Notes to the financial statements

The primary purpose of the notes to financial statements is to provide further explanations to the information on the face of the financial statements. Using the notes to the financial statements, the notes give a full picture of the entity’s financial position and results of operations by explaining both the amounts and the methods used in the reporting.

Disclosures about methods are governed by ASC 235 as the accounting policy disclosures, while disclosures about amounts are covered by the specific guidance for each type of transaction or account. This chapter describes U.S. GAAP requirements (ASC 235); IFRS (IAS 1) has its own policy-disclosure rules, which aren’t covered here.

Accounting policy disclosure

According to the Codification, accounting policies are the specific accounting principles and the methods of applying those principles that management judges most appropriate for presenting the entity’s financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP). These are the principles and methods the entity has adopted for preparing its financial statements.

These need to be disclosed because the accounting policies have a significant impact on the presentation of the:

• Financial position (assets, liabilities)
• Results of operations (revenues, expenses, gains, losses)
• Cash flows

Users can interpret the statements only if they understand which accounting policies the company used.

What to disclose

Companies need to disclose accounting policies that materially affect the financial position, results of operations and cash flows. According to the Codification, the accounting policy disclosures shall encompass those accounting principles and methods that involve any of the following:

• A selection from existing acceptable alternatives
• Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry
• Unusual or innovative applications of GAAP

The Codification lists items that commonly require policy disclosure:

• Basis of consolidation
• Depreciation methods
• Amortization of intangibles
• Inventory pricing
• Recognition of revenue from contracts with customers
• Recognition of revenue from leasing operations

The policy note should focus on methods and principles; it should not include account-level details or the dollar composition of specific items, since those disclosures belong in the note covering that account.

Example: Inventory pricing policy note

Choosing FIFO over LIFO is a selection from acceptable alternatives; the note might state: “Inventory is valued using the first-in, first-out (FIFO) method,” while the dollar composition of inventory appears in the inventory note instead.

Format of the notes to the financial statements

The Codification also mentioned that the accounting policy disclosures are preferred to be presented as the initial note prior to all other disclosures, although there is flexibility in terms of the format and location depending on the company preparing the financial statements.

Duplication of information

The disclosures shall not duplicate details when they are already presented elsewhere in the financial statements. Companies should use cross-referencing to the other parts of the report to avoid repeating redundant information.

Other common note disclosures

Notes also commonly disclose the following:

• Subsequent events (ASC 855): events after the balance-sheet date. Conditions that already existed at that date are recognized in the financial statements; new conditions arising after it are only disclosed in the notes.
• Contingencies (ASC 450): a loss that is probable and reasonably estimable is accrued. A loss that is reasonably possible, or probable but not estimable, is disclosed in the notes instead. A remote loss generally needs no disclosure.
• Related-party transactions (ASC 850): disclose the nature of the relationship, a description of the transactions, their dollar amounts, and any balances due to or from the related party.

Income taxes, leases, segments, and consolidation each get their own later chapters.