Notes to Financial Statements

The notes to financial statements (also called footnotes or disclosures) are an integral part of a complete set of financial statements. They provide additional detail, context, and explanations that cannot be conveyed by the numbers alone on the face of the financial statements. :::info Key Concept

Financial statements and their notes are inseparable. An auditor's opinion covers both the financial statements and the notes. Information in the notes is considered equally authoritative to amounts on the face of the statements.

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Structure of the Notes

Notes are typically organized in the following order:

1. Summary of significant accounting policies (always Note 1)
2. Detailed disclosures for major balance sheet and income statement items
3. Commitments and contingencies
4. Related party transactions
5. Subsequent events
6. Other required disclosures

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Note 1: Summary of Significant Accounting Policies

This is always the first note and describes the accounting methods and principles the entity uses. It allows users to understand how the numbers were prepared.

Required Disclosures

Policy Area	What to Disclose
Basis of presentation	Consolidation principles, fiscal year-end
Revenue recognition	Performance obligations, timing, variable consideration
Inventory	Valuation method (FIFO, LIFO, weighted average), lower of cost or NRV
Depreciation	Methods (straight-line, declining balance), useful lives
Income taxes	Deferred tax methodology, uncertain tax positions
Financial instruments	Classification, measurement, fair value methods
Leases	Classification criteria, discount rate approach
Intangible assets	Amortization methods, useful lives
Stock-based compensation	Valuation model (Black-Scholes, lattice), assumptions
Foreign currency	Functional currency determination, translation method

:::tip Exam Tip

The summary of significant accounting policies discloses the methods chosen when GAAP permits alternatives. If GAAP mandates only one method, no disclosure of the "choice" is necessary — but the policy is often disclosed anyway for user convenience.

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Example Note Disclosure

Note 1 — Summary of Significant Accounting Policies

Inventory: Bear Co. values inventory at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (FIFO) method.

Property, Plant, and Equipment: PP&E is recorded at historical cost and depreciated using the straight-line method over estimated useful lives of 5 to 40 years. Land is not depreciated.

Revenue Recognition: Revenue is recognized when control of goods or services transfers to the customer, in accordance with ASC 606. The Company identifies performance obligations, determines the transaction price, allocates the price, and recognizes revenue upon satisfaction of each obligation.

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Remaining Notes — Major Topics

Inventory Disclosures

Entities must disclose:

• Inventory composition (raw materials, WIP, finished goods)
• Costing method
• Any LIFO reserve (if LIFO is used)
• Write-downs to net realizable value Example — Gies Co.:

  Note 3 — Inventories

  Inventories consist of the following at December 31:

  Component	Amount
  Raw materials	$85,000
  Work-in-process	120,000
  Finished goods	195,000
  Total inventories	$400,000

  During the year, the Company recognized a write-down of $15,000 to reduce finished goods inventory to net realizable value, recorded in cost of goods sold.

Property, Plant, and Equipment

Required disclosures include:

• Balances by major class
• Depreciation methods and useful lives
• Accumulated depreciation
• Depreciation expense for the period Example — MAS Inc.:

  Note 4 — Property, Plant, and Equipment

  Asset Class	Useful Life	Cost	Accum. Depr.	Net
  Buildings	30 years	$1,200,000	($400,000)	$800,000
  Equipment	5–10 years	650,000	(260,000)	390,000
  Vehicles	5 years	180,000	(108,000)	72,000
  Land	N/A	300,000	—	300,000
  Total		$2,330,000	($768,000)	$1,562,000

  Depreciation expense was $155,000 for the year ended December 31.

Fair Value Measurements

ASC 820 requires disclosure of the fair value hierarchy for assets and liabilities measured at fair value:

Level	Inputs	Description
Level 1	Quoted prices	Unadjusted quoted prices in active markets for identical assets/liabilities
Level 2	Observable inputs	Quoted prices for similar items, or observable inputs (interest rates, yield curves)
Level 3	Unobservable inputs	Entity's own assumptions and models
Example disclosure:

	Level 1	Level 2	Level 3	Total
Trading securities	$150,000	—	—	$150,000
AFS debt securities	—	$200,000	—	$200,000
Contingent consideration	—	—	$45,000	$45,000

warning

Transfers between levels of the fair value hierarchy must be disclosed, along with the reasons for the transfer.

Contingencies

A contingency is an existing condition involving uncertainty about a possible gain or loss that will be resolved by a future event.

Likelihood	Loss Treatment	Gain Treatment
Probable (likely)	Accrue if estimable; disclose	Disclose only (do not accrue)
Reasonably possible	Disclose only	Disclose only
Remote	No disclosure required (exception: guarantees)	No disclosure required
Example — Kingfisher Industries:

Note 8 — Contingencies

The Company is a defendant in a lawsuit filed by a former supplier alleging breach of contract and seeking damages of $500,000. Management, in consultation with legal counsel, believes the likelihood of an unfavorable outcome is reasonably possible. No accrual has been made, but an unfavorable resolution could result in a loss of up to $500,000.

If the loss were probable and estimable at $350,000:

Debit

Credit

Loss from litigation

$350,000

Estimated liability from litigation

$350,000

note

Gain contingencies are almost never accrued. They are disclosed only when realization is probable — and even then, wording must avoid misleading implications that the gain is certain.

Pension and Postretirement Benefits

Defined benefit plan disclosures include:

• Projected benefit obligation (PBO) and plan assets
• Components of net periodic pension cost
• Assumptions (discount rate, expected return on plan assets, rate of compensation increase)
• Amounts in AOCI (prior service cost, net actuarial loss) Example — Illini Security:

  Note 9 — Pension Benefits

  Component	Amount
  Projected benefit obligation	($2,400,000)
  Fair value of plan assets	2,100,000
  Funded status (net liability)	($300,000)

  Net periodic pension cost for the year included service cost of $180,000, interest cost of $120,000, expected return on plan assets of ($105,000), and amortization of prior service cost of $15,000.

Segment Reporting

ASC 280 requires disclosure of financial information about an entity's operating segments — components that engage in business activities, have discrete financial information, and are regularly reviewed by the chief operating decision maker (CODM). Required disclosures per segment:

• Revenue (external and intersegment)
• Profit or loss
• Total assets
• Depreciation and amortization
• Capital expenditures

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Risks and Uncertainties (ASC 275)

Nature of Operations

Describe what the entity does — its principal markets, industry, and types of revenue-generating activities.

Bear Co. is a manufacturer and distributor of consumer electronics products, primarily operating in the United States and Canada.

Use of Estimates

:::info Required Disclosure

All financial statements prepared in conformity with GAAP must include a disclosure stating that the preparation of financial statements requires management to make estimates and assumptions that affect reported amounts.

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The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Significant Estimates

When it is reasonably possible that an estimate will change materially in the near term, the entity must disclose the nature of the uncertainty. Examples of significant estimates:

• Allowance for doubtful accounts
• Inventory obsolescence reserves
• Warranty obligations
• Useful lives of long-lived assets
• Valuation allowances for deferred tax assets
• Fair value of financial instruments (Level 3)
• Litigation accruals

Concentrations

Entities must disclose concentrations that could create vulnerability if the concentrated element were disrupted:

Type of Concentration	Example
Revenue concentration	One customer represents 40% of revenue
Supplier concentration	Single-source supplier for key component
Geographic concentration	All operations in one region subject to natural disaster
Labor concentration	60% of workforce covered by a single union contract
Credit concentration	Major receivable from one customer
Example — BIF Partners:

Note 11 — Concentrations

Approximately 35% of the Company's revenue for the year ended December 31 was derived from a single customer, Illini Entertainment. As of December 31, the accounts receivable balance due from this customer was $420,000. The loss of this customer would have a material adverse effect on the Company's operations.

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Subsequent Events (ASC 855)

Subsequent events are events or transactions that occur after the balance sheet date but before the financial statements are issued (or available to be issued).

Two Types

Type	Description	Accounting Treatment
Recognized (Type 1)	Provides additional evidence about conditions that existed at the balance sheet date	Adjust the financial statements
Nonrecognized (Type 2)	Provides evidence about conditions that arose after the balance sheet date	Disclose in the notes (do not adjust)

:::tip Exam Tip — Type 1 vs. Type 2

Ask: Did the condition exist at the balance sheet date?

• Yes → Recognized event → Adjust the statements
• No → Nonrecognized event → Disclose only :::

Examples

Type 1 — Recognized (adjust):

• Settlement of litigation where the underlying event occurred before year-end
• Customer bankruptcy confirming a receivable was uncollectible at year-end
• Discovery of an error in the financial statements Type 2 — Nonrecognized (disclose):
• Fire destroying a warehouse in January (condition arose after year-end)
• Business combination completed after year-end
• Issuance of debt or equity after year-end
• Loss from a natural disaster after year-end Example — Kingfisher Industries (Type 1): A lawsuit filed against the Company in November was settled on February 10 (before financial statement issuance) for $200,000. At year-end, the Company had accrued $150,000.

Debit

Credit

Loss from litigation

$50,000

Estimated liability from litigation

$50,000

The accrual is adjusted from $150,000 to $200,000 because the settlement provides evidence about conditions at the balance sheet date. Example — MAS Inc. (Type 2): On January 25 (before financial statement issuance), a fire destroyed the Company's main distribution warehouse. The estimated loss is $2,000,000. Because the fire occurred after the balance sheet date, no adjustment is made to the December 31 financial statements. The event is disclosed in the notes:

Note 14 — Subsequent Events

On January 25, a fire destroyed the Company's main distribution warehouse. The estimated uninsured loss is approximately $2,000,000. The Company is currently assessing the full impact and working with its insurance carrier on the claim.

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Complete Set of Financial Statements

For reference, a complete set of financial statements under U.S. GAAP includes:

1. Balance sheet (statement of financial position)
2. Income statement (statement of operations)
3. Statement of comprehensive income (may be combined with income statement)
4. Statement of cash flows
5. Statement of changes in stockholders' equity
6. Notes to financial statements

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Summary of Key Disclosure Requirements

Topic	Key Disclosure
Accounting policies	Methods chosen when GAAP permits alternatives
Inventory	Composition, method, write-downs
PP&E	Cost, accumulated depreciation, useful lives, methods
Fair value	Hierarchy levels, valuation techniques
Contingencies	Nature, estimated loss, likelihood assessment
Pensions	PBO, plan assets, funded status, assumptions
Segments	Revenue, profit, assets by operating segment
Estimates	Nature of significant estimates with material uncertainty
Concentrations	Customer, supplier, geographic, labor, credit risks
Subsequent events	Type 1 (adjust) vs. Type 2 (disclose)

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:::danger Common Exam Pitfalls

1. Accruing gain contingencies — gains are almost never accrued; only disclosed when probable.
2. Confusing recognized (Type 1) and nonrecognized (Type 2) subsequent events — ask whether the condition existed at year-end.
3. Omitting the use of estimates disclosure — it is required for all GAAP financial statements.
4. Thinking notes are optional — they are an integral, required part of financial statements.
5. Not disclosing concentrations that create material vulnerability.
6. Classifying a remote contingent loss as requiring disclosure — remote losses generally need no disclosure (except for guarantees). :::

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Practice Problem

Illini Entertainment has the following situations at its December 31 year-end (financial statements will be issued on March 15):

1. A lawsuit filed against the company in October has a probable unfavorable outcome. Legal counsel estimates the loss at $100,000 to $300,000, with $180,000 being the best estimate.
2. One customer accounts for 45% of revenue.
3. On February 1, the company acquired a competitor for $5,000,000.
4. On January 20, a customer declared bankruptcy. The receivable of $75,000 was outstanding at December 31 and is now uncollectible. Required: For each item, state whether to accrue, disclose, or both.

Details

Solution

5. Accrue $180,000 and disclose. The loss is probable and the best estimate within the range is $180,000. If no best estimate existed, accrue the minimum of the range ($100,000) and disclose the range.

Debit

Credit

Loss from litigation

$180,000

Estimated liability from litigation

$180,000

2. Disclose the customer concentration. No accrual needed — this is a risk disclosure under ASC 275.
3. Disclose only (Type 2 subsequent event). The acquisition occurred after the balance sheet date and reflects conditions that arose after year-end. Disclose the nature of the transaction and estimated financial effect.
4. Adjust (Type 1 subsequent event). The customer's financial difficulties existed at year-end; the bankruptcy confirms the receivable was impaired at December 31.

Debit

Credit

Bad debt expense

$75,000

Allowance for doubtful accounts

$75,000

(Or write off directly against the receivable if no allowance method is used.)