Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws Chapter 1 Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

How Companies Manipulate Financial Reporting: Overstate earnings Use confusing “profit” terminology Report profits while failing to generate cash Make future earnings look better by taking huge, one-time charges Boost or delay revenue & expenses Keep debt off balance sheet Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Problems with Auditors Auditor's reports should provide: “Independent” opinion about fairness of financial statement presentations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

But. . .are auditors truly independent? Numerous cases & judgements against auditing firms Sometimes provide “clean” reports for problem statements Accounting firms consult for companies they audit Officers previously employed by audit accounting firm Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Problems with Analysts Hype marginal companies Conflicts of interest Recommend “buy” in severe market downturns SEC warns public to treat analysts’ advice with caution Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

What do you need if you rely on corporate financial statements for important decisions? Basic understanding of financial reports Ability to evaluate information Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Corporate Financial Statements Based on Generally Accepted Accounting Principles (GAAP) Should reflect economic reality Should achieve financial information that is: understandable relevant Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Authorities Primarily Responsible for Establishing GAAP Securities & Exchange Commission (SEC) Financial Accounting Standards Board (FASB) U.S. Congress Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

SEC (Public Sector) Regulates companies that issue securities to the public Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

SEC Requires: Prospectus for new security offerings Annual reports (10-K) Quarterly reports (10-Q) Other reports (Filed as 8-K) Proxy statement Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

FASB (Private Sector) Issues Statements of Financial Accounting Standards Interpretations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The SEC Relies on FASB for most accounting rule-making in U.S. Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

What’s in an Annual Report? (The Slick Stuff) Impressive front cover Colored photographs on shiny paper Dazzling graphics Positive letter to shareholders Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Statements in an Annual Report: 1. Statement of earnings (income statement) 2. Statement of financial condition (balance sheet) 3. Statement of shareholders’ equity 4. Statement of cash flows Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Annual Report Content Continued: Notes to the financial statements Report of independent auditors Management’s discussion & analysis 5-year summary of selected financial data Market data Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

What’s Actually Required? Financial statements Notes Auditor’s report Management’s discussion 5-year summary of key figures Market data Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Other Material? Presented at the discretion of management Packaged to make company appealing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Watch for a New Financial Ratio Ratio of Public Relations Fluff to Financial Data When that is high & rising. . . Look Out! Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Earnings (Income Statement) Results of a firm’s operations Revenue & expense Sources of other income & expense Net profit or loss Net profit or loss per share Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Financial Position (Balance Sheet) Presents assets liabilities shareholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Shareholders’ Equity Reconciles beginning & ending balances of all shareholders’ equity accounts Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Cash Flows Provides information about inflows & outflows of cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Notes to Financial Statements Immediately follow the four financial statements Must be read to understand financial statements Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More on Notes. . . First note: Summary of accounting policies Other notes Provide specific account details Other information Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Examples of Financial Statement Notes Note 1: Significant Accounting Policies Note 2: Receivables Note 3: Inventories Note 4: Properties Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Examples of Notes Note 5: Payables & Short-Term Borrowings Note 6: Long-Term Borrowings Note 7: Other Long-Term Liabilities Note 8: Commitments & Contingencies Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

And Even More Notes. . . Note 9: Financial Instruments Note 10: Income Taxes Note 11: Restructuring Programs & Cost Reductions Note 12: Retirement Plans Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Notes. . . Note 13: Nonpension Postretirement Benefits Note 14: Stock Option & Compensation Plans Note 15: Acquisitions & Joint Ventures Note 16: Sales of Assets & Divestitures Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The Last of the Notes. . . Note 17: Segment Information Note 18: Subsequent Events Note 19: Quarterly Sales & Earnings Data-- Unaudited Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The Auditors’ Report Management prepares financial statements Independent accountants: Audit financial statements Attest to the fairness of their presentation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The Unqualified Report states: Financial statements are presented fairly Financial statements conform to GAAP Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Unqualified Opinion with Explanatory Language Used when there is/are: Consistency departures Uncertainties caused by future events Events auditors wish to describe Business risk Issues affecting firms existence Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Qualified Report Used where there is a Departure from GAAP Scope limitation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Management Discussion & Analysis (MD&A) Valuable tool in evaluating a company Contains insight into firm’s own perspective on its performance Presents qualitative information not found in financial data Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

MD&A Covers: Favorable trends Unfavorable trends Significant events or uncertainties in the categories of: Liquidity Capital resources Results of operations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Limits to Usefulness of MD&A: It is management’s “take” on the company’s situation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Five-Year Summary & Market Data Provides an overview of the firm’s Performance Financial condition Many key items do not appear in summary Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Market Price Data Snapshot of common stock performance over a two-year period Shows high & low quarterly stock price Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Enron’s 1996 Annual Report Problems Revenue growing faster than earnings Operating income declining Negative cash flow Erratic trend in cash flow from operations Number & volume of contingencies & commitments Murky or inadequate explanations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Caution Flags: Change in auditors Departure from “unqualified” opinion in auditor’s report with “exception or explanatory” language or qualification Charges filed by SEC against firm or auditors Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Caution Flags. . . Rising ratio of fluff to financial data Allowance for doubtful accounts not keeping pace with accounts receivable Revenue & earnings: growing at different rates moving in opposite directions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Even More Caution Flags. . . Negative or erratic cash flow from operations Earnings & cash flow from operations moving: At different rates In opposite directions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Still More Caution Flags: Numerous unquantified contingencies & commitments Company puts name on sports arena Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing