How to Understand Financial Statement Notes
Footnotes to financial statements provide a wealth of information about the company and its financial operations. The footnotes are an integral part of the financial statements and provide a qualitative explanation of the quantitative data provided in the body of the financial statements. The footnotes are divided into two major sections: The first section explains the accounting methods used, such as inventory method, revenue recognition method and depreciation method; the second section is the disclosure and financial detail section. This section provides important disclosures and additional financial detail data that support and explain the numbers in the body of the financial statements. These include long-term debt and/or capital financing, contingent liabilities from lawsuits, mergers and acquisitions, union contract issues and many other items.
When reading the footnotes to financial statements it is important to have a basic understanding of generally accepted accounting principles (GAAP) and an understanding of industry standards for the company you are dealing with. This knowledge will help you understand the footnotes and put the information disclosed in the proper context and perspective.
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Instructions
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Analyze the company's significant accounting policies and procedures. This section of the notes explains the accounting methods used, which allows you to compare the company's methods to generally accepted accounting principles (GAAP) and to industry standards. If the company is using a policy that differs from others in the industry or one that is too aggressive, it could be a sign of inappropriate activity; perhaps the company is trying to manipulate the financial statements to cover up an undesirable event or give the perception of better performance. There can be a difference from industry standards and even from GAAP if there is a justifiable reason, but the reason should be clearly disclosed in the footnotes and should be verifiable.
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Analyze the disclosure and financial details section. In this section, look for disclosure of matters that will impact the future financial performance of the company. These could include a product liability class action lawsuit that could cost the company tens of millions of dollars or a new patent on improvements to the company's leading product that will give the company 17 years of exclusive rights to market the product. Other less dramatic disclosures like new capital financing for plant and equipment, larger-than-expected sales increases (or declines) for the year are also important. Look at cumulative effects of different items. For example, there may be several insignificant disclosures related to assets that are significant when taken together. Look for anything that will have a significant impact on future financial performance and evaluate those items to determine your response as an investor.
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Draw conclusions about the financial statements from your analysis. Based on your analysis of the financial statements as a whole (that is, including the footnotes) you should have a good understanding of the company, its financial standing and its prospects. This is the type of information investors use to make their investment decisions.
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