Explanatory notes are discussions of items that accompany the financial statements, which are the income statement, the balance sheet, and the statement of cash flows. These notes are important disclosures that further explain numbers on the financial statements. The reason for these notes harkens back to fulfilling the needs of the external users of the financial statements.
Notes that show the basis for presentation
The first order of business when preparing explanatory notes is explaining, in general, the business and significant accounting policies.
For such a note, the company gives a thumbnail sketch of the business. Common topics for discussion include what the company is in the business of doing and how it does that work. For example, does the company manufacture the product itself or contract it out?
Notes that advise on significant accounting policies
Information about accounting policies assists financial readers in better interpreting a company's financial statements, thus resulting in a more fair presentation of the financial statements. A note is needed for each significant accounting choice by the company.
Financial accountants use the terms footnote, note, and explanatory note pretty much interchangeably as all three terms represent the same explanatory information.
At the very least, the explanatory notes should include what depreciation methods are in use, how a company values its ending inventory, the basis of consolidation, accounting for income taxes, information about employee benefits, and accounting for intangibles.
Notes about depreciating assets
Depreciation is spreading the cost of a long-term asset over its useful life (which may be years after the purchase). A business values its ending inventory using inventory valuation methods. The methods a company opts to use for both depreciation expense and inventory valuation can cause wild fluctuations in the amount of assets shown on the balance sheet and the amount of net income (loss) shown on the income statement.
The user needs to know which methods the company uses when comparing financial statement figures with another company’s figures. Differences in net income could merely be a function of depreciation or valuation methodology, and the user would be unaware of that fact without the footnote.
Notes about valuing inventory
Companies have two inventory issues that must be disclosed in the notes: the basis upon which the company states inventory (lower of cost or market) and the method in use to determine cost. GAAP allows three different cost flow assumptions: specific identification; weighted average; and first in, first out (FIFO).
Accounting for depreciation and inventory is usually addressed in whichever note gives a summary of accounting policies.
Notes that disclose subsequent events
The company also has to address any subsequent events that happen after the close of the accounting period. How the company handles this type of event hinges on whether the event is a Type I or Type II event.
Type I events affect the company’s accounting estimates booking on the financial statements. Type II events aren’t on the books at all before the balance sheet date and have no direct effect on the financial statements under audit. The purchase or sale of a division of the company is a classic example of a Type II event.
Type II events are also called nonrecognized events. Here’s why: If they’re material, they must be disclosed in footnotes to the financial statements, but the financial statements don’t have to be adjusted.
Notes that explain intangibles
Intangible assets aren’t physical in nature, like a desk or computer. Two common examples of intangibles are patents, which are licensing for inventions or other unique processes and designs, and trademarks, which are unique signs, symbols, or names that the company uses.
Besides explaining the different intangible assets the company owns via an explanatory note, the business needs to explain how it has determined the intangible asset’s value showing on the balance sheet.
Notes that consolidate financial statements
Consolidation refers to the aggregation of financial statements of a group company as a consolidated whole. In this section of the footnotes, the company confirms that the consolidated financial statements contain the financial information for all its subsidiaries. Any deviations, including deviations from all subsidiaries, also must be explained.
Notes that spell out employee benefits
Employee benefit plans provide benefits to both employees and former employees. One example is a health and welfare benefit plan that provides medical, dental, vision, vacation, and dependent care (just to name a few) benefits to employees and former employees.
The footnotes also spell out details about the company’s expense and unpaid liability for employees’ retirement and pension plans. These details include the obligation of the business to pay for post-retirement health and medical costs of retired employees.
Notes that reveal contingencies
A contingent liability exists when an existing circumstance may cause a loss in the future, depending on other events that have not yet happened and, indeed, may never happen. For example, the company may be involved in an income tax dispute.
Disclosing this contingent liability is a requirement if the company will owe a substantial amount of additional tax penalties and interest if the unsolved examination ends up in the government’s favor.
Notes about reporting debt
The notes to the financial statements also must disclose claims by creditors against the assets of the company. The note shows how the company is financing present and future costs. It also gives the user of the financial statements a look at future cash flows, which can affect the payment of dividends.