by Mark J. O'Connell
A complete set of financial statements includes footnotes. These notes describe important economic facts not disclosed in the balance sheet, income statement, or cash flow statement and many of the notes add important detail to items in your statements. Business owners often skip over footnote disclosures because they are already aware of some and don’t understand the rest. However, important users of your financial statements (banks, creditors, sureties, etc.) rely on them for decision-making. Accordingly, you should review your footnotes as closely as your financial statements, think about the message they convey, and ask your CPA to improve your understanding.
Concentrations of risk
Examples of concentration of risk include:
-Having too much of your sales to one or more customer(s)
-Having too much of your purchases from limited sources (supplier or country)
-Having bank balances over the FDIC-insured limit
These disclose potential vulnerabilities in your company’s financials. Look for ways to reduce these exposures.
Maturity and terms of debt
As we covered earlier, the balance sheet presents the amount of debt due in the next 12 months as a current liability and the balance as a long-term liability. This footnote details the principal payments required in future years. These amounts, plus related interest on the debt, dictates cash flow required in those periods.
The term of the debt is also disclosed; along with interest rate and collateral (and personal guarantees) for the debt.
Don’t skip this one. We frequently see the useful life of equipment and other assets based on income tax rules, and those rules use an unrealistic, shorter useful life. GAAP depreciation is designed to reflect the wear and tear (expense) on your equipment over its useful life, tax depreciation accelerates deductions to save you taxes. Using tax depreciation instead of book (GAAP) depreciation has two unfavorable implications. First, depreciation for the early years of ownership will be overstated, and your net income will be understated. Second, the value of your balance sheet assets owner’s equity will be understated.
Related party transactions
Related party transactions are typically loans with shareholders and lease payments on real estate owned by the shareholders. This note also covers sales or purchases with related parties, which may or may not be on the same terms as with an independent party. Any ‘self-dealing’ transaction is subject to scrutiny by outsiders, so the details here are critical.
There are many other important notes specific to industries; examples include contracts in progress and surety bonds for contractors, inventory for retail, wholesale, and manufacturing companies, grants for non-profits and so forth.
Please read the notes to your financial statements carefully each year because others are. They have vital information for you to utilize, and almost every note sends a message.
At this point, we have covered each of the components of your financial statements, and there is more to cover in each case. Moving forward, we will cover key internal financial reports and financial analysis.
We recently published an article on Social Security’s future. This is a significant near and long-term issue, and the impact is significant to all Americans. If you missed it, drop us an email at email@example.com, and we will send it asap.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.