it will be able to get for a long-lived asset when the time comes to dispose of it. If something happens to make you believe that your original estimate of salvage value was wrong, and you change it, you’ve changed your accounting estimate.

A change in accounting estimate has to be recognized currently and prospectively. If salvage value is recalculated, for example, current and future financial statements show the salvage value as corrected. No change is made in earlier financial statements.

» Reporting entities reflect which business combinations are shown on the financial statements, also known as consolidated financial statements. When a business owns more than 50 percent of another business, the investor business is called a parent, and the investee is the subsidiary. If something changes in the way the subsidiaries show up on the financial statements, that’s a change in reporting entity.

Changes in reporting entities are shown retrospectively to the financial statements of all previous periods, so you have to show the dollar amount effect of the change of reporting entities in the balances of all related assets and liabilities. Any offsetting amount goes to the beginning balance of retained earnings.

Business combinations

Accounting textbooks typically cover basic business combinations, which include these three:

» Mergers: Two or more companies combine into a single entity. Mergers are usually regarded as friendly combinations – not hostile takeovers.

» Acquisitions: One company acquires another business. The business doing the acquiring takes over, and in essence, the target (acquired) company ceases to exist. Acquisitions usually aren’t quite as friendly as mergers.

» Dispositions: A company transfers, sells, or otherwise gets rid of a portion of its business. A shoe manufacturer that makes dress shoes, slippers, and tennis shoes, for example, might decide to sell its slipper division to another company.

If a company involves itself in any of these three activities during the financial reporting period, it has to explain the transaction and spell out the effect of the business combination on the financial statements. Business combination information goes in the explanatory notes to the financial statements very early; it first crops up in the first or second note and is addressed as needed in subsequent notes.

If a company is involved in a disposition, GAAP dictates that it disclose not only the facts and circumstances surrounding the disposition, but also any anticipated operational losses from getting rid of a portion of its business. The losses are calculated net of tax, which means you factor in any increase or decrease in tax due because of the disposition. The company must also show any loss or gain on the sale of that portion of the business (also net of tax) on the income statement. These results are pulled out and reported separately because they won’t continue into the future. This activity is typically posted to an account called income (or loss) from discontinued operations.

Contingencies

A contingent liability exists when an existing circumstance may cause a loss in the future depending on other events that have yet to happen (and indeed may never happen). The company might be involved in an income tax dispute, for example. Disclosing this contingent liability is a requirement if the company will owe a substantial amount of additional tax penalties and interest should the unresolved examination end up in the government’s favour. See Book 4, Chapter 4 for a general discussion of contingencies.

Here’s a truncated example of a contingency note:

NOTE: COMMITMENTS AND CONTINGENCIES

As of December 31, 2022, we were contingently liable for guarantees of indebted-

ness owed by third parties in the amount of $3 million. These guarantees relate to

third-party vendors and customers and have arisen through the normal course of

business. The amount represents the maximum future payments that we could be

responsible to make under the guarantees; however, we do not consider it

probable that we will be required to satisfy these guarantees.

A contingent liability needs to be reported not only as a disclosure via a footnote to the financial statements, but also in the financial statements if it’s probable and the amount of loss can be reasonably estimated. This disclosure specifically states that the company doesn’t consider the loss contingency probable, so footnote disclosure without inclusion in the financial statements is all that’s required for this example.

Events that happen after the balance sheet date

The company also must address any events that happen after the close of the accounting period but before the financial statements are released. Like contingent liabilities, depending on their nature, subsequent events may require only a disclosure in the footnotes to the financial statements, or they may require both a disclosure and an adjustment of the figures in the financial statements to reflect the dollar-amount effect of the subsequent event.

How the company handles an event that happens after the balance sheet date depends on whether the event is classified as Type I or Type II:

» Type I events: These events affect the company’s accounting estimates reflected on the books but not confirmed as of the balance sheet date. (See the earlier section “Accounting changes” for an explanation of accounting estimates.) A good example is the estimate for uncollectible accounts. This estimate exists on the books at the balance sheet date, but the company can’t be sure of the resolution of the estimate until a subsequent event occurs, such as a customer’s bankruptcy filing. At that point, the company confirms that the amount is uncollectible.

If the confirming event (such as the bankruptcy) occurs after the balance sheet date but before the financial statements are finalised, the company has to adjust its financial statements. Footnote disclosure can be used to explain the event as well.

» Type Il events: These events aren’t on the books before the balance sheet date and have no direct effect on the financial statements under audit. The purchase or sale of a division of the company is a classic example of a Type II event.

These events are also called non-recognized events. This means that if they’re material, they have to be disclosed in footnotes to the financial statements, but the financial statements don’t have to be adjusted.

Here’s a truncated example of a note on an event that took place after the balance sheet date:

NOTE: SUBSEQUENT EVENT

On February 1, 2022, we entered into an agreement to sell our ownership interests in our ABC division to XYZ Manufacturing for approximately $5 million in cash. The

transaction is subject to certain regulatory approvals. We expect the transaction to

close in the 4th quarter of 2022.

Segment reports

Business segments are components that operate within a company. A clothing manufacturer might make dresses, blouses, pants, and sweaters, all of which are business segments. If a business has various segments, it must disclose info about each segment – such as its type, geographic location, and major customer base – so that the users of the financial statements have sufficient information. Here’s a truncated example of such a note:

NOTE: SEGMENT REPORTING

As of December 31, 2022, our organisational structure consisted of the following

operating segments: North America and Europe. Our North American segments

derive the majority of their revenue from the sale of finished clothing. Our

European segment derives the majority of its revenue from the sale of fabric and

notions to other European companies.