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.
- 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?
- 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.
- 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.