the stock market crash, equity investing became a passion. People borrowed money to get into the market, paying higher and higher prices for stock. Sound familiar? Not too different from what occurred just before the 2000 crash of technology and Internet stocks.
1933–1934: Congress created the SEC and gave it authority to develop financial accounting and reporting standards and rules to deter companies from distributing misleading information.
1973: The Financial Accounting Standards Board (FASB) was created to establish standards for financial accounting and reporting. The SEC recognized the generally accepted accounting principles (GAAP) as the official reporting standards for federal securities laws.
1984: The FASB formed the Emerging Issues Task Force, which keeps an eye on changes in business operations and sets standards before new practices become entrenched.
2002: The FASB began work with the International Accounting Standards Board (IASB) to converge international financial reporting systems.
Each department head usually receives a report from the top managers showing the department's expenses and revenue and whether it's meeting its budget. If the department's numbers vary significantly from the amount that was budgeted, the report indicates red flags. The department head usually needs to investigate the differences and report what the department is doing to correct any problems. Even if the difference is increased revenue (which can be good news), the manager needs to know why the discrepancy exists, because an error in the data input could have occurred.
Reports on inventory are critical, not only for managing the products on hand, but also for knowing when to order new inventory. I talk more about inventory controls and financial reporting in Chapter 14.
Tracking cash is vital to the day-to-day operations of any company. The frequency of a company's cash reporting depends on the volatility of its cash status — the more volatile the cash, the more likely the company needs frequent reporting to be sure that it has cash on hand to pay its bills. Some large firms actually provide cash reporting to their managers daily. I talk more about cash reporting in Chapters 15 and 16; Chapter 15 focuses on incoming cash, and Chapter 16 deals with outgoing cash.
Dissecting the Annual Report to Shareholders
The annual report gives more details about a company's business and financial activities than any other report. This document is primarily for shareholders, although any member of the general public can request a copy. Glossy pictures and graphics fill the front of the report, highlighting what the company wants you to know. After that, you find the full details about the company's business and financial operations; most companies include the full 10-K that they file with the SEC.
Breaking down the parts
The annual report is broken into the following parts (I summarize the key points of each of these parts in Chapter 5):
Highlights: These are a narrative summary of the previous year's activities and general information about the company, its history, its products, and its business lines.
Letter from the president or chief executive officer (CEO): This letter is directed to the shareholders and discusses the company's key successes or explains any major failures.
Auditors’ report: This report tells you whether the numbers are accurate or whether you need to have any concerns about the future operation of the business.
Management's discussion and analysis: In this part, you find management's discussion of the financial results and other factors that impact the company's operations.
Financial statements: The key financial statements are the balance sheet, income statement, and statement of cash flows. In the financial statements, you find the actual financial results for the year. For details about this part of the report, check out the following section, “Getting to the meat of the matter.”
Notes to the financial statements: In the notes, you find details about how the numbers were derived. I talk more about the role of the notes in Chapter 9.
Other information: In this part, you find information about the company's key executives and managers, officers, board members, and locations, along with new facilities that have opened in the past year.
Getting to the meat of the matter
No doubt, the most critical part of the annual report for anyone who wants to know how well a company did financially is the financial statements section, which includes the balance sheet, the income statement, and the statement of cash flows.
The balance sheet
The balance sheet gives a snapshot of the company's financial condition. On a balance sheet, you find assets, liabilities, and equity. The balance sheet got its name because the total assets must equal the total liabilities plus the total equities so that the value of the company is in balance. Here's the equation:
Assets = Liabilities + Equities
Assets appear on the left side of a balance sheet, and liabilities and equities are on the right side. Assets are broken down into current assets (holdings that the company will use in the next 12 months, such as cash and savings) and long-term assets (holdings that the company will use longer than a 12-month period, such as buildings, land, and equipment).
Liabilities are broken down into current liabilities (payments on bills or debts that are due in the next 12 months) and long-term liabilities (payments on debt that are due after the next 12 months).
The equities portion of the balance sheet can be called owner's equity (when an individual or partners closely hold a company) or shareholders’ equity (when shares of stock have been sold to raise cash). I talk more about what information goes into a balance sheet in Chapter 6.
The income statement
The income statement, also known as the profit and loss statement (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of one quarter or an entire year. Many companies prepare P&Ls on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: revenue, net income, and earnings per share of stock.
The income statement also tells you how much the company is spending to produce or purchase the products or services it sells, how much the company costs to operate, how much it pays in interest, and how much it pays in income tax. To find out more about the information you can find on an income statement, go to Chapter 7.
