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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 l.jpg

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 l.jpg
How Companies Manipulate Financial Reporting: a Few Loose Screws

  • 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


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Problems with Auditors a Few Loose Screws

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 l.jpg
But. . .are auditors truly independent? a Few Loose Screws

  • 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


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Problems with Analysts a Few Loose Screws

  • 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 l.jpg
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


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Corporate Financial Statements statements for important decisions?

  • 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


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Authorities Primarily Responsible for Establishing GAAP statements for important decisions?

  • 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 l.jpg
SEC (Public Sector) statements for important decisions?

  • Regulates companies that issue securities to the public

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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SEC Requires: statements for important decisions?

  • 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


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FASB (Private Sector) statements for important decisions?

  • Issues

    • Statements of Financial Accounting Standards

    • Interpretations

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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The SEC statements for important decisions?

  • Relies on FASB for most accounting rule-making in U.S.

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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What’s in an Annual Report? statements for important decisions?(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 l.jpg
Financial Statements in an Annual Report: statements for important decisions?

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


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Annual Report Content statements for important decisions? 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


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What’s Actually Required? statements for important decisions?

  • 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


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Other Material? statements for important decisions?

  • Presented at the discretion of management

  • Packaged to make company appealing

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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Watch for a New Financial Ratio statements for important decisions?

  • 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


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Statement of Earnings statements for important decisions?(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


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Statement of Financial Position statements for important decisions?(Balance Sheet)

  • Presents

    • assets

    • liabilities

    • shareholders’ equity

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


Statement of shareholders equity l.jpg
Statement of statements for important decisions?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 l.jpg
Statement of Cash Flows statements for important decisions?

  • Provides information about inflows & outflows of cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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Notes to Financial Statements statements for important decisions?

  • 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


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More on Notes. . . statements for important decisions?

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 l.jpg
Examples of Financial Statement Notes statements for important decisions?

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


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More Examples of Notes statements for important decisions?

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


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And Even More Notes. . . statements for important decisions?

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


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Notes. . . statements for important decisions?

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


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The Last of the Notes. . . statements for important decisions?

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


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The Auditors’ Report statements for important decisions?

  • 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 l.jpg
The Unqualified Report states: statements for important decisions?

  • 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 l.jpg
Unqualified Opinion with Explanatory Language statements for important decisions?

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 l.jpg
Qualified Report statements for important decisions?

Used where there is a

  • Departure from GAAP

  • Scope limitation

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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Management Discussion & Analysis (MD&A) statements for important decisions?

  • 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


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MD&A Covers: statements for important decisions?

  • 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


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Limits to Usefulness of MD&A: statements for important decisions?

  • It is management’s “take” on the company’s situation

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing


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Five-Year Summary & statements for important decisions?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


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Market Price Data statements for important decisions?

  • 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 l.jpg
Enron’s 1996 Annual Report Problems statements for important decisions?

  • 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


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Caution Flags: statements for important decisions?

  • 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 l.jpg
More Caution Flags. . . statements for important decisions?

  • 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


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Even More Caution Flags. . . statements for important decisions?

  • 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


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Still More Caution Flags: statements for important decisions?

  • Numerous unquantified contingencies & commitments

  • Company puts name on sports arena

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing