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Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws. Chapter 1. How Companies Manipulate Financial Reporting:. Overstate earnings Use confusing “profit” terminology Report profits while failing to generate cash

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Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

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  1. 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

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

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

  10. 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

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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

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

  21. 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

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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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

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