U.S. Generally Accepted Accounting Principles (GAAP) requires countless disclosures, much to the dismay of many business owners. However, the comprehensive financial statement footnotes that ensue are filled with useful information.
The following examples show hidden risk factors you may uncover by looking over footnote disclosures. This valuable information will help both when evaluating your company’s performance and when evaluating the performance of publicly traded competitors or potential M&A targets.
Unreported or contingent liabilities
Not all future obligations are displayed on a company’s balance sheet. Detailed footnotes may reveal an IRS inquiry, an environmental claim or a potentially damaging lawsuit. Footnotes also break down the details of loan terms, warranties, contingent liabilities and leases.
Companies may give preferential treatment to, or receive it from, related parties. Footnotes should disclose related parties with whom the company conducts business. Take, for example, a retailer who rents retail space from the owner’s parents. Because he rents below market he saves about $200,000 per year. The retailer doesn’t disclose this favorable related-party deal, making his business appear more profitable on the income statement that it actually is. Say the owner’s parents pass away unexpectedly and the owner’s sister, who inherits the real estate, raises the rent. Since the related-party deal has not been disclosed in the footnotes, the retailer could fall on hard times and the stakeholders could be blindsided.
Footnotes disclose the nature and justification for a change in accounting principle, as well as that change’s effect on the financial statements. There are valid reasons (like a regulatory mandate) for changing an accounting method but dishonest managers can use these same procedures to manipulate financial results. Some examples are accounting changes in depreciation or various inventory reporting methods.
Footnotes divulge critical events that could substantially impact future earnings or damage business value. Outside stakeholders appreciate advance notice of looming problems, like stricter regulations in the year ahead or the recent loss of a major customer.
The Financial Accounting Standards Board (FASB) has recently been attempting to redo its rules – without compromising reporting transparency – in order to minimize “disclosure overload.” Examples of disclosure-related projects currently on the FASB’s radar include fair value measurements, government assistance, inventory and income taxes. JLK Rosenberger can help you understand the latest developments in footnote disclosures. We can also discuss any concerns you may have when reviewing the fine print in your company’s footnotes — or in the disclosures made by other companies. Call us at 818-334-8623 or click here to contact us.