If there's one piece of advice we hear often, it's that it is always good to read the fine print. Why should it be any different for a company's financial statements? If the income statement, balance sheet and statement of cash flow make up the core of a company's financial information, then the footnotes are the fine print that explain this core.
However, what is often not provided along with this wise advice is a set of instructions on exactly how to read a company's footnotes. This article will not only explain what footnotes are, but what they mean and how to use them to your financial benefit.
What Are Footnotes?
Pick up any financial report and you'll always find references to the footnotes of the financial statements. The footnotes describe in detail the practices and reporting policies of the company's accounting methods and disclose additional information that can't be shown in the statements themselves. In other words, footnotes expand on the quantitative financial statements by providing qualitative information that allows for a greater understanding of a company's true financial performance over a specified time period.
Footnotes information can generally be split into two different areas. The first deals with the accounting methods a company chooses to formulate its financial information, such as revenue recognition policies. The second provides an expanded explanation of important company operational and financial results.
This area, which tends to be at the beginning of the footnotes, identifies and explains a company's major accounting policies. These footnotes are broken into specific accounting areas (revenue, inventory, etc.), which detail a company's policy with regard to that account and how its value is determined.
For example, one of the most important financial measures is revenue. In the footnotes, you will often find a revenue recognition note, which describes how a company determines when it has earned its revenue. Due to the often complex nature of business operations, the point at which a sale can be booked (put on the financial statements) is not always clear cut. This section will give an investor valuable insight into when a company books revenue. For example, Ford Motor Co. recognizes a sale at the time that a dealership takes possession of a Ford vehicle.
What to Look For
There are two things to focus on when analyzing a company's accounting methods found in the footnotes. The first thing is to look at a company's accounting method and how it compares to the generally accepted accounting method and industry standards. If the company is using a policy that differs from others in the industry or one that seems far too aggressive, it could be a sign that the company may be trying to manipulate its financial statements to cover up an undesirable event or give the perception of better performance.
As an example of using revenue recognition at car company X, let's assume that instead of booking revenue upon ownership transfer, company X books the revenue when a car is produced. This strategy is far too aggressive, because company X can't ensure that dealerships will ever take possession of that car. Another example would be a magazine company that books all of its sales at the start of the subscription. In this case, the company has not performed its side of the sale (delivering the product) and should only book revenue when each magazine is sent to the subscriber.
The second item of importance to examine is any changes made in an account from one period to the next, and the effect it will have on the bottom-line financial statements. In the company X example, imagine the company switched from the delivery method to the production method. Booking revenue before goods are transferred would increase the aggressiveness of company X's accounting. The company's financial statements would become less reliable, because investors would not be sure how much of the revenue was derived from actual sales, and how much represented product that was produced but not delivered by company X.
It is important when tackling this area to first gain a basic understanding of the Generally Accepted Accounting Principles (GAAP) standards of computing financial information. This will allow you to identify when a company is not following this standard.
Disclosure and Financial Details
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. The disclosure segment gives details about long-term debt, such as maturity dates and interest rates, which can give you a better idea of how borrowing costs are laid out. It also covers details regarding employee stock ownership and stock options issued, which are also important to investors.
Other details mentioned in the footnotes include errors in previous accounting statements, looming legal cases in which the company is involved and details of any synthetic leases. These types of disclosures are of the utmost importance to investors with an interest in the company's operations.
Another important focus when looking at the disclosure segment is what is left off of the financial statements. When a company is meeting accounting standards, the rules may allow it to keep a large liability off the financial statements and report it in the footnotes instead. If investors skip the footnotes, they will miss these liabilities or risks the company faces.
Problems With Footnotes
Although footnotes are a required part of any financial statement, there are no standards for clarity or conciseness. Management is required to disclose information "beyond the legal minimum" to avoid the risk of being sued. Where this minimum lies, however, is based on management's subjective judgment. Furthermore, footnotes must be as transparent as possible without harmfully releasing trade secrets and other pertinent information about things that give the company its competitive edge.
Another problem with the footnotes is that sometimes companies attempt to confuse investors by filling the notes with legal jargon and technical accounting terms. Be suspicious if the description is difficult to decipher—the company may have something to hide. If you see situations in which the company is writing only a paragraph on a major event or issue, or using convoluted language to skirt it entirely, it may be wise to simply move on to another company.
The Bottom Line
Informed investors dig deep, looking for information that others typically wouldn't seek out. No matter how boring it might be, read the fine print. In the long run, you'll be glad you did.