New York University



How to read those annual reports

Accounting principles are the same the world over, but financial reports can still be a challenge. Peter Knutson goes back to basics to take the struggle out of the numbers

Peter H. Knutson is associate professor emeritus of accounting at the Wharton School, University of Pennsylvania and a Sloan fellow in the Wharton Financial Institutions Center.

The annual report of your company has arrived with a thud. Now, what do you do with it? You have avoided learning accounting and the little they did teach you has long been forgotten. Yet the annual report contains financial statements and you need to find out what they say. This article addresses the needs of both those who answer to this description and others who wish to refresh their knowledge of accounting at a basic level.

The equation

The basic accounting equation is:

Assets = Liabilities + Owners' equity,

The terminology may vary around the world, but the notion is constant. That is, the economic resources (assets) of an enterprise are equal to the claims of those who provide the resources, creditors (liabilities) and owners (owners' equities). To understand accounting, think of:

A = L + OE

In its basic form, accounting is the process of measuring and reporting an enterprise's assets and liabilities; owners' equity being the difference between the two.

Defining assets

Assets are defined as an enterprise's economic resources. However, in accounting, there are restraints on reporting their value. A business can report an asset only when it exists. That is the case where the enterprise:

• expects the asset to cause its future net cash flows to increase;

• has already done what is needed to be entitled to benefit from the asset;

• has the ability to obtain benefits and keep others from accessing them.

That definition means the valuation of assets is done in retrospect. For example, a company that signs a contract to build a dam will be better off in an economic sense when the contract is signed. However, the assets arising under that contract will be recognised in the financial statements only when the work is done.

Most assets are recorded at their purchase price until events prove the value has changed. Enhancements of value are validated by exchanges between the company and outsiders. Exchanges virtually always involve changing the form of an asset. For example, at the time of a sale, stocks (inventories) are converted into debtors (receivables). Decreases in value are recorded when they occur. Because decreases frequently occur without a transaction with an outsider, recording and reporting them can be subjective.

Defining liabilities and equity

Liabilities are present obligations either to convey assets, or render services to someone in the future as a result of past transactions. Therefore, the first step in liability measurement is to test for the existence of liabilities.

Most liabilities are payable in cash. They are reported at those amounts, reduced to their present value by discounting amounts due more than one year in the future. Usually, the discount rate is the one in effect when the liability was incurred. The value of many liabilities can only be estimated. For example, consider the liabilities of an insurance company for claims on loss," that have not yet been reported.

Liabilities that will be satisfied by providing services can be easy to measure. Examples include royalties, rents, subscriptions, ticket sales and so on, received in advance. The price of these has been established and either they have been performed or they have not—hence the liability—exists only for unperformed services. On the other hand, measuring the cost of other obligations, such as warranties or life-long health care for retired employees can be very difficult. They are reported as estimates, which is better than nothing at all.

Owners' equity poses no problems. It is the excess of assets over liabilities. Therefore, it depends on how assets and liabilities are measured.

Financial reports

A financial report includes three major financial statements plus additional disclosures necessary for completeness. These disclosures often arc called "footnotes" but are more accurately called “notes to the financial statements”. The three major financial statements are:

• Balance sheet, sometimes called the "statement of financial position".

• Income statement, sometimes called the "profit and loss statement" or the "earnings statement".

• Statement of cash flows.

Also, although it is not considered a major statement, most corporate financial reports include a statement of changes in shareholders' equity.

The balance sheet

The balance sheet is a listing of, on one side, all the enterprise's assets. The other side is an organised listing of liabilities, plus the owners' equity. It forms the basic accounting equation for an enterprise, hence its name.

Assets are presented on the balance sheet in order of liquidity. The first category is current assets, which comprises cash and assets that will be turned into cash (such as stocks and debtors) within one year or the current operating cycle, if greater. The current operating cycle is the period it takes for cash to be converted into stocks (inventory), into debtors (accounts receivable), and back into cash again. Other categories include:

• property, plant and equipment: the long-term tangible assets;

• investments: holdings of financial instruments and other long-term assets being held for purposes other than productive activities;

• intangible assets: patents, copyrights, leasehold improvements and others, including goodwill. There may be a category caged other assets, for assets that managers are unable or unwilling to categorise.

Liabilities are classified between current liabilities, those payable within the period used to define current assets and all other liabilities, which are called noncurrent liabilities. Noncurrent liabilities are frequently sub-classified as long-term debt (the amounts owing in the form of long-term financial instruments such as bonds and mortgages) and other noncurrent liabilities.

For corporate enterprises, share holders' equity is classified as paid-in capital, the amounts received as investments by the owners; retained earnings, the cumulative amount of earnings reinvested in the company; and treasury stock, a deduction for the cumulative amount paid by the company to buy back its shares. Given the complexity of the transactions, the owners' equity section of a balance sheet may be complicated and confusing.

Income statement and cash flows

These two statements are dynamic, in contrast to the static nature of the balance sheet. The balance sheet tells us where we are. The income statement and statement of cash flows say how we arrived there. They cover the period between two balance sheets. (The accounting period is one year, but publicly-owned companies report more frequently.) The relative value of these two statements is often debated, debated, but a company must be both profitable and liquid to survive.

The income statement lists first the revenues of the enterprise. Revenues are the gross increase in company value from selling goods and services to customers. Expenses are deducted from revenues to obtain the profit or income of the enterprise. They make up the gross decrease in company value from the production and delivery of goods and services to customers. Expenses are the costs incurred to earn the revenues.

The concept of business income was defined by the economist J.R. Hicks as the amount a company could distribute to its owners without decreasing its capital. That definition means that every change in asset or liability valuation, other than transactions with the owners, affects the amount of periodic income.

In the US, certain of those changes are not reported on the income statement, but are held in owners' equity, waiting to appear on the income statements of one or more later periods. However, US corporations are required to include them in a supplementary income number called comprehensive income. In the UK, the profit and loss (income) statement includes only operating items, but is supplemented by the statement of total recognised gains and losses (STRGL), known affectionately as "the struggle".

The statement of cash flows presents gross cash flows, both positive and negative, classified as: operating cash flows; investing cash flows; and financing cash flows. Operating flows are the cash flows relating to income statement items: collections from customers, payments to suppliers, employees, utilities and so on. The format in which operating cash flows are presented usually does not show the flows directly. Instead, the presentation usually starts with the net income number, followed by a list of the items which caused income to be different from cash flow from operations (increases in debtors and stocks, depreciation, changes in accrued liabilities and so on). That presentation ends with the net cash flow from operating activities.

Investing cash flows are the payments and receipts from: buying property, plant and equipment; disposing of plant assets; buying other businesses: selling subsidiaries; and buying and selling financial instruments for investment.

Financing cash flows comprise the transactions by which the enterprise raises capital. These include: borrowing; debt repayments (although interest paid is an operating cash flow): proceeds from issuing share capital (capital stock); dividend payments; and amounts paid to buy back shares.

Using statements

A previous article pointed out the pitfalls of using accounting numbers to measure rates of return (see signpost). In short, limitations arise because financial statements focus on the past and do not record values which exist but have not been validated by a transaction. In addition, many costs that add value are recorded as expenses rather than as assets because it is too difficult to extract the value-adding part and in many cases the value created has little direct relation to the cost incurred.

Take, for example, research by a drug company. Much is spent on projects that fail, whereas successful products may have value many times the cost of development. Therefore, research and development costs are treated as expenses in the period they are incurred as an expediency. Many other costs receive similar treatment.

Despite the limitations of accounting numbers, much good use can be made of them. For example, within an enterprise, comparisons can be made over time and period-by-period changes will divulge information because each period's numbers will have been prepared in a comparable way. Comparisons between enterprises require greater care, but are useful when companies within a sector use comparable accounting. In the, absence of comparable accounting, analysts make, adjustments, using information in the financial statement notes, to enhance comparability. Period-by-period comparisons are called time-series analyses. Comparisons across different enterprises are called cross-sectional analyses.

Financial statement analysis employs many methods, including:

• common-size statements;

• percentage-change analysis;

• financial ratio analysis.

A common-size balance sheet is one where each asset liability and owners' equity account is presented as a percentage of total assets. It allows the analyst to compare financial structures of different companies, or of a single company over time, as it they were of equal size. It permits A focus on the array of assets deployed by each company in each period and the various financing sources for those assets. Its strength is in enabling comparisons.

A common-size income statement sets total revenues or sales equal to 100 per cent and expresses each of the remaining income statement lines as a percentage of revenues (sales). As with the balance sheet, it also facilitates cross-sectional and time-series analysis by holding size constant and focusing on proportions.

Percentage change is strictly a time-series analysis, but also can be applied cross-sectionally. It first computes the change in a balance sheet or income statement item by deducting the previous period amount from the current amount. The change is then divided by the previous amount and expressed as a percentage. The percentage change in individual items can be compared with the change in a control item, such as total assets or revenues. The strength of this technique is that it quickly identifies areas needing further attention.

Financial ratios are used to measure liquidity, efficiency, solvency and profitability. Note that a ratio is calculated by dividing one accounting number by another, thereby possibly magnifying the effects of uncertain ties in the numbers. Furthermore, all ratio analysis is relative, among enterprises and over time. There are no absolutes! Ratio examples include:

• Current ratio. This liquidity ratio is calculated by dividing current assets by current liabilities. It measures the ability to pay bills.

• Stock (inventory) turnover. This efficiency ratio is calculated by dividing the period's cost of goods sold by the average stocks (inventory) held during the period. It shows how many times stocks are sold during the year. The average number of days stock is held during the year may be computed by dividing 365 by the turnover.

• Times interest earned. This is a solvency ratio computed by dividing the income before interest and taxes (income available to cover interest) by the interest expense for the year. It is a rough measure of the ability to service debt.

• Return on equity. This useful profitability ratio is calculated by dividing the net income by the average owners' equity during the period. Many analysts use this ratio as a starting point, proceeding from there to disaggregate it into various components in their search for explanations of why results have varied.

What can change?

There are several developments that 1 could change the nature of financial statements. Two are of particular interest now: internationalisation and fair value accounting.

First, the International Accounting Standards Committee (IASC) formed in 1973 to harmonise standards around the world. In 1995, the TASC agreed with the International Organisation of Securities Commissioners (IOSCO) to complete a set of core standards by 1999.

The core standards have been completed and in 1999 IOSCO recommended that its members allow multinational issuers to use 30 IASC standards in cross-border offerings and listings. In February, the US Securities and Exchange Commission (SEC) asked interested parties to comment on issues arising if the SEC were to allow foreign registrants to use IASC accounting in filings with: the SEC without reconciliation to US accounting principles.

It is too early to predict what the SEC might do. However, the prospect is for an increase in the number of foreign enterprises issuing securities in the US and listing them on US exchanges.

Second is the issue of financial reports relying on historic cost for asset valuation. Recently, bodies that set accounting standards have pro posed changes that would report changes in the value of financial instruments in the period they occurred, not when they were realised by disposal. Perhaps, the greatest impetus for fair value accounting is an international working group of standards bodies established by the IASC. It includes several national accounting standard-setters and its work is near completion. Given that the group has a broad membership, its conclusions are likely to become world standards.

Conclusion

The basic concepts of accounting are simple: A = L + OE. However, they are seldom easy to apply. Accounting measurements require a trade-off between reliability (of historic cost) and relevance (the strongest argument for fair value). Accounting should represent the economic reality. It seeks to depict in numbers. It should be free from bias that would favour either the buyer or seller of a security. Accounting and financial reports yield useful information, but must be read with care. Finally, accounting provides vital information for efficient markets, which would collapse without financial reports. *

Further reading

* Anthony, R.N. and Pearlman, L.K. (1999), Essentials of Accounting, Reading, MA: Addison-

Wesley. On CD-Rom, by Ivy Software. ~ivysoft

* Tracy, J.A. (2001) Accounting for Dummies, IDG Books.

* Murray, D., Neumann, B. and Elgers, P. (2000) Using Financial Accounting. An Introduction.

Cincinnati: South-Western College Publishing.

* Weil, R. L. (1998) Accounting: the Language of Business, Sun Lakes, AZ: Thomas Horton.

* Schoenebeck, K.P.(2001) Interpreting and Analyzing Financial Statements, Englewood Cliffs, NJ: Prenlice-Hall.

* Mufford, O.W. and Comiskey, E.E. (1996) Financial Warnings. New York: John Wiley.

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