Understanding accounting disclosures gives investors the ability to recognize early warning signs that can help prevent investment disasters. Companies are required to disclose the impact of adopting new accounting rules. This information sometimes reveals some bad news that may hurt stock prices. The adverse reaction could come from the revelation of off-balance-sheet entities, reduced earnings per share (EPS) or increased debt load. Reading between the lines of these disclosures will give the diligent investor an advantage. This overview provides a quick way to evaluate the investment risk that arises from adopting new accounting rules. (For related reading, see An Investor's Checklist To Financial Footnotes.)
Finding the Disclosures
Companies are required to disclose the potential impact of adopting new accounting regulations. Unfortunately, the disclosures are filled with legal boilerplate that may be difficult to read.
Accounting policy disclosures have their own financial notes and/or are discussed in another note. Some companies also repeat the disclosures in the management discussion and analysis (MD&A) section of their 10-K, 10-Q filings and annual company reports. The disclosure may be addressed in several areas, but the main one is usually one of the notes to financial statements with a title like "Summary of Significant Accounting Policies." In 10-Qs and company quarterly reports, the discussion of new accounting rules will most likely be limited to a note entitled "Recently Adopted Accounting Policies." Generally, each new rule is discussed in its own paragraph.
A quick way to read these disclosures is to focus on the second and last sentence. The second sentence will talk about what the rule does and the last sentence discloses management's expectation of what impact the new rule will have. The first sentence generally gives the name of the rule and indicates when the company has or will adopt it. It is best to read the entire disclosure to fully understand the potential ramifications, but focusing on both the second and the last sentence provides the most important information.
Determining What the Disclosures Reveal
Investors should focus on the last sentence where management discusses the new accounting techniques that may impact the company. There are three phrases investors should pay attention to that will raise green, yellow or red flags.
The Green Flag
"No material impact" according to management's assessment indicates the change will have no impact on financial reporting. An example of this is in Huffy Corp.'s, 10-Q for June 2003. Note 11 discussed recently adopted accounting standards. The first item is Statement of Financial Accounting Standards (SFAS) 143, which is accounting for asset retirement obligations. The last sentence reads, "The cumulative effect of implementing SFAS 143 has had an immaterial effect on the company's financial statements taken as a whole." (To view delisted stocks financial statements, visit the U.S. Securities and Exchange Commission)
The Yellow Flag
Phrases may vary, but pay attention if the last sentence tells you that rule will have an impact. You need to be extra careful of elusive language, which management may use because it is reluctant to disclose bad news. Look out for statements like: "The adoption of SFAS 142 did not have an impact on the company's results of operations or its financial position in 2002." Note that this statement does not address how the new rule may impact future results.
The Red Flag
The absence of any conclusive statement indicating the impact of the accounting changes is a big red flag. If the disclosure is missing in this statement, it could mean that management either has not determined the effect of the new accounting or has chosen not to break any bad news to investors. If a definitive impact statement is missing, investors will need to read the entire disclosure in order to evaluate the investment risk.
Take a look at General Electric's (NYSE:GE) 2002 financial statements. In the "Accounting Changes" section of the financial notes, GE states:
"In November 2002, the Financial Accounting Standards Board (FASB) issued Interpretation No. (FIN) 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The resulting disclosure provisions are effective for year-end 2002 and such disclosures are provided in notes 29 and 30. Recognition and measurement provisions of FIN 45 become effective for guarantees issued or modified on or after January 1, 2003.
In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities and an Interpretation of Accounting Research Bulletin No. 51. FIN 46's disclosure requirements are effective for year-end 2002 and such disclosures are provided in note 29. We plan to adopt FIN 46's accounting provisions on July 1, 2003."
The disclosure only indicates that these changes will become effective in the future and does not provide any information on the impact of the change. Investors need to determine what this impact may be. In this case, GE had significant amounts of off-balance-sheet liabilities that would increase the debt load on its balance sheet. Investors need to evaluate how the market might react when the debt is consolidated. In GE's case, there might be little reaction due to the stature of the company and its management. In other situations, such news may be unexpected to those who did not bother to read between the lines.
The Bottom Line
Changes in generally accepted accounting principles (GAAP) are meant to correct accounting rules that can result in financial disasters for investors. Companies must disclose when the rules will be adopted and what impact they will have. Reading between the lines of disclosures made in Securities and Exchange Commission filings and corporate reports may give investors an early warning system to spot potential issues such as increased debt load from consolidating off-balance-sheet entities. Unambiguous impact statements are signs of a credible and competent management team. Lack of a clear impact statement or no statement at all is a warning sign. (For more insight, see Footnotes: Start Reading The Fine Print.)