Chapter 9
Scouring the Notes to the Financial Statements
In This Chapter
Describing the notes and their importance
Understanding the fine print of accounting methods
Finding out about financial commitments
Getting acquainted with mergers and acquisitions
Reading notes about pensions and retirement
Detailing segmented businesses
Keeping an eye out for red flags
Would you ever sign an important contract without reading the fine print first? Probably not. Remember this philosophy when you read financial statements because the corporate world certainly doesn’t escape the cliché about sweeping dust under the carpet. Hiding problems in the notes to the financial statements is a common practice for companies in trouble.
In this chapter we explain the role of notes as part of the financial statements, discuss the most common issues addressed in the notes, and point out some key warning signs that should raise a red flag if you see them mentioned in the notes. And to help you become a note-reading expert, we refer to the financial reports of Tesco and Marks and Spencer (both retailers) throughout the chapter. (See Appendix A for these companies’ financial statements. To view their complete annual reports, you can find Tesco’s at www.tesco.com by looking at the section called ‘Investor Relations’ and then ‘Annual Reports’. For Marks and Spencer go to www.marksandspencer.com and then to the section about the company and then to ‘Investors’.)
Deciphering the Small Print
Learning how to read and understand the small print of the notes to the financial statements can be a daunting task. Companies usually present these notes in the least visually appealing way and fill them with accounting jargon so that they’re hard for the general public to understand. By publishing these notes, the company fulfils its obligations to give the required financial report to the reader, but it’s hard for the reader to actually understand the information presented.
But don’t give up. There’s lots of important information in these notes that you need to know, including accounting methods used, red flags about the company’s finances, and any legal entanglements that may threaten the company’s future. We point out the key sections of the notes to the financial statements and what types of information to pluck out of these sections.
The first indication that you’ll see that there are notes to the financial statement is at the bottom of the financial statements. You see a comment that the accompanying notes form part of the financial statements. Also, the various line items in the income statement, balance sheet and cash-flow statement will have a number next to them which refers to the number of the relevant note. You find the actual notes on numerous pages after the financial statements.
The notes have no specific format, but you’re likely to find at least one note regarding several key issues in every company’s financial report.
Small doesn’t matter
You won’t see this icon very often in this chapter since the disclosure requirements for listed companies are very similar to those for unlisted companies. In fact, as UK accounting standards converge with the international standards, the differences will reduce even further. Where there are differences at the moment, they tend to be in the detail, not the broad principles. Almost everything we say in this chapter applies to both listed and unlisted entities.
The only significant difference in disclosure requirements is for those companies that satisfy the legal definition to be small (basically turnover less than £5.6 million, total assets less than £2.8 million and less than 50 employees – but look at the technical stuff in Chapter 3 for the details). These companies follow their own standard – the Financial Reporting Standard for Small Entities (FRSSE) which lays out much reduced disclosure requirements.
Accounting Policies Note: Laying Out the Rules of the Road
The first note in almost every company’s financial report gives you the ammunition to understand the accounting policies used to develop the financial statements. This note explains the accounting rules the company used to develop its numbers. The note is usually called ‘Accounting policies’.
Issues discussed in this note include:
Basis of consolidation: The way in which the company deals with other companies in which it has an investment. (See Chapter 10 for more information about consolidation.)
Asset types: The types of things owned by the company. (Refer to Chapters 4 and 6 for more information on assets.)
Method of valuation: How the company values its assets. (Refer to Chapters 4 and 6 for more information on valuation.)
Methods of depreciation and amortisation: The methods the company uses to charge for the use of its assets. (Refer to Chapters 4 and 6 for more information on depreciation and amortisation.)
How revenue and expenses are recognised: The method that the company uses to record the money it takes in from sales and the money it pays out to cover its expenses. (Refer to Chapters 4 and 7 for more information on revenue and expenses.)
Pensions: The obligations the company has to its current and future pensioners.
Financial instruments: The company’s use of financial instruments such as loans as well as more esoteric instruments such as derivatives or hedges.
Share-based payment: Employee incentive plans involving share ownership.
Taxes: The company’s methods for dealing with current tax and deferred tax. (Refer to Chapter 7 for more details about deferred tax.)
For example, if companies use different methods to value their inventory, this could have a major impact on net income. (We explain the impact of inventory valuation on net income in Chapter 15.) Many times, you won’t actually have enough detail to make apples to apples comparisons of two companies that use different accounting policies, but you need to be aware that the policies differ as you analyse the company’s financial results and be alert to the fact that you may be comparing apples to oranges.
Depreciation
One significant difference in accounting policies that can affect the bottom line is the amount of time a company allows for the depreciation of assets. Whilst one company may use a 15–25 year timeframe, another may use a 10–40 year span. The timeframe used for depreciation directly impacts the value of the assets on the balance sheet. A faster depreciation method reduces the value of these assets more quickly on the balance sheet.
Depreciation expenses are also charged as an expense against revenue. A company that writes off its buildings more quickly, say in 25 years rather than up to 40 years, has higher depreciation expenses and lower net income than if it takes longer to write off its buildings. We discuss how depreciation works in greater detail in Chapter 4.
Revenue
You can find some noteworthy differences between companies by reading the revenue-recognition section of the summary of significant accounting policies. Differences between the timing of revenue recognition can impact the total revenues reported. For example, one company might indicate that it recognises revenue when the product is shipped to the customer. Another company might recognise revenue upon the customer’s receipt of the product. If products are shipped at the end of the month, a company that includes shipped products includes the revenues in that month, but a company that only recognises revenue when the product is received might not include the revenue until the following month.
Rights of return: Some companies expect a significant level of returns from their customers – think mail order, for example. When does the company recognise revenue on such sales? On despatch? Or after the return period has passed? Or do they make a provision for expected returns?
Collectibility: The amount of income reported depends on whether or not all the revenue is likely to be collected. Successful collection can depend on the business environment, a customer’s financial condition, historical collection experience, accounts receivable aging, and customer disputes. If collectibility is uncertain, the revenue isn’t reported.
There is clearly great scope for the company to form a range of different judgements as to what revenue should be recognised. We talk more about accounts-receivable collections and how to analyse them in Chapter 16.
Expenses
Expenses differ widely among companies. As you read this part of the accounting policies note, be sure to notice the types of expenses a company chooses to highlight. Sometimes the differences between companies can actually give you an insight into how the company operates. Here are two key areas where you may see differences in how a company reports expenses:
Product development: Some companies develop all their products in-house, whereas others pay royalties to inventors, designers, and others to develop and market new products. In-house product development is reported as research and development expenses. The cost of research activities are written off as incurred but when the research reaches the development phase, then the costs may be included in the balance sheet as an asset. International Accounting Standards (IAS) 38 has detailed rules and conditions to cover this point. If the company primarily develops new products by using outside sources, the costs appear as royalty expenses once production starts.
Advertising: Some companies indicate that all advertising is expensed at the time the advertising is printed or aired. Others may write off advertising over a longer period of time. IAS 38 indicates that advertising costs should normally be written off as incurred, but companies may want to claim that an asset has been created by advertising expenditure. For example, one company that depends on catalogue sales might like to spread out the expense of this type of advertising over several months, or even a year, if it can prove that sales continued to come in during that longer period of time. Other companies in the same industry might consider that all of the costs should be expensed immediately.
Working Out Financial Borrowings and Other Liabilities
How a company manages its borrowings is critical to its short- and long-term profitability. You can find out a lot about a company’s financial management by reading the notes related to financial liabilities. You always find at least one note about the financial borrowings and other liabilities that impact the short- and long-term financial health of the company.
IAS 32 requires companies to disclose information about their exposure to interest rate risk which includes maturity dates and effective interest rates. However, the method of displaying the information may well vary.
Short-term borrowings
Short-term borrowings can have a greater impact on a company’s earnings each year, as well as on the amount of cash available for operations, than long-term borrowings. The reason is that a company must pay back short-term borrowings over the next 12 months, whereas for a long-term loan, a company must pay only interest and, possibly, some of the principal in the next 12 months.
The type of short-term borrowings you see on a company’s balance sheet varies greatly, depending on the type of company but the most common form of short-term borrowing in the UK is the bank overdraft. Companies whose sales are seasonal may carry a lot more short-term borrowings to get themselves through the slow times than companies that have a consistent cash flow from sales throughout the year.
Seasonal companies carry large lines of credit (or large overdraft limits) to help them buy or produce their products during the off-season times so that they can have enough product to sell during the high season. For example, a company that sells toys sells most of its product during the Christmas or other peak toy-selling seasons; during the other times of the year it has fewer sales.
Another way that companies raise cash if they don’t have enough on hand is to sell their accounts receivable. To get immediate cash, the company can sell the receivables to a bank or other financial institution and get immediate cash rather than wait for the customer to pay. (Accounts receivable involve credit extended to customers, which sometimes results in short-term cash-flow problems. By selling these receivables, companies can raise cash for immediate needs rather than wait until they collect the money.) We talk more about accounts-receivable management in Chapter 16.
Long-term borrowings
Both medium- and long-term notes or bonds fall into the long-term-borrowings category. Medium-term notes or bonds are amounts that a company borrows for 2–10 years. Long-term notes or bonds include all amounts borrowed for over 10 years.
In the discussion of long-term financial borrowings, you find two key pieces of information. One shows the terms of the borrowings, and the other permits you to work out the amount of cash that a company must pay toward its debt for each of the next five years and beyond. Table 9–1 shows Tesco’s long-term borrowings. Note that MTN stands for Medium Term Note.
In the notes below Table 9–1, Tesco indicate that there has been a partial redemption of two of the Notes, namely the 6 per cent MTN maturing in 2008 and the 5.125 per cent MTN maturing in 2009.
The company also explains the details relating to two of the MTNs which seem to be somewhat different from the others. The 4 per cent RPI MTN is redeemable at par indexed for increases in the Retail Price Index (RPI) over the life of the MTN. The 3.322 per cent LPI MTN is similarly redeemable at par indexed for increases in RPI but has the added condition that the maximum indexation in any one year is 5 per cent. They have omitted to explain the terms attaching to the 2 per cent RPI MTN – perhaps they are the same as the 4 per cent RPI MTN?
The par value of a loan is the amount originally borrowed and is normally the amount to be repaid (redemption value) unless there is an agreement to the contrary. The amount included in the balance sheet for any loan is based on the amount borrowed and the redemption value but also takes into account any transaction costs – this is why the balance sheet value is usually slightly different from the par value.
Notice that Tesco refer to the effect on interest rates of hedging transactions. To understand what is happening here you need to read the Operating and Financial Review where the company explains its objectives when managing interest rate risk – to limit their exposure to interest rate increases while retaining the opportunity to benefit from interest rate reductions.
Marks and Spencer is a bit more straightforward with its long-term-borrowings information, as Table 9–2 shows.
| 2007 £m | 2006 £m | |||
|---|---|---|---|---|
| Medium term notes | 1,177.3 | 779.0 | ||
| Securitised loan notes | - | 307.3 | ||
| Finance lease liabilities | 57.2 | 47.5 | ||
| Total non-current borrowings | 1,234.5 | 1,133.8 | ||
| and other financial liabilities |
Marks and Spencer explain that the balance for medium term notes relates to fixed rate bonds of £375 million at a rate of 6.375 per cent repayable on 7 November 2011, £400 million at a rate of 5.625 per cent repayable on 24 March 2014 and £400 million at a rate of 5.875 per cent repayable on 29 May 2012.
Further, the securitised loan notes related to three separate bonds securitised against 45 of the group’s properties which were redeemed on 12 March 2007 in order to release the properties for use in the limited partnership with the group’s pension scheme. This is explained further in a separate note to the accounts.
The notes to the accounts contain more information on the borrowings of the two companies. One issue is the extent to which the interest rates on borrowings are fixed.
Tesco’s financial statements show that, for banks and other loans, £1,791 million are at fixed rates and £3,726 million are at floating rates. Overdrafts are always at floating rates and the Tesco overdraft explains £1,052 million of the balance. This means that, if we remove the overdraft from the figures, then about 60 per cent of the borrowings are at floating rates down from 67 per cent in the previous year. This brings them in line with the objective stated in their OFR that a minimum of 40 per cent of borrowings should be on fixed or capped interest rates.
For Marks and Spencer, the equivalent figures are fixed rate loans £1,375 million, floating rate loans £321 million. They have an overdraft of £160 million, so the percentage of borrowings which are at floating rates is only 10 per cent. This is down from 46 per cent in the previous year as a result of the maturation during the year of about £900 million of medium term notes whose interest rates were linked to bank rate.
We take a closer look at this issue and how it impacts the companies’ liquidity in Chapter 12. We also show you how potential lenders analyse a company’s borrowing habits.
Lease obligations
Rather than purchase plants, equipment, and facilities, many companies choose to lease them. You usually find at least one note to the financial statements that spells out a company’s lease obligations. Whether the lease is shown on the balance sheet or in the notes depends on the type of lease:
Finance leases: These leases give the lessee (the company leasing the asset for use in its business) substantially all the risks and rewards of ownership. At the end of the lease, legal ownership may pass to the lessee or may remain with the original owner (the lessor). Hire purchase contracts are finance leases where ownership does pass to the lessee at the end of the HP contract. This type of lease is shown as a long-term obligation on the balance sheet, whilst the cash price of the asset is included within the property, plant, and equipment heading in the balance sheet.
Operating leases: Any lease that does not satisfy the definition of a finance lease is classified as an operating lease. This type of lease is mentioned in the notes to the financial statements but isn’t shown on the balance sheet.
When reading the notes, be sure to look for an explanation about the types of leases a company has and what percentage of its fixed assets is under operating leases. Some high-tech companies have higher obligations in operating-lease payments than they do in long-term liabilities (but remember they don’t show as liabilities on the balance sheet). When calculating debt ratios (ratios that show the proportion of debt versus the type of asset or equity being considered), many analysts use at least two-thirds, and sometimes the entire amount, of these hidden operating-lease costs in their debt-measurement calculations to judge the liquidity of a company. We show you how to calculate debt ratios in Chapter 12.
Accounting for Share-Based Payment: Something New in the Accountants’ World
Share-based payment is not new but the way we account for it is. By share-based payment, we mean that payment is made by the issue of shares or share options rather than cash. Such payment is sometimes used for suppliers when a start-up business is short of cash but the most common use of share-based payment is for employees through the use of incentives.
Here’s a simple example: X PLC has agreed that its managing director can buy shares in the company. This is achieved by granting the MD an option. The option says that the MD can buy 10,000 shares at a price of £20 per share as long as the MD is still employed by the company in three year’s time. These conditions are known as the vesting conditions. The £20 price is actually the current price of the shares and the idea is that the MD benefits from any growth in the share price over the three-year period. Why not, the MD helped to create that growth? If the value of the share goes down, the option isn’t exercised and lapses. If the share price goes up, the MD pays the company £200,000 for the shares and, of course, can immediately sell them for the higher market price.
For many years, companies have been required to disclose such agreements with directors. Indeed, in the directors’ remuneration report, there is a mass of information concerning options granted, exercised or lapsed with respect to each individual director.
What is new is that the share option’s fair value at the date it is granted has to be figured out and reflected in the income statement and balance sheet. This is how it works.
The starting point is to place a value on the option. It is unlikely that an identical option is available on the open market and so the first problem is to try to estimate what a reasonable market price for such an option would be. This may involve employing an external expert to use one of the complicated mathematical models which apply in this situation.
Suppose the expert says that the options are worth £6 each. The total value of the MD’s options at the date of grant is therefore £60,000. This cost is charged as part of payroll costs but spread over the three years of the options life – so £20,000 is charged each year as a cost in the income statement with a corresponding credit to a new reserve account within equity.
This calculation is straightforward (if a bit bizarre) but consider the complications that arise where the company grants share options to 5,000 employees who must meet various targets before the shares can vest at the end of the three-year period. Now, the valuation of the option is the easiest bit of the calculation. Each year during the three-year period, the company must estimate how many share options will eventually be exercised taking into account the expected number of leavers and the progress towards achievement of the targets. An appropriate charge is made in the income statement each year so as to ensure that the amount included in equity always reflects the best estimate of the number of shares options that will ultimately vest.
Mergers and Acquisitions: Noteworthy Information
Sometimes one company decides to buy another. Other times, two companies decide to merge into one. In the past, different method of accounting were used depending on whether an acquisition or a merger took place. Recently, the IASB decided that it would be better to treat all business combinations in the same way. Merger accounting was banned and all business combinations are now accounted for using the purchase method (also known as acquisition accounting). For the moment, companies following UK GAAP are still permitted to use both merger accounting and acquisition accounting depending on the detailed situation.
If a company acquired another company or merged during the year covered by the annual report, a note to the financial statements is dedicated to the financial implications of that transaction. In this note, you see information about:
The market value of the company purchased
The amount paid for the company
Any exchange of shares involved in the transaction
Information about the transaction’s impact on the bottom line
When a company acquires another company, it frequently pays more for that acquisition than for the total value of its assets. The additional money spent to buy the company falls into the line item called ‘goodwill’. Goodwill includes added value for customer base, locations, customer loyalty, and intangible factors that increase a company’s value. If a company has goodwill built over the years from previous mergers or acquisitions, you see that indicated on the balance sheet as an asset. We discuss goodwill in greater detail in Chapter 4.
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Pondering Pension and Retirement Benefits
You may not think of pension and other retirement benefits as types of debt, but they might be. In fact, for most companies that offer pension benefits, the amount of money they owe their employees is higher than the amount they owe to bondholders and banks. Some companies offer both pensions (which are an obligation to pay pensioners a certain amount for the rest of their lives after they leave the company) and other retirement benefits such as private health care.
When looking at the note about pension and other retirement benefits, find out which type of plan the company offers:
Defined benefit plan: The company promises a retirement benefit to each of its employees who are members of the plan and is obligated to pay that benefit. This type of plan includes traditional retirement plans in which employees get a set monthly or annual benefit from the company after retirement. Usually, the pension is based on the number of year’s service with the company and the final salary earned (or the average of a number of years of service towards the end of employment). These schemes are often known as final salary schemes for obvious reasons.
Defined benefit plans carry obligations for the company for as long as an employee lives and, sometimes, for as long as both the employee and his spouse live. Determining how much that benefit will cost in the future is based on assumptions regarding how much return is expected from the retirement portfolios and how long the employees and their spouses live after retirement. As people live longer, pension obligations become much greater for those companies that offer defined benefit plans.
In the UK, most companies who offer a defined benefit pension scheme pay contributions into a separate legal entity – a trust – which invests the funds and pays pensions. The company has a responsibility to make contributions sufficient to meet its eventual obligations. It is the responsibility of an actuary (a statistician who looks at lifespan and other risk factors to make assumptions about a company’s long-term pension obligations) to determine how big those contributions should be.
Defined contribution plan: The employer and, usually, the employee both make contributions to a company scheme or to the employee’s personal pension plan. In the UK, all companies, other than the very smallest, are obliged to set up a pension scheme – but they are not, at present, compelled by law to make payments in to it.
Usually, the employer commits to pay an amount into the scheme each year based on a percentage of the employee’s wages until the employee leaves or retires. In the defined contribution scheme, the company isn’t required to pay any additional money to the scheme after the employee retires and there is no guarantee on the level of pension that is finally paid.
In the notes to the financial statement, you find a description of any pension schemes offered by the company. If the only scheme is defined contribution then you simply see a statement of the amount paid into the fund.
If, on the other hand, the company is offering a defined benefit scheme then the notes go on for page after page. You find a description of the assumptions made by the actuary in establishing the contribution rates and the current funding position of the scheme.
Discount rate: The interest rate used to determine the present value of the projected benefit obligations.
Rate of return on assets: The expected long-term return the company expects to earn on the assets in the retirement investment portfolio.
Rate of increases in salaries: The estimate the company makes related to salary increases and the impact those increases have on future pension obligations.
Each of these rates requires that assumptions be made about unknown future events involving the state of the economy, interest rates, investment returns, and employee life spans. A company can do no more than make an educated guess – guided by the actuary. To be sure that a company’s guesses are reasonable, all you can do is check that the company makes similar guesses to those of other companies in the same industry. You also should look for information in the notes about whether the company’s retirement savings portfolio is sufficient to meet its expected current and future pension obligations. If the company’s retirement savings portfolio falls short, it may be a red flag that future cash-flow problems are possible.
How safe is your pension really?
In the 1990s, most pension funds were over-funded – meaning that they had more than enough money to meet future needs. This led to companies taking contribution holidays – on the advice of the actuary. The government was particularly concerned that pension schemes should not be over-funded because they were giving tax relief on contributions and therefore tax-relief is not available when a fund becomes significantly over-funded.
Then, with the stock market crash of the early 21st Century, funds lost billions of pounds. Also, life expectancy was increasing and, all of a sudden, most pension schemes became under-funded – some to a massive extent. It was at about the same time that the UK Accounting Standards Board brought in a new rule that required companies to recognise in their balance sheets the surplus or deficit on a defined benefit scheme. Some companies reacted by increasing contributions to try to remove deficits; others closed schemes to new employees – or even to existing employees – to reduce the problem.
At the time of writing, the stock market is improving and a lot of schemes are moving back into the black. Indeed the majority of company schemes are now properly funded. But, as we all know, investments can go down as well as up, and we have now seen how the volatility in the stock market is translated into very large surpluses or deficits in company accounts. The trend to close defined benefit pension schemes is likely to continue in order to reduce the risk for the company.
For example, Tesco’s retirement scheme shows a deficit of £950 million at February 2007 – down from £1,211 million at the start of the year. Marks and Spencer’s deficit stands at £283 million down from £795 million.
Breaking Down Business Breakdowns
Can you imagine what it takes to manage a multibillion-pound company? Just reading the numbers can be a daunting task. Think about how many products are sent out to make that many sales and how many people are needed to keep the business afloat.
Most major companies deal with their massive size by splitting up the company into manageable segments. This division makes managing all aspects of the business, from product development, to product distribution, to customer satisfaction easier so that the company can better track the performance of each of its product lines.
In the Operating and Financial Review, you may find some detail about:
Target markets: These are the key market segments that a company targets, such as age group (teens, tots, adults), locations (UK, Europe, US, for instance), or interest groups (such as sportsmen, hobbyists, and so on). Target markets are limited only by the creativity of the marketing team, which develops the groups of customers that they want to win over.
The largest customers: The company usually names its top customers that buy their product. For example, a manufacturer that sells a large portion of its products to major retailers such as Tesco or Marks and Spencer usually gives some details about these relationships.
Manufacturing and other operational details: A company gives you information about how it groups its product manufacturing and where its products are manufactured. If the company manufactures its products internationally, look for indications about problems that may have occurred during the year related to those operations. Sometimes labour or political strife can have a great impact on a company’s manufacturing operations. Also, weather conditions can greatly impact manufacturing conditions. For example, if the company’s manufacturing for a certain product line is in Singapore, and Singapore experienced numerous damaging storms, the company may indicate that the problem occurred and that it had difficulty producing enough product for market.
Trade sanctions: All companies that operate internationally must deal with trade laws, which differ in every country. Some countries impose high tariffs on products coming from outside their borders to discourage importing. Sometimes countries impose sanctions on other countries for actions taken by politicians they disagree with. For example, the US doesn’t allow trade with Cuba for political reasons, so a company that buys products from Cuba can’t import into the US.
In the notes to the financial statements, you find at least one note related to the segment breakdowns. This note gives you details about how each of a company’s segments is doing. IAS 14 requires disclosure of segmental information covering both business and geographical segments although how a company defines its defines its segments is a matter for the judgement of management within the limitations laid down by the standard.
The existing standard IAS 14 is being replaced by a new standard, IFRS 8 which will be compulsory for financial statements for years ending on or after 31 December 2009. This new standard is one of the first standards that has been amended by the IASB so as to converge with the standard used in the USA. IFRS 8 has already caused considerable controversy mainly because it permits companies to give less geographical information than was previously required.
Reviewing Significant Events
Each year, companies face significant challenges. One year a company may find out that its customers are suing it for a defective product. Another year a company may get notice from the government that one of its manufacturing facilities is polluting the environment. You may also find mention in the notes about significant events that are not related to external forces – for example, the decision to close a factory or combine two divisions into one.
You can look in a number of places in the notes for information on significant events. Sometimes an event has its own note, such as a note about the discontinuation of operations. Other times, it is just part of a note called ‘Commitments and Contingencies’. Scan the notes to find significant events that impact a company’s financial position.
You’re most likely to find significant events mentioned in the notes regarding topics such as:
Lawsuits: Lawsuits (which you usually find in ‘Commitments and Contingencies’) that are pending against the company are explained. These suits can sometimes have a huge impact on a company’s future. For example, GlaxoSmithKline has a general statement in its annual report declaring that it has a number of product liabilities lawsuits impending. You would need to read the notes to the accounts to make a judgement on the potential damage that these might do.
Environmental concerns: These concerns can become a significant event if the company is involved in a major environmental cleanup because of discharges from one of its plants. Clean-up can cost millions of dollars. For example, Exxon has paid more than $900 million in compensation related to damages from the Valdez oil spill in Alaska’s Prince William Sound in 1989 and will still have to pay more in reparations.
Restructuring: Any time a company decides to regroup its products, close down a plant, or make some other major change to the way it does business, this is restructuring. You usually find an individual note explaining the restructuring and how that impacts the company’s income during the current year and all other years in which there is an impact from the decision to restructure.
Discontinued operations: Sometimes a company decides not to restructure but to close down an operation entirely. When this happens, you’re likely to find a separate note on the financial impact of the discontinued operations, which likely includes the costs of closing down facilities and laying off or relocating employees.
Many times the information included in these notes discusses not only the financial impact of an event in the current year, but also any impact expected on financial performance in future years.
When a company discusses lawsuits and potential environmental liability cases in the notes, it commonly indicates that in the opinion of management, the matter in question won’t result in a material loss to the company. Use your own judgement after reading the details management provides. If you think the company may be facing bigger problems than the company mentioned, do your own research on the matter before investing in a company.
Finding the Red Flags
As you probably know by now, some companies love hiding their dirty washing in the small print of the notes to the financial statements. As you read through the notes, keep an eye out for possible red flags.
Also be on the lookout for potential lawsuits that could result in huge settlements. If you see a lawsuit has been filed against a company, search for stories in the financial press that discuss the lawsuit in greater detail than the company might include in the notes. The financial press usually covers major lawsuits filed against a company.
Significant events aren’t the only things that can raise red flags. You may also see signs of trouble in the way that a company values assets or in decisions made to change accounting policies. The notes involving the long-term obligations a company has to its pensioners may also be a good spot to find some potential red flags.
Finding out about valuing assets and liabilities
Valuing assets and liabilities leaves room for accounting creativity. If assets are overvalued, you may be led to believe that the company owns more than it actually does. If liabilities are undervalued, you may think the company owes less than it actually does. Either way, you get a false impression about the company’s financial position.
Considering changes in accounting policies
How a company puts together its numbers is just as critical as the numbers themselves. The accounting policies adopted by the company drive these numbers. Whenever a company indicates in the notes to the financial statements that it’s changing accounting policies, your red flag should go up. We discuss the key accounting policies and how they can impact income in the section ‘Accounting Policies Note: Laying Out the Rules of the Road’ earlier in this chapter. You can find more detail about accounting policies in Chapter 4.
Changes in accounting policies aren’t always a sign of a problem. In fact, many times the change is related to requirements specified by the International Accounting Standards Board (IASB). No matter what the reason for the change, be sure you understand how that change impacts your ability to compare year-to-year or quarter-to-quarter results.
Decoding obligations to pensioners and future pensioners
As noted in ‘Pondering Pension and Retirement Benefits’ earlier in this chapter, obligations to pensioners and future pensioners can be a bigger drain on a company’s resources than debt obligations. The note to the financial statements related to pension benefits is probably one of the most difficult to understand. Look specifically at the notes that show a company’s long-term payment obligations to pensioners and the cash available to pay those obligations. If you find any indication that the company may have difficulty meeting these obligations mentioned in the note, this could be the sign of a major cash-flow problem in the future. Don’t hesitate to call and ask questions if you don’t understand the presentation.