The primary financial statements provide a summary of the financial position of a firm. These financial statements are accompanied by a series of explanations, found in the footnotes. In the footnotes the company makes several important disclosures about accounting methods, valuation, excluded liabilities, assumptions made and a variety of other important issues.
Since the financial statements provide only a summary of what the company is required to report, it is important for financial analysts to read the disclosures and other supplementary information to know the real story.
The four general types of notes are:
- Summary of significant accounting policies: assumptions and estimates.
- Additional information about the summary totals.
- Disclosure of important information that is not recognized in the financial statements.
- Supplementary information required by the FASB, IFRS or the SEC.
Let’s take the example of Apple Inc. In their annual report there is a disclosure about Revenue Recognition, which reads as follows:
“The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred”
Another note about derivative instruments reads as follows:
“The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value.”
Yet another disclosure about inventory reads as follows:
“Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The Company’s inventories consist primarily of components and finished goods for all periods presented.”
As you can see, the notes to financial statements provides enormous information about how the company manages its business and the practices it follows and an analyst must use such information in his analysis.
Another important section that is considered very important is the management’s commentary generally labeled as Management’s Discussion and Analysis (MD&A).
In this section, the management discusses many important issues and uses it as an opportunity to communicate key financial activities of the company. It covers the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. The management analyses financial activities based on currently known facts, decisions or conditions. It also discusses the current year results in comparison with prior year, with emphasis on the current year. Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect the business. The management’s discussion contains many forward-looking statements that involve risks and uncertainties.