Traditional numerical financial statements, such as balance sheets and income statements, are great for providing you raw financial data. But these numbers are not valuable to readers without some context as to what it means. Footnote disclosures are one method that financial report drafters use to provide that context.
Footnote disclosures describe how the numbers in the balance sheet, income statement, and cash flow statements were determined and provide a sense of where the company is going. Financial statements are required to provide full disclosure. This means that the company cannot just provide information about what it has done in the recent past, but must disclose future risks as well. By definition, the financial statements are backwards looking. The balance sheet shows you the asset values as of a certain day, while the income statement and cash flows show how the business performed over a series of time periods. The financial footnotes complete the company’s obligation to disclose.
Importance of Footnotes
A company’s income could have grown over the past three years, providing a reasonable expectation of continued success. However, the notes could detail significant future tax obligations, pension payments and stock options that could change that assessment very quickly. Or the company could be involved in a significant lawsuit, which if successful, could make it difficult for the corporation to continue operation. This is the type of information that is located in the footnotes.
Important Financial Footnotes
Financial statements are premised on assumptions, some of which are common, others that are specific to the business. The summary of accounting policies and practices discuss how the business assesses things like useful life for assets (which determines depreciation expense) and how inventory is valued (which affects cost of goods sold). These have a direct relationship to how much income the business reports and are subjective to a degree. Disclosures on stock options are also important to review, as it is a preferred method for compensating executives and influence the share price directly.
Footnotes can be incredibly long and complicated, especially the footnotes involving publicly traded companies. Financial reports can be as long as 300 pages, composed entirely of dense language, making it incredibly difficult to read through the entirety of them. To understand footnotes, you need to understand the business to a degree. Different businesses have different key metrics. For example, inventory is vital for a manufacturer, but a service industry has no inventory at all. Identify the key metrics, determine how the business measures that metric, and then compare that process to other comparable businesses in the industry. This is to ensure that when you compare the business to others in the industry, the numbers measure the same thing. Look for those metrics and items that do not seem to fit within the ordinary course of business, such as upcoming lawsuits and large acquisitions. Finally, the report will contain important updates regarding what has happened to the business between the end of the tax period and the issuance of the report. Review that data to see if anything happened that would materially alter the status of the company.
If you are drafting financial statements, consult with a certified public accountant for help in drafting. Also, if you are preparing these reports for investors or an investing institution, contact a public accounting firm to do an independent audit of the statements. An independent audit will provide your financial statements additional credibility with those that review the documents. While every effort has been taken to ensure this article’s completeness and accuracy, it is not intended to be financial advice.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.