Chapter 5

Exploring the Anatomy of an Annual Report

In This Chapter

Decoding company messages

Getting management’s view

Hearing the auditor’s opinions

Summing up the financial report

The financial statements are the meat of any annual report, but they contain lots of trimmings that you need to be able to read and understand. Although companies must follow set rules for how they format the key financial statements, how they present the rest of the report is left to their creativity.

In this chapter, we explain the six standard parts of an annual report and why they’re so critical. We also define the other parts of an annual report and their purposes.

Meeting the Basic Parts of an Annual Report

Some companies spend a lot of money putting on a glossy show with colour pictures throughout the report. Others just put out a pretty ordinary black and white version without pictures. Most are trying to present a useful report on the state of their business. The major components of an annual report are standard, although the order in which companies present them may vary.

When you see a fat, glossy annual report from a company, you can be certain that you’ll find a lot of froth and spin about all the good things that it has accomplished. No matter how fancy or plain the annual report is you, as a careful reader, need to focus on these key parts:

Chairman’s statement: A report from the chairman about progress during the preceding year and prospects for the future. (See the section ‘Everything but the Numbers’, later in this chapter, for more on what to look for in this statement.)

Operating review: Sometimes called the Operating and Financial Review or OFR, this is a report by the key directors of the main divisions of the company giving management’s view on progress. The Finance Director or Chief Financial Officer will, for example, write the finance part of the report. (See ‘Getting the real gen from management’ in this chapter.)

Directors’ report and Directors’ remuneration report: These reports give information required by the Companies Act or the stock exchange. (See ‘Share-based payments’ in this chapter.)

Auditor’s report: A statement by the auditor regarding the findings of their audit of the company’s books. (See ‘Bringing the auditor’s answers to light’ in this chapter.)

Financial statements: These include the balance sheet, income statement, and the statement of cash flows. (See ‘Presenting the Financial Picture’ in this section.)

Notes to the financial statements: The notes give additional information about the contents of the financial statements. (See ‘Reading the notes’ in this chapter.)

Corporate Governance Report: This report is about how the company applies the principles of good corporate behaviour as outlined in the Companies Act and the UK Combined Code on Corporate Finance.

Translating the language of reports to shareholders

Maintaining a long and proud tradition, reports to shareholders present companies in the best possible light, minimising whatever trouble may lie under the surface. A careless reader may feel reassured by the ‘everything’s-hunky-dory’ tone, but a few often-used niceties may indicate that things aren’t what they seem and can tip off careful readers.

‘Challenging’ is frequently used when a company is facing significant difficulties selling its product or service.

‘Restructuring’ means something isn’t working. Be sure to find out what that something is and how much the company is spending to fix the problem.

Sometimes, reports to shareholders gloss over mistakes by using a phrase like ‘corrective actions are being taken’. Look for details about the cause of the problem and the plan for corrective actions in the notes to the financial statements or further management discussion and analysis.

If you come across the term ‘difficulties’, look for details about the difficulties highlighted in the management reviews or notes to the financial statements.

For more on the reports and statements parts of the annual report, go to the sections ‘Getting the real gen from management’ and ‘Reading the notes’ later in this chapter.

Everything but the Numbers

Most people think of numbers when they hear the words annual report, but an investor with savvy can find a lot more useful information in the text. Some parts of the report are fluff pieces written for public consumption, but others can give you great insight into the company’s prospects, as well as highlighting areas of management concern. You just need to be like a detective: Read between the lines, and read the small print.

Debunking the statements to shareholders

What would an annual report be if not an opportunity for the head honchos to tout their company’s fabulousness? Near the front of most annual reports you find statements to the shareholders from the chairman of the board, and possibly, other key executives.

In these statements, you usually find information about the key business activities for the year, or at least, the most successful ones, a general statement about the company’s financial condition, performance summaries of key divisions or subsidiaries that are the shining stars, and what the company’s key prospects are.

Don’t put too much stock by these statements, no matter how appealing they look and how exciting their message. While the chairman and other executives are heavily involved in writing the reports to shareholders, the company’s public relations department usually carefully designs them to highlight the positive aspects of the company’s year. Negative results, when mentioned at all, are usually hidden in the middle of a paragraph somewhere in the middle of the report. These statements will focus on the positive news and try to minimise the bad news. Do read the company’s optimistic view, but don’t depend on these statements to make a decision about whether or not you should invest in the company. You can find more definitive information in other parts of the report that can help you make investment decisions.

Making sense of the corporate message

After the reports to shareholders but before the juicy information, you often find more ‘rah-rah’ text in the form of a summary about the company’s key achievements throughout the year. Like the Chairman’s statement, these pages present the messages the company wants to portray, which may or may not give you the true picture. Few companies include much information about negative results in this section. Often chock-full of glossy, colourful images, this section is public relations fluff focusing on the best performance highlights of the year. Having said all that, the managers of the business don’t want to be caught out with a straight lie: that’s why it’s generally possible to detect what’s really going on as long as you can read between the lines like the examples in ‘Translating the language of reports to shareholders’.

Although this section is basically advertising, it may give you a good overview of what the company does and the key parts of its operations. The company will present its key divisions or units, what the top products are within these divisions, and a brief summary of the financial results of the main divisions. In addition, you usually find some discussion of market share and position in the market of the company’s key products or services.

Meeting the people in charge

Want to find out who’s running the show? After the corporate statements and financial review section, one or two pages list the members of the board of directors and, sometimes, a brief bio of each member. You also find a listing of top executives or managers and their responsibilities. If you want to complain to someone at the top, this is the place where you can find out where to send your letters!

But seriously, reviewing the backgrounds of the company’s leaders can help you get an idea of the experience these leaders bring to the company. If they don’t impress you, that may be a good sign that you should walk away from the investment.

Getting the real gen from management

The Operating and Financial Review (OFR) section is one of the most important sections of an annual report. It may not be the most fun section to look at but in this section you find the key discussions about what went smoothly over the year as well as what went wrong.

The OFR has been a part of UK reporting for many years based on a code of best practice. However, a couple of years ago, the government set out to make the OFR compulsory and, to this end, the Accounting Standards Board (ASB) produced a standard setting out the required contents of such a report. At the last minute the legislation was repealed on the grounds of cutting red tape. The ASB converted their standard into a best practice statement and things went on much as before.

But the government reintroduced the compulsory OFR by a back-door route by including most of the previous requirements in a new extended business review which is now part of the Directors’ Report. Welcome back red tape!

Read the OFR section carefully. It has a lot of the meat-and-potatoes information that gives you details about how the company’s doing. Remember that the information may be split between the OFR and the Directors’ Report.

Investors monitor the OFR section closely to make sure that companies present all critical information about current operations, capital, and liquidity. Management should also include forward-looking statements about known market and economic trends that could impact the company’s liquidity and material events. These statements also include uncertainties that can mean that the reported information doesn’t necessarily reflect future operating results or future financial conditions. For example, if a company manufactures its products in a country that’s facing political upheaval or labour strife, those conditions may impact the company’s ability to continue manufacturing its products at the same low cost. The company must report this information, indicating how this situation may impact the company’s future earning potential.

Investors pay special attention to a number of key factors that the OFR and Directors’ Report generally cover, including:

Revenue recognition: In a retail store, recognising revenue can be a relatively straightforward process: A customer buys a product off the shelves, and the revenue is recognised, that is, recorded in the company’s books. But things aren’t that cut and dried in many complex corporate deals. For example, in the computer and hardware industry, revenue recognition can be complex because purchase contracts frequently include multiple parts, such as software, hardware, services, and training. The point at which the revenue is actually recognised for each of these parts can vary, depending on the terms of a contract. If a contract goes over the boundaries of two company years, the rules state that the point at which the revenue is recognised depends on the stage of completion of the contract.

The timing of revenue recognition is currently a very live issue in the UK and has been perceived as an area of potential abuse. Two recent standards on the subject have been issued by the Accounting Standards Board. We deal with this topic in more detail in Chapter 22.

When reading financial reports for a particular industry, reviewing how management describes its revenue recognition process compared to other similar companies in the same industry may be important.

Restructuring charges: When a company restructures a portion of its firm – which can include shutting down factories, disbanding a major division, or enacting other major changes related to how the company operates – management discusses the impact the changes have had or may have in the future on the company. Costs for employee redundancy, facility shutdowns, and other costs related to restructuring are explained in this portion of the report.

Impairments of assets: Investors expect companies to report any losses to assets in a timely manner. If an asset is damaged, destroyed, or for any reason loses value, companies must report that loss to shareholders. Look for information about the loss of value of assets in the OFR. Also look for information about the depreciation of these assets (refer to Chapter 4 for more details on depreciation, amortisation, and impairment).

Pension valuations: Accounting for pension plans includes many assumptions, such as the amount of interest or other gains that the company expects to make on the assets held in its pension plans and the expenses a company anticipates paying out when employees retire. If a company has a pension plan for its employees, you should find discussion about how the company finances this plan and whether or not the company expects to have difficulty meeting its plan’s requirements. This discussion may be here or in the notes to the accounts where a detailed description of pension obligations is given. This problem of valuing pension schemes is limited to defined benefit final salary schemes where the pension fund guarantees the pensioner a certain percentage of final salary. This is why many firms are changing to ‘money purchase’ schemes where the pension paid is defined solely by the value of the pensioner’s own pension fund.

Environmental and product liabilities: All companies face some liability for products that fail to operate as expected or possibly could cause damage to an individual or property. In some industries – such as oil, gas, and chemical companies – an error can cause considerable environmental damage. You’ve probably heard stories about a chemical spill destroying a local stream or drinking water supply, or an oil spill wiping out an area’s entire ecological system. In the OFR section, a company must acknowledge the liabilities it faces and the way it prepares financially for the possibility of taking a loss after the liability is paid. The company must estimate its potential losses and disclose the amount of money it has set aside or the insurance it has to protect against such losses.

Share-based payments: In order to attract and keep top executives, many companies offer share incentives (such as awarding shares as bonuses) as part of an employee remuneration package. This part of the annual report normally mentions a summary of any share-based payments as part of the discussion about equity. Where the executives are directors of the company then the full details of their pay and benefits will be included in the Directors’ Remuneration Report.

Many recent scandals have included disclosures of unusually high share-based remuneration packages for top executives. Keep a watchful eye (or ear) out for discussion of bonuses or other employee compensation that involves giving employees shares or share options which result in them being able to buy shares below the market value.

Allowance for doubtful debts: Any company that offers credit to customers will encounter some non-payers. If it is a significant sum, for example in the accounts of a bank, management will discuss what level of loss it is allowing for on accounts that aren’t paid and whether or not this allowance is an increase or decrease from the previous year. If the allowance for doubtful debts increases, it may indicate a problem with collections or may be a sign of significant problems in the industry as a whole.

The discussion in this section of the annual report can get very technical. If you find things you don’t understand, you can always ring the investor relations department to ask for clarification. Investor relations departments are more forthcoming than they used to be, but some will still only give you statutorily mandatory information. Whenever you’re considering an investment in a company’s shares, be certain that you understand the key points being discussed in the OFR. Any time you find the information beyond your comprehension, don’t hesitate to research further and ask a lot of questions before investing in the stock.

In the OFR, managers usually focus on three key areas: company operations, capital resources, and liquidity.

Company operations

Management commentary on this topic focuses on the income generated and expenses related to the company’s operations. To get some idea of how well the company may perform in the future, look for:

Discussion about whether sales increased or decreased

How well its various product lines performed

Discussions about economic or market conditions that may have impacted the company’s performance

The OFR section also discusses:

Distribution systems: How products are distributed.

Product improvements: Changes to products that improve their performance or appearance.

Manufacturing capacity: The number of manufacturing plants and their production capability. The OFR may also mention the percentage of the company’s manufacturing capacity that it is using.

If a company uses only 50 per cent of its manufacturing capacity, that may be an indication that the company has lots of extra resources that are idle. If a company is using 100 per cent of its manufacturing capacity, that may indicate that the company has maxed out its resources and may need to expand. Sometimes manufacturing capacity is referred to in a comment rather than a stated percentage.

Research and development projects: The research or development the company is doing to develop new products or improve current products.

The manager also comments on key profit results and how they may have differed from the previous year’s projections. You should also look for cost information related to product manufacturing, purchasing or the costs of providing services. Cost-control problems can mean that future results may not be as good as the current year’s, especially if management mentions that the cost of raw materials and commodities, such as oil, isn’t stable. Look for statements about interest expenses, major competition, inflation, or other factors that may impact the success of future operations.

Capital resources

You will expect to see an indication of whether the company can fund its operations for the long term. In addition to a statement whether the company is in a strong financial position or not, you find discussions about:

Acquisitions or major expansion plans.

Any major capital expenditure carried out over the past year or planned in future years.

Company debt (amounts that the company owes to outsiders).

Plans the company may have for taking on new debt.

Other key points about the company’s cash flow. This information varies depending on the industry; the discussion may focus on items that are unique to the operation of the particular company.

Liquidity

A company’s liquidity is its cash position and its ability to pay its bills on a short-term or day-to-day basis. We cover how to analyse liquidity in Chapters 12, 15, and 16.

Bringing the auditor’s answers to light

Any company other than a small company must provide financial reports that have been audited by an outside auditor. (We talk more about the audit process in Chapter 18.) You usually find the auditor’s report before the financial information or immediately following it.

Before you read the financial statements or the notes to the financial statements, be sure that you’ve read the auditor’s report. Read the auditor’s report first to find out whether the auditor raised any red flags about the company’s financial results. Then you know whether the auditor expressed concerns about any aspect of the company’s financial results and what those questions are. You won’t find answers to the questions raised in the auditor’s report. To find the details, you need to read the OFR, financial statements, and the notes to the financial statements. But if you haven’t read the auditor’s report, you may overlook some critical details. In the majority of cases the auditor’s report is standard and contains no reservations on the auditor’s part.

To lend credibility to management’s assurances, and to conform with their statutory duty, the company calls in independent auditors from an outside accounting firm to audit a company’s internal controls and financial statements. Auditors don’t check every transaction, so their reports don’t provide you with 100 per cent assurance that the financial statements don’t include misstatements about the company’s assets and liabilities. Auditors don’t endorse a company’s financial position or give indications about whether or not a company is a good investment.

Studying the standard auditor’s report

The auditor’s report is usually standard with few, if any, particular variations. The purpose of the report is to record the fact that the auditors have done their job, how they did the job, and what is their considered opinion of the prepared accounts.

Most standard auditor’s reports include these paragraphs:

Introductory paragraph: In the introductory paragraph, you find information about the time period that the audit covers, and the sections of the report that the auditor is reporting on. The auditors often take this opportunity to disclaim any liability to any user of the accounts other than the shareholders of the company.

Respective responsibilities of the directors and auditor: This paragraph states that management is responsible for the financial statements and that the auditors only express an opinion about the financial statements based on their audit. Essentially, this is a ‘protect-your-ass’ paragraph where the auditors attempt to limit their responsibility for possible inaccuracies.

Basis of audit opinion (or scope paragraph): In this paragraph, the auditors describe how they carried out the audit, including a statement that they used the generally accepted audit standards which currently are the International Standards on Auditing (ISAs) – as adapted by the Auditing Practices Board for use in the UK and Ireland. These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatements. A material misstatement is an error that significantly impacts the company’s financial position. For example, if the company reported a significant amount of revenue before it was actually earned, that’d be a material misstatement.

Opinion paragraph: In the opinion paragraph, the auditors state their opinion of the financial statements. If the auditors don’t find any problems with the statements, they simply say that these statements are prepared ‘in accordance with IFRS as adopted by the EU’. For more on IFRS (International Financial Reporting Standards), see Chapter 18.

When an auditor’s report follows the outline described here, it’s called a standard auditor’s report. And because the auditors have not found any alarming situations, it’s also an unmodified audit report. The company must print the report as the auditors presented it and there are strict rules limiting their ability to fire an auditor whose report they do not like.

Mulling over the modified auditor’s report

If the auditors modify their report then they will explain the reasons why. The modified report may be a qualified report in which the auditors report a disagreement over the figures or the information provided in the notes to the accounts. An alternative form of modification (not a qualification) is where the auditors wish to draw attention to an important matter in the accounts – not because they disagree with what the company has said but because they want to make sure the reader gets the message. (We discuss possible problems auditors may encounter later in this section.) A non-standard auditor’s report and a standard auditor’s report have the same structure; the only difference is that the non-standard report includes information about the problems the auditors found.

When you see a modified auditor’s report, be sure that you find a discussion of the problems in the OFR and in the notes to the financial statements. Also, when reading the OFR, be certain that you understand how management is handling the problems noted by the auditors and how these problems could impact the long-term financial prospects of the company before you invest your hard-earned money. (Call the investor relations department to ask for clarification, if you need to.) If you’ve already invested, look carefully at the issues to be sure you want to continue holding shares in the company.

A modified auditor’s report may include paragraphs that discuss problems that the auditors found such as the following:

Accounting policy changes: If a company decides to change its accounting policies or how it applies an accounting method, they report this fact in the list of accounting policies in the notes to the accounts. These changes may not indicate a problem. For example, if a company changes how it reported an asset because that change is required by a new accounting standard then that’s a good reason for making the change. If the auditors agree that the company had a good reason for making the change, then there will be no reference to the change in the auditor’s report.

If there is a change in accounting policy, be sure to look in the notes portion of the annual report for the full explanation of the change and how it could impact the financial statements. When companies change an accounting policy or method, they need to adjust the results of previous years by means of a prior period adjustment so that you can still compare the previous year’s results to the current year’s. You should look for a note to the accounts which indicates the effect of the adjustment. In the case of a major change, such as the introduction of International Financial Reporting Standards (IFRS), there may be a reconciliation showing what the figures would have been under previous practices.

If the auditors disagree with the company’s decision to change accounting methods, they question the change and provide a qualified opinion (which we discuss later in this section).

Significant uncertainties: The best example of a significant uncertainty is the damages the company must pay if it loses a pending lawsuit. Life is full of uncertainties and this is true of the financial world also. The directors must make their best estimate of the financial effect of uncertainties and include their estimates in the accounts. Taking the example of the pending lawsuit, the directors may include a provision in the balance sheet for their best estimate of the potential liability which they then explain by way of a note. Alternatively, if the directors are confident that the lawsuit will be won then they don’t include a provision but will simply refer to the lawsuit in the notes to the accounts. If the auditors disagree with the directors’ treatment of the uncertainty then they qualify their opinion. If, on the other hand, they consider that the directors have done the best they can but believe that the uncertainties could have a significant impact on the company, the auditors include a paragraph drawing the situation to the attention of the readers. This statement is known as an emphasis of matter and is not a qualified opinion.

Going-concern problems: Another example of a significant uncertainty is going concern. If the auditors have substantial doubt that a company has the ability to stay in business, they’ll draw attention to this by an emphasis of matter paragraph. Problems that can lead to this type of paragraph in the auditor’s report include ongoing losses, capital deficiencies, or a significant contract dispute. If the auditors mention going-concern then it’s a major red flag. You should examine the OFR and the notes to see what the company is doing about the problem. Unless they tell a very good story, you should be very hesitant about investing in this company.

Qualified opinion – limitation of scope: A qualified opinion doesn’t always mean that you should be alarmed, but it does mean that you should do additional research to make sure that you understand the qualification. Sometimes, there’s no problem at all; a qualified opinion may simply indicate that there wasn’t sufficient information available at the time of the audit to determine whether or not the issue raised will have a significant financial impact on the company. The auditor’s report indicates whether the problem is limited to a particular issue or whether the effect is so great that they can’t express an opinion on the accounts. You should look in the notes to the financial statements or the OFR for any explanation of the matter that caused the auditors to issue a qualified opinion on the grounds of limitation of scope.

Qualified opinion – disagreement: A disagreement is obviously a serious matter. The auditor may disagree with the figures or the disclosures in the notes. You can be sure that there was a lot of discussion between the company and the auditor before the auditor made the decision to qualify since the repercussions for the company may be serious. In the event that there is a disagreement, the auditor will indicate the extent of that disagreement. They might say that ‘except for’ the particular problem identified the accounts still show a true and fair view. Alternatively, if the problem is too great then they will express an ‘adverse’ opinion which is that the accounts do not show a true and fair view. It should be noted that qualified opinions on the grounds of disagreement aren’t common.

Work performed by a different auditor: In many cases, work being done by a different auditor isn’t a problem and won’t be mentioned in the report. In the UK, if a different auditor handles the audit of a subsidiary then the auditor of the parent company has the responsibility of forming the overall view. Reference to reliance on the other auditors shouldn’t be necessary. Similarly, if a company changes auditors, the incoming auditor has the responsibility to form the overall view of the accounts – including the balances audited at the end of the previous year by the outgoing auditor. If there are no problems then there might not be any reference in the auditor’s report to the change of auditor.

As an investor, you need to know why the company changed auditors, and you should research the issue. You probably won’t find the reason for the change in the annual report, so you may have to research the change in news reports or analysts’ reports about the company. Because changing auditors can negatively impact a company’s share price, companies are very careful about changing auditors. The City usually gets concerned whenever a change of auditors occurs because it can be a sign of a major accounting problem that hasn’t surfaced yet.

Presenting the Financial Picture

The main course of any annual report is the financial statements. In this part, you find out what the company owns, what the company owes, how much revenue the company took in, what expenses it paid out, and how much profit it made or how much it lost. We cover each of the following statements in great detail throughout the book, so we mention them briefly here and indicate in which chapters you can find additional information.

When looking at a company’s financial results, make sure that you’re comparing periods of similar length or a similar collection of months. For example, a retail store usually has much better results in the last quarter of the year (from October to December) because of the Christmas season than it does in the first quarter (from January to March). Comparing these two quarters doesn’t make sense when you’re trying to determine how well a company is doing. To judge a retail company’s growth prospects, compare the fourth quarter of one year with the fourth quarter of another year. We talk more about income statements in Chapter 7 and tell you how to analyse these statements in Part III.

Balance sheet: The balance sheet gives a snapshot of a company’s assets and liabilities at a specific point in time. We discuss all the parts of a balance sheet in Chapter 6, and talk about analysing the financial reports in Part III.

Income statement: The income statement reviews a company’s operations over a specific period of time. In an annual report this statement covers activities in the 12 months of the previous company year. We discuss the income statement in Chapter 7 and how to analyse that statement in Part III.

The income statement is also known as the profit and loss account or the P&L account. It is also referred to as an income and expenditure account in the case of not for profit companies such as charities.

Statement of cash flows: The statement of cash flows discusses the actual flow of cash into and out of the company. The statement has three sections focusing on changes to cash status from operations, investing, and financing. Like the income statement, the statement of cash flows reflects what has happened over a specific period of time. We discuss this statement in greater detail in Chapter 8, and we talk about cash-flow analysis in Chapter 13.

Summarising the Financial Data

Knowing that most people won’t spend the time reading all the way through the annual report, many companies summarise their numbers in various ways. The two most common ways to summarise are to highlight the financial data presented in the financial statements and to summarise some key information in the notes to the financial statements. But beware: Some summaries highlight the good news and skip over the bad.

Finding the highlights

The highlights to the financial data summarise the financial results for the year being reported. Typically, this summary is called the financial highlights, but companies can be creative because they aren’t a required part of the report. And because the highlights aren’t a required part of the financial statement, they’re not always presented according to generally accepted rules, so don’t count on their accuracy. You usually find the financial highlights at the front of the annual report after the report from the chairman of the board. Some companies include them inside the back cover of the annual report.

You frequently find financial highlights at the front of the annual report, designed in a graphically pleasing way. Most companies show a 5-year or 10-year summary that doesn’t include much detail but allows you to see the growth trends of the company. Although this type of summary can be a good historical overview, don’t count on it. Instead, do your own research of a company’s financial history to be sure that you’re aware of both the good and bad news. Remember that even outstanding companies have some bad years that they want to gloss over.

The directors’ report includes key performance indicators (KPIs) but since the directors are free to choose which KPIs to publish, they are hardly likely to choose KPIs which show the company in a bad light.

Reading the notes

The notes to the financial statements is the section where you find any warts on a company’s financial record. The notes to the financial statement are a required part of the annual report that give you the details behind the numbers presented in the financial statements. Companies like to hide their problems in this part of the financial report. In fact, some companies even print this part of the annual report in smaller type.

The notes to the financial statements section cover a wide range of issues some of which are:

Accounting methods used

Changes to accounting methods

Key financial commitments that can impact current and future operations

Lease obligations

Pension and retirement benefits

If any red flags pop up in a company’s annual report, this part is where you can find the financial details and explanations. You may also find problems mentioned in the OFR section, but the full explanations for these problems are probably covered in greater detail in the notes section.

Don’t get turned off by the visually unpleasing presentation. The notes to the financial statement is one of the most critical parts of the annual report. We cover the importance of the notes to the financial statements in more detail in Chapter 9.