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How to Find Red Flags in the Notes of a Financial Report

Companies love hiding their dirty laundry in the small print of the notes to the financial statements. As you read through the notes, keep an eye out for possible red flags.

Whenever you see notes titled “Restructuring,” “Discontinued operations,” and “Accounting changes,” look for red flags that may mean continuing expenses for a number of years. The company may detail the costs of any of these changes. Be sure to consider long-term financial impacts that may be a drain on the company's future earnings — which may mean stock prices will suffer.

Also be on the lookout for potential lawsuits that may result in huge settlements. If you see that a lawsuit has been filed against the company, search for stories in the financial press that discuss the lawsuit in greater detail than what's included in the notes.

Significant events aren't the only sources of red flags. You may also see signs of trouble in the way the company values assets or in decisions it makes to change accounting policies. The notes involving the long-term obligations the company has to its retirees may also be a good spot to find some potential red flags.

The financial press often mentions red flags that analysts spot in companies’ financial reports. Read the financial press to pick up the potential problem spots, and look for the details in the financial statements and the notes to those statements.

Valuing assets and liabilities

Valuing assets and liabilities leaves room for accounting creativity. If assets are overvalued, you may be led to believe that the company owns more than it actually does. If liabilities are undervalued, you may think the company owes less than it actually does. Either way, you get a false impression about the company's financial position.

When you don't understand something, ask questions of the firm's investor relations staff until they present the information in a manner that you understand. If you're confused about the presentation of asset or liability valuation, don’t worry, other financial readers are confused as well.

Changes in accounting policies

How a company puts together its numbers is just as critical as the numbers themselves. The accounting policies the company adopts drive these numbers. Whenever a firm indicates in the notes to the financial statements that it's changing accounting policies, your red flag needs to go up.

Changes in accounting policies aren't always a sign of a problem. In fact, many times, the change is related to requirements the Financial Accounting Standards Board (FASB) or the SEC specifies. Regardless of the reason for the change, be sure you understand how that change impacts your ability to compare year-to-year or quarter-to-quarter results.

If you see a change in accounting methods, but you don't see an indication that the FASB or SEC required it, dig deeper into the reasons for the change and find out how the change impacts the valuation of assets and liabilities or the company's net income. You can find some explanation in the accounting policies note, but if you don't understand the explanation there, call the investor relations department.

Obligations to retirees and future retirees

Obligations to retirees and future retirees can be a bigger drain on a company's resources than debt obligations. The note to the financial statements related to pension benefits is probably one of the most difficult to understand. Look specifically at the charts that show the company's long-term payment obligations to retirees and the cash available to pay those obligations.

If you find any indication that the company may have difficulty meeting the obligations mentioned in either the text of this note or the charts, it may be a sign of a major cash flow problem in the future. Don't hesitate to call and ask questions if you don't understand the presentation.

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