Footnotes are of two kinds. First, the main accounting methods used by the business are identified and briefly explained. For instance, the particular accounting method used to determine the company's cost of goods sold expense and its ending inventory cost is identified (Chapter 20 explains these methods).
For many expenses (and even for sales revenue) most businesses can choose between two or three generally accepted accounting methods. The company's selections of accounting methods have to be made clear in footnotes. A footnote is needed for each significant accounting choice by the business. Footnotes assume some familiarity with accounting terminology, as you can see in the footnote from Caterpillar's financial statements quoted just below.
A footnote from a recent annual report of Caterpillar Inc. regarding its inventory accounting method reads as follows (from page 27 of Caterpillar's electronic filing of its 1997 10-K with the Securities & Exchange Commission):
Inventories are valued principally by the LIFO (last-in, first-out) method. The value of inventories on the LIFO basis represented approximately 85% of total inventories at current cost value at December 31, 1997, and 1996, and 90% at December 31, 1995.
If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,067, $2,123, and $2,103 [million] higher than reported at December 31, 1997, 1996, and 1995, respectively.
This footnote reveals that Caterpillar's inventories in its balance sheets at these year-ends would have been $2 billion higher if the company had selected an alternative accounting method. And, its cost of goods sold expense for each year would have been different (but "only" by a few million dollars).
Companies disclose their choice of depreciation methods in footnotes. (Chapter 21 discusses different depreciation methods). Other common footnotes explain the consolidation of the company's financial statements. Many large businesses consist of a family of corporations under the control of one parent company. The financial statements of each corporation are grouped together in one integrated set of financial statements. Intercorporate dealings are eliminated as if there were only one entity. Affiliated companies in which the business has made investments are not consolidated if the company does not have a controlling interest in the other business.
The second type of footnotes provide additional disclosure that cannot be placed in the main body of the financial statements. For example, the maturity dates, interest rates, collateral, or other security provisions, and many other details of the long-term debt of a business are presented in footnotes. Annual rentals required under long-term operating leases are given. Details regarding stock options and employee stock ownership plans are spelled out, and the potential dilution effects on earnings per share are illustrated in a footnote. Major lawsuits and other legal actions against the company are discussed in footnotes.
Details about the company's employees' retirement and pension plans are also disclosed in footnotes. Obligations of the business to pay for postretirement health and medical costs of retired employees are presented in footnotes. The list of possible footnotes is a long one. In preparing its annual report, a business needs to go down a long checklist of items that may have to be disclosed, and then write the footnotes. This is no easy task. The business has to explain in a relatively short space what can be rather complex.
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