It’s a common piece of advice that we hear: it’s always a good idea to read the fine print before making a decision. Is there any reason why this should be any different for a company’s financial statements? If the income statement, balance sheet, and statement of cash flow form the foundation of a company’s financial information, then the footnotes serve as the fine print that explains the foundation of financial information.
Sadly, what is frequently not provided in conjunction with this sound advice is a comprehensive set of instructions on how to properly read a company’s footnotes. Throughout this article, you will learn not only what footnotes are, but also what they mean and how you can use them to your financial advantage.
What Are Footnotes and How Do They Work?
Pick up any financial report, and you’ll find references to the footnotes of the financial statements in almost every single one of them. It is in the footnotes that the practices and reporting policies of the company’s accounting methods are described in greater detail, as well as additional information that cannot be shown in the financial statements themselves.
Instead, footnotes supplement quantitative financial statements by providing qualitative information that allows for a better understanding of an organization’s true financial performance over a specified time period, as illustrated in the following example:
The information contained in footnotes can generally be divided into two categories. A company’s accounting methods, such as its revenue recognition policies, are what determines how its financial information is presented in the first of these categories. Detailed explanations of significant company operational and financial results are provided in the second section.
Accounting Methods are a collection of procedures that are used to keep track of financial transactions.
This section, which is usually found at the beginning of the footnotes, identifies and explains the major accounting policies followed by a company. These footnotes are divided into specific accounting areas (revenue, inventory, and so on), and they provide information about a company’s policy with regard to that account as well as how its value is calculated.
For example, revenue is one of the most important financial metrics to consider. It is common to find a revenue recognition note in the footnotes of financial statements. This note describes how a company determines when it has earned its revenue. In part because of the often complex nature of business operations, the point at which a sale can be booked (and thus recorded on the financial statements) is not always obvious.
This section will provide valuable insight into when a company records revenue for the purposes of investing. For example, Ford Motor Co. recognizes a sale when a Ford vehicle is taken into possession by a dealership from the manufacturer.
What to Keep an Eye Out For
When examining a company’s accounting methods, which can be found in the footnotes, there are two things to keep in mind. The first step is to examine a company’s accounting method and see how it compares to the generally accepted accounting method and industry standards, as well as other relevant factors.
The use of a policy that differs from others in the industry or that appears to be far too aggressive could be a sign that the company is attempting to manipulate its financial statements in order to conceal an undesirable event or give the impression of better performance than it is actually achieving.
Imagine that car company X, instead of recording revenue upon ownership transfer, records revenue when a car is manufactured. This would be an example of revenue recognition in action. This is an overly aggressive strategy because company X cannot guarantee that dealerships will ever take possession of the vehicle in question. One more example would be a magazine company that completes all of its sales at the beginning of the subscription period. It should only be recorded as revenue when each magazine is delivered to the subscriber in this situation because the company has not fulfilled its end of the bargain (delivering the product).
The second item of importance to examine is any changes that have occurred in an account from one period to the next, as well as the impact that these changes will have on the bottom-line financial statements of the company. Consider the case of company X, in which the company switched from the delivery method to the production method of production.
Incorporating revenue into the accounting system before goods are delivered would increase the aggressiveness of company X’s accounting. Due to the uncertainty surrounding how much of the company’s revenue came from actual sales and how much represented product that was produced but not delivered by company X, the company’s financial statements would become less trustworthy for investors to trust.
First and foremost, it is critical to gain a fundamental understanding of the Generally Accepted Accounting Principles (GAAP) standards for computing financial information before attempting to tackle this area. As a result, you will be able to recognize when a company is not adhering to the standard.
Financial Disclosure and Accountability
The financial statements included in an annual report should be straightforward and easy to understand.
Other calculations are relegated to the footnotes in order to maintain this level of clarity. Information about long-term debt, such as maturity dates and interest rates, is provided in the disclosure segment, which can help you gain a better understanding of how borrowing costs are calculated. It also includes information on employee stock ownership and stock options granted, both of which are important to investors.
Other details mentioned in the footnotes include accounting errors in previous financial statements, pending legal cases in which the company is involved, and specifics on any synthetic leases that have been entered into. These types of disclosures are extremely important to investors who have a vested interest in the company’s operations and should not be overlooked.
Another important consideration when examining the disclosure segment is what information is not included in the financial statements. When a company complies with accounting standards, the rules may permit it to exclude a significant liability from the financial statements and report it in the footnotes instead of the financial statements. If investors do not read the footnotes, they will be unaware of the liabilities or risks that the company is exposed to.
Footnotes Create Difficulties
The inclusion of footnotes in a financial statement is a requirement, but there are no standards for clarity or conciseness in their content. Managers are required to disclose information that goes “beyond the legal minimum” in order to avoid the possibility of being sued. Management’s subjective judgment, on the other hand, determines where this bare minimum should be. Also important is that footnotes are as transparent as possible, without compromising the confidentiality of trade secrets or other pertinent information about things that give the company a competitive advantage.
In addition, one issue with footnotes is that some businesses use them to try to confuse investors by including legal jargon and technical accounting terms in the footnotes. If the description is difficult to decipher, be wary: the company may be concealing something important about itself. You should be wary of companies that write only a paragraph on a major event or issue, or that use convoluted language to avoid addressing it at all. It may be best to simply move on to another company if you notice this type of behavior.
What’s the bottom line?
Informed investors go to great lengths to gather information that others would not normally seek out. Read the fine print, no matter how tedious the subject matter may be. In the long run, you’ll be glad you took the initiative.