one another before a new trendcan be called. The concept of conﬁrmation is perhaps the most interesting for anyone buying and selling stocks. On the overall market, a change in direction of one average is conﬁrmed when asecond average follows suit. The same concept is applied effectivelyto stocks.Any number of important indicators can be employed in conﬁrmation. For example, a company’s earnings are higher than expected; at the same time, the stock has fallen several points but youread a story revealing that the company is buying back shares of itsown stock. (When companies buy their own shares, those shares arepermanently retired and can never be resold, which has the effect ofhelping the value of publicly traded shares, because there are fewerremaining.) You take the decision as a sign that the company itselfthinks its stock is a bargain at the current price. The higher earningsare an initial sign, in your opinion, that the share price is going to
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rise. The buy-back of shares by the company conﬁrms this point ofview.5. Price trends are conﬁrmed by volume of trading. Trends meaneverything to investors and traders, especially those moving in andout of positions quickly. Swing traders rarely act on singular events.The initial indicator of a change in trend is the three-to-ﬁve perioddirection previously mentioned. But swing traders don’t spot asetup until they get conﬁrmation. A two-part conﬁrmation is considered very, very strong. After a three-or-more trend, the tradingpattern narrows (meaning the gap between a high and low price inone trading day is very small), and at the same time, the volume oftrading spikes to an unusually high level. Although this is a veryshort-term indicator, it mirrors the market-wide conﬁrmation of theDow Theory on a smaller scale. When a stock’s volume grows, it isdue to increased interest among traders, and that usually means achange is coming. A downtrend leads to a volume-based setup of anuptrend, and an uptrend leads to a volume-based setup of a downtrend.6. Trends continue until subsequent signals prove that they haveended and new trends have begun. One dilemma that every investorfaces is knowing when to move out of a position. Even if you haveperfect timing going in, how do you know when to leave? Hereagain, as long as all of the indicators remain in place, the trendremains. An uptrend continues up until you receive indicators anda setup that the trend is over. A downtrend continues down untilthe setup changes.What if the direction in price changes without any obvioussetup? It can happen because random movements are always possible, but it is not the rule. If you see no setup indicating a change indirection but the price turns anyhow, it may be the third of threetrends. You will recall that the Dow Theory identiﬁes an uptrend, adowntrend, and a temporary reversal as the third trend. When thisoccurs, the usual pattern is for price to return to the previously established direction.It is fair to say that when using the Dow Theory for stock timing, the overall market is broad but individual stock selection is nar-
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row. So the generalized observations of the Dow Theory can alsobe narrowly applied to time buy and sell decisions for each stock.
Valuable Technical TestsA fundamental indicator is one based on the numbers, meaningproﬁt or loss and valuation of assets, liabilities, capital stock, andcash ﬂow. A technical indicator is devoted solely to the stock priceand the movement of price over time. Many investors use a combination of both fundamental and technical indicators to decide whento buy, hold, or sell stock; and one popular indicator, the P/E ratio,combines the two, involving a technical factor (price) with a fundamental one (earnings).When you use technical indicators you are relying on evermoving price trends. The technician believes that price is the mostimportant determining factor in locating bargains and in pickinglong-term value. Many technicians are also chartists, and believethat you can anticipate future price movement by studying trendson a chart of recent price movement and patterns.There are hundreds of technical indicators and theories, somevery simple and others very complex. The following discussionhighlights a few of the basic and most beneﬁcial technical signs,most likely to be useful in combination with fundamental indicatorsand for the timing of buy and sell decisions. First, though, it is important to note the natural conﬂict between fundamental and technical approaches to investing.A fundamental approach relies on historical and recent ﬁnancialtrends in the belief that basic corporate strength and growth mandate which companies are most likely to experience future pricegrowth. As a result, fundamental investors tend to be more conservative and are likely to place money into shares of stock for the longterm. A technical approach is based on relatively short-term pricemovement in the belief that never-ending supply and demand determine how a stock’s price changes. While acknowledging that fundamental trends affect price, technicians tend to be more interested in
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short-term price movement, and are more likely to act as speculators than as long-term investors.These observations are never entirely accurate. But it is useful tobe aware of the vast differences between fundamental and technicalanalysis when combining both approaches. They are entirely different sets of assumptions, but they are also different aspects of thesame overall tendency. A well-managed company with consistent,growing fundamentals is also likely to experience low volatility andever higher stock prices over time. That is the basic observationworth remembering.Among the most useful technical indicators, one of the mostimportant is the trading range of a stock. This is the gap betweenthe most recent highest and lowest prices at which a stock trades.There is a tendency for stocks to remain within a well-deﬁnedrange, and the breadth of that trading range, or the price gap between high and low price, is also known as volatility. The greaterthe volatility, the greater the potential for growth and the potentialfor loss; in other words, the higher the opportunity/risk. The lowerthe volatility, the lower the risk and the lower the possibility of priceappreciation.A trading range may be very consistent or horizontal in nature;it can also gradually increase or decrease in price levels. The toplevel of the trading range is called resistance and the bottom is support. Three common types of trading ranges are shown in Figure4-1.Resistance and support are the cornerstones of most technicalanalysis. As long as price remains within the trading range boundaries, it is predictable to some extent. However, when price movesabove resistance or below support, patterns that are called breakout,the whole situation changes. It means a new trading range is beingestablished or that price is moving temporarily, only to retreat later.Perhaps as important as breakouts are tests of resistance andsupport. As a general technical rule, when price approaches eitheredge of the trading range but fails to break through, it anticipates aprice movement in the opposite direction. While breakout is a bigevent, failed tests of resistance and support are equally important.When price fails to move above resistance, it signals that buyers do
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FIGURE 4.1. TRADING RANGE
horizontal
resistance
support
increasing
ce
resistan
support
decreasing
resistan
ce
supp
ort
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not have enough strength to force prices higher, and when pricefails to move below support, it signals that sellers cannot outbidbuyers within the established price range.A common pattern of these resistance and support levels iscalled head and shoulders, so named because it is characterized bythree movements, with the middle one higher than the ﬁrst and third(when testing resistance). A reverse head and shoulders occurs onthe way down, with the head lower than the ﬁrst and third shouldersin the pattern. Figure 4-2 shows these patterns.The pattern in each of these is the same, but the resistance testoccurs at the top of the trading range while the support test occursat the bottom. These patterns are important simply because the attempt to break through resistance or support fails. The ‘‘rule’’among technicians is that when movement in one direction fails, itusually means movement is going to occur in the opposite direction.When the ‘‘shoulders’’ are closer to the resistance or support levels,the pattern is modiﬁed and called a triple top or triple bottom of therange; the signs are the same, however, with a failure to breakthrough indicating that movement will occur in the opposite direction.Another important pattern is the gap, which is the distance between one day’s closing price and the next day’s opening price.Gaps occur in different ways and have different meanings. A summary of the types of gaps is provided in Figure 4-3.A common gap is simply a one-time distance between a subsequent day’s trading range and often has no real signiﬁcance. Technicians, upon seeing a gap, would check a day’s trading volumeto decide whether it means anything in terms of important pricemovement.A breakaway gap occurs when the price actually goes throughresistance at the top or through support at the bottom, often signaling a change in the trading range itself. However, such gaps oftenlead to periods of price congestion (little if any important movement) and then a retreat to ﬁll the gap.The runaway gap is a series of gaps over a quick period of trading days, all involving price going in the same direction and indicat-
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The ‘‘Practical’’ Dow Theory
FIGURE 4.2. HEAD AND SHOULDERS PATTERNS
head and shoulders (testing resistance)
resistance
support
reverse head and shoulders (testing support)
resistance
support
ing a major trend. This often occurs based on rumors like earningssurprises, takeovers, or management changes but the runaway gapis a signiﬁcant trend and has to be watched carefully.Finally, an exhaustion gap occurs after a strong trend in onedirection and precedes movement in the opposite direction. It occurs when sellers exhaust their momentum and buyers enter positions because price has become a bargain. In the opposite direction,
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FIGURE 4.3. GAPS
common gapsbreakaway gap
runaway gaps
PRICEexhaustion gap
T I M E
an exhaustion gap occurs at the end of a big price run-up, whenbuyers have exhausted their momentum and traders begin to takeproﬁts.Technical signals can be exciting and revealing. The technicianslive from moment to moment, anticipating price movement about
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to occur. The day-to-day charts are only the starting point; the convenience and technical advantages of the Internet have made it possible for technical analysis on 60-, 15-, and even 5-minute charts.The examination of patterns can occur over a single trading day orliterally by the minute. When a technician spots a pattern and makesa move proving to be proﬁtable, it is a satisfying conﬁrmation of thetheory itself.Not as exciting but somewhat more reliable is the range of fundamental indicators. These are based on a company’s reported ﬁnancial outcome, and include tests of proﬁtability as well ascapitalization. Fundamental analysis is more conservative and lessexciting than technical analysis, but it forms the premise for mostpeople’s selection of stocks and decisions about when to buy or sell.The next chapter takes a look at the range of fundamental indicatorsthat every investor needs to understand.
Notes1 As of December 2005, the DJIA represented 23.8% of the total U.S. market,according to Dow Jones & Company (www.djindexes.com).2 Greiner, Perry, The History of the Dow Theory, 1963, Cycles News and Views,at www.cyclesman.com/History of Dow Theory.htm.3 Alfred Cowles, ‘‘Can Stock Market Forecasters Forecast?’’, Econometrica,1933.
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A FEW VA LUA BL EFUNDAMENTALS
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inancial statements are complex accounting documents, but you donot need to become an expert at interpreting them; you only needto be able to ﬁnd a few very important tests to help pick or rejectstocks. By studying current ratio in conjunction with debt ratio youcan quickly decide how much a corporation depends on stockholders’ equity, how much on borrowed money, and more to the point,how well the company manages its working capital.Beyond ﬁnancial strength is the question of proﬁtability. Revenue trends can be very revealing. For example, when you see revenues rising but proﬁts falling, that is a red ﬂag. The net return(proﬁts as a percentage of revenues) should be healthy and consistent from one year to the next, and should also be studied on thebasis of core earnings.
Reading Financial StatementsThe ﬁnancial statements are nothing more than a summary of account balances in a company’s books and records. These are shownas of the end of a ﬁscal quarter or ﬁscal year.91
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The balance sheet lists the value of all assets (property), liabilities (debt), and net worth (capital stock and retained earnings) asof the last day of the period being reported. The income statementshows the sum of all revenues, costs, expenses, and proﬁt or lossfor a period of time (a quarter or year). The ending date of thisperiod corresponds with the reporting date of the balance sheet.The two primary ﬁnancial statements are often accompanied bya series of supplementary schedules providing additional details: athird statement showing cash ﬂow for the period covered and anextensive number of footnotes, including disclosures and additionalinformation about the highly summarized balance sheet and incomestatement.Fundamental analysis should begin with an examination of speciﬁc accounts on the balance sheet. This is so-called for two reasons. First, it is a listing of the ending balances of all asset, liability,and net worth accounts. Second, the total of liabilities and net worthaccounts exactly equals the total of all asset accounts. This equalbalance occurs because under the double-entry system of bookkeeping, every entry contains two sides: a debit and a credit. Thebooks are only in balance when the sum of all debt-balance accountsis the same as the sum of all credit-balance accounts; this providesa simple but effective mathematical control. At the end of the quarter, when the books are ‘‘closed’’ (meaning no additional entries aremade until the following period) the sums of all income accountsare zeroed out and moved to the retained earnings account. Thismeans that the balance sheet will also zero out.The oddities of double-entry bookkeeping aside, it is importantto recognize the valuable information you can ﬁnd on the balancesheet. You do not have to be an expert at ﬁnancial analysis to extracta few valuable nuggets; in fact, if you invest through an online brokerage service, you probably get free reports as part of the service.For example, Charles Schwab & Company (www.schwab.com)gives members free access to Argus Ratings, Goldman Sachs Ratings, Market Edge, Reuters Research, S&P Stock Reports, andSchwab Equity Ratings. Rather than needing to get balance sheetsand interpret them, you can easily locate key information. The mostcomplete ﬁnancial data among this group are found in the S&P
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Stock Reports, which provide 10-year summaries of key ﬁnancialinformation.There are numerous sections of the balance sheet, but the threeprimary sections are (1) assets, (2) liabilities, and (3) net worth.The balancing formula is:Assets  Liabilities
Net Worth
The features and sections of the balance sheet are summarizedin Figure 5-1.The ﬁgure shows a highly summarized version of the balancesheet, but this is often how the report actually is provided in published reports. The details of these accounts and any special disclosures are provided in supplementary schedules and footnotes. Thesections of the balance sheet are:Current assets include any asset convertible to cash within 12months, including cash, accounts receivable, securities, and inventory.Long-term assets are also called capital assets and include thepurchase value of land and buildings, autos and trucks, and equipment and machinery, as well as a reduction for accumulated depreciation, which is the sum of depreciation expenses claimed eachyear. All depreciable capital assets are continually depreciated untiltheir book value (original cost less depreciation) equals zero. Oneexception: Land cannot be depreciated but is always carried at original cost. The way depreciation works brings up one of the odditiesof accounting. Asset values decline as they are depreciated, eventhough some assets (notably real estate) tend to increase in valueover time. As a building is depreciated, its value falls until it reacheszero, even though its true market value may be many multiples ofits original purchase price.Other assets may include both tangible and intangible assets.Prepaid and deferred assets are usually expenses that don’t applyuntil a later period, and are set up to be amortized over a numberof years. Intangible assets include any covenants or goodwill assets
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FIGURE 5.1. BALANCE SHEET
AssetsCurrent AssetsLong-Term AssetsOther Assets
xxxxxxxxx
Total Assets
xxx
LiabilitiesCurrent LiabilitiesLong-Term Liabilities
xxxxxx
Total Liabilities
Net WorthCapital StockRetained Earnings
xxx
Total Net Worth
xxx
Total Liabilities andNet Worth
xxx
samedollarvalue
assigned a value but lacking any physical properties. For example, acompany will place considerable value on its brand names, reputation, and other nonphysical attributes that are valuable in determining a company’s acquisition value.Current liabilities include all debts that are due to be paid withinthe next 12 months. This includes 12 months of payments due onlong-term loans.
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Long-term liabilities are all noncurrent debts, including notespayable and bonds (contractual obligations requiring payment ofinterest as well as speciﬁc repayment of principal).Capital stock is the ﬁxed value of outstanding shares at the original issue price, even when current market value is different. Capitalstock may be common (voting stock is the best-known type) or preferred (more conservative, but nonvoting).Retained earnings represent the total of all proﬁt or loss reported by the company over its entire existence. At the end of eachyear, the sum of all revenue, cost, and expense accounts is closedout and the net transferred to the retained earnings account. Aproﬁt increases retained earnings, whereas a loss reduces it.The income statement, also called the operating statement, ormore formally, the statement of proﬁt and loss, is described in detailin Chapter 2. The income statement is also a source for valuablefundamental analysis, speciﬁcally revenue, costs, expenses, and netproﬁt. Like the balance sheet, it shows a single line for each account,even though a lot of detail is usually involved in arriving at the numbers. The income statement covers a range of time, usually threemonths (one quarter) or a full ﬁscal year.The income statement is usually shown in comparative form.This means that the current quarter is shown ﬁrst and then the samequarter is shown for the previous year. A full-year report also showsthe latest year next to the previous year. This comparative information is valuable as a starting point because it provides an immediatelook at how the performance of the current year compares to themost recent previous year. In using online brokerage services, theprimary lines of the income statement are shown for many years.The S&P Stock Reports include 10 years of revenue, net proﬁt, andcore earnings as well as per-share information, P/E ratio, dividendsdeclared and paid, and many other valuable account totals and ratios.Most investors will ﬁnd the free research to be far more practicaland useful than a more complex set of ﬁnancial statements. It isimportant to understand the concept of how value and history arereported, but for fundamental analysis, using summarized results
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and ratios online is a much easier, faster, and more accurate approach than paper statements.
The Company’s Annual Report: Public RelationsSectionsThe annual report is actually quite a confusing document. Traditionally, this has been one of the primary sources investors haveused for ﬁnancial and other updates and news. But increasingly,investors have come to recognize that these reports are more publicrelations than ﬁnancial in nature, and that it is easier to access ﬁnancial summaries online, via S&P Stock Reports and other services provided free by online brokerage services.For anyone who wants to get free annual reports there are manysources. First, you can go to the homepage of any listed companyand look for the ‘‘investor relations’’ link. From there you can locateand either download or read the report instantly. One very usefulsite, http://www.zpub.com/sf/arl, links to many good resources forreading annual reports and other useful ﬁnancial Web sites.Even though you can get most of your ﬁnancial informationdirectly from research services, it is useful to see how companiesstructure their reports, even if your purpose is to read the company’s spin on bad news. Many annual reports describe negatives insuch a way that they sound very positive. For example, General Motors, one of the old-time U.S. companies in one of the worst capitalpositions among the DJIA, takes the same positive public relationsapproach to its annual report that virtually all companies take.Looking at the S&P Stock Reports, you ﬁnd that GM’s net proﬁtand loss has been dismal over three years:
Year
(in millions of dollars)Net Proﬁt (Loss)
200620052004
$ ( 1,978)(10,417)2,701
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A Few Valuable Fundamentals
Even worse, the company’s debt exceeds its net worth, meaningthe book value of GM is negative. The net worth for the same threeyears was:
Year
(in millions of dollars)Net Worth
200620052004
$ ( 5,441)14,65327,726
Even in the face of rising annual net losses and a reduction inthe latest reported year of more than $20 billion in net worth, theannual report’s letter from the president does not explain GM’s situation in frank terms. Rather, the tone of the letter is unjustiﬁablyupbeat, including statements like ‘‘. . . in 2006, the entire GM teamrose up to meet the collective challenge we face . . .’’ It is not explained what that team effort meant in light of the nearly $2 billionin losses, but the letter also addresses this proﬁtability problem byexplaining, ‘‘Returning GM to proﬁtability is obviously very important, and we’re working intently to achieve that goal.’’1Remember, the annual report is generated by a company for theprimary purpose of attracting and keeping investors. So when thereis bad news to report, it is going to be cloaked in the most positivelight possible. Anyone reading the statements about GM might thinkthat it was on course for bigger proﬁts than ever, and even if true, itis impossible to tell anything speciﬁc from the analysis of the explanation provided by the company and its ﬁnancial history. The evergrowing levels of debt, which exceeded the company’s book valuefor the ﬁrst time in 2006, is an extraordinary problem not directlyaddressed in the explanations.Several sections of the annual report are devoted mostly to public relations for the company. These include the chairman’s letter,sales and marketing, and management discussion and analysis(which includes a confusing mix of required ﬁnancial disclosuresand positive messages). These sections also typically include extravagant photos of happy employees, prosperous ﬁelds or plants, andhighlighted verbiage emphasizing all of the good news.
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Actual ﬁnancial disclosures are provided in highly technicalparts of the document, speciﬁcally a multiyear summary of ﬁnancialhighlights (often excluding some of the more important ratios andresults that you need and that vary greatly between companies), theauditor’s opinion letter, and ﬁnancial statements. As part of the ﬁnancial statements, extensive footnotes are included, mostly verytechnical accounting explanations of how valuation was calculated,items left off the ﬁnancial statements, and details of some items reported. Most people are not able to follow the footnotes easily,which may run over 100 pages in many cases. Some of the important footnotes include listings of pending litigation, off-balancesheet liabilities, and one-time accounting adjustments or changesmade by the company. You will gain far more information fromthese highly summarized forms by referring to the online analysis.The problem with ﬁnancial statements and footnotes is that theyare far from user-friendly. The accounting industry is seeminglyoblivious to the fact that nonaccountants simply do not understandwhat these reports reveal or hide, or how to interpret them. Thereis no incentive for auditing ﬁrms to explain their reports in plainEnglish; in fact, given the federal legislation and oversight of theSecurities and Exchange Commission (SEC) of the entire accounting industry, auditors have an incentive to disclose only what is absolutely required by law. The legislation passed a few years ago, theSarbanes–Oxley Act (SOX), imposed new requirements on auditors following a decade of widespread abuse and conﬂicts of interestin the industry. Unfortunately for investors, today’s annual report isnot much better than it has been in the past in disclosing information. In fact, the call for transparency has done little to change howannual reports are put together.One huge problem is the lack of reporting uniformity amongcompanies. Even simple sections of the annual report like ‘‘selected’’ﬁnancial highlights varies greatly among companies. Some includethree-year summaries only and others list as many as 10 years. Theselection of data is also inconsistent, varying widely and making itimpossible for anyone to use annual reports to make meaningfulcomparisons among different companies. The only way to accomplish this is, again, to go directly to online analytical services like the
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S&P Stock Reports, where information is reported uniformly. It isunfortunate that listed companies do not work together to create auniform standard for reporting ﬁnancial information. It is also apoor record that no effort has been made by the accounting industry, regulatory agencies, or stock exchanges to impose a requirementfor consistency in format, information, and even titles used in ﬁnancial reporting.Investors relying on company-generated annual reports aretruly on their own when it comes to gaining information. Even ifyou send an e-mail to the stockholder relations department of alisted company, you often will not receive a response, depending onyour questions and the level of care and concern within the company itself.
Annual Report Disclosure SectionsThe disclosures made in annual reports are spread out among several sections. A portion of the management discussion and analysissection is supposed to highlight signiﬁcant trends and changes. Thedegree of accuracy varies; few if any companies come out and explain what weaknesses have occurred. In GM’s annual report, thereis no mention of the fact that for the ﬁrst time, long-term debt wentabove 100 percent of total capitalization, placing equity in the red.This is extraordinary and signiﬁcant, but was not included in itsmanagement discussion and analysis. The various sections of GM’sannual report provide great detail about many ﬁnancial aspects ofoperations, including:Industry, a summary of the U.S. and global automotive marketand GM’s perception about its role within that market. This is moreof a self-promotional section than actual disclosure.Revenue and net loss is summarized and explained, one of thefew purely ﬁnancial discussions in the report.Strategy is a detailed discussion of GM’s explanation of howits role in the market will emerge; this is also a self-promotionalsection.
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Key factors affecting future and current results is certainly apromising title, and would have been a perfect place to explainGM’s long-term debt problems. Unfortunately, this section focusesinstead on the ‘‘turnaround plan’’ (marketing and self-promotion),labor negotiations, and the bankruptcy of GM’s largest parts supplier, Delphi (DPHIQ).GMAC—sale of 51 percent interest is a discussion of GM’s saleof interests in its ﬁnancing arm, General Motors Acceptance Corporation.Investigations explains the ongoing federal audits and investigations of GM’s current and past accounting practices.Liquidity and capital resources is another discussion in whichlong-term debt could and should have been explained, but there wasno mention of the topic. One very important disclosure is that thefour major credit rating agencies rate GM’s credit as speculative orcontaining ‘‘substantial risk.’’ This is the closest the company comesto talking about its own long-term debt and its dramatic rise in recent years.Dividends explains the company’s policy regarding dividenddeclarations and payments.Accounting estimates, standards, and disclosures are mostlytechnical and include required disclosures.So even in the ‘‘discussion and analysis’’ of ﬁnancial results ofoperations, there is very little in the way of actual discussion andanalysis. A lot of important but negative items are excluded, anda lot of marketing and self-promotion are woven throughout thesections.GM is not the only culprit in the dismal state of affairs of annualstatement reporting. Just about every listed company is guilty of thesame glossing over of facts and casting bad news in a rosy light.Declining years’ sales are often described as ‘‘robust, but we can dobetter’’ and a net loss is explained away as ‘‘a transitional period inour return to proﬁtability.’’ The only conclusion that makes anysense is that you cannot trust management to provide realistic transparency or to discuss its ﬁnancial condition with integrity. There is
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no help either from regulators, auditing ﬁrms, or stock exchanges.The best source for objective, neutral information is found in independent ratings services.The ‘‘sales and marketing’’ section of the annual report, in spiteof its title, is really just another form of self-promotional material.Even the least competitive company is going to view this section asthe place to explain why the company is going to do great things inthe future. It also uses this section to explain away declining marketshare (a growing interest in this industry) and competitive failure(a challenging competitive environment) in the most positive lightpossible. You really do not gain a sense of the real situation fromany material presented in the annual report, where the ‘‘rule’’ is thatall of the news is good, and any bad news is going to be qualiﬁedor explained away. Thus, terms like restructuring, turnaround, andtransition will be abundant in the annual report of companies whoseoperating results were poor.
The Annual Report’s FootnotesPerhaps the most revealing section of the annual report is the footnotes. Unfortunately, most of the language and discussion is verytechnical. Footnotes are lengthy and complex, but you can ﬁnd speciﬁc and valuable information if you know what to look for.The ﬁnancial statements are highly summarized expressions ofvaluation (balance sheet) and results from operations (incomestatement). Depending on a company’s industry and any unusualcircumstances during the past year, the footnotes can be quite extensive. Footnotes deal with a lot of the details, covering areas suchas:1. Accounting disclosures and changes. The most technicaltypes of footnotes deal with the complex discussions of accounting.Many of the ﬁnancial statement accounts can be interpreted in various ways, so companies need to explain what methods they used.For example, the method used for reporting the value of inventoriescan drastically affect working capital on the balance sheet as well as
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net proﬁt on the income statement. When companies make changesin their valuation or when they have to restate previously reportedoutcomes, a footnote is where the details are reported.2. Details backing up summarized accounts. Many accounts arereported on the ﬁnancial statements in single-value summaries, buta lot of detailed information goes into that number. One example isthe capital asset section of the balance sheet; another is the generalexpenses reported on the income statement. Executive compensationis also likely to be reported in a footnote; for example, the highestpaid executives may be listed along with the different kinds of compensation they have been paid. A footnote also is included to explainstock options granted to executives or employees, and extensive information is provided to explain how pension assets and liabilitieswere calculated. The true liability is usually left out of reported liabilities, so a substantial number can change a company’s long-termvaluation.3. Methods used for valuing of reserves and estimated future income and expenses. Accounting rules include provisions for speciﬁckinds of reserves. For