Interpreting Financial Statement Footnotes: What to Watch Out For

Financial statement footnotes can provide a wealth of useful information. Too often, however, no one bothers to read them. Experienced bankers know to look beyond the numbers and read the footnotes to find out qualitative details and narrative disclosures, as well as what’s not being said. Omissions often forewarn of financial uncertainty and even fraud. Here are some examples that bankers should watch out for.

Contingent liabilities

U.S. Generally Accepted Accounting Principles (GAAP) require companies to disclose uncertainties or contingencies, such as litigation exposure, disputed contracts, uncertain tax positions and potential environmental cleanup costs. If significant, these liabilities could impair a borrower’s ability to service its debt.

Management may intentionally downplay such contingencies. But an auditor or forensic accountant finds them by examining original source documents, such as bank statements, sales contracts and warranty documents. They also send letters to the company’s attorney, requesting information about pending lawsuits and other contingent claims.

When these contingent liabilities are reported, bankers need to ask for as many details as possible. If management’s response is hostile or vague, it could be a warning sign that trouble is brewing.

Significant events

GAAP financial statements also disclose any significant events or one-time charges that are likely to affect future financial statements, such as the beginning of manufacturing obsolescence or discontinued operations. Other items that must be disclosed include:

• Impairment of inventory and goodwill,
• Development of competitive products or technology,
• Strategic asset purchases, and
• Significant credits or discounts against sales.

In some cases, GAAP requires a borrower to disclose these items even when they occur after the financial statement date. Auditors and forensic accountants typically unearth these types of events through inquiry procedures. They may, for example, conduct interviews with employees who are likely to know about one-time charges, including sales, engineering, warehouse or internal accounting staff.

Related-party transactions

Related parties are considered individuals or companies with the ability to influence one another’s financial transactions. For example, an executive or board member may have an undisclosed financial interest in one of the company’s suppliers. Unscrupulous borrowers may manipulate related-party transactions to illegally shift profits to other entities.

Even if not intended to defraud, transactions among related parties may require an accountant to normalize the earnings. If, for example, the company rents facilities from a related party at a below-market rate, it will skew the bottom line by understating expenses. Forensic accountants can uncover undisclosed transactions by comparing a list of key employees with public records of businesses that have relationships with the company. If the company’s officers are also listed as officers of these businesses, it’s important to evaluate whether these transactions occur at arm’s length.

Accounting changes

A company’s choice of accounting methods can shape its financial results. For instance, the cash-basis method, though not GAAP, records revenue only as it’s received and expenses only as they’re paid. Under the accrual method, income is recorded at the time of sale, regardless of when payment is received. And expenses are recorded only when goods or services are received.

Companies must disclose changes in accounting methods, estimates, principles and practices if the change materially affects their financial statements. Such changes include those in depreciation methods, standards for revenue recognition and calculation of accruals. In general, a borrower should have a legitimate business reason for changing an accounting method. If you’re skeptical about the motive, consider asking how its financial results would be different under the previous method of accounting.

No footnotes?

Footnotes are an important part of financial statements that are reviewed or audited by a CPA, but they’re optional when financial statements are compiled or prepared in-house. If a borrower’s financial statements don’t include footnote disclosures — and you want to know more details — consider asking the company to work with an external accountant to upgrade its level of assurance and provide audited or reviewed financial statements that conform to GAAP.

Sustainability disclosures gain momentum

The term “sustainability” encompasses a broad range of environmental, social and governance (ESG) issues that may affect a borrower’s financial condition and performance. Examples include the size of the company’s carbon footprint, efforts to replace fossil fuels with renewable energy sources, and overall use of natural resources, as well as workplace, health and safety, and consumer product safety risks.

Sustainability reports aren’t mandatory in the United States, but public companies increasingly are required by the Securities and Exchange Commission to include sustainability disclosures about such issues as climate change and the use of conflict minerals in their financial reports. Many private companies may join the bandwagon to prove to bankers and other stakeholders that they’re environmentally responsible, cost conscious and creditworthy.

On the flip side, a lack of information about sustainable business practices could be a warning sign that a borrower isn’t paying attention to these critical — and potentially costly — issues. For example, environmental issues (such as pollution or carbon emissions) can lead to fines, remedial costs and reputational damage. And the sale of unsafe products can result in product liability lawsuits, recalls and boycotts.

ESG disclosures help shareholders and bankers better understand a company’s business, financial condition and economic risks. If your borrowers aren’t providing comprehensive sustainability disclosures, consider asking for more details.

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