Disclosures in Financial Reports: Footnotes

A business’s financial report is much more than just the financial statements; a financial report needs additional information, called disclosures. Footnotes are one form of disclosure included in a financial report. Virtually all financial statements need footnotes to provide additional information for several of the account balances.

Footnotes for financial reports come in two types:

One or more footnotes are included to identify the major accounting policies and methods that the business uses. The business must reveal which accounting methods it uses for booking its revenue and expenses. In particular, the business must identify its cost of goods sold expense (and inventory) method and its depreciation methods.

Some businesses have unusual problems regarding the timing for recording sales revenue, and a footnote should clarify their revenue recognition method. Other accounting methods that have a material impact on the financial statements are disclosed in footnotes as well.
Other footnotes provide additional information and details for many assets and liabilities. For example, during the asbestos lawsuits that went on for many years, the businesses that manufactured and sold these products included long footnotes describing the lawsuits.

Details about stock option plans for executives are the main type of footnote to the capital stock account in the owners’ equity section of the balance sheet.

Some footnotes are always required. Deciding whether a footnote is needed (after you get beyond the obvious ones disclosing the business’s accounting methods) and how to write the footnote is largely a matter of judgment and opinion, although certain standards apply:

The Financial Accounting Standards Board (FASB) has laid down many disclosure standards for businesses reporting under U.S. generally accepted accounting principles.
The SEC mandates disclosure of a broad range of information for publicly owned corporations.
International businesses abide by disclosure standards adopted by the International Accounting Standards Board (IASB).

One problem that most investors face when reading footnotes is that they often deal with complex issues (such as lawsuits) and rather technical accounting matters. For an example of the latter, following is a footnote from the 2003 annual 10-K report of Caterpillar, Inc. filed with the SEC.

D. Inventories: Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 75% of total inventories at December 31, 2006, and about 80% of total inventories at December 2005, and 2004.

If the FIFO (first-in, first out) method had been in use, inventories would have been $2,403 million, $2,345 million and $2,124 million higher than reported at December 31, 2006, 2005, and 2004, respectively.

Yes, these dollar amounts are in millions of dollars. But what does this mean? Caterpillar’s inventory cost value for its inventories at the end of 2006 would have been $2.4 billion higher if the FIFO accounting method had been used.

In other words, this particular asset would have been reported at a 38 percent higher value than the $6.4 billion reported in its balance sheet at year-end 2006. Of course, you have to have some idea of the difference between the LIFO and FIFO accounting methods to make sense of this footnote.

You may wonder how different the company’s annual profits would have been if they had used a different accounting method. A business’s managers can ask its accountants to do this analysis. But, as an outside investor, you would have to compute these amounts yourself (assuming you had all the necessary information). Businesses disclose which accounting methods they use, but they do not disclose how different annual profits would have been if an alternative method had been used.