Published Articles by David Balovich
||NOTES TO FINANCIAL STATEMENTS
This is the third in a series of columns on financial statements.
Of the five components, the notes to the financial statements are the most important. The
balance sheet and income statement
report numbers but it is the notes that inform us as to how the numbers came into being.
Upon looking at the notes, they may at first seem overwhelming and boring. They certainly
do not make for light reading. We
may have to work through each note slowly and carefully to understand the information that
each note is trying to convey.
The notes section generally begins with a statement of accounting policies. This is
particularly important because of the
alternative choices of accounting methods allowed, even within the constraints of
generally accepted accounting principles
(GAAP). In cases where the firm has a choice of methods, that choice will likely have an
impact on both the balance sheet and
the income statement. The analysis of financial information is not meaningful unless we
know what choices have been made by
Some of the information that will be revealed to us in the notes include:
If the company is reliant on one key customer. If the company is required to maintain
compensating balances with its lender.
What method the company used to value inventory. If the company has any contingent
liabilities. Are there any securities
outstanding, such as convertible bonds.
This and other information is revealed to us about the financial statements we are looking
at. The important thing to know
about the notes is that they explain exactly which choices the firm has made and we have
to determine the implications of those
The balance sheet and income statement by themselves are incapable of telling the full
story. To avoid being mislead by the
numbers, it is necessary to understand the information in the statements and this is done
through the notes that accompany the
When notes are not included in the financial statements, the auditors in their opinion
letter tell us how important they are. They
usually include a paragraph that states:
Management has elected to omit the notes to the financial statements. If the notes had
been included the reader would be more
The auditors have politely informed us that we haven't a clue of what we are reading. If
notes are not included then we have to
Next week the Balance Sheet.
I wish you well.
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