Chapter 5

Exploring the Anatomy of an Annual Report

In This Chapter

Getting acquainted with the parts of the annual report

Looking at the three most important documents

Summing up the financial information

No doubt the financial statements are the meat of any annual report, but lots of trimmings make up an annual report, and you need to be able to read and understand them. Although companies must follow set rules for how they format the key financial statements, how they present the rest of the report is left to their creativity.

Some companies spend millions of dollars putting on a glossy show with color pictures throughout the report. Others put out a plain-vanilla, black-and-white version without pictures. Still, the major components of an annual report are standard, although the order in which companies present them may vary.

When you see a fat, glossy annual report from a company, you can be certain that you'll find a lot of fluff in it and probably a lot of spin about all the good things the company accomplished. No matter how fancy or plain the annual report is, as a careful reader, you need to focus on four key parts, listed in order:

• Auditors’ report: A statement by the auditors regarding the findings of their audit of the company's books
• Financial statements: The balance sheet, income statement, and statement of cash flows
• Notes to the financial statements: Additional information on the data in the financial statements
• Management's discussion and analysis: Management's perspective regarding the company's results

In this chapter, I explain why these four parts of an annual report are so critical. I also define the other parts of an annual report and their purposes.

Everything but the Numbers

Most people think of numbers when they hear the words annual report, but any savvy investor can find a lot more useful information in the report than just numbers. Some parts of the report are fluff pieces written for public consumption, but others can give you great insight into the company's prospects, as well as suggest some areas of management concern. You just need to be a detective: Read between the lines, and read the fine print.

Debunking the letter to shareholders

What would an annual report be if not an opportunity for the head honchos to tout their company's fabulousness? Near the front of most annual reports, you find a letter to the shareholders from the chief executive officer (CEO) and the chairman of the board; other key executives may have signed their names, too.

Don't put too much stock in this letter, no matter how appealing it looks and how exciting its message is. Few CEOs actually write the letter to shareholders; the company's public relations department usually carefully designs the letter to highlight the positive aspects of the company's year. Negative results, when mentioned at all, are typically hidden in the middle of a paragraph somewhere in the middle of the letter.

In these letters, you usually find information about the key business activities for the year, such as a general statement about the company's financial condition, performance summaries of key divisions or subsidiaries that were the shining stars, and the company's major prospects.

Don't let these letters fool you. They will focus on the positive news and try to minimize the bad news. Do read the company's optimistic view, but don't depend on this letter to make a decision about whether to invest in the company. You can find more definitive information in other parts of the report to help you make investment decisions.

Making sense of the corporate message

After the letter to shareholders, but before the juicy information, you usually find more rah-rah text in the form of a summary of the company's key achievements throughout the year. Like the president's letter, these pages present more of the type of message the corporation wants to portray, which may or may not give you the true picture. Few companies include much information about negative results in this section. Often chock-full of glossy, colorful images, this section is pure public relations fluff that focuses on the year's top performance highlights.

Although you may enjoy the pictures, don't count on the info printed around them to help you make any decisions about the company. Even if a company doesn't use pretty color pictures, this section usually includes bold graphics and lots of headlines that focus on the successes. Don't expect to find any warning signs in this image-setting section.

Although this section is basically advertising, it may give you a good overview of what the company does and the key parts of its operations. The firm generally presents its key divisions or units, highlights the top products within these divisions, and gives a brief summary of the financial results of the top divisions. In addition, you usually find some discussion of market share and position in the market of the company's key products or services.

Meeting the people in charge

Want to find out who's running the place? After the corporate message, one or two pages list the members of the board of directors and sometimes a brief bio of each member. You also find a listing of top executives or managers and their responsibilities. If you want to complain to someone at the top, this is where you can find out where to send your letters!

But seriously, reviewing the backgrounds of the company's leaders can help you get an idea of the experience these leaders bring to the company. If they don't impress you, it may be a good sign that you should walk away from the investment.

Finding basic shareholder information

At the end of the key financial statements, you usually find a statement of shareholders’ equity, which is a summary of changes to shareholders’ equity over the past three years. The key parts of this statement for current-year results are in the equity section of the balance sheet (one of the key financial statements that I talk about in greater detail in Chapter 6).

This information is good to know because you can get an overview of changes to shareholders’ equity over the past three years, but you don't need this information to analyze a company's prospects. When I show you how to analyze results by using information about shareholders’ equity, I use numbers that you can find on the balance sheet.

Getting the skinny from management

The management's discussion and analysis (MD&A) section is one of the most important sections of an annual report. The MD&A may not be the most fun section to look at, but in it you find the key discussions about what went smoothly over the year and what went wrong.

Read the MD&A section carefully. It has a lot of the meat-and-potatoes information that gives you details about how the company's doing.

The Securities and Exchange Commission (SEC) monitors the MD&A section closely to make sure that companies present all critical information about current operations, capital, and liquidity. Management must also include forward-looking statements about known market and economic trends that may impact the company's liquidity and material events, as well as uncertainties that may cause reported information to not necessarily reflect future operating results or future financial conditions. For example, if a company manufactures its products in a country that's facing political upheaval or labor strife, those conditions may impact the company's ability to continue manufacturing its products at the same low cost. The company must report this information, indicating how this situation may impact its future earning potential.

The SEC pays special attention to a number of key factors that the MD&A is supposed to cover:

• Revenue recognition: In a retail store, recognizing revenue can be a relatively straightforward process: A customer buys a product off the shelves, and the revenue is recognized — that is, recorded in the company's books. But matters aren't that cut-and-dried in many complex corporate deals. For example, in the computer and hardware industries, revenue recognition can be complex because purchase contracts frequently include multiple parts, such as software, hardware, services, and training. When a company actually recognizes the revenue for each of these parts can vary, depending on the terms of a contract.

  When reading financial reports for a particular industry, reviewing how management describes its revenue-recognition process compared to similar companies in the same industry is important.

• Restructuring charges: When a company restructures a portion of itself — which can include shutting down factories, disbanding a major division, or enacting other major changes related to how the company operates — management discusses the impact this had on the company (or may have in the future). This portion of the report explains costs for employee severance, facility shutdowns, and other expenses related to restructuring.
• Impairments to assets: The SEC expects companies to report any losses to assets in a timely manner. If an asset is damaged or destroyed, or for any reason loses value, companies must report that loss to shareholders. Look for information about the loss of value to assets in the MD&A. Also look for information about the depreciation or amortization of these assets (see Chapter 4 for more details on depreciation and amortization).
• Pension plans: Accounting for pension plans includes many assumptions, such as the amount of interest or other gains the company expects to make on the assets it holds in its pension plans and the expenses the company anticipates paying out when employees retire. If the company has a pension plan for its employees, you'll find a discussion about how the company finances this plan and whether it expects to have difficulty meeting its plan's requirements.
• Environmental and product liabilities: All companies face some liability for products that fail to operate as expected or products that may cause damage to an individual or property. In some industries — such as oil, gas, and chemicals — an error can cause considerable environmental damage. You've probably heard stories about a chemical spill destroying a local stream or drinking water supply, or an oil spill wiping out an area's entire ecological system. In the MD&A section, the company must acknowledge the liabilities it faces and the way it prepares financially for the possibility of taking a loss after paying the liability. The company must estimate its potential losses and disclose the amount of money it has set aside or the insurance it has to protect against such losses.
• Stock-based compensation: To attract and keep top executives, many companies offer stock incentives (such as shares of stock as bonuses) as part of an employee compensation package. This part of the annual report must mention details of any stock-based compensation. Many recent scandals have included disclosures of unusually lavish stock-based compensation programs for top executives. Keep a watchful eye (or ear) out for discussion of bonuses or other employee compensation that involves giving employees shares of stock or selling employees’ shares of stock below the market value.
• Allowance for doubtful accounts: Any company that offers credit to customers will encounter some nonpayers in the group. Management must discuss what it allows for loss on accounts that aren't paid and whether this allowance increased or decreased from the previous year. An increase in the allowance for doubtful accounts may indicate a problem with collections or be a sign of significant problems in the industry as a whole.

The discussion in this section of the annual report can get technical. If you don't understand what you read, you can always make a call to the investor relations department to ask for clarification. Whenever you're considering a major investment in a company's stock, be certain that you understand the key points in the MD&A. Any time you find the information beyond your comprehension, don't hesitate to research further and ask a lot of questions before investing in the stock.

In the MD&A, managers focus on three key areas: company operations, capital resources, and liquidity.

Company operations

Management commentary on this topic focuses on the income the company's operations generate and the expenses related to them. To get an idea of how well the company may perform in the future, look for the following:

• Discussion about whether sales increased or decreased
• Details on how well the company's various product lines performed
• Explanations of economic or market conditions that may have impacted the company's performance

The MD&A section also discusses these areas:

• Distribution systems: How products are distributed.
• Product improvements: Changes to products that improve their performance or appearance.
• Manufacturing capacity: The number of manufacturing plants and their production capability. The MD&A also mentions the percentage of the company's manufacturing capacity that it's using. For example, if the firm uses only 50 percent of its manufacturing capacity, it may have a lot of extra resources that are idle. If the company is using 100 percent of its manufacturing capacity, it may have maxed out its resources and may need to expand.
• Research and development projects: The research or development the business is doing to develop new products or improve current products.

The manager also comments on key profit results and how they may differ from the previous year's projections.

Management as a whole?

Also look for cost information related to product manufacturing or purchase. Cost-control problems may mean that future results won't be as good as the current year's, especially if management mentions that the cost of raw materials isn't stable.

Look for statements about interest expenses, major competition, inflation, or other factors that may impact the success of future operations.

Capital resources

A company's capital resources are its assets and its ability to fund its operations for the long term. In addition to a statement that the company is in a strong financial position, you'll find discussions on these topics:

• Acquisitions or major expansion plans
• Any major capital expenses carried out over the past year or planned in future years
• Company debt
• Plans the company may have for taking on new debt
• Other key points about the company's cash flow

Liquidity

A company's liquidity is its cash position and its ability to pay its bills on a short-term or day-to-day basis. I cover how to analyze liquidity in Chapters 12, 15, and 16.

Getting guarantees from management

Management has been required to include a section called “Corporate Responsibility for Financial Reports” or “Management's Responsibility for Financial Reports” since the financial reporting scandals of the late 1990s and early 2000s. When the Sarbanes-Oxley Act of 2002 passed Congress, this guarantee became more critical.

Today the chief executive officer (CEO) and chief financial officer (CFO) must prepare a statement to accompany the audit report to certify that, “based on such officer's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report,” according to Section 302 of the Act.

Executives were asked to provide these letters in the past, but this new requirement must include a certified statement, signed and notarized for public view, indicating that management takes full responsibility and can be held legally accountable for what's in the financial reports.

Executives can now be held personally responsible for their actions and may face up to a five-year prison term, fines, and other disciplinary action. They may also face civil and criminal litigation, and the SEC may bar them from serving as a corporate officer or director.

CEOs and CFOs have responded to this new requirement by looking for ways to shield their money and property from shareholder lawsuits and federal prosecution. The key question not yet answered is whether we will actually see this enforced and whether it will protect investors and the public from the corporate scandals we have seen in the past.

Bringing the auditors’ answers to light

Any publicly traded company must provide financial reports that outside auditors have examined. (I talk more about the audit process in Chapter 18.) You usually find the auditors’ report (a letter from the auditors to the company's board of directors and shareholders) either before the financial information or immediately following it.

Before you read the financial statements or the notes to the financial statements, be sure that you've read the auditors’ report. You read the auditors’ report first to find out whether the auditor raised any red flags about the company's financial results. But you don't find the answers to these questions in the auditors’ report. To find the details, you need to read the MD&A, the financial statements, and the notes to the financial statements. But if you haven't read the auditors’ report first, you may overlook some critical details.

To lend credibility to management's assurances, companies call in independent auditors from an outside accounting firm to audit their internal controls and financial statements. Auditors don't check every transaction, so their reports don't give you 100 percent assurance that the financial statements don't include misstatements about the company's assets and liabilities. Auditors don't endorse the company's financial position or give indications about whether the company is a good investment.

Most standard auditors’ reports include these three paragraphs:

• Introductory paragraph: Here you find information about the time period the audit covers and who's responsible for the financial statements. In most cases, this paragraph states that management is responsible for the financial statements and that the auditors only express an opinion about the financial statements based on their audit. Essentially, this is a “protect your fanny” paragraph in which the auditors attempt to limit their responsibility for possible inaccuracies.
• Scope paragraph: In this paragraph, the auditors describe how they carried out the audit, including a statement that they used generally accepted audit standards. These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatements. A material misstatement is an error that significantly impacts the company's financial position, such as reporting revenue before it's actually earned.
• Opinion paragraph: Here the auditors state their opinion of the financial statements. If the auditors don't find any problems with the statements, they simply say that these statements are prepared “in conformity with generally accepted accounting principles” (or GAAP). For more on GAAP, see Chapter 2.

When an auditors’ report follows the outline I describe here, it's called a standard auditors’ report. And because no qualifiers (or red flags) limit the auditors’ opinions, it's also an unqualified audit report.

If the auditors find a problem, the report is a nonstandard auditors’ report. In a nonstandard report, auditors must explain their opinions in a qualified audit report — in other words, they qualify their opinions and note problem areas. (I discuss possible problems auditors may encounter later in this section.) A nonstandard auditors’ report and a standard auditors’ report have the same structure; the only difference is that the nonstandard report includes information about the problems the auditors found.

When you see a nonstandard auditors’ report, be sure that you find a discussion of the problems in the MD&A and in the notes to the financial statements. Also, when reading the MD&A, be certain that you understand how management is handling the problems the auditors noted and how these problems may impact the company's long-term financial prospects before you invest your hard-earned dollars. (Call the investor relations department to ask for clarification, if you need to.) If you've already invested, look carefully at the issues to be sure you want to continue holding your stock in the company.

A nonstandard auditors’ report may include paragraphs that discuss problems the auditors found, such as the following:

• Work performed by a different auditor: In many cases, this isn't a major problem. Maybe a different auditor handled the audit in previous years or audited a subsidiary of a newly acquired company.

  But whenever a company changes auditors, you need to know why it made the change, and you need to research the issue. You probably won't find the reason for the change in the annual report, so you may have to research the change in news reports or analysts’ reports. Because changing auditors can negatively impact a firm's stock price, companies are usually very careful about doing so. Wall Street typically gets concerned whenever a change of auditors occurs because it can be a sign of a major accounting problem that hasn't surfaced yet.

• Accounting policy changes: If a company decides to change its accounting policies or how it applies an accounting method, the auditors must note the change in a nonstandard auditors’ report. These changes may not indicate a problem, and if the auditors agree that the company had a good reason for making the change, you most likely have no reason for concern. For example, if the company changed how it reported an asset because the SEC required that change, then it's a good reason for making the change.

  If the auditors disagree with the company's decision to change accounting methods, they question the change and provide a qualified opinion (which I discuss later in this section) in the nonstandard auditors’ report. If their report indicates a change in accounting policy, be sure to look in the notes portion of the annual report for the full explanation of the change and how it may impact the financial statements. When companies change an accounting policy or method, the change impacts your ability to compare the previous year's results to the current year's.

• Material uncertainties: If the auditors find an area of uncertainty, it's impossible for management or the auditors to determine the potential financial consequences of an event. Uncertainties may include debt-agreement violations, damages the company must pay if it loses a pending lawsuit, or the loss of a major customer or market share. If the auditors believe that these material uncertainties may impact future earnings, they include a paragraph about the uncertainty and give a qualified opinion.

  If a loss is probable and the auditors can estimate it, the financial statements usually reflect this loss, and the auditors give an unqualified opinion. So in reality, the impact of a known loss can be a greater problem than a possible loss with unknown consequences. The company and the auditors have a responsibility to make you aware of the uncertainty so that you can factor it into any decisions you make about your potential dealings with or investment in the company.

• Going-concern problems: If the auditors have substantial doubt that the company has the ability to stay in business, they indicate that the company has a going-concern problem. Problems that can lead to this type of paragraph in the auditors’ report include ongoing losses, capital deficiencies, or a significant contract dispute. If you see a statement by the auditors that the company has a going-concern problem, it's a major red flag and a good indication that you don't want to invest in this company.
• Specific disclosures: Sometimes auditors indicate concerns about a specific financial matter but still give the company a nonqualified opinion.

  Many times the auditor believes that these are matters the public needs to know about but aren't signs of a serious problem. For example, if the company is doing business with another company that has officers involved in both firms, the auditor may note this issue in a special paragraph. The notes to the financial statements explain any specific disclosure in greater detail.

• Qualified opinions: Any time the auditors issue a nonstandard report, they also issue a qualified opinion in the final paragraph of the report. A qualified opinion isn't always cause for alarm, but it does mean that you need to do additional research to make sure you understand the qualification. Sometimes a qualified opinion simply indicates that the auditors didn't have sufficient information available at the time of the audit to determine whether the issue raised will have a significant financial impact on the company. Look in the notes to the financial statements or the MD&A for any explanation of the matter that caused the auditors to issue a qualified opinion.

Presenting the Financial Picture

The main course of any annual report is the financial statements. In this part, you find out what the company owns, what the company owes, how much revenue it took in, what expenses it paid out, and how much profit it made or how much it lost. I cover each of the following statements in great detail throughout the book, so I mention them briefly here and indicate in which chapters you can find additional information.

When looking at a company's financial results, make sure that you're comparing periods of similar length or a similar collection of months.

For example, a retail store usually has much better results in the last quarter of the year (from October to December) because of the holiday season than it does in the first quarter (from January to March). Comparing these two quarters doesn't make sense when you're trying to determine how well a business is doing. To judge a retail company's growth prospects, compare the fourth quarter of one year with the fourth quarter of another year. I talk more about income statements in Chapter 7 and tell you how to analyze these statements in Part III.

• Balance sheet: Also known as the statement of financial position, this document gives a snapshot of a company's assets and liabilities at a specific point in time. I discuss all the parts of the balance sheet in Chapter 6, and I talk about analyzing the financial reports in Part III.
• Income statement: Also known as the profit and loss statement or P&L statement, this document reviews a company's operations over a specific amount of time. This period can last for one month, one quarter, six months, one year, or any other period indicated at the top of the statement. I discuss the income statement in Chapter 7 and how to analyze the statement in Part III.
• Statement of cash flows: This document discusses the actual flow of cash into and out of the company. The statement has three sections focusing on changes to cash status from operations, from investing, and from financing. Like the income statement, the statement of cash flows reflects results over a specific period of time. I discuss this statement in greater detail in Chapter 8, and I talk about cash-flow analysis in Chapter 13.

Summarizing the Financial Data

Knowing that most people won't spend the time to read all the way through the annual report, many companies summarize their numbers in various ways. The two most common ways to summarize are to highlight the financial data presented in the financial statements and to summarize some key information in the notes to the financial statements. But beware: Most summaries highlight the good news and skip over the bad.

Finding the highlights

The highlights to the financial data summarize the financial results for the year being reported. Typically, this summary is called the financial highlights, but companies can be creative because this section isn't a required part of the report. And because the highlights aren't required, they're not always presented according to GAAP rules, so don't count on their accuracy. You usually find the financial highlights at the front of the annual report, after the letter from the CEO and chairman of the board. Some companies include them inside the annual report's back cover.

You frequently find financial highlights at the front of the annual report, designed in a graphically pleasing way. Most companies show either a 10-year or 11-year summary that doesn't include much detail but allows you to see the firm's growth trends. Although this type of summary can be a good historical overview, don't count on it. Instead, do your own research of the company's financial history to be sure that you're aware of both the good and the bad news. Remember that even outstanding companies have some bad years that they want to gloss over.

Reading the notes

The notes to the financial statements is the section where you find any warts on a company's financial record. The notes are a required part of the annual report, and they give you the details behind the numbers presented in the financial statements. Companies like to hide their problems in the notes; in fact, most companies even print this part of the annual report in smaller type.

Most of the details in the notes discuss the impact that the following business aspects may have on the company's future financial health:

• Accounting methods used
• Changes to accounting methods
• Key financial commitments that can impact current and future operations
• Lease obligations
• Pension and retirement benefits

If any red flags pop up in a company's annual report, this part is where you can find the financial details and explanations. The auditors’ report probably highlights any potential problems and red flags that you want to search for in the notes. You may also find problems mentioned in the MD&A section, but the notes section probably covers the full explanations for these problems in greater detail.

Don't get turned off by the visually unpleasing presentation. The notes to the financial statements is one of the most critical parts of the annual report. I cover the importance of the notes in more detail in Chapter 9.