Chapter 9
In This Chapter
Describing the notes and their importance
Understanding the fine print of accounting methods
Finding out about financial commitments
Getting acquainted with mergers and acquisitions
Reading notes about pensions and retirement
Detailing segmented businesses and significant events
Keeping an eye out for red flags
Would you ever sign an important contract without reading the fine print first? I didn't think so. Remember this philosophy when you read financial statements because the corporate world certainly doesn't escape the cliché about sweeping ashes under the rug. Hiding problems in the notes to the financial statements is a common practice for companies in trouble.
In this chapter, I explain the role of the notes as part of the financial statements, I discuss the most common issues addressed in the notes, and I point out some key warning signs that raise a red flag if you see them mentioned in the notes. And to help you become a note-reading expert, I refer to the financial reports of Hasbro and Mattel (both toy companies) throughout the chapter. (You can view their complete annual reports at www.hasbro.com and www.mattel.com.)
Figuring out how to read and understand the small print of the notes to the financial statements can be a daunting task. Most times, companies present these notes in the least visually appealing way and deliberately fill them with accounting jargon so they're hard for the general public to understand. By making these notes so difficult to decipher, companies fulfill their obligations to the Securities and Exchange Commission (SEC) to give the required financial report to the reader, but at the same time, they make it hard for the reader to actually understand the information presented.
But don't give up. These notes contain a lot of important information that you need to know, including accounting methods used, red flags about a company's finances, and any legal entanglements that may threaten the company's future. I point out the key sections of the notes to the financial statements and what types of information to pluck out of these sections.
The first indication of the notes to the financial statements appears at the bottom of the financial statements. You see an indication that the accompanying notes are an integral part of the statement. In the same small print, you find the actual notes on numerous pages after the financial statements.
The notes have no specific format, but you're likely to find at least one note regarding several key issues in every company's financial report. Read on to find out what these key issues are.
The first note in almost every company's financial report gives you the ammunition you need to understand the accounting policies used to develop the financial statements. This note explains the accounting rules the company used to develop its numbers. The note is usually called the “Summary of significant accounting policies.” Issues discussed in this note include:
For example, if companies use different methods to value their inventory, this can have a major impact on net income. I explain the impact of inventory valuation on net income in Chapter 15. Many times, you don't actually have enough details to make apples-to-apples comparisons of two firms that use different accounting policies, but you need to be aware that the policies differ as you analyze the companies’ financial results, and be alert to the fact that you may be comparing apples to oranges.
One significant difference in accounting policies that can affect the bottom line is the amount of time a company allows for the depreciation of assets. One company may use a 15- to 25-year time frame, and another may use a 10- to 40-year span. The time frame used for depreciation directly impacts the value of the assets, which is recorded on the line item of the balance sheet called Cost less accumulated depreciation. A faster depreciation method reduces the value of these assets more quickly.
Depreciation expenses are also deducted from general revenue. A company that writes off its buildings quickly — say, in 25 years rather than up to 40 years — has higher depreciation expenses and lower net income than a company that takes longer to write off its buildings. I discuss how depreciation works in greater detail in Chapter 4.
You can find some noteworthy differences between companies by reading the revenue recognition section of the summary of significant accounting policies. Differences regarding the timing of revenue recognition can impact the total revenues reported. For example, one company may recognize revenue when a product ships to the customer. Another company may recognize revenue when the customer receives the product. If products are shipped at the end of the month, a company that includes shipped products may include the revenue in that month, but a company that recognizes revenue only when products are received may not include the revenue until the next month.
Other revenue-recognition differences to pay attention to include the following:
Expenses differ widely among companies. As you read this part of the accounting policies note, be sure to notice the types of expenses the company chooses to highlight. Sometimes the differences between companies can give you insight into how the companies operate. Here are two key areas where you may see differences in how a company reports expenses:
Although Mattel states the recalls didn't have a significant impact on its bottom line, costs to straighten out this mess legally and administratively totaled $42 million, according to Note 4. Product recalls cost the company another $68.4 million. Luckily for Mattel, the company was able to put a fix in place before its key fourth-quarter sales period during the holiday season. Otherwise, some popular Mattel toys may not have been available for Christmas and Chanukah shoppers. But that $110.4 ($42 + $68.4) million equaled about 18 percent of Mattel's net income of about $600 million, which, to me, seems like a significant impact.
How a company manages its debt is critical to its short- and long-term profitability. You can find out a lot about a company's financial management by reading the notes related to financial commitments.
You always find at least one note about the financial borrowings and other commitments that impact the short- and long-term financial health of the company.
For accounting purposes on the financial statements, only two types of debt are recognized: current debt and long-term debt. Current debt is due over the next 12 months, and long-term debt includes debt that a company must pay during any period beyond the next 12 months. Both medium- and long-term notes or bonds fall into the long-term debt category. Medium-term notes or bonds are debt that a company borrows for two to ten years. Long-term notes or bonds include all debt borrowed for more than ten years.
In the discussion of long-term financial debts, you find two key charts. One chart shows the terms of the borrowings, and the other shows the amount of cash that the company must pay toward this debt for each of the next five years and beyond.
Table 9-1 Mattel's Long-term Debt
Long-term Debt |
As of Year End 2012 (in Thousands) |
As of Year End 2011 (in Thousands) |
Medium-term notes (6.5% to 6.51%, weighted average 6.53%) due from November 2013 |
$50.000 |
$100.000 |
Senior notes (fixed rate) due March 2013 (5.625%) |
$350,000 |
$350,000 |
Senior notes (fixed rate) due October 2020 and October 2040 (4.35% to 6.2%) |
$500,000 |
$500,000 |
Senior notes due (fixed rate) November 2016 and November 2041 (4.35% to 6.2%) |
$600,000 |
$600,000 |
Less: Current portion (to be paid in 2008) |
($400,000) |
($50,000) |
Total long-term debt |
$1,100,000 |
$1,500,000 |
If a company is managing its debt well, it frequently looks for opportunities to lower its interest expenses. Because interest rates have dropped considerably, when you see interest rates on these charts that are significantly higher than interest rates available in the current market environment, you need to wonder whether the company is doing a good job of managing its debt.
Table 9-2 Hasbro's Long-term Debt (Carrying Cost)
Long-term Debt |
As of Year End 2012 (in Thousands) |
As of Year End 2011 (in Thousands) |
6.35% notes due 2040 |
$500,000 |
$500,000 |
6.125% notes due 2014 |
$436,526 |
$440,977 |
6.60% debentures due 2028 |
$109,895 |
$109,875 |
6.3% notes due 2017 |
$350,00 |
$350,00 |
Total notes due |
$1,396,421 |
$1,400,872 |
I take a closer look at this issue and how it impacts the companies’ liquidity in Chapter 12. I also show you how potential lenders analyze a company's borrowing habits.
Short-term debt can have a greater impact than long-term debt on a company's earnings each year, as well as on the amount of cash available for operations. The reason is that companies must pay short-term debt over the next 12 months, whereas for long-term debt, they must pay only interest and some of the principal in the next 12 months.
The type of short-term debt you see on a firm's balance sheet varies greatly, depending on the type of business. Companies whose sales are seasonal may carry a lot more short-term debt to get themselves through the slow times than companies that have a consistent cash flow from sales throughout the year.
Seasonal companies carry large lines of credit to help them buy or produce their products during the off-season times so they can have enough product to sell during the high season. For example, a company that sells toys sells most of its product during the Christmas or other peak toy-selling seasons; during the other times of the year, it has very low sales. So Mattel and Hasbro — both toy companies with significant seasonal financing needs — maintain large lines of credit to be ready for Christmas and peak toy-selling seasons.
Another way that firms raise cash if they don't have enough on hand is to sell their accounts receivable (credit extended to customers). A company can sell the receivables to a bank or other financial institution and quickly get cash for immediate needs instead of waiting for the customers to pay. I talk more about accounts receivable management in Chapter 16.
Instead of purchasing plants, equipment, and facilities, many companies choose to lease them. You usually find at least one note to the financial statements that spells out a company's lease obligations. Many analysts consider lease obligations to be just another type of debt financing that doesn't have to be shown on the balance sheet. Whether the lease is shown on the balance sheet or in the notes depends on the type of lease:
Companies that must constantly update certain types of equipment to avoid obsolescence use operating leases rather than capital leases. At the end of the lease period, the companies return the equipment and replace it by leasing new, updated equipment. Operating leases have the lowest monthly payments.
Sometimes one company decides to buy another. Other times, two companies decide to merge into one.
If a company acquires another company or merges during the year the annual report covers, a note to the financial statements is dedicated to the financial implications of that transaction. In this note, you see information about
When a company acquires another company, it frequently pays more for that acquisition than for the total value of the purchased company's assets. The additional money spent to buy the firm falls into the line item called Goodwill. Goodwill includes added value for customer base, brand name, locations, customer loyalty, and intangible factors that increase a business's value. If a company has goodwill built over the years from previous mergers or acquisitions, you see that indicated on the balance sheet as an asset. I discuss goodwill in greater detail in Chapter 4.
You may not think of pension and other retirement benefits as types of debt, but they are. In fact, for most companies that offer pension benefits, the amount of money they owe their employees is higher than the amount they owe to bondholders and banks. Some companies offer both pensions (which are an obligation to pay retirees a certain amount for the rest of their lives after they leave the company) and other retirement benefits (which include contributions to retirement savings plans such as 401(k)s or profit-sharing plans).
When looking at the note about pensions and other retirement benefits, find out which type of plan the company offers:
Defined benefit plans carry obligations for the firm for as long as an employee lives — and sometimes for as long as both the employee and his spouse live. Determining how much that benefit will cost in the future is based on assumptions regarding how much return the company expects from its retirement portfolios and how long its employees and their spouses will live after retirement. As people live longer, pension obligations become much greater for companies that offer defined benefit plans. Many companies are phasing out this type of retirement benefit.
Each of these rates requires assumptions about unknown future events involving the state of the economy, interest rates, investment returns, and employee life spans. A company can do no more than make an educated guess. To be sure that the company's guesses are reasonable, all you can do is check that it makes guesses that are similar to the guesses of other companies in the same industry. Also look for information in the notes about whether the company's retirement savings portfolio is sufficient to meet its expected current and future pension obligations. This information is usually shown in a chart as part of the note. If the company's retirement savings portfolio falls short, it may be a red flag for future cash-flow problems.
Can you imagine what it takes to manage a multibillion-dollar company? Just reading the numbers can be a daunting task. Think about how many products are sent out to make that many sales and how many people are needed to keep the business afloat.
Most major firms deal with their massive size by splitting up the company into manageable segments. This division makes managing all aspects of the business — from product development, to product distribution, to customer satisfaction — easier.
These segments help the company more easily track the performance of each of its product lines. In the notes to the financial statements, you find at least one note related to these segment breakdowns. This note gives you details about how each of the company's segments is doing, as well as the product lines that fall under each segment.
You may also find some details about these areas:
How a company breaks down its management segments varies depending on the industry and management preferences. Some companies divide into regions based on geography; others designate segments based on product lines or customer target groups.
If a company operates internationally, you usually see the U.S. market segments separated from the non-U.S. segments, and sometimes you find the international portion broken into regions, such as Europe, Asia, or the Middle East.
You don't find any hard-and-fast rules about how to segment a business. How a company segments itself depends on how the company has operated historically or what management style the company's executives adopt.
Each year, every company faces significant challenges. One year, a firm may find out that its customers are suing it for a defective product. Another year, a business may get notice from a state or local government that one of its manufacturing facilities is polluting the environment.
You may also find in the notes mention of significant events that aren't related to external forces, such as the decision to close a factory or combine two divisions.
You can look in a number of places in the notes for information on significant events. Sometimes an event has its own note, such as a note about the discontinuation of operations. Other times the event is just part of a note called “Commitments and Contingencies.” Scan the notes to find significant events that impact the company's financial position. You're most likely to find significant events regarding topics such as the following:
Many times the information included in these notes discusses not only the financial impact of an event in the current year, but also any impact expected on financial performance in future years.
When a company discusses lawsuits and potential environmental liability cases in the notes, it commonly indicates that, in the opinion of management, the matter in question won't result in a material loss. Use your own judgment after reading the details that management provides. If you think the company may be facing bigger problems than it mentions, do your own research on the matter before investing in that company.
As you probably know by now, companies love hiding their dirty laundry in the small print of the notes to the financial statements. As you read through the notes, keep an eye out for possible red flags.
Significant events aren't the only sources of red flags. You may also see signs of trouble in the way the company values assets or in decisions it makes to change accounting policies. The notes involving the long-term obligations the company has to its retirees may also be a good spot to find some potential red flags.
Valuing assets and liabilities leaves room for accounting creativity. If assets are overvalued, you may be led to believe that the company owns more than it actually does. If liabilities are undervalued, you may think the company owes less than it actually does. Either way, you get a false impression about the company's financial position.
How a company puts together its numbers is just as critical as the numbers themselves. The accounting policies the company adopts drive these numbers. Whenever a firm indicates in the notes to the financial statements that it's changing accounting policies, your red flag needs to go up. I discuss the key accounting policies and how they can impact income in the section “Accounting Policies Note: Laying out the Rules of the Road,” earlier in this chapter. You can find more details about accounting policies in Chapter 4.
Changes in accounting policies aren't always a sign of a problem. In fact, many times, the change is related to requirements the Financial Accounting Standards Board (FASB) or the SEC specifies. Regardless of the reason for the change, be sure you understand how that change impacts your ability to compare year-to-year or quarter-to-quarter results.
As noted in the “Pondering Pension and Retirement Benefits” section earlier in this chapter, obligations to retirees and future retirees can be a bigger drain on a company's resources than debt obligations. The note to the financial statements related to pension benefits is probably one of the most difficult to understand. Look specifically at the charts that show the company's long-term payment obligations to retirees and the cash available to pay those obligations. If you find any indication that the company may have difficulty meeting the obligations mentioned in either the text of this note or the charts, it may be a sign of a major cash flow problem in the future. Don't hesitate to call and ask questions if you don't understand the presentation.