Reading Financial Reports for Dummies (7 page)

By 2008, more than 100 countries agreed to accept the International Financial Reporting Standards (IFRS; see Chapter 20) developed by the London-based International Accounting Standards Board (IASB). Beginning in 2002, the U.S.

agreed to look at ways to converge the IFRS and the U.S. GAAP (see Chapter 18). The U.S. is on track to allow companies to file required reports using either U.S. GAAP or IFRS by 2011.

Staying within the walls of the

company: Internal reporting

Not all an accounting department’s financial reporting is done for public consumption. In fact, companies usually produce many more internal reports than external ones to keep management informed. Firms can design their internal reports in whatever way makes sense to their operations.

Each department head usually receives a report from the top managers showing the department’s expenses and revenue and whether it’s meeting its budget. If the department’s numbers vary significantly from the amount that was budgeted, the report indicates red flags. The department head usually needs to investigate the differences and report what the department is doing to correct any problems. Even if the difference is increased revenue (which can be good news), the manager still needs to know why the difference exists, because an error in the data input could have occurred. I talk more about reports and budgeting in Chapter 14.

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Part I: Getting Down to Financial Reporting Basics
Reports on inventory are critical, not only for managing the products on hand but also for knowing when to order new inventory. I talk more about inventory controls and financial reporting in Chapter 15.

Tracking cash is vital to the day-to-day operations of any company. The frequency of a company’s cash reporting depends on the volatility of its cash status — the more volatile the cash, the more likely the company needs frequent reporting to be sure that it has cash on hand to pay its bills. Some large firms actually provide cash reporting to their managers daily. I talk more about cash reporting in Chapters 16 and 17; Chapter 16 focuses on incoming cash, and Chapter 17 deals with outgoing cash.

Finding the roots of financial reporting

Accounting practices can be traced back to

borrowed money to get into the market,

the Renaissance, but financial reporting wasn’t

paying higher and higher prices for stock.

recognized as a necessity until centuries later.

Sound familiar? Not too different from what

✓

occurred just before the 2000 crash of tech-

1494:
Italian monk Luca Pacioli became

nology and Internet stocks.

known as the “father of accounting” for

his book
Everything about Arithmetic,
✓
1933–1934:
Congress created the SEC

Geometry and Proportions,
which includes

and gave it authority to develop financial

a section on double-entry accounting (see

accounting and reporting standards and

Chapter 4). Pacioli warned his readers that

rules that would deter companies from dis-

an accountant shouldn’t go to sleep at night

tributing misleading information.

until his debits equal his credits.

✓
1973:
The Financial Accounting Standards

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1700–1800:
For-profit corporations started

Board (FASB) was created to establish

to appear in Europe as early as the 18th

standards for financial accounting and

century. In 1800, only about 330 corpora-

reporting. The SEC recognized the gener-

tions operated in the U.S.

ally accepted accounting principles (GAAP)

✓

as the official reporting standards for fed-

1800s:
As public ownership of stock

eral securities laws.

increased, regulators realized that some

standardized distribution of information ✓
1984:
The FASB formed the Emerging Issues to investors was a priority. The New York

Task Force, which keeps an eye on changes

Stock Exchange was the first to jump into

in business operations and sets standards

the fray, and in 1853, it began requiring

before new practices become entrenched.

companies listed on the exchange to pro-

✓
2002:
The FASB began work with the

vide statements of shares outstanding and

International Accounting Standards Board

capital resources.

(IASB) to converge international financial

✓
1929:
Before the stock market crash,

reporting systems.

equity investing became a passion. People

Chapter 1: Opening the Cornucopia of Reports

17

Dissecting the Annual Report

to Shareholders

The annual report gives more details about a company’s business and financial activities than any other report. This document is primarily for shareholders, although any member of the general public can request a copy.

Glossy pictures and graphics fill the front of the report, highlighting what the company wants you to know. After that, you find the full details about the company’s business and financial operations; most companies include the full 10-K that they file with the SEC.

Breaking down the parts

The annual report is broken into the following parts (I summarize the key points of each of these parts in Chapter 5):

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Highlights:
These are a narrative summary of the previous year’s activities and general information about the company, its history, its products, and its business lines.

✓

Letter from the president or chief executive officer (CEO):
This is a letter directed to the shareholders that discusses the company’s key successes or explains any major failures.

✓

Auditors’ report:
This is a report that tells you whether the numbers are accurate or whether you should have any concerns about the future operation of the business.

✓

Management’s discussion and analysis:
In this part, you find a management discussion of the financial results and other factors that impact the company’s operations.

✓

Financial statements:
The key financial statements are the balance sheet, income statement, and statement of cash flows. In the financial statements, you find the actual financial results for the year. For details about this part of the report, check out the following section, “The meat of the matter.”

✓

Notes to the financial statements:
In the notes, you find details about how the numbers were derived. I talk more about the role of the notes in Chapter 9.

✓

Other information:
In this part, you find information about the company’s key executives and managers, officers, board members, locations, and new facilities that have opened in the past year.

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Part I: Getting Down to Financial Reporting Basics
The meat of the matter

No doubt, the most critical part of the annual report for those who want to know how well a company did financially is the financial statements section, which includes the balance sheet, the income statement, and the statement of cash flows.

The balance sheet

The
balance sheet
gives a snapshot of the company’s financial condition. On a balance sheet, you find assets, liabilities, and equity. The balance sheet got its name because the total assets must equal the total liabilities plus the total equities so that the value of the company is in balance. Here’s the equation: Assets = Liabilities + Equities

Assets are shown on the left side of a balance sheet, and liabilities and equities are on the right side. Assets are broken down into
current assets
(holdings that the company will use in the next 12 months, such as cash and savings)
and
long-term assets
(holdings that the company will use longer than a 12-month period, such as buildings, land, and equipment).

Liabilities are broken down into
current
liabilities
(payments on bills or debts that are due in the next 12 months)
and
long-term liabilities
(payments on debt that are due after the next 12 months).

The equities portion of the balance sheet can be called
owner’s equity
(when an individual or partners closely hold a company) or
shareholders’ equity
(when shares of stock have been sold to raise cash). I talk more about what information goes into a balance sheet in Chapter 6.

The income statement

The
income statement,
also known as the
profit and loss statement
(P&L),
gets the most attention from investors. This statement shows a summary of the financial activities of one quarter or an entire year. Many companies prepare P&Ls on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: revenue, net income, and earnings per share of stock.

In the income statement, you also find out how much the company is spending to produce or purchase the products or services it sells, how much the company costs to operate, how much it pays in interest, and how much it pays in income tax. To find out more about the information you can find on an income statement, go to Chapter 7.

Chapter 1: Opening the Cornucopia of Reports

19

The statement of cash flows

The
statement of cash flows
is relatively new to the financial reporting game.

The SEC didn’t require companies to file it with the other financial reports until 1988. Basically, the statement of cash flows is similar to the income statement in that it reports a company’s performance over time. But instead of focusing on profit or loss, it focuses on how cash flows through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. I talk more about the statement of cash flows in Chapter 8.

How the number crunchers are kept in line

Every public company’s internal accounting team and external audit team must answer to government entities. The primary government entity responsible for overseeing corporate reporting is the SEC. Reports filed with the SEC

are reviewed by its staff. If SEC employees have any questions or want additional information, they notify the company after the reports are reviewed.

Financial statements filed with the SEC and for public consumption must adhere to the
generally accepted accounting principles
(GAAP)
.
To meet the demands of these rules, financial reporting must be relevant, reliable, consistent, and presented in a way that allows the report reader to compare the results to prior years, as well as to other companies’ financial results. To find out more about GAAP, turn to Chapter 18.

With GAAP in place, you may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years. Filing statements according to GAAP has become a game for many companies. Unfortunately, investors and regulators find that companies don’t always engage in transactions for the economic benefit of the shareholders but sometimes do so to make their reports look better and to meet the quarterly expectations of Wall Street. Many times, companies look financially stronger than they actually are. For example, as scandals have come to light, companies have been found to overstate income, equity, and cash flows while understating debt. I talk more about reporting problems in Chapter 23.

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Part I: Getting Down to Financial Reporting Basics
Chapter 2

Recognizing Business Types

and Their Tax Rules

In This Chapter

▶ Exploring sole proprietorships

▶ Taking a look at partnerships

▶ Checking out limited liability companies

▶ Comparing different types of corporations

All businesses need to prepare key financial statements, but some businesses can make less formal statements than others. The way a business is legally organized greatly impacts the way it must report to the public and the depth of that reporting. For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and as more and more outsiders — such as investors and creditors — become involved, financial reporting becomes more formalized until the company reaches the point where audited financial statements are required.

Each business structure also follows a different set of rules about what financial information the business must file with state, local, and federal agencies.

In this chapter, I review the basics about how each type of business structure is organized, how taxation differs, which forms must be filed, and what types of financial reports are required.

Flying Solo: Sole Proprietorships

The simplest business structure is the
sole proprietorship
—
the IRS’s automatic classification for any business started by an individual. Most new businesses with only one owner start out as sole proprietorships. Some never grow into anything larger. Others start adding partners and staff and may 22
Part I: Getting Down to Financial Reporting Basics
realize that incorporating is a wise decision for legal purposes. (Check out

“Seeking Protection with Limited Liability Companies” and “Shielding Your Assets: S and C Corporations,” later in the chapter, to find out more about incorporating.)

To start a business as a sole proprietor, you don’t have to do anything official like file government papers or register with the IRS. In fact, unless you formally
incorporate
— follow
a process that makes the business a separate legal entity — the IRS considers the business a sole proprietorship. (I talk more about incorporation and the process of forming corporations in the upcoming section, “Shielding Your Assets: S and C Corporations.”) The fact that the business isn’t a separate legal entity is the biggest risk of a sole proprietorship. All debts or claims against the business are filed against the sole proprietor’s personal property. If a sole proprietor is sued, insurance is his only form of protection against losing everything he owns.