Which of the following must be disclosed in the notes to the financial statements?

Supplemental notes to the published financial statements of a company

What are Financial Statement Notes?

Financial statement notes are the supplemental notes that are included with the published financial statements of a company. The notes are used to explain the assumptions used to prepare the numbers in the financial statements, as well as the accounting policies adopted by the company. They help different types of users, such as financial analysts and investors, to interpret all the numbers added to the financial statements.

When conducting an audit of the financial statements, the auditor conducts a thorough investigation of all the information contained in the financial statements, including the notes to the financial statements. Auditors use the notes to determine if the accounting policies used are appropriate, properly applied, and are reflected in the reported results of the company.

The notes may also provide information on underlying issues relating to the overall financial health of the company. The auditor bases his audit opinion on the financial statement numbers, as well as the notes to the financial statements.

Summary

• Financial statement notes refer to the additional notes included in the financial statements of a company,
• The notes are used to make important disclosures that explain the assumptions used to prepare the financial statements of a company.
• Common notes to the financial statements include accounting policies, depreciation of assets, inventory valuation, subsequent events, etc.

Common Notes to the Financial Statements

The following are the common items that appear in the notes to the financial statements:

1. Basis of presentation

The first section in the financial statement notes explains the basis of preparing and presenting the key financial statements.

2. Accounting policies

The accounting policies section provides information on the accounting policies adopted by management in preparing the financial statements. Disclosing the accounting policies helps users interpret and understand the financial statements better.

Some of the disclosures included here are the depreciation method used, how the company values inventory, accounting for intangibles, etc. All the significant accounting policies adopted in the financial statements must be disclosed in the section.

3. Depreciation of assets

Depreciation refers to the reduction in the value of a fixed asset over time due to normal wear and tear. The asset depreciation section provides information on the method adopted by the company when depreciating the assets.

Depending on the depreciation method used, there may be significant fluctuations between the net income in the income statement and the value reported in the balance sheet. Providing information on the depreciation method in the notes informs the users of the differences in net incomes reported in the financial statements.

4. Valuation of inventory

The valuation of inventory note informs users how the company valued its inventory, making it easy for them to compare inventory figures from one period to another or vis-à-vis other competing entities. The section provides information on two main inventory issues, i.e., how inventory amount is stated and the method used to determine inventory cost.

GAAP rules require companies to state their inventory lower of cost or market (LCM). It means that the company will value the inventory at the lowest replacement cost, which can be either the wholesale cost of inventory or the cost of the inventory in the market. To determine inventory cost, GAAP allows three different methods, which include the weighted average, specific identification, and the first-in, first-out (FIFO) method.

5. Subsequent events

Information on any subsequent events can be found also in the financial statement notes section. Subsequent events refer to events that occur after the balance sheet date but before the release of the financial statements. How the company handles the events depends on whether they change the conditions in existence as of the balance sheet date.

The two types of subsequent events are:

Additional information: An event that provides information on conditions in existence as of the balance sheet date, including additional information that affects estimates used to prepare the financial statements. An example would be a business combination after the balance sheet date.

New events:  An event that provides new information about conditions that did not exist as of the balance sheet date. An example would be the damage or theft of a machine in a factory.

Generally accepted accounting principles state that financial statements should include the effects of all subsequent events that provide additional information about conditions in existence as of the balance sheet date. Subsequent events that are new events, however, should not be reflected in the financial statements, but if material, must be disclosed in the notes to the financial statements.

6. Intangible assets

The notes to the financial statement also include information on any intangible assets owned by the company. Intangibles are assets that have no physical form, and they include trademarks and patents. The section details all the intangible assets that the company owns and how it determined the value of intangibles reported on the balance sheet.

7. Consolidation of financial statements

The consolidation of the financial statements section confirms that the statements being issued contain financial statements of all of the subsidiaries of the company and how it accounts for them. It details the basis of consolidating the financial statements, and any deviations from the subsidiaries should be explained.

8. Employee benefits

The employee benefits section of the notes mentions the benefits that the company provides to its employees, including health insurance, health savings accounts, retirement plans, etc.

Typical information that a company discloses in the notes includes the health and welfare plans for its employees, such as the medical, vacation, fringe benefits. It also provides information about the paid and unpaid expenses and liabilities for employee retirement plans.

9. Contingent liability

A contingent liability refers to liability that may occur, but it depends on the outcome of an uncertain future event. An example of a contingent liability is an outstanding lawsuit against the company or an income tax dispute. Disclosing the contingent liabilities informs users that the company may incur a loss in the future if the impending event ends up against the company’s favor.

Additional Resources

Thank you for reading CFI’s guide to Financial Statement Notes. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Analysis of Financial Statements
• Forensic Audit Guide
• Depreciation Methods
• IFRS vs. US GAAP