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.