By Ben McClure
The financial statements are not the only parts found in a business's annual and quarterly SEC filings. Here are some other noteworthy sections:
Management Discussion and Analysis (MD&A)
As a preface to the financial statements, a company's management will typically spend a few pages talking about the recent year (or quarter) and provide background on the company. This is referred to as the management discussion and analysis (MD&A). In addition to providing investors a clearer picture of what the company does, the MD&A also points out some key areas in which the company has performed well.
Don't expect the letter from management to delve into all the juicy details affecting the company's performance. The management's analysis is at their discretion, so understand they probably aren't going to be disclosing any negatives.
Here are some things to look out for:
- How candid and accurate are management's comments?
- Does management discuss significant financial trends over the past couple years? (As we've already mentioned, it can be interesting to compare the MD&As over the last few years to see how the message has changed and whether management actually followed through with its plan.)
- How clear are management's comments? If executives try to confuse you with big words and jargon, perhaps they have something to hide.
- Do they mention potential risks or uncertainties moving forward?
The Auditor's Report
The auditors' job is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure. This is the purpose behind the auditor's report, which is sometimes called the "report of independent accountants".
By law, every public company that trades stocks or bonds on an exchange must have its annual reports audited by a certified public accountants firm. An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements.
The typical auditor's report is almost always broken into three paragraphs and written in the following fashion:
|Independent Auditor\'s Report
Recounts the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited.
Lists how the generally accepted accounting principles (GAAP) were applied, and what areas of the company were assessed.
Provides the auditor\'s opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy.
While the auditor's report won't uncover any financial bombshells, audits give credibility to the figures reported by management. You'll only see unaudited financials for unlisted firms (those that trade OTCBB or on the Pink Sheets). While quarterly statements aren't audited, you should be very wary of any annual financials that haven't been given the accountants' stamp of approval.
The Notes to the Financial Statements
Just as the MD&A serves an introduction to the financial statements, the notes to the financial statements (sometimes called footnotes) tie up any loose ends and complete the overall picture. If the income statement, balance sheet and statement of cash flows are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. Therefore, if you aren't reading the footnotes, you're missing out on a lot of information.
The footnotes list important information that could not be included in the actual ledgers. For example, they list relevant things like outstanding leases, the maturity dates of outstanding debt and details on compensation plans, such as stock options, etc.
Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is practicing "cookie jar accounting" and is changing policies only to take advantage of current conditions in order to hide poor performance.
Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt - such as maturity dates and the interest rates at which debt was issued - can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings involving the company.
The majority of investors and analysts read the balance sheet, income statement and cash flow statement but, for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn't. No matter how boring it might be, read the fine print - it will make you a better investor.
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