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Friday, November 13, 2015

What do My Financial Statements Mean? The Notes to the Financial Statements

My last three posts dealt with each of the three primary financial statements: the balance sheet, the income statement and the cash flow statement. Today's post will look at what in my opinion are often overlooked and ignored by many business owners: the notes.

One of the reasons why the notes are ignored so often is that business owners do not understand most of them and do not obtain useful information from them. It is indeed an unfortunate reality that the professional accounting standards often do not require disclosure of the information that would be most helpful to a user analyzing the financial statements. Most professional accountants prepare financial statements either for a specific user such as the bank manager or for use in filing tax returns. Usually in the latter case there are no notes, as they are not required for financial statements prepared on a Notice to Reader basis. In the former case, where the financial statements are prepared on an audited or Review Engagement basis, notes usually are prepared, but only  the minimum required disclosures are usually included.

So What Do The Notes Contain And Why Are They Important?

The notes contain three basic categories of information:


  • They explain the accounting policies being used to measure and report transactions and thus the entire basis of presentation.
  • They provide additional detail of items reported in the financial statements.
  • They provide qualitative information that would be considered important to a reader that cannot be adequately captured in the financial statements.
The first note is always the accounting policies note, and it is this note that is usually completely ignored by most business owners. Although business owners really should be involved in deciding what policies make the most sense for their particular business, for many small businesses this task is left to the accountant. Another thing that often happens is an accountant will acquire the client from another accountant and will simply follow whatever policies were used in the past. Consequently what can happen is that inappropriate accounting policies that do not reflect the economic reality of the business get used for years, resulting in statements that while useful for preparing the annual tax return, are of little more value. 

I'm not going to bore you with all the different accounting policies here, as your accountant can have that discussion with you. Instead, I want to alert you to the questions you should consider and answer for your accountant so that he or she can ensure that the appropriate policies are being used from the start:

  • When you decide to make an allowance for uncollectible accounts receivable, do you look at specific accounts, or do you provide a blanket, estimated allowance based on historical experience, like 1% of all accounts for example?
  • Does your inventory consist of individually identifiable, distinct units, or are they a large quantity of identical items?
  • When you sell inventory, what sells first? The oldest units you bought? The latest ones? Can't tell?
  • For each major category of asset, such as office equipment, premises, computer systems, software etc., how many years do you expect that the business will use the asset before it has to be upgraded or replaced?
  • For intangible, intellectual property assets, how long do you expect that they will have value to the business?
  • At what point do you consider a sale to have taken place? Is it when you deliver goods or render services, is it when you receive payment? 
  • For long-term construction or manufacturing contracts, how do you record the revenue during the contract? Do you attempt to determine the progress of the contract at year end and attempt to estimate the proportion of the revenue earned to that point? Or do you wait until the contract has been completed?
  • Do you make an estimate of inventory that for whatever reason will not sell for full price, or will not sell at all? How do you determine that? Do you look at a complete list of inventory and consider each item, or do you provide a blanket allowance based on experience?
Knowing the answers to the above will help your accountant ensure that your financial statements are the most meaningful they can be. 

Most of the rest of the notes to the financial statements are usually additional details or breakdowns of items contained in either the balance sheet, income statement or cash flow statement such as:

  • Breakdown of inventory between raw materials, work-in-progress and finished goods, along with the allowance for obsolete inventory. 
  • Breakdown of which assets are included in property, plant and equipment - their original cost, the depreciation (amortization) taken to date and the remaining net book value.
  • Breakdown of assets acquired on long-term lease showing similar information.
  • Details of bank credit lines obtained whether used or not, including all significant terms and conditions and a statement as to whether those conditions have been complied with. 
  • Details of any warranty arrangements offered to customers.
  • Details of long-term bank loans other loans or lease obligations.
  • Details of issued shares and authorized but not issued shares.
  • Details of major components of revenue.
  • Details of sales made to or purchases made from related companies
  • Details of what makes up the income tax expense and how the income taxes shown on the financial statements reconciles to the tax return.
Most of these are understandable to most readers except for the last one. The last note is required under the professional standards in Canada. The reason it is required is that in some cases there is a significant difference between a company's taxable income and the income shown on the financial statements, due to special tax write-offs that the company is eligible for. If a reader were to simply apply the known tax rate to the financial statement income, the expense number they would calculate would be different from the expense shown on the financial statements, which of course would be confusing. So this note is meant to clear up the confusion by explaining what the differences are. 

The third category of information disclosure is qualitative information that is important to a reader that cannot be adequately disclosed in the statements. Usually this is related to events that have taken place after the date of the financial statements that could have a significant impact on the business, such as:

  • Acquisition of a business division or merger with another business.
  • Loss or acquisition of a major customer or key supplier.
  • A catastrophe that results in the destruction of corporate property.
  • A lawsuit that has been filed against the business. 
Occasionally, the disclosure can be similar to the above, but related to events that occurred before the date of the financial statements that was still unresolved as of that date. 

Most business owners, in my experience are reluctant to provide these disclosures. However, they are essential if you are going to provide financial statements to external parties. I'm also of the belief that many of them do not paint the negative picture that many owners think: things happen all the time in business, and the disclosure of the above will not necessarily hurt the business, although it may lead to questions from readers. 

That concludes my discussion of financial statements and what they mean. I hope you all found it useful. 

Have a great weekend everyone!

10 comments:

  1. sounds like u may miss having these discussions with clients......

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    1. Yes and no I'm very happy to be running my stamp business now. But I do have some knowledge that I know can be useful to my readers. So to the extent that I can share it, that is what I am doing.

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  2. This is very informative thank you.

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  3. Im sry if u said this before but how long have you been an accountant?

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  4. what does steph do for a living?

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  5. This comment has been removed by the author.

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