The guts of an annual financial report are the three primary financial statements are briefly explained below:
- Income Statement: This is the summary of a company’s sales revenue and expenses for the year (the profit-making activities of the business) and, of course, it reports the company’s final profit or net income for the year. A publicly owned business corporation must report earnings per share in its income statement. A nonpublic company doesn’t have to report earnings per share, but it is useful information to its shareholders.
- Balance Sheet: Also called the statement of financial condition, this is a summary of the company’s assets, liabilities, and owners’ equity at the close of business on the last day of the income statement period. To understand a balance sheet you need to understand the differences between the basic types of assets used by a business (inventory versus fixed assets, for instance), and the difference between operating liabilities (mainly accounts payable and accrued expenses) versus debt on which the business pays interest. Also, you should know the difference between the two different sources of owners’ equity—capital invested by the owners in the business versus profit earned but not distributed to owners, which is called retained earnings.
- Cash Flow Statement: Profit generates cash flow, but the amount of cash flow from profit during the year is not equal to net income for the year. This third financial statement starts with a section summarizing cash flow from profit for the year, which is an extremely important number. The statement also reports other sources of cash for the year, and what the company did with its available cash during the year. The cash flow statement exposes the financial strategy of the business.
In short, the three financial statements revolve around the three financial imperatives of every business—to make profit, to remain in healthy financial condition, and to make good use of cash flow. The three financial statements usually fit on three pages of an annual financial report, one statement on each page.
Although generally accepted accounting principles (GAAP) do not strictly require it, most businesses—large and small—present two-year or three-year comparative financial statements. This permits easy comparison of the year just ended with last year, and the year before that.
A typical annual report contains more than the basic three financial statements. This post focuses on one additional piece of information in annual financial reports be called “Footnotes To Financial Statements“. Footnotes provide the so-called fine print. Without footnotes financial statements would be incomplete, and possibly misleading. Footnotes are an essential supplement to financial statements.
Top-level managers should never forget that they are responsible for the company’s financial statements and the accompanying footnotes. The footnotes are an integral, inseparable part of the financial statements.
In fact, financial statements state this fact on the bottom of each page, usually worded as follows:
The accompanying footnotes to the financial statements are an integral part of these statements.
The auditor’s report covers footnotes as well as the financial statements. In short, footnotes are necessary for adequate disclosure in financial reports. The over-arching concept of financial reporting is adequate disclosure, so that all those who have a legitimate interest in the financial affairs of the business are provided the relevant information they need to make informed decisions and to protect their interests in the business.
The Two Types of Footnotes
Footnotes are of two kinds:
First, the main accounting methods used by the business are identified and briefly explained. For instance, the particular accounting method used to determine the company’s cost of goods sold expense and its ending inventory cost is identified.
For many expenses (and even for sales revenue) most businesses can choose between two or three generally accepted accounting methods. The company’s selections of accounting methods have to be made clear in footnotes. A footnote is needed for each significant accounting choice by the business. Footnotes assume some familiarity with accounting terminology, as you can see in the footnote from Caterpillar’s financial statements quoted just below.
A footnote from a recent annual report of Royal Bali Cemerlang regarding its inventory accounting method reads as follows:
Inventories are valued principally by the LIFO (last-in, first-out) method. The value of inventories on the LIFO basis represented approximately 85% of total inventories at current cost value at December 31, 2007, and 2006, and 90% at December 31, 2005.
If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,067, $2,123, and $2,103 million higher than reported at December 31, 2007, 2006, and 2005, respectively.
This footnote reveals that Royal Bali’s inventories in its balance sheets at these year-ends would have been $2 billion higher if the company had selected an alternative accounting method. And, its cost of goods sold expense for each year would have been different (but “only” by a few million dollars).
Companies disclose their choice of depreciation methods in footnotes. Other common footnotes explain the consolidation of the company’s financial statements. Many large businesses consist of a family of corporations under the control of one parent company. The financial statements of each corporation are grouped together in one integrated set of financial statements. Inter-corporate dealings are eliminated as if there were only one entity. Affiliated companies in which the business has made investments are not consolidated if the company does not have a controlling interest in the other business.
The second type of footnotes provides additional disclosure that cannot be placed in the main body of the financial statements. For example: the maturity dates, interest rates, collateral, or other security provisions, and many other details of the long-term debt of a business are presented in footnotes. Annual rentals required under long-term operating leases are given. Details regarding stock options and employee stock ownership plans are spelled out, and the potential dilution effects on earnings per share are illustrated in a footnote. Major lawsuits and other legal actions against the company are discussed in footnotes.
Details about the company’s employees’ retirement and pension plans are also disclosed in footnotes. Obligations of the business to pay for postretirement health and medical costs of retired employees are presented in footnotes. The list of possible footnotes is a long one. In preparing its annual report, a business needs to go down a long checklist of items that may have to be disclosed, and then write the footnotes. This is no easy task. The business has to explain in a relatively short space what can be rather complex.
Management Discretion in Writing Footnotes
Managers have to rely on the experts—the chief financial officer of the organization, legal counsel, and the outside CPA auditor—to go through the checklist of footnotes that may be required. Once every required footnote has been identified, key decisions still have to be made regarding each footnote.
Managers have much discretion or flexibility regarding just how candid to be and how much detail to reveal in each footnote. Clearly managers should not give away the farm—they should not divulge information that would damage a competitive advantage the business enjoys. Managers don’t have to help their competitors. The idea is to help the company’s debt holders and stockholders—to report to them information they’re entitled to. But, just how much information do the debt holders and stockholders need or are they legally entitled to?
This is a very difficult question to answer in black-and-white terms. Beyond certain basic facts exactly what should be put in a footnote for ”fair” disclosure is not always clear and definite.
Too little disclosure, such as withholding information about a major lawsuit against the business, would be misleading and the top executives of the business would be liable for this lack of disclosure. Beyond the “legal minimum,” which will be insisted on by the company’s CPA auditors, footnote disclosure rules and guidelines are vague and murky. Managers have rather broad freedom of choice regarding how frank to be and how to express what they put in footnotes.
One point that I must call to your attention concerns the readability of footnotes in general. Many investors and securities analysts complain about the dense fog in footnotes. Footnote writing can be so obtuse that you have to suspect that the writing is deliberately obscure. The rules require footnotes, but the rules do not demand that the footnotes be clear and concise so that an average financial report reader can understand them.
Frequently the sentence structure of footnotes seems intentionally legalistic and awkward. Technical terminology abounds in footnotes. Poor writing seems more prevalent in footnotes on sensitive matters, such as lawsuits or ventures that the business abandoned with heavy losses. A lack of candor is obvious in many footnotes.
Creditors and stockholders cannot expect managers to expose all the dirty linen of the business in footnotes, or to confess all their bad decisions. But, better clarity and more frankness certainly would help and would not damage the business.
Some companies go to great efforts to be frank and clear, and even entertaining in their footnotes and other disclosures in their annual financial reports.
True, stockholders can ask questions at their annual meetings with top managers and the board of directors of the business. However, managers can be just as evasive in their answers as in their footnotes.
In short, creditors and investors frequently are stymied by poorly written footnotes. You really have only one option, and that’s to plow through the underbrush of troublesome footnotes, more than once if necessary. Usually you can tell if particular footnotes are important enough to deserve this extra effort.