Financial Footnotes: Reading the Fine Print

One piece of advice we hear often is that it’s always good to read the fine print. A company’s financial statements shouldn’t be any different. The footnotes are the fine print that explains the details of the income statement, balance sheet, and statement of cash flow that provide a company’s financial information.

Key Takeaways

• Financial footnotes are add-ons to a company’s financial statements.
• Footnotes provide further detail about a company’s cash flow, income statement, and balance sheet.
• Footnotes typically identify accounting methods and a company’s financial results.
• They should also provide disclosure regarding debts and stock options.

What Are Footnotes?

Pick up any financial report and you’ll find references to the footnotes of the financial statements. They describe in detail the practices and reporting policies of the company’s accounting methods and they disclose additional information that can’t be shown in the statements themselves.

Footnote information can generally be split into two 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.

Important

Footnotes expand on quantitative financial statements by providing qualitative information that allows for a greater understanding of a company’s true financial performance over a specified time.

Accounting Methods

This area tends to be at the beginning of the footnotes. It identifies and explains a company’s major accounting policies. These footnotes are broken into specific accounting areas such as revenue and inventory that detail a company’s policy about that account and how its value is determined.

One of the most important financial measures of a company is revenue. You’ll often find a revenue recognition note in the footnotes that describes how a company determines when it’s earned its revenue. The point at which a sale can be booked and placed on the financial statements isn’t always clear-cut due to the often complex nature of business operations. Ford Motor Co. recognizes a sale when a dealership takes possession of a Ford vehicle.

This section will give an investor valuable insight into when a company books revenue.

What to Look For

Focus on two things when analyzing a company’s accounting methods found in the footnotes.

The Accounting Method

The first is a company’s accounting method and how it compares to the Generally Accepted Accounting Principles (GAAP) and industry standards. 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 if it’s using a policy that differs from others in the industry or one that seems far too aggressive.

Let’s assume that Company X books the revenue when a car is produced rather than booking revenue upon ownership transfer. 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 its sales at the start of subscriptions. The company hasn’t performed its side of the sale by delivering the product and should only book revenue when each magazine is sent to the subscriber.

Changes Made in an Account

Any changes made in an account from one period to the next are the second item of importance to examine. This can affect the bottom-line financial statements.

Imagine Company X 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 wouldn’t be sure how much revenue was derived from actual sales and how much of the represented product was produced but not delivered by Company X.

It’s important to first gain a basic understanding of the Generally Accepted Accounting Principles standards of computing financial information. This will allow you to identify when a company isn’t following this standard.

Disclosure and Financial Details

The financial statements in an annual report are supposed to be clean and easy to follow. Other calculations are placed in the footnotes to maintain this cleanliness.

The disclosure segment gives details about long-term debt such as maturity dates and interest rates that 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 found in the disclosure segment is what’s left off of the financial statements. The rules of a company’s accounting standards may allow it to keep a large liability off the financial statements and report it in the footnotes instead. Investors will miss these liabilities or risks that the company faces if they skip the footnotes.

Problems With Footnotes

Footnotes are a required part of any financial statement but 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 is based on management’s subjective judgment, however. 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 is that companies will sometimes attempt to confuse investors by filling the footnotes with legal jargon and technical accounting terms. Be suspicious if a description is difficult to decipher. The company may have something to hide. It may be wise to simply move on to another company if you see a situation in which one is writing only a paragraph on a major event or using convoluted language to skirt it entirely.

What Are the Generally Accepted Accounting Principles (GAAP)?

GAAP was introduced after the Stock Market Crash of 1929 and the Great Depression. The principles provide a set of accounting procedures and fundamental rules for U.S. companies and corporations including nonprofits and government entities. All publicly traded companies must follow GAAP.

What Is a Synthetic Lease?

A synthetic lease is an operating lease in which a parent company’s special purpose entity purchases an asset and leases it back to the parent company. The asset might be equipment or real estate. The parent company can purchase the asset at the end of the lease term, negotiate a renewal of the lease, or relinquish the asset under specific, typically preset terms.

What Is a Stock Option?

An option contract grants an investor the right to buy or sell a stock for a predetermined price on or before a predetermined time. The right is granted in exchange for paying a premium. The investor isn’t obligated to buy or sell at these terms but they lose the right to do so when the option contract expires.

The Bottom Line

Footnotes are a required part of any financial statement but there are no specific standards that must be followed about how they’re set forth. Ask questions if you’re unsure about what you’re seeing there.

Informed investors dig deep looking for information that others typically wouldn’t seek. Read the fine print no matter how boring it might seem at first glance. You’ll be glad you did in the long run.