Starting with the financial statements

In Chapters 5, 6, and 7, I explain the fundamentals of the three primary financial statements of a business. To review briefly:

• Income statement: The income statement summarizes sales revenue and other income (if any) and expenses and losses (if any) for the period. It ends with the bottom-line profit for the period, which most commonly is called net income or net earnings. (Inside a business, a profit performance statement is commonly called the profit and loss, or P&L, report.)
• Balance sheet: The balance sheet summarizes the financial condition, consisting of amounts of assets, liabilities, and owners’ equity at the closing date of the income statement period (and at other times as needed by managers). Its formal name is the statement of financial condition or statement of financial position.
• Statement of cash flows: The statement of cash flows reports the net cash increase or decrease during the period from the profit-making activities reported in the income statement and the reasons this key figure is different from bottom-line net income for the period. It also summarizes sources and uses of cash during the period from investing and financing activities.

This troika of financial statements constitutes the bedrock of a financial report. At a minimum, every financial report should include these three financial statements and their footnotes. (Caution: Smaller private businesses are notoriously skimpy on their footnotes.)

The three primary statements, plus footnotes to the financials and other content, are packaged in an annual financial report that is distributed to the company’s investors and lenders so they can keep tabs on the business’s financial health and performance. Abbreviated versions of their annual reports are distributed quarterly by public companies, as required by federal securities laws. Private companies do not have to provide interim financial reports, though many do. In this chapter, I shine a light on the process of preparing the annual financial report so you can recognize key decisions that must be made before a financial report hits the streets.

Keeping in mind the reasons for financial reports

A financial report is designed to answer certain basic financial questions:

• Is the business making a profit or suffering a loss, and how much?
• How do assets stack up against liabilities?
• Where did the business get its capital, and is it making good use of the money?
• What is the cash flow from the profit or loss for the period?
• Did the business reinvest all its profit or distribute some of the profit to owners?
• Does the business have enough capital for future growth?

People should read a financial report like a road map: to point the way and check how the trip is going. Managing and putting money in a business is a financial journey. A manager is like the driver and must pay attention to all the road signs; investors and lenders are like the passengers who watch the same road signs. Some of the most important road signs are the ratios between sales revenue and expenses and their related assets and liabilities in the balance sheet.

In short, the purpose of financial reporting is to deliver important information that the lenders and owners of the business need and are entitled to receive. Financial reporting is part of the essential contract between a business and its lenders and investors. Although lawyers may not like this, the contract can be stated in a few words:

Give us your money, and we’ll give you the information you need to know regarding how we’re doing with your money.

Financial reporting is governed by statutory and common law, and it should abide by ethical standards. Unfortunately, financial reporting sometimes falls short of both legal and ethical standards.

Businesses assume that the readers of the financial statements and other information in their financial reports are knowledgeable about business and finance in general and understand basic accounting terminology and measurement methods. Financial reporting practices, in other words, take a lot for granted about readers of financial reports. Don’t expect to find friendly hand-holding and helpful explanations in financial reports. I don’t mean to put you off, but reading financial reports is not for the faint of heart. You need to sit down with a cup of coffee (or something stronger) and be ready for serious concentration.

Footnotes: Nettlesome but needed

Footnotes are attached to the three primary financial statements and are usually placed at the end of the financial statements. Within the financial statements, you see references to particular footnotes. And at the bottom of each financial statement, you find the following sentence (or words to this effect): “The footnotes are integral to the financial statements.”

You should read all footnotes for a full understanding of the financial statements, although I should mention that some footnotes are dense and technical. For one exercise, try reading a footnote that explains how a public corporation puts the value on its management stock options in order to record the expense for this component of management compensation. Then take two aspirin to get rid of your headache.

Footnotes come in two types:

• One or more footnotes identify the major accounting policies and methods that the business uses. The business must reveal the principal accounting methods it uses for booking its revenue and expenses. In particular, the business must identify its cost of goods sold and depreciation expense methods. Some businesses have unusual problems regarding the timing for recording sales revenue, and a footnote should clarify their revenue recognition method. Other accounting methods that have a material impact on the financial statements are disclosed in footnotes as well. (Chapter 8 explains that a business must choose among alternative accounting methods for recording revenue and expenses and for their corresponding assets and liabilities.)
• Other footnotes provide additional information and details for many assets and liabilities. For example, a business may owe money on many short-term and longer-term debt issues; a footnote presents a schedule of maturity dates and interest rates of the debt issues. Details about stock option plans for executives are the main type of footnote for the capital stock account in the stockholders’ equity section of the balance sheet of corporations.

Some footnotes are always required; a financial report would be naked without them. Deciding whether a footnote is needed (after you get beyond the obvious ones disclosing the business’s accounting methods) and how to write the footnote is largely a matter of judgment and opinion. The general benchmark is whether footnote information is relevant to the investors and creditors of the business. But how relevant? This is the key question. For public companies, keep in mind that the SEC lays down specific requirements regarding disclosures in the quarterly and annual filings with the SEC.

Look at the following footnote from Caterpillar’s annual report. For your reading pleasure, here’s footnote D in its 2014 annual 10-K report filed with the SEC (page A-13):

• D. Inventories: Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 60% of total inventories at December 31, 2014, 2013, and 2012.
• If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,430 million, $2,504 million and $2,750 million higher than reported at December 31, 2014, 2013, and 20012 respectively.

Yes, these dollar amounts are in millions of dollars. Caterpillar’s inventory cost value for its inventories at the end of 2014 would have been $2,430 million (or $2.43 billion) higher if the FIFO accounting method had been used. Of course, it helps to have to have a basic understanding of the difference between the two accounting methods — LIFO and FIFO — to make sense of this note (see Chapter 8).

You may wonder how different Caterpillar’s annual profits would have been if the FIFO cost of goods sold expense accounting method had been in use. A business’s managers can ask its accounting department to do this analysis, but as an outside investor, you would have to compute these amounts yourself (assuming you had all the necessary information). Businesses disclose their accounting methods, but they don’t disclose how different annual profits would have been if alternative methods had been used.

Other disclosures in financial reports

The following discussion includes a fairly comprehensive list of the various types of disclosures (in addition to footnotes) found in annual financial reports of publicly owned businesses. A few caveats are in order:

• Not every public corporation includes every one of the following items, although the disclosures are fairly common.
• The level of disclosure by private businesses — after you get beyond the financial statements and footnotes — is generally much less than in public corporations. A private business may include one or more of the following disclosures, but by and large, it isn’t required to do so — and in my experience, only a minority do.
• Tracking the actual disclosure practices of private businesses is difficult because their annual financial reports are circulated only to their owners and lenders. In other words, a private business keeps its financial report as private as possible.

In addition to the three financial statements and footnotes to the financials, public corporations typically include the following disclosures in their annual financial reports to their stockholders:

• Cover (or transmittal) letter: A letter from the chief executive of the business to the stockholders, which usually takes credit for good news and blames bad news on big government, unfavorable world political developments, a poor economy, or something else beyond management’s control
• Management’s report on internal control over financial reporting: An assertion by the chief executive officer and chief financial officer regarding their satisfaction with the effectiveness of the internal controls of the business, which are designed to ensure the reliability of its financial reports and to prevent financial and accounting fraud
• Highlights table: A table presenting key figures from the financial statements, such as sales revenue, total assets, profit, total debt, owners’ equity, number of employees, and number of units sold (such as the number of vehicles sold by an automobile manufacturer or the number of “revenue seat miles” flown by an airline, meaning one airplane seat occupied by a paying customer for 1 mile); the idea is to give the stockholder a financial thumbnail sketch of the business
• Management discussion and analysis (MD&A): A discussion of the major developments and changes during the year that affected the financial performance and situation of the business (by the way, the SEC requires this disclosure to be included in the annual financial reports of publicly owned corporations)
• Segment information: A report of the sales revenue and operating profits (before interest and income tax and perhaps before certain costs that cannot be allocated among different segments) for the major divisions of the organization or for its different markets (international versus domestic, for example)
• Historical summaries: A financial history that extends back three years or longer that includes information from past financial statements
• Graphics: Bar charts, trend charts, and pie charts representing financial conditions; photos of key people and products

• Promotional material: Information about the company, its products, its employees, and its managers, often stressing an overarching theme for the year

  Most companies use their annual financial report as an advertising or public relations opportunity.

• Profiles: Information about members of top management and the board of directors

  Of course, everyone appears to be well-qualified for his or her position. Negative information (such as prior brushes with the law) is not reported. One interesting development in recent years is that several high-level executives have lied about their academic degrees.

• Quarterly summaries of profit performance and stock share prices: Summaries that show financial performance for all four quarters in the year and stock price ranges for each quarter (required by the SEC for public companies)

• Management’s responsibility statement: A short statement indicating that management has primary responsibility for the accounting methods used to prepare the financial statements, for writing the footnotes to the statements, and for providing the other disclosures in the financial report

  Usually, this statement appears near the independent CPA auditor’s report.

• Independent auditor’s report: The report from the CPA firm that performed the audit, expressing an opinion on the fairness of the financial statements and accompanying disclosures

  Public corporations are required to have audits; private businesses may or may not have their annual financial reports audited. Unfortunately, the wording of audit reports has become more and more difficult to understand. The standards that govern CPA audit reports have mimicked the trend of accounting and financial reporting standards. Audit reports used to be three paragraphs that you could understand with careful reading. Even I can’t be sure about some audit reports I read these days.

• Company contact information: Information on how to contact the company, the web address of the company, how to get copies of the reports filed with the SEC, the stock transfer agent and registrar of the company, and other information

I should mention that annual financial reports have virtually no humor — no cartoons, no one-liners, no jokes. (Well, the CEO’s letter to shareowners may have some humorous comments, even when the CEO doesn’t mean to be funny.) Financial reports are written in a somber and serious vein. The tone of most annual financial reports is that the fate of the Western world depends on the financial performance of the company. Gimme a break!

Managers of public corporations rely on lawyers, CPA auditors, and their financial and accounting officers to make sure that everything that should be disclosed in the business’s annual financial reports is included and that the exact wording of the disclosures is not misleading, inaccurate, or incomplete. This is a tall order.

Both federal and state laws, as well as authoritative accounting standards, have to be observed in financial report disclosures. Inadequate disclosure is just as serious as using wrong accounting methods for measuring profit and for determining values for assets, liabilities, and owners’ equity. A financial report can be misleading because of improper accounting methods or because of inadequate or misleading disclosure. Both types of deficiencies can lead to nasty lawsuits against the business and its managers.

Window dressing: Pumping up the ending cash balance and cash flow

Suppose you manage a business and your controller has just submitted for your review the preliminary, or first draft, of the year-end balance sheet. (Chapter 6 explains the balance sheet, and Figure 6-2 shows a balance sheet for a business.) Figure 9-1 shows the current assets and current liabilities sections of the balance sheet draft, which is all we need here.

Wait a minute: a $10 cash balance? How can that be? Maybe your business has been having some cash flow problems and you’ve intended to increase your short-term borrowing and speed up collection of accounts receivable to help the cash balance. No one likes to see a near-zero cash balance — it makes them kind of nervous, to put it mildly, no matter how you try to cushion it. So what do you do to avoid setting off alarm bells?

Your controller is probably aware of a technique called window dressing, a very simple method for making the cash balance look better. Suppose your fiscal year-end is October 31. Your controller takes the cash collections from customers paying their accounts receivable that are actually received on November 1, 2, 3, and 4 and records these four days of cash receipts as if these cash collections had been received on October 31. After all, the argument can be made that the customers’ checks were in the mail — that money is yours, as far as the customers are concerned.

Window dressing reduces the amount in accounts receivable and increases the amount in cash the same amount — it has no effect on your profit figure for the period. It makes your cash balance look a touch better. Window dressing can also be used to improve other accounts’ balances, which I don’t go into here. All these techniques involve holding the books open to record certain events that take place after the end of the fiscal year (the ending balance sheet date) to make things look better than they actually were at the close of business on the last day of the year.

Sounds like everybody wins, doesn’t it? You look like you’ve done a better job as manager, and your lenders and investors don’t panic. Right? Wrong! Window dressing is deceptive to your creditors and investors, who have every right to expect that the end of your fiscal year as stated on your financial reports is truly the end of your fiscal year. I should mention, however, that when I was in auditing, I encountered situations in which a major lender of the business was fully aware that it had engaged in window dressing. The lender did not object because it wanted the business to fluff the pillows to make its balance sheet look better. The loan officer wanted to make the loan to make the business look better. Essentially, the lender was complicit in the accounting manipulation.

Window dressing can be the first step on a slippery slope. A little window dressing today, and tomorrow, who knows? Maybe giving the numbers a nudge now will lead to more serious accounting deceptions or even out-and-out accounting fraud. Moreover, when a business commits some accounting hanky-panky, should the chief executive of the business brief its directors on the accounting manipulation? Things get messy, to say the least!

Be aware that window dressing improves cash flow from operating activities, which is an important number in the statement of cash flows that creditors and investors closely watch. (I discuss the statement of cash flows and cash flow from operating activities in Chapter 7.) Suppose, for example, that a business holds open its cash receipts journal for several days after the close of its fiscal year. The result is that its ending cash balance is reported $3.25 million higher than the business actually had in its checking accounts on the balance sheet date. Also, its accounts receivable balance is reported $3.25 million lower than was true at the end of its fiscal year. This makes cash flow from profit (operating activities) $3.25 million higher, which could be the main reason in the decision to do some window dressing.

Smoothing the rough edges off year-to-year profit fluctuations

You shouldn’t be surprised when I tell you that business managers are under tremendous pressure to make profit and keep profit on the up escalator year after year. Managers strive to make their numbers and to hit the milestone markers set for the business. Reporting a loss for the year, or even a dip below the profit trend line, is a red flag that stock analysts and investors view with alarm. Everyone likes to see a steady upward trend line for profit; no one likes to see a profit curve that looks like a roller coaster. Most investors want a smooth journey and don’t like putting on their investment life preservers.

Managers can do certain things to deflate or inflate profit (net income) recorded in the year, which are referred to as profit smoothing techniques. Other names for these techniques are income smoothing and earnings management. Profit smoothing is like a white lie told for the good of the business and perhaps for the good of managers as well. Managers know that there’s always some noise in the accounting system. Profit smoothing muffles the noise.

The general view in the financial community is that profit smoothing is not nearly as serious as cooking the books, or juggling the books. These terms refer to deliberate, fraudulent accounting practices such as recording sales revenue that hasn’t happened or not recording expenses that have happened. Nevertheless, profit smoothing is still serious and, if carried too far, could be interpreted as accounting fraud. Managers have gone to jail for fraudulent financial statements.

Theoretically, having an audit by a CPA firm should root out any significant accounting fraud when the business is knowingly perpetrating the fraud or when it’s an innocent victim of fraud against the business. But in fact, there continue to be many embarrassing cases in which the CPA auditor failed to discover major fraud by or against the business. I could write a whole book on accounting fraud and not worry about running out of material. Several books have been published on this topic, which you can find by using the search words “accounting fraud” or “cooking the books” in your search engine. I would recommend Forensic Accounting For Dummies (Wiley) by Frimette Kass-Shraibman and Vijay Sampath.

Reports from publicly owned companies

Around 10,000 corporations in the United States are publicly owned, and their stock shares are traded on the New York Stock Exchange, NASDAQ, or other electronic stock markets. Publicly owned companies must file annual financial reports with the SEC — the federal agency that makes and enforces the rules for trading in securities (stocks and bonds). These filings are available to the public on the SEC’s huge database (see the sidebar “Financial reporting on the Internet”).

The annual financial reports of publicly owned corporations include most of the disclosure items I list earlier in the chapter (see the section “Making Sure Disclosure Is Adequate”). As a result, annual reports published by large publicly owned corporations run 30, 40, or 50 pages (or more). As I’ve mentioned before, the large majority of public companies make their annual reports available on their websites. Many public companies also present condensed versions of their financial reports — see the section “Recognizing condensed versions” later in this chapter.

Annual reports from public companies generally are very well done — the quality of the editorial work and graphics is excellent; the color scheme, layout, and design have good eye appeal. But be warned that the volume of detail in their financial reports is overwhelming. (See the next section for advice on dealing with the information overload in annual financial reports.)

Publicly owned businesses live in a fish bowl. When a company goes public with an IPO (initial public offering of stock shares), it gives up a lot of the privacy that a closely held business enjoys. A public company is required to have its annual financial report audited by an independent CPA firm. In doing an audit, the CPA passes judgment on the company’s accounting methods and adequacy of disclosure. The CPA auditor has a heavy responsibility to evaluate the client’s internal controls to prevent financial reporting fraud.

Reports from private businesses

Compared with their public brothers and sisters, private businesses generally issue less impressive annual financial reports. Their primary financial statements with accompanying footnotes are pretty much it for most small private businesses. Often, their financial reports may be printed on plain paper and stapled together. A privately held company may have few stockholders, and typically one or more of the stockholders are active managers of the business, who already know a great deal about the business. I suppose that a private company could email its annual financial report to its lenders and shareowners, although I haven’t seen this.

Investors in private businesses have one potential advantage compared with public companies. They can request confidential information from managers at the annual stockholders’ meetings (which isn’t practical for a stockholder in a large public corporation). The annual stockholders meeting of a private business is not open to the public, so information can be kept private. Also, major lenders to a private business can demand that certain items of information be disclosed to them on a confidential basis as a condition of the loan.

Up to the present, we have had one set of accounting and financial reporting standards for all businesses, large and small, public and private. However, the blunt truth of the matter is that smaller private companies do not comply fully with all the disclosure requirements that public companies have to comply with. The business and financial communities at large have accepted the “subpar” financial reporting practices of smaller private businesses. Perhaps the recently established Private Company Council (see Chapter 2) will recommend adopting less-demanding disclosure rules by private companies. Or they might leave well enough alone.

A private business may have its financial statements audited by a CPA firm but generally is not required by law to do so. Frankly, CPA auditors cut private businesses a lot of slack regarding disclosure. I don’t entirely disagree with enforcing a lower standard of disclosure for private companies. The stock share market prices of public corporations are extremely important, and full disclosure of information should be made publicly available so that market prices are fairly determined. On the other hand, you could argue that the ownership shares of privately owned businesses are not traded, so there’s no urgent need for a complete package of information.

Browsing based on your interests

How do investors in a business deal with the information overload of annual financial reports? Very few persons take the time to plow through every sentence, every word, every detail, and every number on every page — except for those professional accountants, lawyers, and auditors directly involved in the preparation and review of the financial report. It’s hard to say how most managers, investors, creditors, and others interested in annual financial reports go about dealing with the massive amount of information — very little research has been done on this subject. But I have some observations to share with you.

An annual financial report is like the Sunday edition of a large city newspaper, such as The New York Times or the Los Angeles Times. Hardly anyone reads every sentence on every page of these Sunday papers, much less every word in the advertisements — most people pick and choose what they want to read. They browse their way through the paper, stopping to read only the particular articles or topics they’re interested in. Some people just skim through the paper. Some glance at the headlines. I think most investors read annual financial reports like they read Sunday newspapers. The complete information is there if you really want to read it, but most readers pick and choose which information they have time to read in depth.

Annual financial reports are designed for archival purposes, not for a quick read. Instead of addressing the needs of investors and others who want to know about the profit performance and financial condition of the business but have only a limited amount of time, accountants produce an annual financial report that is a voluminous financial history of the business. Accountants leave it to the users of annual reports to extract the main points. Financial statement readers use certain key ratios and other tests to get a feel for the financial performance and position of the business. (Chapters 10 and 16 explain how readers of financial reports get a fix on the financial performance and position of a business.)

Recognizing condensed versions

Here’s a well-kept secret: Many public businesses and nonprofit organizations don’t send a complete annual financial report to their stockholders or members. They know that few persons have the time or the technical background to read thoroughly the full-scale financial statements, footnotes, and other disclosures in their comprehensive financial reports. So they present relatively brief summaries that are boiled-down versions of their complete financial reports. For example, my retirement fund manager, TIAA-CREF, puts out only financial summaries to its participants and retirees. Also, AARP issues condensed financial reports to its members.

Typically, these summaries — called condensed financial statements — do not provide footnotes or the other disclosures that are included in the complete and comprehensive annual financial reports. If you really want to see the official financial report of the organization, you can ask its headquarters to send you a copy (or, for public corporations, you can go to the SEC database — see the earlier sidebar “Financial reporting on the Internet”).

Using other sources of business information

Keep in mind that annual financial reports are only one of several sources of information to owners, creditors, and others who have a financial interest in the business. Annual financial reports, of course, come out only once a year — usually two months or so after the end of the company’s fiscal (accounting) year. You should keep abreast of developments during the year by reading the quarterly reports of the business. Also, I’d advise you to follow the businesses you invest in by reading the financial press and watching TV programs. And it’s a good idea to keep up with blogs about the companies on the Internet, subscribe to newsletters, and so on. Financial reports present the sanitized version of events; they don’t divulge scandals about the business. You have to find out the negative news about a business by the means I just mentioned.

Not everything you may like to know as an investor is included in the annual financial report. For example, information about salaries and incentive compensation arrangements with the top-level managers of the business are disclosed in the proxy statement, not in the annual financial report. A proxy statement is the means by which the corporation solicits the vote of stockholders on issues that require stockholder approval — one of which is compensation packages of top-level managers. Proxy statements are filed with the SEC and are available on its database.