What you can learn from footnote disclosures

footnote disclosures

The small print on your company’s financial statements give investors and lenders insight into knowledge that’s vital to business and investment decisions. These footnotes include account balances, accounting practices and potential risk factors. Make sure your footnote disclosures cover these areas. 

1. Transactions with related parties

If companies may employ friends or relatives (or give or receive preferential treatment in transactions with these parties), it’s important that this information be contained in the footnotes.

For example, say, a shoe boutique rents a retail store from the owner’s cousin at discounted rents, saving roughly $100,000 each year. If the owner doesn’t disclose this related-party deal, lenders may be led to believe that the business is more profitable than it really is. When the owner’s cousin unexpectedly dies—and the person who inherits the real estate raises the rent—the owner could fall on hard times and the stakeholders could be blindsided by the undisclosed risk.

2. Contingent or unreported liabilities.

Under some circumstances, a company’s balance sheet won’t reflect all future obligations. For example, footnotes can reveal potentially damaging lawsuits, IRS inquiries, or environmental claims.

These notes also contain specifics on items like loan terms, warranties, leases, and other contingent liabilities. On some occasions, managers might conceal or downplay liabilities to avoid violating loan agreements or revealing financial problems to stakeholders.

3. Changes to accounting principle

Footnotes must explain the nature of and cause for any change in accounting principle, in addition to how that change affects the financial statements. Although valid reasons exist to change an accounting method, dishonest managers might use accounting changes to manipulate financial results.

4. Any major event

If a company recently lost a major customer or is about to be subject to stricter regulatory oversight in the coming year, disclosures may warn of this fact. Significant events that could materially impact future earnings or impair business value are disclosed in footnotes—but again, a dishonest manager may be tempted to downplay significant events to preserve the company’s credit standing.

How much is enough?

The Financial Accounting Standards Board has eliminated some footnote disclosures in recent years and simplified others. While too many disclosures can be burdensome, it’s important that companies don’t cut back on critical disclosures too much. After all, transparency is key to effective corporate governance.

Please contact your trusted Smolin Advisor with any questions or concerns.