Reading Financial Reports for Dummies (10 page)

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New corporate cash:
At some point, a growing company usually maxes out its ability to borrow funds, and it must find people willing to invest in the business. Selling stock to the general public can be a great way for a company to raise cash without being obligated to pay interest on the money.

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Owner diversification:
People who start a new business typically put a good chunk of their assets into starting the business and then reinvest most of the profits in the business in order to grow the company.

Frequently, founders have a large share of their assets tied up in the company. Selling shares publicly allows owners to take out some of their investment and diversify their holdings in other investments, which reduces the risks to their personal portfolios.

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Increased liquidity:
Liquidity
is a company’s ability to quickly turn an asset into cash (if it isn’t already cash). People who own shares in a closely held private company may have a lot of assets but little chance to actually turn those assets into cash. Selling privately owned shares of stock is very difficult. Going public gives the stock a set market value and creates more potential buyers for the stock.

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Company value:
Company owners benefit by knowing their firm’s worth for a number of reasons. If one of the key owners dies, state and federal inheritance tax appraisers must set the company’s value for estate tax purposes. Many times, these values are set too high for private companies, which can cause all kinds of problems for other owners and family members. Going public sets an absolute value for the shares held by all company shareholders and prevents problems with valuation. Also, businesses that want to offer shares of stock to their employees as incentives find that recruiting with this incentive is much easier when the stock is sold on the open market.

Looking at the negative side

Regardless of the many advantages of being a public company, a great many disadvantages also exist:

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Part I: Getting Down to Financial Reporting Basics

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Costs:
Paying the costs of providing audited financial statements that meet the requirements of the SEC or state agencies can be very expensive — sometimes as high as $2 million annually. (I discuss the audit process in greater detail in Chapter 18.) Investor relations can also add significant costs in employee time, printing, and mailing expenses.

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Control:
As stock sells on the open market, more and more shareholders enter the picture, giving each one the right to vote on key company decisions. The original owners and closed circle of investors no longer have absolute control of the company.

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Disclosure:
Although a private company can hide difficulties it may be having, a public company must report its problems, exposing any weaknesses to competitors, who can access detailed information about the company’s operations by getting copies of the required financial reports. In addition, the net worth of a public company’s owners is widely known because their stock holdings must be disclosed as part of these reports.

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Cash control:
In a private company, an owner can decide her own salary and benefits as well as the salary and benefits of any family member or friend involved in running the business. In a public company, the board of directors has to approve and report any major cash withdrawals, whether for salary or loans, to shareholders.

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Lack of liquidity:
When a company goes public, a constant flow of buyers for the stock isn’t guaranteed. In order for a stock to be liquid, a shareholder must be able to convert that stock to cash. Small companies that don’t have wide distribution of their stock can be hard to sell on the open market. The market price may even be lower than the actual value of the firm’s assets because of a lack of competition for shares of the stock. When not enough competition exists, shareholders have a hard time selling the stock and converting it to cash, making the investment nonliquid.

A failed IPO or a failure to live up to shareholders’ expectations can change what may have been a good business for the founders into a bankrupt entity.

Although founders may be willing to ride out the losses for a while, shareholders rarely are. Many IPOs that raised millions before the Internet stock crash in 2000 are now defunct companies.

Filing and more filing: Government

and shareholder reports

Public companies have an unending stream of reports they must file with the SEC. They must file financial reports quarterly as well as annually. They also must file reports after specific events, such as bankruptcy or the sale of a company division.

Chapter 3: Public or Private: How Company Structure Affects the Books
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Quarterly reports

Each quarter, public companies must file audited financial statements on Form 10Q in addition to information about the company’s market risk, controls and procedures, legal proceedings, and defaults on payments.

Yearly report

Each year, public companies must file an annual report with audited financial statements and information about

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Company history:
How the company was started, who started it, and how it grew to its current level of operations

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Organizational structure:
How the company is organized, who the key executives are, and who reports to whom

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Equity holdings:
A list of the major shareholders and a summary of all outstanding stock

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Subsidiaries:
Other businesses that are wholly or partially owned by the company

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Employee stock purchase and savings plans:
Plans that allow employees to own stock by purchasing it or participating in a savings plan

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Incorporation:
Information about where the company is incorporated

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Legal proceedings:
Information about any ongoing legal matters that may be material to the company

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Changes or disagreements with accountants:
Information about financial disclosures, controls and procedures, executive compensation, and accounting fees and services

In addition to the regular reports, public companies must file an 8-K, a form for reporting any major events that could impact the company’s financial position. A major event may be the acquisition of another company, the sale of a company or division, bankruptcy, the resignation of directors, or a change in the fiscal year. A public company must report any event that falls under this requirement on the 8-K to the SEC within four days of the event’s occurrence. I discuss the rules for SEC Form 8-K in greater detail in Chapter 19.

Adhering to the rules of the Sarbanes-Oxley Act

All the scandals about public companies that emerged in the early 2000s have made this entire reporting process riskier and more costly for company owners. In 2002, Congress passed a bill called the Sarbanes-Oxley Act to try to correct some of the problems in financial reporting. This bill passed as details emerged about how corporate officials from companies like Enron, MCI, and Tyco hid information from the SEC.

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Part I: Getting Down to Financial Reporting Basics
Bearing the burden and expense

of Sarbanes-Oxley

Many major corporations already have the inter-

and make the companies private again, or merge

nal controls in place and the documentation

with larger companies, or even liquidate.

that the Sarbanes-Oxley Act requires. Smaller

When a private company thinks about going

companies are going to be harder hit with these

public, it must consider whether the process is

new requirements. The SEC’s only concession

worth the costs. With the new Sarbanes-Oxley

for smaller companies is an extension on when

rules in place, a small company pays close to

they must be in compliance with the new rules

$3 million in legal, accounting, and other costs

on internal controls. All small businesses had to

of being public. Prior to Sarbanes-Oxley, these

be in compliance by November 2004.

costs totaled closer to $2 million. Large corpo-

The rules imposed by Sarbanes-Oxley were such

rations budget over $7 million to cover the costs

a significant burden on small companies that

of being a public company nowadays.

some of them decided to buy out shareholders

New SEC rules issued after the Sarbanes-Oxley Act passed require CEOs and CFOs to certify financial and other information contained in their quarterly and annual reports. They must certify that

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They’ve established, maintained, and regularly evaluated effective disclosure controls and procedures.

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They’ve made disclosures to the auditors and audit committee of the board of directors about internal controls.

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They’ve included information in the quarterly and annual reports about their evaluation of the controls in place, as well as about any significant changes in their internal controls or any other factors that could significantly affect controls after the initial evaluation.

If a CEO or CFO certifies this information, and the information later proves to be false, he can end up facing criminal charges. Since the passage of the Sarbanes-Oxley Act, companies have delayed releasing financial reports if the CEO or CFO has any questions rather than risking charges. You’ll probably hear more about delays in reporting as CEOs and CFOs become more reluctant to sign off on financial reports that may have questionable information. Shareholders often panic when they hear about a delay, and stock prices drop.

Chapter 3: Public or Private: How Company Structure Affects the Books
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The Sarbanes-Oxley Act has added significant costs to the entire process of completing financial reports, affecting the following components:

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Documentation:
Companies must document and develop policies and procedures relating to their internal controls over financial reporting.

Although an outside accounting firm can assist with the documentation process, management must be actively involved in the process of assessing internal controls — they can’t delegate this responsibility to an external firm.

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Audit fees:
Independent audit firms now look a lot more closely at financial statements and internal controls in place over financial reporting, and the SEC’s Public Company Accounting Oversight Board (PCAOB) now regulates the accounting profession. The PCAOB inspects accounting firms to be sure they’re in compliance with the Sarbanes-Oxley Act and SEC rules.

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Legal fees:
Because companies need lawyers to help them comply with the new provisions of the Sarbanes-Oxley Act, their legal expenses are increasing.

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Information technology:
Complying with the Sarbanes-Oxley Act requires both hardware and software upgrades to meet the internal control requirements and the speedier reporting requirements.

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Boards of directors:
Most companies must restructure their board of directors and audit committees to meet the Sarbanes-Oxley Act’s requirements, ensuring that independent board members control key audit decisions. The structure and operation of nominating and compensation committees must eliminate even the appearance of conflicts of interest. Companies must make provisions to give shareholders direct input in corporate governance decisions. Businesses also must provide additional education to board members to be sure they understand their responsibilities to shareholders.

A Whole New World: How a Company

Goes from Private to Public

So the owners of a company have finally decided to sell the company’s stock publicly. Now what? In this section, I describe the role of an investment banker in helping a company sell its stock. I also explain the process of making a public offering.

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Part I: Getting Down to Financial Reporting Basics
Teaming up with an investment banker

The first step after a company decides to go public is to choose who will handle the sales and which market to sell the stock on. Few firms have the capacity to approach the public stock markets on their own. Instead, they hire an investment banker to help them through the complicated process of going public. A well-known investment banker can help lend credibility to a little-known small company, which makes selling the stock easier.

Investment bankers help a company in the following ways:

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They prepare the required SEC documents and register the new stock
offering with the SEC.
These documents must include information about the company (its products, services, and markets) and its officers and directors. Additionally, they must include information about the risks the firm faces; how the business plans to use the money raised; any outstanding legal problems; holdings of company insiders; and, of course, audited financial statements.

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They price the stock so it’s attractive to potential investors.
If the stock is priced too high, the offering could fall flat on its face, with few shares sold. If the stock is priced too low, the company could miss out on potential cash that investors, who buy IPO shares, can get as a windfall from quickly turning around and selling the stock at a profit.

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They negotiate the price at which the stock is offered to the general
public and the guarantees they give to the company owners for selling the stock.
An investment banker can give an
underwriting guarantee,
which guarantees the amount of money that will be raised. In this scenario, the banker buys the stock from the company and then resells it to the public. Usually, an investment banker puts together a syndicate of investment bankers who help find buyers for the stock.

Another method that’s sometimes used is called a
best efforts agreement.