Chapter 1
In This Chapter
Reviewing the importance of financial reports
Exploring the different types of financial reporting
Discovering the key financial statements
Financial reports give a snapshot of a company's value at the end of a particular period, as well as a view of the company's operations and whether it made a profit. The business world couldn't function without financial reports. Yes, fewer scandals would be exposed because companies wouldn't be tempted to paint false but pretty financial pictures, but you'd still need a way to gauge a firm's financial health.
At this point in time, nothing's available that can possibly replace financial reports. Nothing can be substituted that'd give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the folks who work for a company wouldn't know how to make it more efficient and profitable because they wouldn't have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures and make plans for future improvements.
This chapter introduces you to the many facets of financial reports and shows you how internal and external players use them to evaluate a company's financial health.
Financial reporting gives readers a summary of what happens in a company based purely on the numbers. The numbers that tell the tale include the following:
A company's accounting department is the key source of its financial reports. This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called double-entry accounting, which requires a company to record resources and the assets it uses to get those resources. For example, if you buy a chair, you must spend another asset, such as cash. An entry in the double-entry accounting system shows both sides of that transaction — the cash account is reduced by the chair's price, and the furniture account value is increased by the chair's price.
This crucial method of accounting gives companies the ability to record and track business activity in a standardized way. Accounting methods are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry accounting, turn to Chapter 4.
Many people count on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:
Employees also make career and retirement investment decisions based on the company's financial reports. If the reports are misleading or false, employees may lose most, if not all, of their 401(k) retirement savings, and their long-term financial futures may be at risk.
If a firm's financial reports are false or misleading, creditors may loan money at an interest rate that doesn't truly reflect the risks they're taking. And by trusting the misleading information, they may miss out on a better opportunity.
Companies don't produce financial reports only for public consumption. Many financial reports are prepared for internal use only. These internal reports help managers accomplish these tasks:
This list identifies just a few of the many uses companies have for their internal financial reports. The actual list is endless and is limited only by the imagination of the executives and managers who want to find ways to use the numbers to make business decisions. I talk more about using internal reports to optimize results in Chapters 14, 15, and 16.
Not every company needs to prepare financial statements, but any company seeking to raise cash through stock sales or by borrowing funds certainly does. How public these statements must be depends on the business's structure.
Most businesses are private companies, which share these statements only with a small group of stakeholders: managers, investors, suppliers, vendors, and the financial institutions that they do business with. As long as a company doesn't sell shares of stock to the general public, it doesn't have to make its financial statements public. I talk more about the reporting rules for private companies in Chapter 2.
Even if a firm doesn't need to make its financial reports public, if it wants to raise cash outside a very small circle of friends, it has to prepare financial statements and have a certified public accountant (CPA) audit them, or certify that the financial statements meet the requirements of the generally accepted accounting principles (or GAAP, which you can find out more about in the section “Keeping the number crunchers in line,” later in this chapter). Few banks consider loaning large sums of money to businesses without audited financial statements. Investors who aren't involved in the daily management of a business also usually require audited financial statements.
One big change in a company's operations after it decides to publicly sell stock is that it must report publicly on both a quarterly and annual basis to its stockholders. Companies send these reports directly to their stockholders, to analysts, and to the major financial institutions that help fund their operations through loans or bonds. The reports often include glossy pictures and pleasingly designed graphics at the beginning, keeping the less eye-pleasing financial reports that meet the SEC's requirements in the back.
Companies must release quarterly reports within 45 days of the quarter's end. Companies with holdings over $75 million must file more quickly. In addition to the three key financial statements — the balance sheet, the income statement, and the statement of cash flows (check out the upcoming section “Getting to the meat of the matter” for details on these documents) — the company must state whether a CPA has audited (see Chapter 18) or reviewed (a much less intensive look at the data) the numbers. A report reviewed rather than audited by a CPA holds less weight.
Most small companies must file their annual reports within 90 days of the end of their fiscal year. Companies with over $75 million in assets must file their reports within 60 days. The annual report includes the information presented in the quarterly reports and much more, including a full business description, details about the management team and its compensation, and details about any filings done during the year.
Reports for the government are more extensive than the glossy reports sent to shareholders (see the preceding section). Companies must file many types of forms with the SEC, but I focus on only three of them in this book:
Firms must file this report within 90 days of the end of the fiscal year (companies with more than $75 million in assets must file within 60 days). In addition to the information included in the glossy annual reports sent to shareholders (see the preceding section), investors can find more detailed information about company history, organizational structure, equity holdings, subsidiaries, employee stock purchase and savings plans, incorporation, legal proceedings, controls and procedures, executive compensation, accounting fees and services, and changes or disagreements with accountants about financial disclosures.
More companies these days operate across country borders. For years, each country had its own set of rules for preparing financial reports to meet government regulations. Global companies had to keep separate sets of books and report results under different sets of rules in each country in which they operated.
Today most countries have agreed to accept the International Financial Reporting Standards (IFRS; see Chapter 20) developed by the London-based International Accounting Standards Board (IASB). Beginning in 2002, the U.S. agreed to look at ways to converge the IFRS and the U.S. GAAP (see Chapter 18). The U.S. allows companies based outside its borders to file required reports using either U.S. GAAP or IFRS, but U.S.-based companies must still use GAAP to file their reports. The process of converging U.S. standards with international standards is still a work in process.
Not all of an accounting department's financial reporting is done for public consumption. In fact, companies usually produce many more internal reports than external ones to keep management informed. Firms can design their internal reports in whatever way makes sense to their operations.
Each department head usually receives a report from the top managers showing the department's expenses and revenue and whether it's meeting its budget. If the department's numbers vary significantly from the amount that was budgeted, the report indicates red flags. The department head usually needs to investigate the differences and report what the department is doing to correct any problems. Even if the difference is increased revenue (which can be good news), the manager needs to know why the difference exists, because an error in the data input could have occurred. I talk more about reports and budgeting in Chapter 14.
Reports on inventory are critical, not only for managing the products on hand, but also for knowing when to order new inventory. I talk more about inventory controls and financial reporting in Chapter 15.
Tracking cash is vital to the day-to-day operations of any company. The frequency of a company's cash reporting depends on the volatility of its cash status — the more volatile the cash, the more likely the company needs frequent reporting to be sure that it has cash on hand to pay its bills. Some large firms actually provide cash reporting to their managers daily. I talk more about cash reporting in Chapters 16 and 17; Chapter 16 focuses on incoming cash, and Chapter 17 deals with outgoing cash.
The annual report gives more details about a company's business and financial activities than any other report. This document is primarily for shareholders, although any member of the general public can request a copy. Glossy pictures and graphics fill the front of the report, highlighting what the company wants you to know. After that, you find the full details about the company's business and financial operations; most companies include the full 10-K that they file with the SEC.
The annual report is broken into the following parts (I summarize the key points of each of these parts in Chapter 5):
No doubt, the most critical part of the annual report for anyone who wants to know how well a company did financially is the financial statements section, which includes the balance sheet, the income statement, and the statement of cash flows.
The balance sheet gives a snapshot of the company's financial condition. On a balance sheet, you find assets, liabilities, and equity. The balance sheet got its name because the total assets must equal the total liabilities plus the total equities so that the value of the company is in balance. Here's the equation:
Assets appear on the left side of a balance sheet, and liabilities and equities are on the right side. Assets are broken down into current assets (holdings that the company will use in the next 12 months, such as cash and savings) and long-term assets (holdings that the company will use longer than a 12-month period, such as buildings, land, and equipment).
Liabilities are broken down into current liabilities (payments on bills or debts that are due in the next 12 months) and long-term liabilities (payments on debt that are due after the next 12 months).
The equities portion of the balance sheet can be called owner's equity (when an individual or partners closely hold a company) or shareholders’ equity (when shares of stock have been sold to raise cash). I talk more about what information goes into a balance sheet in Chapter 6.
The income statement, also known as the profit and loss statement (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of one quarter or an entire year. Many companies prepare P&Ls on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: revenue, net income, and earnings per share of stock.
In the income statement, you also find out how much the company is spending to produce or purchase the products or services it sells, how much the company costs to operate, how much it pays in interest, and how much it pays in income tax. To find out more about the information you can find on an income statement, go to Chapter 7.
The statement of cash flows is relatively new to the financial reporting game. The SEC didn't require companies to file it with the other financial reports until 1988. Basically, the statement of cash flows is similar to the income statement, in that it reports a company's performance over time. But instead of focusing on profit or loss, it focuses on how cash flows through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. I talk more about the statement of cash flows in Chapter 8.
Every public company's internal accounting team and external audit team must answer to government entities. The primary government entity responsible for overseeing corporate reporting is the SEC. Its staff reviews reports filed with the SEC. If SEC employees have any questions or want additional information, they notify the company after reviewing the reports.
With GAAP in place, you may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years. Filing statements according to GAAP has become a game for many companies. Unfortunately, investors and regulators find that companies don't always engage in transactions for the economic benefit of the shareholders, but sometimes do so to make their reports look better and to meet the quarterly expectations of Wall Street. Many times, companies look financially stronger than they actually are. For example, as scandals have come to light, companies have been found to overstate income, equity, and cash flows while understating debt. I talk more about reporting problems in Chapter 23.