Understanding the Corporate
Annual Report: Nuts, Bolts, and
a Few Loose Screws
Chapter 1
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
How Companies Manipulate
Financial Reporting:
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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
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
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
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
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
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
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
SEC (Public Sector)
• Regulates companies that issue securities to
the public
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
SEC Requires:
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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
FASB (Private Sector)
• Issues
– Statements of Financial Accounting Standards
– Interpretations
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
The SEC
• Relies on FASB for most accounting rulemaking in U.S.
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
What’s in an Annual Report?
(The Slick Stuff)
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Impressive front cover
Colored photographs on shiny paper
Dazzling graphics
Positive letter to shareholders
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
Annual Report Content Continued:
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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
What’s Actually Required?
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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
Other Material?
• Presented at the discretion of management
• Packaged to make company appealing
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
Statement of Earnings
(Income Statement)
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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
Statement of Financial Position
(Balance Sheet)
• Presents
– assets
– liabilities
– shareholders’ equity
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Statement of
Shareholders’ Equity
• Reconciles beginning & ending balances of
all shareholders’ equity accounts
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Statement of Cash Flows
• Provides information about inflows &
outflows of cash
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
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
Examples of Financial Statement
Notes
Note 1:
Note 2:
Note 3:
Note 4:
Significant Accounting Policies
Receivables
Inventories
Properties
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
More Examples of Notes
Note 5:
Note 6:
Note 7:
Note 8:
Payables & Short-Term
Borrowings
Long-Term Borrowings
Other Long-Term Liabilities
Commitments & Contingencies
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
And Even More Notes. . .
Note 9:
Note 10:
Note 11:
Note 12:
Financial Instruments
Income Taxes
Restructuring Programs &
Cost Reductions
Retirement Plans
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
Notes. . .
Note 13:
Note 14:
Note 15:
Note 16:
Nonpension Postretirement
Benefits
Stock Option & Compensation
Plans
Acquisitions & Joint Ventures
Sales of Assets & Divestitures
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
The Last of the Notes. . .
Note 17:
Note 18:
Note 19:
Segment Information
Subsequent Events
Quarterly Sales & Earnings Data-Unaudited
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
The Unqualified Report states:
• Financial statements are presented fairly
• Financial statements conform to GAAP
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
Qualified Report
Used where there is a
• Departure from GAAP
• Scope limitation
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002
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
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
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
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
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
Enron’s 1996 Annual Report
Problems
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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
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
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
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
Still More Caution Flags:
• Numerous unquantified contingencies &
commitments
• Company puts name on sports arena
Fraser/Ormiston: Understanding the
Corporate Annual Report (C) 2002