Understanding Business Accounting For Dummies, 2nd Edition (59 page)

Making Sure that Disclosure Is Adequate

The primary financial statements (including the statement of changes in owners' equity, if reported) are the backbone of a financial report. In fact, a financial report is not deserving of the name if the primary financial statements are not included. But, as mentioned earlier, there's much more to a financial report than the financial statements. A financial report needs
disclosures.
Of course, the financial statements provide disclosure of the most important financial information about the business. The term disclosures, however, usually refers to additional information provided in a financial report. In a nutshell, a financial report has two basic parts: (1) the primary financial statements and (2) disclosures.

The chief officer of the business (usually the CEO of a publicly-owned company, the president of a private corporation, or the managing partner of a partnership) has the primary responsibility to make sure that the financial statements have been prepared according to prevailing accounting standards and that the financial report provides adequate disclosure. He or she works with the chief financial officer of the business to make sure that the financial report meets the standard of adequate disclosure. (Many smaller businesses hire an independent qualified accountant to advise them on their financial statements and other disclosures in their financial reports.)

Types of disclosures in financial reports

For a quick survey of disclosures in financial reports - that is to say, the disclosures in addition to the financial statements - the following distinctions are helpful:

Footnotes
that provide additional information about the basic figures included in the financial statements; virtually all financial statements need footnotes to provide additional information for the account balances in the financial statements.

Supplementary financial schedules and tables
to the financial statements provide more details than can be included in the body of financial statements.

A wide variety of
other information
is included, some of which is required if the business is a company quoted on a stock market subject to government regulations regarding financial reporting to its shareholders and other information that is voluntary and not strictly required legally or according to GAAP.

Footnotes: Nettlesome but needed

Footnotes appear at the end of the primary financial statements. Within the financial statements you see references to particular footnotes. And at the bottom of each financial statement, you find the following sentence (or words to this effect): ‘The footnotes are integral to the financial statements.' You should read all footnotes for a full understanding of the financial statements.

Footnotes come in two types:

One or more footnotes must be included to identify the
major accounting policies and methods
that the business uses. (Chapter 13 explains that a business must choose among alternative accounting methods for certain expenses, and for their corresponding operating assets and liabilities.) The business must reveal which accounting methods it uses for its major expenses. In particular, the business must identify its cost of goods sold expense (and stock) method and its depreciation methods.

Other footnotes provide
additional information and details
for many assets and liabilities. Details about share option plans for key executives are the main type of footnote to the capital stock account in the owners' equity section of the balance sheet.

One problem that most investors face when reading footnotes - and, for that matter, many managers who should understand their own footnotes but find them a little dense - is that footnotes often deal with complex issues (such as lawsuits) and rather technical accounting matters. Let us offer you one footnote that brings out this latter point. This footnote is taken from the recent financial report of a well-known manufacturer that uses a very conservative accounting method for determining its cost of goods sold expense and stock cost value. We know that we have not yet talked about these accounting methods; this is deliberate on our part. (Chapter 13 explains accounting methods.) We want you to read the following footnote from the 1999 Annual Report of this manufacturer and try to make sense of it (amounts are in thousands).

D. Inventories
: Inventories are valued principally by the LIFO (last-in, first-out) method. If the FIFO (first-in, first-out) method had been in use, inventories would have been £2,000 million and £1,978 million higher than reported at December 31, 2006 and 2007, respectively.

Yes, these amounts are in
millions
of pounds. The company's stock cost value at the end of 2006 would have been £2 billion higher if the FIFO method had been used. Of course, you have to have some idea of the difference between the two methods, which we explain in Chapter 13.

You may wonder how different the company's annual profits would have been if the alternative method had been in use. A manager can ask the accounting department to do this analysis. But, as an outside investor, you would have to compute these amounts. Businesses disclose which accounting methods they use but they do not have to disclose how different annual profits would have been if the alternative method had been used - and very few do.

Other disclosures in financial reports

The following discussion includes a fairly comprehensive list of the various types of disclosures found in annual financial reports of larger, publicly-owned businesses - in addition to footnotes. A few caveats are in order. First, not every public company includes every one of the following items although the disclosures are fairly common. Second, the level of disclosure by private businesses - after you get beyond the financial statements and footnotes - is much less than in public companies. Third, tracking the actual disclosure practices of private businesses is difficult because their annual financial reports are circulated only to their owners and lenders. A private business may include any or all of the following disclosures but, by and large, it is not legally required to do so. The next section further explains the differences between private and public businesses regarding disclosure practices in their annual financial reports.