Purpose of Disclosures
While a company's financial statements contain all the relevant financial data about the company, that data is often in need of further explanation. That is where the disclosures on the financial statement come into play.
A financial statement disclosure will communicate relevant information not captured in the statement itself to a company's stakeholders. The disclosures can be required by generally accepted accounting principles or voluntary per management decisions.
What Is Disclosed: Materiality and Impact
All relevant information must be disclosed. "Relevant" means any context that may impact a financial statement's reliability. This may include information about accounting methods, dependencies, or changes in amounts or estimates.
Types of Financial Disclosures
Accounting Changes
If a company makes a significant change to their accounting policies, such as a change in inventory valuation, depreciation methods, or application of GAAP, they must disclose it. Such disclosures alert the financial statement's users as to why the company's financial information may suddenly look different.
Accounting Errors
Accounting errors can result for a variety of reasons including transposition, mathematical computation, and incorrect application of GAAP or failing to revalue assets using fair market value. When an error is discovered, it must be corrected. This often means correcting prior period financial statements. This information must be noted in the disclosure. Keep in mind, significant accounting errors can result in financial audits and possible bankruptcy by the company.
Asset Retirement
Companies retire assets once the asset provides no future benefits to the company. The procedure for retiring an asset requires the company to obtain both a fair market value and salvage value for the asset. Usually, the difference between the sale price and the asset's salvage value results in a net loss. The net loss is then included on the company's income statement, which is then explained via a disclosure.
Insurance Contract Modifications
Insurance contract modifications affect a company's balance sheet. Since companies use the balance sheet to determine the total economic value added by their company's operations. A financial disclosure is necessary to explain why the insurance contract was modified and what current or future implications may occur. Examples of insurance contracts include the business owner's life insurance policy or the general liability insurance for business operations.
Other items
Other items requiring disclosure are noteworthy events and transactions. These events are infrequent but made a significant impact on the current financial period.
Credit Cards Represent Debt
Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).
Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).
Methods of Making a Disclosure
Disclosures may be simple statements regarding the change or provide a lengthy explanation for the reason to change the company's accounting policies and procedures.
Voluntary disclosure in accounting is the provision of information by a company's management beyond requirements, such as generally accepted accounting principles and Securities and Exchange Commission rules, where the information is believed to be relevant to the decision making of users of the company's annual reports.
Voluntary disclosure benefits investors, companies, and the economy; for example, it helps investors make better capital allocation decisions and lowers firms' cost of capital, the latter of which also benefits the general economy. Chau and Gray (2002) also found support for the theory that voluntary disclosure helps reduce conflicts of interest in widely held firms. Firms, however, balance the benefits of voluntary disclosure against the costs, which may include the cost of procuring the information to be disclosed, and decreased competitive advantage.
Structure of Disclosures
Disclosures can span several pages at the end of the financial statements.