Notes to the Accounts — the Hidden Information

Notes to the accounts form an integral part of an annual report and function as a detailed explanation of the figures presented in the financial reports. Without these notes, many transactions, valuations and conditions would be impossible to interpret correctly. They provide context for the accounting principles applied, reveal valuation assumptions for intangible assets and financial instruments, and account for material events after the end of the period.

A careful review of the notes can reveal risks and opportunities that are completely invisible in the summary tables.

In a world where companies can actively choose between different accounting methods to present their financial position favorably, the notes become the critical source of truthful information. Here one can identify whether a company has changed its accounting principles to manipulate the result, whether there are unpaid invoices concealed in accounts receivable, or whether there are unpaid taxes and charges that do not appear clearly.

For an analyst, it is in the notes to the accounts that the real story of a company's financial health and strategic decisions is told.

An effective strategy is to start with the notes to the accounts that directly affect the largest items in the balance sheet and income statement. For example, if inventory makes up a significant part of the assets, one must review the note on inventory valuation. Here one can see whether the company uses FIFO, LIFO or another method, and whether there are impairments that are not obvious from the main statement.

For accounts receivable, it is important to analyze the age distribution to assess the real credit risk and the probability of losses. An increasing proportion of overdue receivables is a clear warning sign.

Another practical application is to analyze notes on financial instruments and lease commitments. A company can have a balance sheet that looks sound, but by reviewing the lease note one can discover significant operating lease commitments that have not been put on the balance sheet, which conceals liabilities and strains on cash flow.

Similarly, notes on derivatives can reveal exposure to market risks that do not appear in the main reporting. By cross-referencing information between different notes, one can also find inconsistencies and indications of aggressive financial reporting.