Though headlines tend to focus on the top and bottom lines when companies release earnings reports, there are many other metrics on these reports that are essential for investors to take note of.
From my experience, investors following the financials of a publicly traded company should pay particularly close attention to these three things: notes to fnancial statements, management discussions of financial statements and independent auditors' reports.
Notes to financial satements
"Notes to financial statements" contain a long list of important pieces of information that can help investors determine the present and the future value of publicly traded companies. Top on the list is significant accounting policies and practices.
The SEC requires that companies disclose the accounting policies that often require management's judgments, revealing the conditions that produce the current and future financial results. Managements' decisions here can have huge and often unexpected impacts on the numbers.
Next on the list is income taxes – the notes provide detailed information about the company's paid tax liabilities and their impact on current net profit, as well as deferred taxes that would affect future net profits.
Third is pension plans and other retirement programs. The notes provide specific information about these programs and whether they over- or under-funded.
Fourth on the list is stock options granted to officers and key employees, and the way they affect reported results. Everyone who has been around Wall Street long enough remembers very well how unfunded options-based compensation programs helped young high-tech companies back in the late 1990s produce rosy financial results quarter after quarter - and what happened next when these programs had to be funded.
Fifth is information about the company's administrative and selling expenses, which are commingled together in the income statement.
"The income statement in the United States and under international accounting standards is such as disgrace in the ways it aggregates so much into a few items, with the selling, general, and administrative expense line item, in particular, covering a multitude of sins," says Columbia University Professor Stephen H. Penman in Financial Statement Analysis and Security Valuation.
Lastly, investors should take note of commitments and contingencies. These are potential losses of the firm due to liabilities, like pending lawsuits, debt guarantees and other negative events.
Management discussions of financial statements
Financial statements are "rearview mirror" statements. They tell us today how the firm performed in the most recent quarters or years and how it is expected to perform in a linear future.
But they leave out the "narrative," the story behind the numbers that explains the company's performance. Investors can find this in a section of the quarterly or annual report entitled something along the lines of "Management's Discussion and Analysis of Financial Conditions and Results of Operations." MD&A is management's opportunity to provide investors with its view of the company's financial performance and conditions, including the risks that may affect future performance.
The SEC's rules governing MD&A require disclosure about trends, events, or uncertainties known to management that would have a material impact on reported financial information.
Independent auditors' reports
SEC filings by publicly traded companies, such as 10Q, are usually unaudited. This means that they have yet to be scrutinized by auditors (i.e. independent certified public accountants who determine whether these statements comply with the federal securities laws).
The Sarbanes-Oxley Act requires publicly held companies that file reports with the SEC to submit financial statements that are accurate, truthful and complete, and prepared according to a set of accounting standards called "Generally Accepted Accounting Principles" (or "GAAP").
In short, there's plenty of information beyond the top and the bottom lines of income statements published every quarter. Investors must closely examine this information with a magnifying glass to determine what these headlines tell them and what they don't tell them about a firm's present and future performance.
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