Accounting is about communication. It is an economic information system and can be thought of as the language of business. Accounting standards are as much a product of political action as they are of careful logic or empirical findings. Accounting principles cannot be discovered; they are created, developed, or decreed and are supported or justified by intuition, authority, and acceptability. This is important to note, as accounting rules may or may not have any inherent logic to them. We have alternatives in our accounting choices; the decisions are political and trade-offs will be made. However, if a user of accounting information understands the economic consequences of each choice, she can base her own accounting choices on her desired outcome and also interpret the decisions made by others.
Accounting information provides individuals, both inside and outside a firm, with a starting point to understand and evaluate the key drivers of a firm, its financial position and performance. This information can then be used to enhance decisions as well as help predict a firm’s future cash flows. The present “current” value of those cash flows provides an estimate for the value of the firm. Accounting systems and information are also required for business and legal reasons. It is therefore essential for managers, investors, and others to be aware of the signals given and received by the business community through financial reports.
Who has access to an organization’s accounting information? It depends on the nature of the organization. For-profit firms can be public or private. A firm goes “public” when its ownership units “shares” can be exchanged “traded” in a public capital market (e.g., the New York Stock Exchange). Public firms are much more heavily regulated by the government and must provide a prescribed set of accounting information to the government and the general public.1 By contrast, private firms do not have to disclose their accounting information to the general public.2
Not-for-profit organizations (charities, churches, private universities, and so on) must file a set of specified information to the government that is made public.
Who (or what group) is responsible for issuing an organization’s annual report? Senior management.
Who (or what group) is the annual report for? There are lots of different potential users including:
• Owners, both current (those who actually own a piece or share of the firm) and potential (those who are thinking about buying a piece or share of the firm),
• Suppliers of goods, services, and funds. Individuals and other firms who do something for the firm and expect, at some point, to receive something (usually cash) from the firm. This includes both current and potential employees (i.e., suppliers of labor),
• Customers (who purchase the firm’s goods and services),
• The government, both in the sense of taxes (getting money from the firm) but also in terms of regulation, since government regulators are supposed to ensure the firm operates and reports according to the law, and
• Various other outside groups, including accounting professors (who will use the firm’s reports in class), reporters (who may use the firm’s reports in a story), environmental groups, and so on.
In sum, senior management publishes annual reports for various users.
What is this report about? What is it meant to tell the users? It is designed to give the users identified above information about the firm’s economic resources, how it obtained those resources, who has claims on the resources, what the firm has done with those resources, and how they have changed over time. It is designed and meant for users who have some understanding of basic business, economics, and accounting.
How are these various groups going to use this information? The information should be used as a starting point in trying to estimate the timing, likelihood, and amount of future cash flows. Why? So they can assess a firm’s financial health and make better informed decisions (i.e., invest in the firm, sell to the firm, lend to the firm, buy from the firm, and so on).
Okay, so if senior management is producing this information for a variety of users, it means management is basically providing outsiders with information about the senior management’s activities. Is that right? Yes, it is like a student (as opposed to a teacher) producing the report card on how well she did. Are there any checks to make sure what management says is true? Actually, there are not many checks we can use for this. Accounting has limitations; it is not, in any sense of the word, trustworthy (more on this in Chapter 2) and it provides limited supervision of senior management. This is why it is critical for anyone using the information in financial statements to understand how the information is prepared.
Consider, if you were senior management, what would you want to say? Well, that depends on whom your message is for.
What does senior management normally tell the owners? It is not uncommon for them to report, “I am great. You could not have a better manager. It is true we lost a lot of money this year, but anyone else would have lost much more. You are lucky to have us, and there is no question you should keep us as your senior management.” Normally, management wants to keep their jobs, and they therefore tell the owners they are doing a good, if not great, job. However, “normally” does not mean always.
What if senior management itself wants to buy the firm from the non-management owners? Imagine you are managing a firm you inherited from your parents. You are working hard and doing your best, but you do not own the firm outright. You have some siblings who also own part of the firm, and they do not help at all. They do not pull their fair share, yet they still demand money from the firm. Because of this, you want to buy them out. What would you tell them? You could say the firm is doing great. Or you could say that the firm is barely making it and that while it is really worth next to nothing, you still want to buy it from them and will pay them some minor amount for their shares. When reading a financial statement, you need to know not just to whom management is talking to, but also what senior management’s bias is. Does senior management want to make the firm look good or bad? It depends on their bias.
What does management normally want to tell bankers and the people or companies who sell goods and services to the firm? Typically, management wants to tell these readers not to worry because the firm will pay what it owes (i.e., repay loans to the banks or pay suppliers for services rendered or goods provided).
What does management want to tell the firm’s employees? We are doing okay but not great, so the firm is unable to give raises this year, but employees’ jobs are secure and they do not need to look for other ones. Note that we have a potential conflict here. Management may want to tell the owners they are doing great, but tell the employees the firm is doing okay.
How about the customers? What does management want to tell them? Again, management wants to tell them that the firm is doing okay, that it will be around to supply them next year, but that it is not doing well enough to give any discounts.
What about the government? Well, the primary governmental entity looking at firm’s financial information is the Internal Revenue Service (IRS). To this group, management probably wants to show minimal profits saying that it does not have much to give to the government this year. Maybe in a few years when the firm is doing better, the government can ask for something.
Notice that what management wants to tell the government is pretty much the exact opposite of what they normally want to tell the firm’s owners. The good news for management today is that in most countries, firms are allowed to produce two sets of financial statements: one for the government (which is private and intended to be read only by the government’s taxing authorities) and another for everyone else. So to some extent, management can plead poverty to the government, while telling others they are doing well. It may seem hard to believe that there are two sets of financial statement reporting about the same firm’s performance in the same year, but it is what happens. Management can make different accounting choices and their decision to do so may depend on whether their report is going to the government or to everyone else. Over time the cumulative numbers will match, but in a given year they may be very different.
Think of the annual report as a public relations tool. Better yet, think of it as a painting. Accounting is an art: it really is much closer to art, or perhaps to the legal profession, than it is to math or science. Management is painting a picture of the firm. Management may try to paint like Rembrandt and give you a picture that illustrates fairly transparently what the firm looks like (you look at the painting and know what the author was painting). However, management may paint more like Picasso. My Dad loved Picasso, but I have never understood him (the painter, not my Dad). Still, I have read that Picasso painted his mistresses, who I have seen in photos and who were beautiful (at least superficially). So, even though when I look at a Picasso painting that is supposedly of a female but to me it does not look human, I know the person being painted was physically beautiful. In accounting, like art, it helps to know something about the composer.
For fun: Can you identify what firm produced the Annual Report covers in Exhibit 1.1?
Exhibit 1.1 What firm produced these covers?
They are for the wine and spirits firm Pernod Ricard whose 37 premium brands include Absolut, Chivas, Glenlivet, G.H. Mumm Champagne, and Kahlua among many others (the reports shown are for the years ending 2006, 2010, and 2015). I am not really sure how they relate to the financials, but clearly they have an artistic bend.
By contrast, the report covers in Exhibit 1.2, for Boeing, reveals its products by showing them on the covers. Boeing is saying “this is who we are and what we do.”
Exhibit 1.2 Boeing Annual Report covers 2012 to 2014
Most firms no longer have fancy covers. They simply have the information required by the government (see www.sec.gov/edgar.shtml) and maybe the firm’s logo. Exhibit 1.3 shows the cover for Apple Inc.
Exhibit 1.3 Apple Inc. Annual Report cover 2015
The covers of annual reports tell you something about the firms that published them. It is like getting dressed in the morning: What you wear tells the world not only something about you but also something about what you want the world to think about you.
And that is what the annual report is meant to do. It is senior management telling the world something about the firm and what senior management wants the world to think about the firm.
So, let us open the cover and take a look at what is inside.
The annual report usually begins with a summary or the highlights of the firm’s results for the year (and usually some prior years) being reviewed. This is generally followed by a letter from the Chief Executive Officer (CEO) of the firm (and sometimes from the chairman of the board as well). This letter should be read carefully, as it outlines the CEO’s view of what happened and where the firm is heading. It often includes an overview of the firm’s strategy, and generally thanks the investors and employees. It should be read as a political statement and a piece of public relations, which is what it is. Still, it can contain valuable information about what the head of the organization is thinking.
Though the exact ordering can differ, the CEO’s letter is usually followed by lots of information on the firm’s products (e.g., what they are, how they are being developed, perhaps even how they compare to those of major competitors). This provides background not only of the firm’s products, but often on the industry and general economy as well. Again, this should be viewed with a great deal of skepticism as the firm is usually trying to present its products and markets in the best possible light.
Next up is normally a brief review of the firm’s major accounting policies, some of which will be discussed in more detail later in the book. It is very important to read the accounting policies as they set the context for the accounting numbers.
Then, somewhere in the middle of the annual report comes the main dish: the financial statements. These are the Balance Sheet, the Income Statement, and the Statement of Cash Flows.3 All three will be discussed in greater detail in the coming chapters.
The financial statements are followed by the Notes to the Financial Statements, which provide details on all the accounting choices that were made when preparing the annual report. The financial statements present an overview or summary, whereas the notes contain much more detail.
Somewhere near the end of the financial statements is The Report of the Independent Auditor. The firm hires and pays an outside group of professionals to examine its financial statements and issue an opinion on their reasonableness. Wait. How can the outside professionals be considered “independent” if they are hired and paid by the firm on which they are reporting? Good question, and many people would argue that the auditors are not completely independent (Enron is a case in point). However, there are three counterpoints to this argument. First, these professionals are in fact hired by a subset of the board of directors who are supposed to be totally separate from management. Second, auditors report to the board and not to the management. Third, and this one is key, the auditors can be sued if they do not do their job properly, especially by the firm’s owners, who the auditors technically report to.
There are four companies today known as the “big four” that audit most of the larger public firms (Deloitte, Ernst and Young, KPMG, and PricewaterhouseCoopers). These are large accounting firms and they provide an array of accounting, auditing, tax, legal, and consulting services. They are perhaps the largest service firms in the world and are substantially larger than the largest consulting firm (in 2015, Deloitte listed $16 billion of U.S. revenues and 70,000 professionals, whereas McKinsey and Company listed 11,000 professionals). The group was once known as the “big eight” but mergers and the demise of Enron’s auditor (Arthur Andersen) reduced the group to four. These are international companies, with the size and expertise to audit the largest public firms. Also, these firms have substantial resources and could pay out large sums if they lost a lawsuit. Arguably, what keeps these firms honest (independent) is that for many of the senior partners their most valuable asset is their ownership unit in their accounting firm. In theory, any one senior partner who fails to do her job properly could expose the firm to massive litigation (Arthur Andersen, the audit firm hired by Enron, collapsed largely because of its misconduct in auditing Enron). To counter this possibility, these firms set up their own internal systems (with a central group auditing the auditors) to ensure their work is done properly, at least in theory. The Sarbanes–Oxley Act (enacted in July 2002) has also done a great deal to increase auditor independence both with increased oversight (and the creation of the Public Company Accounting Oversight Board) and by limiting auditor conflicts of interest (e.g., the nature and extent of non-audit work done by auditors has been greatly reduced).
So, if a firm has a good audit report can the numbers be trusted? NO! ABSOLUTELY NOT! The auditor only expresses an “opinion” on the “fairness” of the financial statements.4 First, the auditor is supposed to assess whether the statements reasonably portray the underlying economics within the accounting framework. However, reasonableness or fairness is subject to interpretation, often a court of law’s interpretation. Users of annual reports should interpret an auditor saying the numbers are reasonable as the auditor saying they are close enough that she is not overly worried about being sued. Second, the auditor does not check everything because that would be much too time consuming, which would delay the annual reports and make the information they contain less useful, and would also be prohibitively expensive. Third, it is possible for the auditor to make a good faith effort, do her job responsibly and professionally, and still fail to discover a major error or fraud. Finally, if the auditor feels the statements are not reasonable, she will probably enter into a negotiation with management to change the numbers prior to publication to avoid having to release a negative audit report.
Does that mean the audit report is basically useless? Not at all. In fact, the report can be quite informative and useful, especially as a starting point. Let me explain by describing the various types of audit reports and what each means.
The first and most common is called an unqualified or clean report. Here the auditor says he was able to do his work, and that the statements appear reasonable and in conformity with generally accepted accounting principles (GAAP) applied consistently over time, the auditor did not find any material misstatements and there is no evidence suggesting that the firm is not a viable going concern.5 This is what you should expect, and you would then go into the statements and notes with a normal degree of skepticism (i.e., caveat emptor).
The second and less common is called a qualified report. Here the auditor notes there is something that the reader should know. Although the auditor finds the numbers are reasonable overall, there was something that the auditor could not examine or determine. If the auditor was hired after the start of the year, this means the auditor would not have been able to check last year’s number herself at the end of last year. The auditor would point this out and note she is relying on the previous auditor. This begs the question: Why did the firm change auditors? 6 A positive explanation is the firm was growing and the prior auditor was too small to continue auditing the growing firm. Investors and creditors may appreciate that the new auditor is larger, hopefully has more expertise, and with its increased size should be able to pay out a larger sum in the event of a lawsuit. A change may also occur when one firm acquires another firm of equal or greater size and the auditor of the acquired firm becomes the auditor of the combined firm. There could also have been a change for certain expertise. The financial statement user should carefully consider whether the change in auditor was for a legitimate reason or whether the change occurred because the prior auditor was unwilling to express a positive opinion on the statements.
The auditor may note that the statements appear reasonable overall but that there is an overriding issue which could not be determined and could alter the economics of the firm. For example, the firm may be subject to a lawsuit that the auditor cannot determine if the firm is likely to win or lose, and the amount is large enough to potentially alter the firm’s financials.
The auditor may also note that the statements appear to be reasonable overall but that there has been a major change in an accounting method. As will be discussed in detail in the coming chapters, firms have many choices over accounting policies and these choices alter the final numbers. Changing policies is allowed, but in the year of the change, numbers must be presented using both the old and the new method and the annual report must explain the reason for the change. Some changes are managerial choices, others are dictated by the government. Regardless of whether the firm made the change voluntarily or after being forced by the government, major policy changes are considered so important that they will be noted in the auditors’ report.
The third and fairly rare type of audit report is called a disclaimer or denial of opinion. In this case the auditor notes that he was unable to perform his work and cannot express an opinion on the financial statements. For instance, this can occur after a fire that destroyed factory records, or perhaps when there is a strike and the auditor cannot access the records.
Finally, the rarest form of opinion is called an adverse opinion. In this case, the auditor expressly notes that the statements are not reasonable (e.g., they do not fairly reflect the firm’s economic condition). This can occur when a firm is in financial distress and likely to be liquidated (when a firm is not considered a going concern all the numbers must be at liquidation value), or if the auditor fundamentally disagrees with the firm’s financial presentation. The latter is very rare because either (a) the auditor and firm will negotiate some changes in the numbers to enable the auditor to express at least a qualified opinion, (b) the auditor will be replaced, or (c) the opinion will simply not be issued.7
In Which Order Should Annual Reports be Read?
The best place to begin reading an annual report is with the auditor’s report at the end. This will usually tell the reader nothing, since it is normally a clean audit report. However, if there is an issue, it will alert the reader at the start. Next the reader should examine the Notes to the Financial Statements, as they put the statements into context. The statements themselves should be read next. All the puffery and the CEO’s letter at the front can be examined last. At least, this is how your author reads an annual report.
How to Read this Book
This book can be read by someone with little or no business background. It is a primer on the basics of accounting, what accountants do, and how to interpret the information in financial statements.
The book is written in a conversational format, often asking questions (which, as you may have already noticed, are in italics) and then providing the answers. The reader may want to pause after a question and think how they would answer before reading on. Real-life examples are included to illustrate the concepts and hopefully make the subject matter more interesting.
The footnotes do not have to be read, but they are meant to be read and add important details.8 After reading the book, you will hopefully have enjoyed yourself and learned a lot about accounting. Welcome aboard.
The Bottom Line
Accounting is an economic information system, it can be thought of as the language of business, and understanding its process, uses, and limitations is essential to understand the economics of a firm.
The following chapter describes the underlying nature of accounting and illustrates the necessary trade-offs that limit the ability of accounting to reflect a firm’s underlying economic reality. There are many “truths” in accounting.
_________________
1The government actually gets two sets of financial data. One is the tax information which all firms must provide to the Internal Revenue Service (IRS) and is not publicly available. The other is the public financial information that the firm provides to the Security and Exchange Commission (SEC) which then posts it on an electronic site called EDGAR. See www.sec.gov/edgar.shtml
2The vast majority of firms are private, and most of these are owner managed (meaning the firms’ owners are also the managers). However, there are some very large firms which are private. For example, Mars Corporation (the large confectionary firm with brands such as M&M’s) is a private company and its accounting information is not available to the general public.
3There is also sometimes a Statement of Changes in Retained Earnings (which is fairly straight forward), a Statement of Changes in Equity (which can be more complex), and a Comprehensive Income Statement (which includes all components of net income/loss and other comprehensive income/loss).
4In some countries, this opinion is set up as certifying the statements are true and correct. Unfortunately, this is far from what is really done by the audit.
5GAAP refers to the guidelines (rules and practices). In the U.S., they are set out by the Financial Accounting Standards Board (FASB), whereas many other countries follow those set out by the International Financial Standards Board whose guidelines are referred to as International Financial Reporting Standards (IFRS).
6There is a movement to force a change of auditors every few years, but the change is in fact very expensive as auditors develop expertise with their clients. Most financial institutions, which are considered critical to the economy, require periodic changes in auditors.
7For example, firms entering bankruptcy often do not issue timely financial statements and thus there is no opinion.
8I have tried to make this book fun while also paying attention to the details.