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Financial Statement Basics: Learning to Read Notes to Financial Statements

written by: John Garger•edited by: Jason C. Chavis•updated: 5/12/2011

Investors looking into investing in a firm must have a working knowledge of basic accounting and the ability to interpret what is found in notes to financial statements.

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    Financial statements are historical documents that show what a form looked like at one point in time in the past. Investors inspecting multiple financial statements of the same company can see trends and changes over time when trying to predict present and future performance of a company.

    The Problem

    One of the problems with financial statements is that they simply list items and their values without any explanation as to why the managers of firm made the decisions that led to the position of firm implied by the statements.

    If financial statements are dollar-amount representations of the decisions made by the manager of a firm, then investors would benefit from explanations of the items contained on them. Sometimes an unexpected event such as a period of extraordinary income needs further clarification to account for anomalous entries. This is especially important because investors know that one of the attributes of a corporation is the separation of the owners from direct control over a firm. Although investors are given voting rights, these rights only allow investors to choose their agents in this principal/agent relationship.

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    Where the Notes Come In:

    Investors are always keen to signaling, the action-speak-louder-than-words principle so important in finance and investing. Often, the financial statements need clarification so investors understand the decisions made by management. The notes to financial statements are as important to these statements as the values and items on them. In the notes, managers have an opportunity to explain changes in accounting procedures, anomalous business dealings, or extraordinary events, all of which can drastically change the items on a financial statement.

    For example, if a firm’s managers decide to change an accounting procedure when measuring inventory in an attempt to reduce the cost of carrying goods, the numbers next to inventory items on financial statements may appear to increase or decrease rapidly between periods. The result can be disastrous if investors are not made aware of this change. Because of the market efficiency principle, all information about a company’s profitability is reflected in the stock price of a firm. Without clear explanations of changes on financial statements, investors may value a firm incorrectly and these errors may cause a change in the value of the firm’s stock.

    In annual financial statements, a management’s discussion is included giving top managers a chance to discuss important issues with the current statements as well as future prospects for the company. Managers must be careful to convey the right message to investors, both current and potential. An incorrect interpretation can change the value of firm quickly. In fact, because financial statements can be misleading as a collection of items and numbers, accounting regulations require managers to provide discussions and explanations on financial statements so ambiguities and anomalies do not mislead investors.

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    Managers of a firm are required to provide discussions and notes on financial statements to investors. These notes can provide a wealth of information about the company’s current position and its future. Often, managerial discussions give managers a chance to portray their own business philosophies to investors to reassure the market that the company is in good hands. Numbers on a financial statement indicate a firm’s health, but sometimes numbers are not enough. The real value of a financial statement can come from the words of the people entrusted to run the organization.