Notes to accounts
Beyond the four statements, companies give detailed notes specifying their accounting policies and providing details of the information in the statements.
There are multiple ways to account for an item, and the analyst must know which methodology the company adopted. For depreciation a company may choose the straight line method or the written down value method; its accounting policies, defined in the annual report, say how each item is treated. Companies must also state clearly any change in policy from the previous year. A company that continuously changes its accounting policies gives reason for suspicion and closer scrutiny of whether it is trying to manipulate its financials.
Contingent liabilities
Contingent liabilities may be incurred depending on the outcome of an uncertain future event, such as a court case the company is fighting that could produce a substantial loss if lost. They are not recorded in the accounts and generally appear in the notes.
- 1Outstanding lawsuits
- 2Disputes with tax authorities
- 3Bank guarantees provided
- 4Product warranty claims
- 5Pending investigations or cases
- 6Changes in foreign exchange, government policies and the like
Most managements will state that they do not see the liability settling against them. The analyst is better off looking at the quantum, especially compared with the size of the P&L and the balance sheet, and exercising caution when contingent liabilities are large relative to both.
Off-balance sheet items
Any asset or liability that does not appear on the balance sheet is an off-balance sheet item. Loans taken are on the books; an operating lease, an alternative way of financing an asset, is off balance sheet. Contingent liabilities are off-balance sheet items too, and so are derivative contracts entered to trade or hedge, which are covered in the notes rather than the balance sheet. Because the existence of so many businesses worldwide has been threatened by derivative transactions, the analyst must analyse all off-balance sheet items in great detail. Positive surprises are fine; negative ones are the risks.
Points to keep in mind
Financial statement analysis is intimidating when the terminology is unknown and addictive once the language is understood. Numbers can be made to look good by assumptions or creative accounting, so the auditors' qualifications in the notes, the fine print, are a very useful part of the annual report. A change in accounting period confuses year-on-year comparison, and one-off items can raise or lower profits enough to change the entire analysis.
Consistent performance year after year is best for investors: a company that continues to grow sales, increase profits, increase net worth, reduce debt, improve margins and finally improve return on net worth (RONW) is one that will create value over the long term.
Reading the audit report
Management prepares the accounts; auditors verify that the statements present a true and fair view. Their opinions rest on the information provided to them, and the nature of the engagement means they cannot vouch for the accuracy of the accounting: the volume of transactions is so large that checking every one is impossible. So auditors verify that the company has adequate control systems to capture and record genuine transactions correctly, then check that those systems were properly implemented, and finally assess whether all accounting standards and principles were followed in measuring and disclosing line items.
| Opinion | When it is given | |
|---|---|---|
| Clean report | Auditors have no issues; format and content are fairly standard across companies, varying only in the financial information presented under the Companies (Auditor's Report) Order | No reservations |
| Disclaimer | Auditors are unable to verify part of the financials because information was not available | Reasons are elaborated |
| Qualified report | Auditors are convinced that all or part of the statements do not reflect a true and fair view, because they disagree with an accounting policy or find other serious discrepancies | Reasons are elaborated |
The analyst should go through the auditor's report to check whether the auditors had any reservations.
A disclaimer means the auditor could not verify, for lack of information. A qualified report means the auditor verified and disagrees. Both come with explanations, and both are reservations the analyst must read.
- Notes to accounts specify significant accounting policies and detail the four statements. Different methods exist for one item (straight line or written down value depreciation), so the analyst must know which the company uses; changes must be disclosed, and a company that keeps changing policies invites suspicion of manipulating its financials.
- Contingent liabilities depend on uncertain future events (a pending court case) and are recorded in the notes rather than the accounts: outstanding lawsuits, disputes with tax authorities, bank guarantees given, product warranty claims, pending investigations, changes in foreign exchange or government policy. Managements always sound positive; compare the quantum with the size of the P&L and balance sheet and exercise caution when it is large.
- Off-balance sheet items are assets or liabilities absent from the balance sheet: operating leases as an alternative way to finance an asset, contingent liabilities, and derivative contracts for trading or hedging, which sit in the notes. Given how many businesses derivatives have threatened, analyse all of them in detail; positive surprises are fine, negative ones are the risk.
- Numbers can be dressed up through assumptions or creative accounting, so read auditors' qualifications in the fine print; changes in accounting period and one-off items can distort comparisons. The value-creating company grows sales, profits and net worth, reduces debt, improves margins and improves return on net worth year after year. Auditors verify a true and fair view based on information provided, testing control systems and standards rather than every transaction, and issue a clean report, a disclaimer, or a qualified report with reasons.