10.4.1 What are footnotes?

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. They also give qualitative information for a better picture of a company's true financial performance.

Footnote information typically falls into two categories. The first relate the accounting methods used by a company, such as revenue recognition policies. The second expound upon the company’s operational and financial performance.

 

10.4.2 Accounting methods

Usually found at the beginning of the footnotes, these identify and explain 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.

 

Take “revenue” as an example. In the footnotes you will often find a revenue recognition note, which describes how a company determines when it has earned its revenue. Given 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 explanatory note will tell an investor when a company books revenue. For example, Honda books a sale when a dealership takes possession of a Honda vehicle.

When analyzing a company's accounting methods in the footnotes, there are two things to focus on. The first is to note a company's accounting method and how it compares to the generally accepted accounting method and industry standards. If the company practice differs from others in the industry, it could indicate that the company is trying to manipulate its financial statements to cover up bad news or exaggerate its performance.

As an example of using revenue recognition to exaggerate performance, imagine that at airline X, instead of booking revenue when passengers actually use the ticket and take the flight, it books the revenue when tickets are reserved. This method is too aggressive, because airline X cannot know that the passenger won’t cancel his plans and reservation. Another example would be a wine of the month club that sells annual subscriptions to its service and bills customers monthly, but that books its sales for all 12 months when 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 month’s wine bottle is sent to the subscriber.

The second important thing to notice is if any changes were made in an accounting method from one period to the next. When comparing information across periods, it is essential that one is comparing apples to apples and not to oranges. In the airline X example above, imagine the company switched from the method of booking a sale when the ticket was used to booking the sale with the ticket was reserved. The airline's financial statements would be less useful, because investors would not be sure how much of the revenue-change between the two periods was derived from actual sales, and how much was due to booking sales earlier.

10.4.3 Disclosure and financial details

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.

The footnotes also include statements correcting errors in previous financial statements. They will also normally provide information on any recent or pending legal issues.

Finally, the disclosure section may contain information that you would think would be included in the financial statements (such as a large long term liability), but that that the accepted accounting standards allow them to put (one might say “hide”) off book in the footnotes.  If you do not read the disclosure section of the footnotes you might miss these items and misjudge the company’s risk profile.

 

10.4.4 Difficult footnotes

There are no standards for ensuring footnotes are clear and readable. Companies may attempt to conceal things from investors by using legal and technical jargon. If the footnotes are difficult to decipher, one should be suspicious. Similarly, if the footnotes give short shrift to major issues or events, it may be better to start looking elsewhere for investment opportunities.

 

10.4.5 Reading the disclosures

Companies are required to disclose all new accounting rules. These disclosures may be reported in many places, but the main one is usually a note to financial statements with a title like "Summary of Significant Accounting Policies." Each new rule will typically be discussed in its own paragraph.

A quick trick to understanding these disclosures without getting bogged down in jargon and details is to focus on the second and last sentence. Normally, the second sentence explains what the rule does and the last sentence presents management's expectation of what impact the change will have. The first sentence typically just introduces the rule, telling its name and when it will go (or went) into effect. Once the big picture of the rule from the second and last sentences is understood, attention can be turned to the details in between.

 

When reading the anticipated impact (last sentence) of disclosures, there are three types of impact statements investors should pay attention to that will raise green, yellow or red flags.

 

The Green Flag
A statement of "No material impact" should be self-explanatory.  Management is confident that the change will have no significant effect on the company’s financial reporting. Unambiguous impact statements – even ones reporting bad news – are signs of a trustworthy and competent management.

 

The Yellow Flag
There are an infinite number of ways to equivocate.  Take notice if the impact sentence suggests that a rule may have an impact, but does not indicate what the impact is or how significant it will be. Be suspicious of elusive language and pay close attention to what is NOT said. For example, consider the following statement: "The adoption of INSERV 201 did not have an impact on the company's results of operations or its financial position in this reporting period." Notice that it does NOT say how the new rule may impact the company in the future. Lack of clear or complete impact statements is a warning sign.

 

The Red Flag
If the final sentence makes no mention of the rule’s impact, that is a huge red flag.  In this case, silence should be taken as an alarm bell. The absence of an impact statement could mean that management either failed to do its due diligence to determine the effect of the rule, or management is hiding bad news from investors. If a definitive impact statement is missing, you must read all of the disclosure to determine the investment risk.

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Language Focus 10.4

Language Focus 4

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Activities

Activity 4