Financial footnotes are like the fine print on an aspirin label. You need to read the fine print to realize that aspirin side effects include gastrointestinal bleeding. Financials footnotes are to companies as fine print are to drugs. For companies, their labels can be found in their SEC filings. Unfortunately, businesses are a lot more complex than drugs. Therefore, their footnotes are a lot longer than a paragraph of fine print on drug labels.
As I have mentioned before, footnotes contain some of the juiciest tidbits that management must disclose about the company but wouldn't want to include in the financial statements. This is because the financial statements receive the greatest scrutiny from investors while financial footnotes tend to get ignored. The fact that footnotes have grown to an average of 12 pages per annual report or 10-K may have a role in deterring investors' interest in the footnotes. Despite the length and potentially convoluted language used in the footnotes, it is absolutely crucial that an investor not skip the footnotes altogether. If you are short on time, at the very least scan the footnotes.
Financial footnotes are usually found in Management Discussion and Analysis (MD & A) in 10-Ks under Summary of Significant Accounting Policies. In 10-Qs, you can find them under the heading Recently Adopted Accounting Policies. Investopedia recommends scanning the second and last sentence of every disclosure so you can decide quickly whether you should pay more attention to certain disclosures. Always read the 10-Ks because full disclosure in 10-Qs is not yet a legal requirement.
When scanning the disclosures, here are some phrases to look for:
No matterial impact - This indicates the change is small enough to have no bearing on the company financials. You can safely skip this.
Have no impact to previously reported numbers - Watch for language that indicates no impact in the past but makes no mention of the future. Here you'll need to use your judgment to decide whether there could be potential impact to future numbers.
The impact was not mentioned - This is a red flag. This usually indicates management may have something really ugly to hide or they haven't analyzed the impact from the change. Either ways, it's bad news for investors because the change most likely would have a material impact.
The following are some of the most common disclosures you might find in the financial footnotes.
The Generally Accepted Accounting Principles (GAAP) change quite frequently. This is perhaps one of the most common disclosures you will see in the footnotes. Here, you want to pay careful attention to the impact from the accounting change. Some companies decide to adopt a change from conservative to aggressive accounting to boost company revenues or earnings. An example of aggresive accounting is when management of a book publisher decides to recognize revenue as soon as the books have been delivered to book stores. But normally books can be returned by the bookstores if they don't sell. A more conservative approach is to recognize revenue after the book has been sold by the bookstores and the return or exchange period has elapsed.
No investors like to own a debt-laden company. Realizing that many investors tend to skip the financial footnotes, management would disclose hidden debt in the footnotes. United Airlines had $5 billion of long-term debt in 2000. But a footnote disclosed the lease payments have a present value of $12.7 billion, due over 26 years on 233 airplanes. [1] Had this debt been excluded from analysis, the investor would have arrived at a valuation far from reality.
When company borrows money from investors, the money often come with debt covenants to protect the debt holders' interests. These debt covenants could range from minimum net worth to maximum loan loss rate. If a company has violated its debt covenants, the company will likely be restricted from paying dividends to shareholders and repurchasing stocks. In a worst-case scenario, lenders could declare the company in default and demand a full payment of outstanding debt which may result in liquidity concerns.
Capital leases are long-term payment plans to buy assets that show up on balance sheets as liabilities. On the other hand, operating leases show up as operating expenses on income statements. Without a footnote disclosure, investors won't know that the company is contractually obligated to make significant monthly payments. Operating leases in the footnotes must be added to long-term debt. Some companies get creative and engage in synthetic leases. Synthetic leases are used to own real estate but not have the liability show up on the balance sheet. The company works out an agreement with a bank or third party that purchases the property on the company's behalf and rents it to the company. The company makes monthly payments and records the payments under operating expenses while retaining ownership of the real estate. The end result is a balance sheet with lesser debt.
Companies that underwrite loans usually securitize the loans to provide liquidity so they can underwrite more loans. Some of these companies managed to do quite well while many others faltered. The danger here is underwriting policies adopted and the dependency on securitizations to survive. These companies are highly leveraged and are not able to hold on to loans underwritten for long. If they fail to securitize, they go bankrupt as in the case of Delta Financial and many others in the subprime crisis.
The footnotes often contains disclosures about looming lawsuits. In this lawsuit trigger-happy society, it is not surprising to see most companies involved in several lawsuits at any time. Again, the phrase to pay close attention to here is "material impact". If a looming lawsuit could potentially have a material impact such as that suffered by the asbestos company USG, you had better put on your magnifying glass and examine the disclosure closely.
I suspect the immense liability ($90 billion for Chrysler and GM by 2017) [2] shouldered by the US automakers may have had a hand in their failures. The issue here is management tend to be too optimistic when predicting the growth of the pension plans. As a result, they cut back on contributions. Of course, the side effect of that is a nice boost to earnings. But, as pensions come due, the companies have to cover the shortfall with current revenue. This is the classic accounting shenanigan of shifting expenses to future periods. Pensions are not the only thing be wary of. Watch for overly dilutive stock option grants, as in the case of Microsoft back in the days. Compare 10-Ks from multiple years to see how management adjusts their assumptions over the years.
Companies are required to disclose any related transactions that occur between the company and management or its relatives. Watch for self-dealing to enrich management and family members at the cost of shareholder equity. Not all related transactions are bad news. Related transactions done at arms' length are still valid and could benefit shareholders if the participation of the related parties is a condition for such transactions to occur.
Audit and compensation committee should not overlap. Each committee must have three directors. Obviously, any member of the management team cannot be on either. The Chairman should not be the CEO because the Chairman is responsible for ensuring the CEO does his job. If they are the same person, there is a conflict of interest. Independent directors are people not related to any member of the management team in the past or the present. A retired CEO of the company is not independent. A brother-in-law is not independent.
References
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
As I have mentioned before, footnotes contain some of the juiciest tidbits that management must disclose about the company but wouldn't want to include in the financial statements. This is because the financial statements receive the greatest scrutiny from investors while financial footnotes tend to get ignored. The fact that footnotes have grown to an average of 12 pages per annual report or 10-K may have a role in deterring investors' interest in the footnotes. Despite the length and potentially convoluted language used in the footnotes, it is absolutely crucial that an investor not skip the footnotes altogether. If you are short on time, at the very least scan the footnotes.
Financial footnotes are usually found in Management Discussion and Analysis (MD & A) in 10-Ks under Summary of Significant Accounting Policies. In 10-Qs, you can find them under the heading Recently Adopted Accounting Policies. Investopedia recommends scanning the second and last sentence of every disclosure so you can decide quickly whether you should pay more attention to certain disclosures. Always read the 10-Ks because full disclosure in 10-Qs is not yet a legal requirement.
Shortcut to Scanning Footnotes
When scanning the disclosures, here are some phrases to look for:
No matterial impact - This indicates the change is small enough to have no bearing on the company financials. You can safely skip this.
Have no impact to previously reported numbers - Watch for language that indicates no impact in the past but makes no mention of the future. Here you'll need to use your judgment to decide whether there could be potential impact to future numbers.
The impact was not mentioned - This is a red flag. This usually indicates management may have something really ugly to hide or they haven't analyzed the impact from the change. Either ways, it's bad news for investors because the change most likely would have a material impact.
What To Look For In Financial Footnotes
The following are some of the most common disclosures you might find in the financial footnotes.
Change in accounting methods
The Generally Accepted Accounting Principles (GAAP) change quite frequently. This is perhaps one of the most common disclosures you will see in the footnotes. Here, you want to pay careful attention to the impact from the accounting change. Some companies decide to adopt a change from conservative to aggressive accounting to boost company revenues or earnings. An example of aggresive accounting is when management of a book publisher decides to recognize revenue as soon as the books have been delivered to book stores. But normally books can be returned by the bookstores if they don't sell. A more conservative approach is to recognize revenue after the book has been sold by the bookstores and the return or exchange period has elapsed.
Hidden debt
No investors like to own a debt-laden company. Realizing that many investors tend to skip the financial footnotes, management would disclose hidden debt in the footnotes. United Airlines had $5 billion of long-term debt in 2000. But a footnote disclosed the lease payments have a present value of $12.7 billion, due over 26 years on 233 airplanes. [1] Had this debt been excluded from analysis, the investor would have arrived at a valuation far from reality.
Debt covenants
When company borrows money from investors, the money often come with debt covenants to protect the debt holders' interests. These debt covenants could range from minimum net worth to maximum loan loss rate. If a company has violated its debt covenants, the company will likely be restricted from paying dividends to shareholders and repurchasing stocks. In a worst-case scenario, lenders could declare the company in default and demand a full payment of outstanding debt which may result in liquidity concerns.
Long term operating leases
Capital leases are long-term payment plans to buy assets that show up on balance sheets as liabilities. On the other hand, operating leases show up as operating expenses on income statements. Without a footnote disclosure, investors won't know that the company is contractually obligated to make significant monthly payments. Operating leases in the footnotes must be added to long-term debt. Some companies get creative and engage in synthetic leases. Synthetic leases are used to own real estate but not have the liability show up on the balance sheet. The company works out an agreement with a bank or third party that purchases the property on the company's behalf and rents it to the company. The company makes monthly payments and records the payments under operating expenses while retaining ownership of the real estate. The end result is a balance sheet with lesser debt.
Securitizations
Companies that underwrite loans usually securitize the loans to provide liquidity so they can underwrite more loans. Some of these companies managed to do quite well while many others faltered. The danger here is underwriting policies adopted and the dependency on securitizations to survive. These companies are highly leveraged and are not able to hold on to loans underwritten for long. If they fail to securitize, they go bankrupt as in the case of Delta Financial and many others in the subprime crisis.
Looming lawsuits
The footnotes often contains disclosures about looming lawsuits. In this lawsuit trigger-happy society, it is not surprising to see most companies involved in several lawsuits at any time. Again, the phrase to pay close attention to here is "material impact". If a looming lawsuit could potentially have a material impact such as that suffered by the asbestos company USG, you had better put on your magnifying glass and examine the disclosure closely.
Pensions and stock options
I suspect the immense liability ($90 billion for Chrysler and GM by 2017) [2] shouldered by the US automakers may have had a hand in their failures. The issue here is management tend to be too optimistic when predicting the growth of the pension plans. As a result, they cut back on contributions. Of course, the side effect of that is a nice boost to earnings. But, as pensions come due, the companies have to cover the shortfall with current revenue. This is the classic accounting shenanigan of shifting expenses to future periods. Pensions are not the only thing be wary of. Watch for overly dilutive stock option grants, as in the case of Microsoft back in the days. Compare 10-Ks from multiple years to see how management adjusts their assumptions over the years.
Related transactions
Companies are required to disclose any related transactions that occur between the company and management or its relatives. Watch for self-dealing to enrich management and family members at the cost of shareholder equity. Not all related transactions are bad news. Related transactions done at arms' length are still valid and could benefit shareholders if the participation of the related parties is a condition for such transactions to occur.
Director independence
Audit and compensation committee should not overlap. Each committee must have three directors. Obviously, any member of the management team cannot be on either. The Chairman should not be the CEO because the Chairman is responsible for ensuring the CEO does his job. If they are the same person, there is a conflict of interest. Independent directors are people not related to any member of the management team in the past or the present. A retired CEO of the company is not independent. A brother-in-law is not independent.
References
- David Henry, Who Else Is Hiding Debt, Business Week, January 28, 2002.
- Ken Bensinger, The end of the road for U.S. carmakers?, LA Times, October 28, 2008.
- Investopedia, Footnotes: Start Reading The Fine Print, Investopedia, May 1, 2002.
- Rick Wayman, An Investor's Checklist To Financial Footnotes, Investopedia, October 1, 2003.
- Ben McClure, Uncovering Hidden Debt, Investopedia, October 20, 2004.
- Investopedia, Evaluating The Board Of Directors, Investopedia, November 19, 2003.
Full disclosure: I do not own shares of any securities mentioned above.
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
