Cumbersome Footnote Disclosure Requirements May Provide Vital Financial Insights

Business owners often think that financial statement footnotes require too many detailed disclosures under U.S. Generally Accepted Accounting Principles (GAAP). In response to these criticisms, the Financial Accounting Standards Board (FASB) has launched a project to minimize so-called “disclosure overload.” But it’s important for the FASB to maintain a balanced approach when cutting back.

Footnotes provide insight into account balances, accounting practices and potential risk factors — knowledge that’s vital to making well-informed banking and investing decisions. Here are key risk factors that you may unearth by reviewing your borrowers’ footnotes.

Unreported or contingent liabilities

A borrower’s balance sheet might not reflect all future obligations. Detailed footnotes may reveal, for example, a potentially damaging lawsuit, an IRS inquiry or an environmental claim.

Footnotes also spell out the details of loan terms, warranties, contingent liabilities and leases. Unscrupulous borrowers may downplay liabilities to avoid violating loan agreements or admitting financial problems to stakeholders.

Related-party transactions

Companies may give preferential treatment to, or receive it from, related parties. It’s important that footnotes disclose all related parties with whom the company — and its management team — conducts business.

For example, say Smoke-n-Mirrors Home Décor rents retail space from its owner’s parents at below-market rents, saving roughly $200,000 each year. Because the retailer doesn’t disclose that this favorable related-party deal exists, its bankers believe that the business is more profitable than it really is. When the owner’s parents unexpectedly die — and the owner’s sister, who inherits the real estate, raises the rent — the retailer could fall on hard times and the stakeholders become blindsided by the undisclosed related-party risk.

Accounting changes

Footnotes disclose the nature and justification for a change in accounting principle, as well as that change’s effect on the financial statements. Valid reasons exist to change an accounting method, such as a regulatory mandate. But dishonest managers can use accounting changes in, say, depreciation or inventory reporting methods to manipulate financial results.

Significant events

Wouldn’t you appreciate a forewarning that a borrower recently lost a major customer or will be subject to stricter regulatory oversight next year? Footnotes disclose significant events that could materially impact future earnings or impair business value. But fraudsters may overlook or downplay significant events to preserve the company’s credit standing.

Disclosure framework project

Footnotes provide bankers and investors with insight into various risks. But the FASB has been simplifying and eliminating disclosures under GAAP that don’t provide sufficient benefits to justify the costs of collecting the information to provide them.

As of this writing, the board is seeking input on its recent exposure drafts on defined benefit plans, fair value measurements and government assistance. Over the next year, more disclosure guidance is expected for such issues as income taxes, inventory and interim reporting. It’s important for bankers and others who rely on financial statements to review these proposals and provide feedback to the FASB.

Outside input

If you unearth any red flags when reviewing a borrower’s footnotes or simply want more details, don’t be afraid to ask. Also consider hiring an outside financial expert to dig deeper if you don’t get the answers you seek.

Looking for more information on key elements of audited financial statements? Contact Lori Wagnon at 404-874-6244 or fill out our form for more information.