CHAPTER 10
EXPLANATORY NOTES
AND OTHER FINANCIAL
INFORMATION
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Learning Objectives
1. Are the explanatory notes an integral
part of the financial statements? Do
the notes provide detailed disclosure
needed by users wishing to gain a full
understanding of the financial
statements?
2. What are the kinds of significant
accounting policies that are explained
in the notes?
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McGraw-Hill/Irwin
Learning Objectives
3. What are the nature and content of
disclosures relating to accounting
changes, business combinations,
contingencies and commitments,
events subsequent to the balance
sheet date, impact of inflation, and
segment information?
4. What is the role of the Securities and
Exchange Commission, and what are
some of its reporting requirements?
©The McGraw-Hill Companies, Inc., 2002
McGraw-Hill/Irwin
Learning Objectives
5. Why is a statement of management’s
responsibility included with the notes?
6. What is the significance of
management’ discussion and analysis
of the firm’s financial condition and
results of operations?
7. What is included in the five-year (or
longer) summary of financial
information?
8. What are the meaning and content of
the independent auditor’s report?
McGraw-Hill/Irwin
©The McGraw-Hill Companies, Inc., 2002
Learning Objective 1
• Are the explanatory notes an
integral part of the financial
statements? Do the notes
provide detailed disclosure
needed by users wishing to
gain a full understanding of
the financial statements?
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General Organization
• The explanatory notes refer to specific items
in the financial statements
• The financial statement sequence is usually
as follows:
– Income statement
– Balance Sheet
– Statement of cash flows
• The placement of the statement of changes
in owners’ equity depends on the complexity
of the statement
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Explanatory Notes
• Full disclosure requires that firms
report all information necessary for a
reasonably astute user not to be
misled
• Explanatory notes generally require
more pages than the statements
themselves
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Learning Objective 2
• What are the kinds of
significant accounting
policies that are explained
in the notes?
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Significant Accounting
Policies
• Management may choose from a
number of choices among generally
accepted accounting practices
• Each firm must disclose the policies
chosen
• Disclosure enables users to make
intelligent comparisons among firms
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Types of Significant
Accounting Policies
• Depreciation method – method used
and useful lives are disclosed
• Inventory valuation method – methods
for each category of inventory are
disclosed. If LIFO used, the difference
between it and what inventory would
have been under FIFO is disclosed
• Basis of consolidation – discloses which
subsidiaries are consolidated, if any
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More Types of Significant
Accounting Policies
• Income taxes – a reconciliation of the
statutory rate and the effective tax rate is
provided. An explanation of deferred taxes
also is included
• Employee benefits – the cost of employee
benefit is disclosed, along with actuarial
assumptions
• Amortization of intangible assets – method
of amortization is disclosed
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More Types of Significant
Accounting Policies
• Earnings per share of common stock –
an explanation of the calculation is
provided
• Stock option and stock purchase plans
– officers and key employees are given
the right to purchase stock at some time
in the future. Details of such plans are
provided
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Details of Other Financial
Statement Amounts
• May include the amount of research and
development expenses
• May include what items are included in
the “other income” category
• Details of long-term debt may be
provided
• Details of other costs and expenses
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Learning Objective 3
• What are the nature and content of
disclosures relating to accounting
changes, business combinations,
contingencies and commitments,
events subsequent to the balance
sheet date, impact of inflation, and
segment information?
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Other Disclosures
• Accounting change – a change in
accounting principle that has a
material effect on the comparability
of the current period with prior
periods. Example: changing from
FIFO to LIFO
• Business combinations – the effect
on the financial statements from
mergers, acquisitions, or
dispositions will be reported
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More Disclosures
• Contingencies and commitments –
firms involved in lawsuits must
disclose the facts of the lawsuit.
Must also disclose if a guarantor of
the indebtedness of another entity
• Events subsequent to the balance
sheet date – a significant event that
will materially impact the financial
statement s must be disclosed
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More Disclosures
• Impact of inflation – a firm must
report the effect of inflation on the
financial statements
• Segment information – must
disclose line of business and
geographic segment operating
profit, capital expenditures,
depreciation and amortization,
identifiable assets, and sales to
unaffiliated customers
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Learning Objective 4
• What is the role of the Securities
and Exchange Commission, and
what are some of its reporting
requirements?
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Reporting to the Securities
and Exchange Commission
• The SEC was created to administer securities
laws
• Securities that are offered for sale to more than
a few investors must be registered with the SEC
• A prospectus is provided to investors prior to
their purchase of securities
• Firms must file annual reports, 10-Ks, with the
SEC
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Learning Objective 5
• Why is a statement of
management’s responsibility
included with the notes?
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Management’s Statement of
Responsibility
• Explains that the responsibility for the
financial statements lies with the
management of the firm
• Usually refers to the firm’ internal
control, the internal audit function, the
audit committee of the board of
directors, and other ethical conduct
matters
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Learning Objective 6
• What is the significance of
management’ discussion and
analysis of the firm’s financial
condition and results of
operations?
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Management’s
Discussion and Analysis
• A discussion by management of the
firm’s activities during the year, its
financial condition, and the results of
operations
• Required by the SEC in annual reports
to them, but now included in most firm’s
annual reports to stockholders
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Learning Objective 7
• What is included in the fiveyear (or longer) summary of
financial information?
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Five-Year (or Longer)
Summary of Financial Data
• Includes key income statement data
• Includes significant ratios such as
earnings as a percent of sales
• Includes earnings and dividends per
share
• May include stock prices
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Learning Objective 8
• What are the meaning and
content of the independent
auditor’s report?
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Independent Auditors’ Report
• Brief (usually three paragraphs) report
• Usually addressed to board of directors and
stockholders
• Identifies the statements that were audited
• Describes the nature and extent of the
auditors’ work
• Contains an opinion about fair presentation
• Contains the name of the audit firm and a
signature
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Financial Statement
Compilations
• A report that states that the financial
statements have not been audited
• Does not provide any assurance as to
the fairness of the financial statements
• Less costly than an audit
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