Financial statements are included in the annual report a company mails to its shareholders. They are, though, only part of the information provided. Critical to understanding the financial statements and to evaluating a firm's performance and financial health are additional disclosures included in the annual report.
Financial statement disclosures are provided (1) by including additional information, often parenthetically, on the face of the statement following a financial statement item and (2) in disclosure notes that often include supporting schedules. Common examples of disclosures included on the face of the balance sheet are the allowance for uncollectible accounts and information about common stock. Disclosure notes, discussed and illustrated in the next section, are the most common means of providing these additional disclosures. The specific format of disclosure is not important, only that the information is, in fact, disclosed.
Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Throughout this text you will encounter examples of items that usually are disclosed this way. For instance, the fair values of financial instruments and “off-balance-sheet” risk associated with financial instruments are disclosed in notes. Information providing details of many financial statement items is provided using disclosure notes. Some examples include:
Property, plant and equipment
Employee benefit plans
The full-disclosure principle requires that financial statements provide all material relevant information concerning the reporting entity.
Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions, but many notes are fashioned to suit the disclosure needs of the particular reporting enterprise. Actually, any explanation that contributes to investors' and creditors' understanding of the results of operations, financial position, or cash flows of the company should be included. Let's take a look at just a few disclosure notes.
Summary of Significant Accounting Policies
There are many areas where management chooses from among equally acceptable alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation, whether to use FIFO, LIFO, or average cost to measure inventories, and whether the completed contract or percentage-of-completion method best reflects the performance of construction operations. The company also defines which securities it considers to be cash equivalents and its policies regarding the timing of recognizing revenues. Typically, the first disclosure note consists of a summary of significant accounting policies that discloses the choices the company makes6 Graphic 3-9 shows you a portion of a typical summary note from a recent annual report of the Starbucks Corporation.
Studying this note is an essential step in analyzing financial statements. Obviously, knowing which methods were used to derive certain accounting numbers is critical to assessing the adequacy of those amounts.
The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods.
When an event that has a material effect on the company's financial position occurs after the fiscal year-end but before the financial statements are issued or “available to be issued,” the event is described in a subsequent event a significant development that takes place after the company's fiscal year-end but before the financial statements are issued. disclosure note.7 Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Graphic 3-10 illustrates the required disclosure by showing a note that Walmart Stores, Inc., included in its January 31, 2009, financial statements, announcing both an increase in the company's annual dividend and the issuance of notes payable.
A subsequent event is a significant development that occurs after a company’s fiscal yearend but before the financial statements are issued or available to be issued.
Summary of Significant Accounting Policies—Starbucks Corporation
Real World Financials
Note 1: Summary of Accounting Policies (in part)Principles of Consolidation
The consolidated financial statements reflect the financial position and operating results of Starbucks, which includes wholly owned subsidiaries and investees controlled by the Company.Cash Equivalents
The Company considers all highly liquid instruments with a maturity of three months or less at the time of purchase to be cash equivalents.Inventories
Inventories are stated at the lower of cost (primarily moving average cost) or market. The Company records inventory reserves for obsolete and slow-moving items and for estimated shrinkage between physical inventory counts.Property, Plant, and Equipment
Property, plant, and equipment are carried at cost less accumulated depreciation. Depreciation of property, plant, and equipment which includes assets under capital leases, is provided on the straight-line method over estimated useful lives, generally ranging from two to seven years for equipment and 30 to 40 years for buildings. Leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease life, generally 10 years.Revenue Recognition
Company-operated retail store revenues are recognized when payment is tendered at the point of sale. Revenues from the Company's store value cards, such as the Starbucks Card, are recognized when tendered for payment, or upon redemption. Outstanding customer balances are included in Deferred revenue on the consolidated balance sheets.
Subsequent Event—Walmart Stores, Inc.
Real World Financials
14 Subsequent Events (in part)
On March 5, 2009, the Company's Board of Directors approved an increase in the annual dividends for fiscal 2010 to $1.09 per share. The annual dividend will be paid in four quarterly installments on April 6, 2009, June 1, 2009, September 8, 2009, and January 4, 2010, to holders of record on March 13, May 15, August 14, and December 11, 2009, respectively.
On March 27, 2009, the Company issued and sold $1.0 billion of 5.625% Notes Due 2034 at an issue price equal to 98.981% of the notes' aggregate principal amount.
We cover subsequent events in more depth in Chapter 13.
Noteworthy Events and Transactions
Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company's financial statements. In this category are related-party transactions, errors and irregularities, and illegal acts. The more frequent of these is related-party transactions.
Sometimes a company will engage in transactions with owners, management, families of owners or management, affiliated companies, and other parties that can significantly influence or be influenced by the company. The potential problem with related-party transactions transactions with owners, management, families of owners or management, affiliated companies, and other parties that can significantly influence or be influenced by the company. is that their economic substance may differ from their legal form. For instance, borrowing or lending money at an interest rate that differs significantly from the market interest rate is an example of a transaction that could result from a related-party involvement. As a result of the potential for misrepresentation, financial statement users are particularly interested in more details about these transactions.
When related-party transactions occur, companies must disclose the nature of the relationship, provide a description of the transactions, and report the dollar amounts of transactions and any amounts due from or to related parties.8Graphic 3-11 shows a disclosure note from a recent annual report of Williams-Sonoma, Inc. The note describes a lease arrangement with a company owned by Howard Lester, Williams-Sonoma's chief executive officer and chairman of the board of directors.
The economic substance of related-party transactions should be disclosed, including dollar amounts involved.
Related-Party Transactions Disclosure—Williams-Sonoma, Inc.
Real World Financials
Note M: Related Party Transactions (in part)
On May 16, 2008, we completed two transactions relating to our corporate aircraft. First, we sold our Bombardier Global Express airplane for approximately $46,787,000 in cash (a net after-tax cash benefit of approximately $29,000,000) to an unrelated third party. This resulted in a gain on sale of asset of approximately $16,000,000 in the second quarter of fiscal 2008. Second, we entered into an Aircraft Lease Agreement (the “Lease Agreement”) with a limited liability company (the “LLC”) owned by W. Howard Lester, our Chief Executive Officer and Chairman of the Board of Directors, for use of a Bombardier Global 5000 owned by the LLC. These transactions were approved by our Board of Directors.
More infrequent are errors, irregularities, and illegal acts; however, when they do occur, their disclosure is important. The distinction between errors and irregularities intentional distortions of financial statements. is that errors are unintentional while irregularities are intentional distortions of financial statements.9 Obviously, management fraud might cause a user to approach financial analysis from an entirely different and more cautious viewpoint.
Closely related to irregularities are illegal acts violations of the law, such as bribes, kickbacks, and illegal contributions to political candidates. such as bribes, kickbacks, illegal contributions to political candidates, and other violations of the law. Accounting for illegal practices has been influenced by the Foreign Corrupt Practices Act passed by Congress in 1977. The Act is intended to discourage illegal business practices through tighter controls and also encourage better disclosure of those practices when encountered. The nature of such disclosures should be influenced by the materiality of the impact of illegal acts on amounts disclosed in the financial statements.10 However, the SEC issued guidance expressing its view that exclusive reliance on quantitative benchmarks to assess materiality in preparing financial statements is inappropriate.11 A number of other factors, including whether the item in question involves an unlawful transaction, should also be considered when determining materiality.
As you might expect, any disclosures of related-party transactions, irregularities, and illegal acts can be quite sensitive. Although auditors must be considerate of the privacy of the parties involved, that consideration cannot be subordinate to users' needs for full disclosure.
We've discussed only a few of the disclosure notes most frequently included in annual reports. Other common disclosures include details concerning earnings per share calculations, income taxes, property and equipment, contingencies, long-term debt, leases, pensions, stock options, changes in accounting methods, fair values of financial instruments, and exposure to market risk and credit risk. We discuss and illustrate these in later chapters in the context of related financial statement elements.
Disclosure notes for some financial statement elements are required. Others are provided when required by specific situations in the interest of full disclosure.
6FASB ASC 235–10–50: Notes to Financial Statements—Overall—Disclosure (previously “Disclosure of Accounting Policies,” Accounting Principles Board Opinion No. 22 (New York: AICPA, 1972)).
7Financial statements are viewed as issued if they have been widely distributed to financial statement users in a format consistent with GAAP. Some entities (for example, private companies) don't widely distribute their financial statements to users. For those entities, the key date for subsequent events is not the date of issuance but rather the date upon which the financial statements are “available to be issued,” which occurs when the financial statements are complete, in a format consistent with GAAP, and have obtained the necessary approvals for issuance. Companies must disclose the date through which subsequent events have been evaluated. (FASB ASC 855: Subsequent Events (previously “Subsequent Events,” Statement of Financial Accounting Standards No. 165 (Stamford, Conn.: FASB, 2009))).
8FASB ASC 850–10–50: Related Party Disclosures—Overall—Disclosure (previously “Related Party Disclosures,” Statement of Financial Accounting Standards No. 57 (Stamford, Conn.: FASB, 1982)).
9“The Auditor's Responsibility to Detect and Report Errors and Irregularities,” Statement on Auditing Standards No. 53 (New York: AICPA, 1988).
10“Illegal Acts by Clients,” Statement on Auditing Standards No. 54 (New York: AICPA, 1988).
11FASB ASC 250–10–S99–1, SAB Topic 1.M: Assessing Materiality (originally “Materiality,” Staff Accounting Bulletin No. 99 (Washington, D.C.: SEC, August 1999)).