Audit disclosures: Why the fine print is important

Reading the Fine Print in Audit Disclosures

Footnotes appear at the end of a company’s audited financial statements. These audit disclosures provide insight into account balances, accounting practices, and potential risk factors — knowledge that’s vital to making well-informed lending and investing decisions. Here are examples of key risk factors that you might unearth by reading between the lines in a company’s footnotes.

Contingent or unreported liabilities in audit disclosures

A company’s balance sheet might not reflect all future obligations. Auditors may find out the details about potential obligations by examining source documents, such as bank statements, sales contracts, and warranty documents. They also send letters to the company’s attorney(s) requesting information about pending lawsuits and other contingent claims.

Detailed footnotes may reveal, for example, an IRS inquiry, a wrongful termination lawsuit, or an environmental claim. Footnotes may also spell out loan terms, warranties, contingent liabilities, and leases. In addition, companies 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. Therefore, footnotes must disclose all related parties with which the company and its management team conduct business.

For example, if a retailer rents space from its owner’s grandparents at below-market rents, saving roughly $240,000 each year. Suppose you’re unaware that this favorable related-party deal exists. In that case, you might believe that the business is more profitable than it is. When the owner’s grandparents unexpectedly die and the rent increases, the company’s stakeholders could be blindsided by the undisclosed related-party risk.

Accounting changes and significant events

Footnotes disclose the nature and justification for a change in accounting principle and 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 depreciation or inventory reporting methods to manipulate financial results.

Footnotes may even forewarn a recent event that could impact future earnings or impair business value. That may include something that’s happened after the end of the reporting period butbeforeissuing the financial statements. Some examples are the loss of a significant customer, a natural disaster, or the death of a key manager.

Why audit disclosures include fine print

Footnotes offer clues to financial stability that the numbers alone might not. But drafting footnote disclosures requires a delicate balance. Most companies want to be transparent when reporting their results. However, indiscriminate disclosures and boilerplate language may detract from meaningful information. That is, information your company’s stakeholders must know. Contact our RRBB accountants and advisors to discuss what’s suitable for your situation.

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