Lita Epstein - Reading Financial Reports For Dummies

You can access reports filed with the SEC online at Edgar, which is run by the SEC. To use Edgar, go to www.sec.gov/edgar.shtml .

More companies these days operate across country borders. For years, each country had its own set of rules for preparing financial reports to meet government regulations. Global companies had to keep separate sets of books and report results under different sets of rules in each country in which they operated.

Today most countries have agreed to accept the International Financial Reporting Standards (IFRS; see Chapter 19) 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. allows companies based outside its borders to file required reports using either U.S. GAAP or IFRS, but U.S.-based companies must still use GAAP to file their reports. The process of converging U.S. standards with international standards is still a work in process, but the U.S. is now represented on the Accounting Standards Advisory Forum to improve worldwide cooperation among standard setters.

Not all of 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.

Accounting practices can be traced back to the Renaissance, but financial reporting wasn't recognized as a necessity until centuries later.

1494: Italian monk Luca Pacioli became known as the “father of accounting” for his book Everything about Arithmetic, Geometry and Proportions, which includes a section on double-entry accounting (see Chapter 4). Pacioli warned his readers that an accountant shouldn't go to sleep at night until his debits equal his credits.

1700–1800: For-profit corporations started to appear in Europe as early as the 18th century. In 1800, only about 330 corporations operated in the U.S.

1800s: As public ownership of stock increased, regulators realized that some standardized distribution of information to investors was a priority. The New York Stock Exchange was the first to jump into the fray, and in 1853, it began requiring companies listed on the exchange to provide statements of shares outstanding and capital resources.

1929: Before the stock market crash, equity investing became a passion. People borrowed money to get into the market, paying higher and higher prices for stock. Sound familiar? Not too different from what occurred just before the 2000 crash of technology and Internet stocks.

1933–1934: Congress created the SEC and gave it authority to develop financial accounting and reporting standards and rules to deter companies from distributing misleading information.

1973: The Financial Accounting Standards Board (FASB) was created to establish standards for financial accounting and reporting. The SEC recognized the generally accepted accounting principles (GAAP) as the official reporting standards for federal securities laws.

1984: The FASB formed the Emerging Issues Task Force, which keeps an eye on changes in business operations and sets standards before new practices become entrenched.

2002: The FASB began work with the International Accounting Standards Board (IASB) to converge international financial reporting systems.

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 needs to know why the discrepancy exists, because an error in the data input could have occurred.

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 14.

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 15and 16; Chapter 15focuses on incoming cash, and Chapter 16deals with outgoing cash.

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.

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

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 letter is directed to the shareholders and discusses the company's key successes or explains any major failures.

Auditors’ report: This report tells you whether the numbers are accurate or whether you need to have any concerns about the future operation of the business.

Management's discussion and analysis: In this part, you find management's 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, “ Getting to 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, and locations, along with new facilities that have opened in the past year.

No doubt, the most critical part of the annual report for anyone who wants 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 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: