Financial Statements and Notes
The notes to financial statements are part of a company's full accounting disclosure in accordance with generally accepted accounting principles (GAAP). The notes to the financial statements expand and provide additional details that the basic numbers reported in the financial statements may not include. Four main types of financial statements include:
1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows
4. Statement of Stockholders’ Equity
After preparing all these financial statements, companies may also include notes to their financial statements. These notes go into detail about the amounts recognized in the statements. They provide a closer look at what the numbers in a statement may mean, while providing greater context to the numbers. At times, notes can provide important information to help users more fully understand the financial statements. For example, organizations with fixed assets would detail in the notes the type of depreciation method they use. Organizations with inventory on their balance sheet would disclose in the notes which valuation method they use (LIFO, FIFO, or weighted average).
Items in the Notes
The first note to the financial statements describes the significant bases of accounting used. The most important of these is whether the company uses the cash or accrual method of accounting.
Cash basis accounting is a method of recognizing and recording revenue or expenses in the period when cash is received or paid. For example, if a company sells its product to a customer but does not collect the cash until a month after the sale, then under the cash basis of accounting, the revenue is not recognized until the cash is actually collected. The same is true for an expense. If a company buys supplies from a vendor but does not pay the vendor until a month later, then under the cash basis of accounting, the transaction is not recorded until the company pays the cash to the vendor.
Accrual basis accounting is a method of recognizing revenue when earned and recording expenses when incurred regardless of the cash received or paid, and is required by generally accepted accounting principles (GAAP). For example, if a company sells its products to a customer but does not collect the cash until a month after the sale, the company will record the revenue on the date of the sale and record a matching receivable. For expenses, the company will record the expense as it accrues. For example, if a company owes its workers for the work they performed to help generate revenue but does not pay them until the next month, the company will record wage expense and a matching payable.
In addition to identifying the basis of accounting in the notes, the company will also disclose other important choices of accounting:
- accounting method for inventory
- depreciation method
- use of estimates
- fair value measurement
- foreign currency translations
Notes to the financial statements may also disclose terms of notes receivable, including information about the interest rates and maturity dates of notes receivable. Some notes to financial statements are optional, and some are required. Notes are essentially used to explain things not clearly evident through numbers. For example, notes can be used to explain extraordinary items, such as losses because of natural disasters. Also, notes can be used to explain contingent liabilities, which are potential liabilities from a past event that will have a future outcome.