How to find the truth in an annual report

Companies may try to mask poor earnings or other problems, but you don't need an accounting degree to get the real story.

By Leslie Kane
Senior Editor

Business is up, and next year profits will soar! At least, that's what the annual reports distributed by many companies want you to believe. To uncover the company's real performance and prospects, you have to know what to look for.

"After the Enron scandal, most companies don't wish to actively mislead consumers," says David Forbes, a financial adviser with Petra Financial Advisors in Colorado Springs. "But they may stretch the limits of candor in their annual reports.

"To get the true picture, examining the profit and loss statement and sales and earnings figures are critical, but you can also gain key information from the chairman's report to shareholders, the auditor's report, and the footnotes," he says. "The trick is to cut through the corporate jargon and euphemisms."

Comparing a company's prior annual reports with the latest one will help you pick up on trends. Notice whether sales and profits have been consistently heading up or down, or whether the company changes its strategy every year.

Examining annual reports from competing companies also helps, says Forbes. This will let you put your company's position in the industry into perspective.

Here's where to look for other telling information:

The letter to shareholders. "The chairman should tell you how his company fared this year, and why," says Forbes. "Did the events or developments that he predicted last year happen? If not, look for honest disclosures.

"A forthright company will be specific: 'Last year we failed to meet our goals. Here's why, and here's our planned response,' " says Forbes. A prepared response shows that management is on top of the situation, he adds.

Be wary of amorphous phrases, such as, "We are very encouraged about future revenue and sales, and our current results don't truly reflect the increased sales we anticipate." That's nothing more than a rally speech, says Joel Rosenberg, an accountant with Price and Rosenberg CPAs in Bardonia, NY. "The chairman may be camouflaging negative results. There's no guarantee that sales will increase; he's trying to make the situation look good."

"We had a challenging year" usually means a decline in sales and profits. And sentences that start with "Except for . . ." and "Despite the . . ." often are clues to problems. Be cautious if you sense that the company's trying to gloss over events that occurred, says Forbes.

Who signed the letter to the shareholders? Was it the chairman or the chief executive officer, who reports to the chairman? "The chairman has fiduciary duty to the shareholders," says Forbes. "If the report is from the CEO instead, I'd wonder if it's because the chairman is uncomfortable with the company results."

Directors' bios. Read the board members' biographies and work affiliations, often found in the footnotes or near the chairman's report. The fewer company executives on the board of directors, the better; an independent board is more likely to represent the shareholders' interests and provide a check on senior management. Having executives on the board may not create problems, but you should take it into account.

Auditor's report. Here, the accounting firm attests that the financial information presented adheres to specified accounting rules. "If the firm includes many disclaimers, it has found things in the company's books that it feels it needs to alert the public about," says Rosenberg. "The auditors should give a clean, unqualified opinion stating that, to the best of their knowledge, the numbers are accurate. If they qualify the opinion, every hair on your body should stand on end."

Rosenberg gives these examples of suspicious statements: "Because of inherent limitations in any internal control, errors or irregularities may occur and not be detected," or "As discussed in note (X), the organization has suffered significant reduction in revenues that raises substantial doubt as to the viability of the company as a continuing entity."

Financial data. Before tackling the numbers, notice whether the income statement is the first table presented. If not, says Forbes, the company may be trying to downplay the information contained in it.

A couple of key numbers can reveal volumes. Look at net sales. Are they going up at a faster rate or at least the same rate as they did the previous year? If sales increases have slowed, look for an explanation.

Also, compare the sales figures with those for inventories and receivables. If inventories are increasing more than sales, the company's producing more than it's selling. If receivables are rising more, the company isn't collecting payments effectively.

Footnotes. Make sure you read these, says Gene Price, an accountant with Price and Rosenberg CPAs. "Footnotes can show that the earnings or other figures may actually be quite different from what they appear to be," says Price.

"The footnotes might disclose, for instance, whether the company's sales are coming from one major customer," says Rosenberg. "If they are, then problems with that customer could mean big trouble for the company."

Check to see if the company has taken "special charges." Those are one-time expenses that it can remove from the earnings computation. For example, if a company lost $10 million in a venture that went kaput or spent $8 million restructuring two of its divisions, it may remove those costs from its income statement, making profits appear higher.

Don't get too riled over a single special charge. But if the company takes special charges consistently, it's playing with business costs to prop up the profit picture, says Rosenberg. "Auditors may segregate extraordinary charges from normal operating income. But if these special charges are not one-shot items, and seem to be constantly recurring, assume that the true earnings are lower than reported."

Also look for references to changes in accounting methods or inventory valuation, new or changed government regulations, debt realignment, litigation results, or forecasts of potential union problems says Rosenberg.

Finally, if you're puzzled by anything you read in a company's annual report, call its investor relations department for clarification, says Rosenberg. Or, ask your accountant to interpret balance sheet figures and explain how the footnote information affects the numbers—and, most important, what they mean to you as an investor.

 

Leslie Kane. How to find the truth in an annual report. Medical Economics Jun. 6, 2003;80:47.