Understanding Business Accounting For Dummies, 2nd Edition (111 page)

Reading the footnotes in annual financial reports is no picnic. The investment pros have to read them because in providing consultation to their clients, they are required to comply with due diligence standards or because of their legal duties and responsibilities of managing other peoples' money.

We suggest you do a quick read-through of the footnotes and identify the ones that seem to have the most significance. Generally, the most important footnotes are those dealing with the following matters:

Share options awarded by the business to its executives:
The additional shares issued under share options dilute (thin out) the earnings per share of the business, which in turn puts downside pressure on the market value of its shares, everything else being the same.

Pending
legal actions, litigation, and investigations by government agencies:
These intrusions into the normal affairs of the business can have enormous consequences.

Segment information for the business:
Most public businesses have to report information for the major segments of the organisation - sales and operating profit by territories or product lines. This gives a better glimpse of the different parts making up the whole business. (However, segment information may be reported elsewhere in an annual financial report than in the footnotes.)

These are just three of the many important pieces of information you should look for in footnotes. But you have to stay alert for other critical matters that a business may disclose in its footnotes - scan each and every footnote for potentially important information. Finding a footnote that discusses a major lawsuit against the business, for example, may make the shares too risky for your portfolio.

Checking for Ominous Skies on the Audit Report

The value of analysing a financial report depends directly and entirely on the accuracy of the report's numbers. Top management wants to present the best possible picture of the business in its financial report (which is understandable, of course). The managers have a vested interest in the profit performance and financial condition of the business.

Independent auditors are like umpires in the financial reporting process. The auditor comes in, does an audit of the business's accounting system and procedures, and gives a report that is attached to the company's financial statements. You should check the audit report included with the financial report. Publicly-owned businesses are required to have their annual financial reports audited by an independent accountancy firm, and many privately-owned businesses have audits done, too, because they know that an audit report adds credibility to the financial report.

What if a private business's financial report doesn't include an audit report? Well, you have to trust that the business prepared accurate financial statements that follow generally accepted accounting principles and that the footnotes to the financial statements provide adequate disclosure.

Unfortunately, the audit report gets short shrift in financial statement analysis, maybe because it's so full of technical terminology and accountant doublespeak. But even though audit reports are a tough read, anyone who reads and analyses financial reports should definitely read the audit report. Chapter 15 provides a lot more information on audits and the auditor's report.

The auditor judges whether the business used accounting methods and procedures in accordance with generally accepted accounting principles (GAAP). In most cases, the auditor's report confirms that everything is hunky-dory, and you can rely on the financial report. However, sometimes an auditor waves a yellow flag - and in extreme cases, a red flag. Here are the two most important warnings to watch out for in an audit report:

The business's capability to continue normal operations is in doubt because of what are known as
financial exigencies
,
which may mean a low cash balance, unpaid overdue liabilities, or major lawsuits that the business doesn't have the cash to cover.

One or more of the methods used in the report is not in complete agreement with GAAP, leading the auditor to conclude that the numbers reported are misleading or that disclosure is inadequate.

Although auditor warnings don't necessarily mean that a business is going down the tubes, they should turn on that light bulb in your head and make you more cautious and sceptical about the financial report. The auditor is questioning the very information on which the business's value is based, and you can't take that kind of thing lightly.

In very small businesses it is likely that the accounts will not be independently audited and their accounts come with a rather alarming caveat, running something like this:
These accounts have been prepared on the basis of information provided by the owners and have not been independently verified
.
A full audit is an expensive process and few businesses that don't have to will go to the expense and trouble to tell them what they probably already know anyway.

Just because a business has a clean audit report doesn't mean that the financial report is completely accurate and above board. As discussed in Chapter 15, auditors don't necessarily catch everything. Keep in mind that the rules of GAAP are pretty flexible, leaving a company's accountants with room for interpretation and creativity that's just short of
cooking the books
(deliberately defrauding and misleading readers of the financial report). Window dressing and profit smoothing - two common examples of massaging the numbers - are explained in Chapter 8.

Finding Financial Facts

Understanding how to calculate financial ratios and how to interpret those data is all fine and dandy, but before you can do anything useful you need to get a copy of the accounts in the first place. Seeing the accounts for your own business shouldn't be too much of a problem. If you're the boss, the accounts should be on your desk right now; if you're not the boss, try snuggling up to the accounts department. If they're too coy to let you have today's figures, the latest audited accounts are in the public domain anyway filed away at Companies House (
www.companieshouse.gov.uk
), as required by law.