12.4. Making Sure Disclosure Is Adequate
The financial statements are the backbone of a financial report. In fact, a financial report is not deserving of the name if the three primary financial statements are not included. But a financial report is much more than just the financial statements; a financial report needs disclosures. Of course, the financial statements themselves provide disclosure of important financial information about the business. The term disclosures, however, usually refers to additional information provided in a financial report.
The CEO of a public corporation, the president of a private corporation, or the managing partner of a partnership has the primary responsibility to make sure that the financial statements have been prepared according to U.S. generally accepted accounting principles (GAAP) — or to international accounting standards, as the case may be — and that the financial report provides adequate disclosure. He or she works with the chief financial officer and controller of the business to make sure that the financial report meets the standard of adequate disclosure. (Many smaller businesses hire an independent CPA to advise them on their financial reports.)
For a quick survey of disclosures in financial reports, the following distinctions are helpful:
Footnotes provide additional information about the basic figures included in the financial statements. Virtually all financial statements need footnotes to provide additional information for several of the account balances.
Supplementary financial schedules and tables to the financial statements provide more details than can be included in the body of financial statements.
A wide variety of other information is presented, some of which is required if the business is a public corporation subject to federal regulations regarding financial reporting to its stockholders. Other information is voluntary and not strictly required legally or according to GAAP.
12.4.1. Footnotes: Nettlesome but needed
Footnotes appear at the end of the primary financial statements. Within the financial statements, you see references to particular footnotes. And at the bottom of each financial statement, you find the following sentence (or words to this effect): "The footnotes are integral to the financial statements." You should read all footnotes for a full understanding of the financial statements, although I should mention that some footnotes are dense and technical. For example, read the footnote that explains how a public corporation put the value on its management stock options in order to record the expense for this component of management compensation. Then take two aspirin to get rid of your headache.
Footnotes come in two types:
One or more footnotes are included to identify the major accounting policies and methods that the business uses. (Chapter 7 explains that a business must choose among alternative accounting methods for recording revenue and expenses, and for their corresponding assets and liabilities.) The business must reveal which accounting methods it uses for booking its revenue and expenses. In particular, the business must identify its cost of goods sold expense (and inventory) method and its depreciation methods. Some businesses have unusual problems regarding the timing for recording sales revenue, and a footnote should clarify their revenue recognition method. Other accounting methods that have a material impact on the financial statements are disclosed in footnotes as well.
Other footnotes provide additional information and details for many assets and liabilities. For example, during the asbestos lawsuits that went on for many years, the businesses that manufactured and sold these products included long footnotes describing the lawsuits. Details about stock option plans for executives are the main type of footnote to the capital stock account in the owners' equity section of the balance sheet.
Some footnotes are always required; a financial report would be naked without them. Deciding whether a footnote is needed (after you get beyond the obvious ones disclosing the business's accounting methods) and how to write the footnote is largely a matter of judgment and opinion, although certain standards apply:
The Financial Accounting Standards Board (FASB) and its predecessors have laid down many disclosure standards for businesses reporting under U.S. generally accepted accounting principles.
The SEC mandates disclosure of a broad range of information for publicly owned corporations.
International businesses abide by disclosure standards adopted by the International Accounting Standards Board (IASB).
All this is quite a smorgasbord of disclosure requirements, to say the least.
One problem that most investors face when reading footnotes — and, for that matter, many managers who should understand their own footnotes but find them a little dense — is that footnotes often deal with complex issues (such as lawsuits) and rather technical accounting matters. Let me offer you one footnote that highlights the latter point. For your reading pleasure, a footnote from the 2003 annual 10-K report of Caterpillar, Inc. filed with the SEC. (Just try to make sense of it — I dare you.)
D. Inventories: Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 75% of total inventories at December 31, 2006, and about 80% of total inventories at December 2005, and 2004.
If the FIFO (first-in, first out) method had been in use, inventories would have been $2,403 million, $2,345 million and $2,124 million higher than reported at December 31, 2006, 2005, and 2004, respectively.
Yes, these dollar amounts are in millions of dollars. But what does this mean? Caterpillar's inventory cost value for its inventories at the end of 2006 would have been $2.4 billion higher if the FIFO accounting method had been used. In other words, this particular asset would have been reported at a 38 percent higher value than the $6.4 billion reported in its balance sheet at year-end 2006. Of course, you have to have some idea of the difference between the two accounting methods — LIFO and FIFO — to make sense of this note (see Chapter 7).
NOTE
You may wonder how different the company's annual profits would have been if an alternative accounting method had been in use. A business's managers can ask its accounting department to do this analysis. But, as an outside investor, you would have to compute these amounts yourself (assuming you had all the necessary information). Businesses disclose which accounting methods they use, but they do not disclose how different annual profits would have been if an alternative method had been used.
12.4.2. Other disclosures in financial reports
The following discussion includes a fairly comprehensive list of the various types of disclosures (other than footnotes) found in annual financial reports of publicly owned businesses. A few caveats are in order. First, not every public corporation includes every one of the following items, although the disclosures are fairly common. Second, the level of disclosure by private businesses — after you get beyond the financial statements and footnotes — is generally much less than in public corporations. Third, tracking the actual disclosure practices of private businesses is difficult because their annual financial reports are circulated only to their owners and lenders. (A private business keeps its financial report as private as possible, in other words.) A private business may include any or all of the following disclosures, but by and large it is not required to do so (and, in my experience, very few do).
In addition to the three financial statements and footnotes to the financials, public corporations typically include the following disclosures in their annual financial reports to their stockholders:
Cover (or transmittal) letter: A letter from the chief executive of the business to the stockholders, which usually takes credit for good news and blames bad news on big government, unfavorable world political developments, a poor economy, or some other thing beyond management's control. (See the sidebar "Warren Buffett's annual letter to Berkshire Hathaway shareholders" for a refreshing alternative.)
Warren Buffett's annual letter to Berkshire Hathaway shareholders
I'd like to call your attention to one notable exception to the generally self-serving and slanted letter from a business's chief executive officer to its stockholders, which you find in most annual financial reports. Warren Buffett is the Chairman of the Board of Berkshire Hathaway, Inc. He has become very well known and is called the "Oracle of Omaha." Mr. Buffett's letters are the epitome of telling it like it is; they are very frank, sometimes with brutal honesty, and quite humorous in places. You can go the Web site of the company (www.berkshirehathaway.com) and download his most recent letter (and earlier ones if you like). You'll learn a lot about his investing philosophy, and the letters are a delight to read even though they're relatively long (20+ pages usually).
Management's report on internal control over financial reporting: An assertion by the chief executive officer and chief financial officer regarding their satisfaction with the effectiveness of the internal controls of the business, which are designed to ensure the reliability of its financial reports (and to prevent financial and accounting fraud).
Highlights table: A table that presents key figures from the financial statements, such as sales revenue, total assets, profit, total debt, owners' equity, number of employees, and number of units sold (such as the number of vehicles sold by an automobile manufacturer, or the number of "revenue seat miles" flown by an airline, meaning one airplane seat occupied by a paying customer for one mile). The idea is to give the stockholder a financial thumbnail sketch of the business.
Management discussion and analysis (MD&A): Deals with the major developments and changes during the year that affected the financial performance and situation of the business. The SEC requires this disclosure to be included in the annual financial reports of publicly owned corporations.
Segment information: A report of the sales revenue and operating profits (before interest and income tax, and perhaps before certain costs that cannot be allocated among different segments) for the major divisions of the organization, or for its different markets (international versus domestic, for example).
Historical summaries: A financial history that extends back beyond the years (usually three) included in the primary financial statements.
Graphics: Bar charts, trend charts, and pie charts representing financial conditions; photos of key people and products.
Promotional material: Information about the company, its products, its employees, and its managers, often stressing an overarching theme for the year. Most companies use their annual financial report as an advertising opportunity.
Profiles: Information about members of top management and the board of directors. Of course, everyone appears to be well qualified for his or her position. Negative information (such as prior brushes with the law) is not reported.
Quarterly summaries of profit performance and stock share prices: Shows financial performance for all four quarters in the year and stock price ranges for each quarter (required by the SEC).
Management's responsibility statement: A short statement indicating that management has primary responsibility for the accounting methods used to prepare the financial statements, for writing the footnotes to the statements, and for providing the other disclosures in the financial report. Usually, this statement appears near the independent CPA auditor's report.
Independent auditor's report: The report from the CPA firm that performed the audit, expressing an opinion on the fairness of the financial statements and accompanying disclosures. Chapter 15 discusses the nature of audits by CPAs and the audit reports that they present to the board of directors of the corporation for inclusion in the annual financial report. Public corporations are required to have audits; private businesses may or may not have their annual financial reports audited.
Company contact information: Information on how to contact the company, the Web site address of the company, how to get copies of the reports filed with the SEC, the stock transfer agent and registrar of the company, and other information.
No humor allowed: Finally, I should mention that annual financial reports have virtually no humor — no cartoons, no one-liners, and no jokes. (Well, the CEO's letter to shareowners may have some humorous comments, even when the CEO doesn't mean to be funny.) I mention this point to emphasize that financial reports are written in a somber and serious vein. Many times in reading an annual financial report I have the reaction that the company should lighten up a little. The tone of most annual financial reports is that the fate of the Western world depends on the financial performance of the company. Gimme a break!
Managers of public corporations rely on lawyers, CPA auditors, and their financial and accounting officers to make sure that everything that should be disclosed in the business's annual financial reports is included, and that the exact wording of the disclosures is not misleading, inaccurate, or incomplete. This is a tall order. The field of financial reporting disclosure changes constantly.
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