Don’t discount the value of footnotes

Footnote disclosures provide insight into account balances, accounting practices, and potential risk factors. This information helps lenders, investors, and other financial statement users make well-informed business decisions.

Here are five critical risk factors that financial statement users monitor when reviewing a company’s financials.

Unreported or contingent liabilities. A company’s balance sheet might not necessarily reflect all future obligations. Detailed footnotes may reveal, for example, a potentially damaging lawsuit, an IRS inquiry, or an environmental claim.

Footnotes also should spell out the details of loan terms, warranties, contingent liabilities, and leases. Struggling companies may downplay liabilities in their footnotes to avoid violating loan agreements or admitting financial problems to stakeholders.

Related-party transactions. Companies may give preferential treatment to, or receive it from, related parties. It’s important that footnotes disclose all related parties with whom the company — and its management team — conduct business.

For example, say a manufacturing company rents space from its owner’s parents at below-market rents, saving roughly $240,000 each year. Because the company doesn’t disclose this favorable related-party deal, its lenders believe that the business is more profitable than it really is. If the owner’s parents unexpectedly die — and the owner’s sister, who inherits the real estate, raises the rent — the manufacturer could fall on hard times, causing stakeholders to be blindsided by the undisclosed related-party risk.

Accounting changes. Footnotes disclose the nature and justification for a change in an accounting principle. They also take note of that change’s effect on the financial statements.

Valid reasons exist to change an accounting method, such as a regulatory mandate or proactive tax planning. However, dishonest managers can use accounting changes in, say, depreciation or inventory reporting methods to manipulate financial results.

Significant events. Footnotes should disclose significant events, including those that happen after the end of the reporting period, but before the financial statements have been finalized. These are events that could materially impact future earnings or impair business value.

Examples include the loss of a major customer, a major pending lawsuit, and impending adverse government regulations. Dishonest business owners and managers may overlook or downplay significant events to preserve the company’s credit standing.

ESG risks. A broad range of environmental, social, and governance (ESG) issues may affect a company’s financial condition and performance. Examples include the size of its carbon footprint, efforts to replace fossil fuels with renewable energy sources, and overall use of natural resources, as well as workplace, health and safety, and consumer product safety risks.

A lack of financial statement disclosures about ESG practices could be a warning sign that management isn’t paying attention to these critical — and potentially costly — issues. For example, environmental issues (such as pollution or carbon emissions) can lead to fines, remedial costs, and reputational damage. And the sale of unsafe products can result in product liability lawsuits, recalls, and boycotts.

ESG reports aren’t mandatory in the United States, but public companies increasingly are required by the Securities and Exchange Commission to include climate-related disclosures and information related to the use of conflict minerals in their financial reports. Many private companies have added ESG disclosures to demonstrate to stakeholders that they’re environmentally responsible, cost conscious, and creditworthy.

Transparency is key

In recent years, the Financial Accounting Standards Board (FASB) has cut back certain burdensome disclosures, especially for private companies. As it simplifies and eliminates disclosures that don’t justify the costs of collecting the information, it also recognizes the need for a balanced approach and urges businesses to strive for transparency in financial reporting.

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