Financial literacy and accountingModule 5, lesson 16 of 19
Notes to the financial statements
What the notes to the accounts contain, from accounting policies and segments to borrowings, related parties and contingent liabilities, and why they matter.
In this lesson
- Explain why the notes are part of the financial statements, not an appendix.
- Read the accounting policies and judgements that shape revenue, depreciation and inventory.
- Use segment information to see which parts of a business earn the profit.
- Find borrowings, related-party transactions and contingent liabilities and judge their size.
Builds on
- How an Indian annual report is organisedThe notes sit alongside the statements in the annual report, which that lesson maps out.
- Provisions, contingent liabilities and impairmentsProvisions, contingent liabilities and impairments are explained mainly in the notes.
On this page
In simple terms
The face of each financial statement fits on a page or two, so it can only show totals. The notes to the financial statements, usually called the notes to accounts, explain those totals: how they were calculated, what is inside them, and what else a reader needs to know that does not appear as a number at all.
The notes are part of the audited financial statements, not an optional appendix. In an annual report they often run to many more pages than the statements themselves, and many of the most important facts about a company appear only there.
Accounting policies and judgements
The first notes describe the company's accounting policies: when it records revenue, how it depreciates assets and over what lives, how it values inventory, and how it treats leases, foreign currency and financial instruments. A separate note usually describes the significant judgements and estimates management made, such as the outcome of long contracts, the recoverable value of assets and the cost of warranties.
These matter because the same business can report different profits under different choices, as earlier lessons showed for depreciation and provisions. A change in accounting policy or estimate is especially worth reading about: the note should explain what changed and how much it moved profit.
Segment information
Companies with several businesses report results for each operating segment, the parts of the business that management reviews separately. Segment notes typically show revenue, profit and assets for each.
Worked example: Two segments, one profit engine
A made-up company reports these segments (₹ crore):
| Segment | Revenue | Segment result | Margin |
|---|---|---|---|
| Pumps | 900 | 150 | 16.7% |
| Motors | 300 | 20 | 6.7% |
| Total | 1,200 | 170 | 14.2% |
Motors provides a quarter of revenue but less than an eighth of the profit. A headline that says "revenue grew 10%" tells you little until you know which segment grew. If the growth came from Motors, profit may barely move.
Borrowings, leases and other liabilities
The borrowings note breaks debt down by type (term loans, debentures, working capital loans), by lender type, by security given, by interest rate and by when it must be repaid. Combined with cash, it shows whether a large repayment falls due soon. Lease liabilities, for shops, offices or aircraft, appear separately and are a form of debt too.
Related-party transactions
Related parties include a company's subsidiaries, associates, directors, key managers, promoters and their relatives, and businesses they control. The notes list transactions with them: sales, purchases, loans, guarantees, rent and remuneration. These dealings are legal when properly approved, but they are also the most common way for value to move from minority shareholders to insiders. Look at their size compared with revenue or profit, how they have changed over the years, and whether the terms look like those an independent party would accept.
Contingent liabilities and commitments
As the provisions and impairments lesson explained, possible obligations such as disputed taxes, lawsuits and guarantees for other companies' loans are disclosed in the notes rather than recorded. Add them up and compare the total with the company's net worth. Commitments, such as contracts already signed to buy equipment, show cash that will be needed soon.
Other notes worth a look
- Employee benefits and share-based payments, which can be large in some industries.
- Events after the balance sheet date, such as an acquisition or a fire, that happened before the report was approved.
- Restatements of earlier years' figures, and the reasons for them.
- Earnings per share, including the share counts used.
Why it matters
Most surprises for investors, such as a guarantee that turns into a loss, profit that came from a change in estimates, or a business segment quietly losing money, were visible in the notes beforehand. Reading them turns the statements from a set of totals into an explanation, and it is where an investor's work most often pays off.
Limitations
- The notes are long and technical, and the most important ones are not always the longest. Use a checklist and keyword searches.
- Disclosure depends on accounting standards and the law; some useful information, such as detailed segment margins, may be given only in summary.
- The notes describe what management judged it must disclose. Gaps are possible, which is one reason the auditor's report matters.
Common mistakes
- Treating the notes as optional reading.
- Skipping the accounting policies, then missing a change that flattered profit.
- Judging growth without segment detail.
- Ignoring related-party transactions and contingent liabilities because they are not on the face of the statements.
Try it yourself
- In any listed company's annual report, find the note on significant accounting policies. How does the company recognise revenue, and what useful lives does it use for its main assets?
- Find the segment note. Which segment earns the highest margin, and which uses the most assets?
- Find the related-party note. Add up purchases from and sales to related parties and compare them with total revenue and costs.
- Add up contingent liabilities and compare the total with net worth.
Key takeaways
- The notes are part of the audited financial statements. They explain how each number was calculated and add information the statements cannot show.
- Accounting policies and the judgements behind them can move profit, so changes in policy deserve close attention.
- Segment information shows which businesses earn the profit and which use the capital.
- The borrowings note shows what is owed, to whom, at what cost and when it falls due.
- Related-party transactions and contingent liabilities are often found only in the notes, and can be large compared with profit or net worth.
Check your understanding
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Terms used in this lesson
- Accounting policies
- The methods a company uses to prepare its accounts, such as when it records revenue and how it depreciates assets, set out in the notes.
- Segment reporting
- The breakdown in the notes of revenue, profit and assets by each separately managed part of a company's business.
- Related-party transaction
- A deal between a company and a party closely connected to it, such as a promoter, director, their relatives or a group company.
- Contingent liability
- A possible obligation, such as a lawsuit or disputed tax demand, that is not probable or cannot be measured. It is described in the notes, not recorded.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.