The notes (also sometimes referred to as footnotes) that accompany the four financial statements are required and are an integral part of the complete set of financial statements. The notes provide information that is essential to understanding the information provided in the primary statements. Volkswagen’s 2009 financial statements, for example, include 91 pages of notes.
The notes disclose the basis of preparation for the financial statements. For example, Volkswagen discloses in its first note that its fiscal year corresponds to the calendar year, that its financial statements are prepared in accordance with IFRS as adopted by the European Union, that the statements are prepared in compliance with German law, that the statements are denominated in millions of euros unless otherwise specified, and that the figures have been rounded, which might give rise to minor discrepancies when figures are added. Volkswagen also discloses that its financial statements are on a consolidated basis—that is, including Volkswagen AG and all of the subsidiary companies it controls.
The notes also disclose information about the accounting policies, methods, and estimates used to prepare the financial statements. As will be discussed in later readings, both IFRS and US GAAP allow some flexibility in choosing among alternative policies and methods when accounting for certain items. This flexibility aims to meet the divergent needs of many businesses for reporting a variety of economic transactions. In addition to differences in accounting policies and methods, differences arise as a result of estimates needed to record and measure transactions, events, and financial statement line items.
Overall, flexibility in accounting choices is necessary because, ideally, a company will select those policies, methods, and estimates that are allowable and most relevant and that fairly reflect the unique economic environment of the company’s business and industry. Flexibility can, however, create challenges for the analyst because the use of different policies, methods, and estimates reduces comparability across different companies’ financial statements. Comparability occurs when different companies’ information is measured and reported in a similar manner over time. Comparability helps the analyst identify and analyze the real economic differences across companies, rather than differences that arise solely from different accounting choices. Because comparability of financial statements is a critical requirement for objective financial analysis, an analyst should be aware of the potential for differences in accounting choices even when comparing two companies that use the same set of accounting standards.
For example, if a company acquires a piece of equipment to use in its operations, accounting standards require that the cost of the equipment be reported as an expense by allocating its cost less any residual value in a systematic manner over the equipment’s useful life. This allocation of the cost is known as depreciation. Accounting standards permit flexibility, however, in determining the manner in which each year’s expense is determined. Two companies may acquire similar equipment but use different methods and assumptions to record the expense over time. An analyst’s ability to compare the companies’ performance is hindered by the difference. Analysts must understand reporting choices in order to make appropriate adjustments when comparing companies’ financial positions and performance.
A company’s significant accounting choices (policies, methods, and estimates) must be discussed in the notes to the financial statements. For example, a note containing a summary of significant accounting policies includes how the company recognizes its revenues and depreciates its non-current tangible assets. Analysts must understand the accounting choices a company makes and determine whether they are similar to those of other companies identified and used as benchmarks or comparables. If the policies of the companies being compared are different, the analyst who understands accounting and financial reporting can often make necessary adjustments so that the financial statement data used are more comparable.
For many companies, the financial notes and supplemental schedules provide explanatory information about every line item (or almost every line item) on the balance sheet and income statement, as illustrated by the note references in Volkswagen’s balance sheet and income statement in Exhibits 3 and 5. In addition, note disclosures include information about the following (this is not an exhaustive list):
financial instruments and risks arising from financial instruments,
commitments and contingencies,
subsequent events (i.e., events that occur after the balance sheet date),
business acquisitions and disposals, and
operating segments’ performance.
|2008||Passenger Cars and Light |
|Sales revenue from external customers||98,710||3,865||10,193||112,768|
|Segment profit or loss||6,431||417||893||7,741|
|2009||Passenger Cars and Light |
|Sales revenue from external customers||86,297||6,385||11,095||103,777|
|Segment profit or loss||2,020||236||606||2,862|
An analyst uses a significant amount of judgment in deciding how to incorporate information from note disclosures into the analysis. For example, such information as financial instrument risk, contingencies, and legal proceedings can alert an analyst to risks that can affect a company’s financial position and performance in the future and that require monitoring over time. As another example, information about a company’s operating segments can be useful as a means of quickly understanding what a company does and how and where it earns money. The operating segment data shown in Exhibit 9 appear in the notes to the financial statements for Volkswagen. (The totals of the segment data do not equal the amounts reported in the company’s financial statements because the financial statement data are adjusted for intersegment activities and unallocated items. The note provides a complete reconciliation of the segment data to the reported data.) From the data in Exhibit 9, an analyst can quickly see that most of the company’s revenues and operating profits come from the sale of passenger cars and light commercial vehicles. Over 80 percent of the company’s revenues was generated by this segment in both years. In 2008, this segment accounted for over 80 percent of the company’s total segment operating profits, although the percentage declined to 70 percent in 2009 because of higher sales growth in the other two segments. Experience using the disclosures of a company and its competitors typically enhances an analyst’s judgment about the relative importance of different disclosures and the ways in which they can be helpful.