In Willy Wonka and the Chocolate Factory, Willy Wonka opens the door to his Chocolate Factory and takes his guests on a magical tour. Along the way, there are traps that pick off his guests one-by-one until there is left only one who has negotiated the factory with seeming success. That success is fleeting when we learn that even the film’s hero, Charlie Bucket, violated the rules and must forfeit the grand prize, but eventually the truth wins out and our young hero wins the day - because of honesty.
While the movie, Willy Wonka and the Chocolate Factory, is just a classic fantasy, it will soon be time for millions of investors to embark on their own magical journeys through the winding and twisting mazes of the Annual Report. The annual report is that book that seems to come magically in the mail every year to tell you how well the company you invested in did the past year. The best part is you don’t even have to order it, but all too often investors open the envelope, see this book that they feel they can’t possibly understand and toss it in the trash. This and the following two month’s articles are meant to help you understand why it makes sense to keep that annual report out of the trash until you actually use it.
First of all, why does your company even send you an annual report? The answer to that is extremely simple - because it is required to report the results of its operations to you on an annual basis. One of the underlying principles of the United States securities industry is that investors must receive relevant material on a timely basis in order for the investing public to make an informed decision about the value of the billions of shares traded daily on the nation’s stock exchanges. One indicator, but not the only indicator, is how well a company did in the preceding year. The annual report is the company’s report card that gives just that information.
The major parts of a company’s annual report are:
- The auditor’s report on the company’s financial statements.
- Management’s discussion and analysis of the financial results of the past year, including certain selected financial data - sort of a state of the company message.
- Other optional information.
This month’s article is going to give you a thumbnail sketch of the process involved in getting the annual report to you. It is a time consuming task involving many people starting with the company’s accounting personnel all the way to its chief executive officer. This can be a few people on up to hundreds, if not thousands, of company employees plus the company’s attorneys, accountants and other advisers.
Throughout a typical year, the company’s accounting personnel collect, record and report all sorts of financial data to management of the typical company. The sales made, cash received, cost of the products sold, other expenses and cash paid out, plus much more are the various bits of data recorded by your company. The system of recording the transactions is the accounting system, and the system used to protect the integrity of the data is the internal control system. The internal control system is the single most important factor underlying the numbers because it is the system that management uses to keep everyone honest and deter employees from stealing from the company. While the failures of companies like Enron and Worldcom were due to bad business practices, the losses to investors stemmed from a lack of internal controls insuring the integrity of the information presented to shareholders.
A company in which you own stock is required to have an audit of its financial statements annually. An audit is sort of hard to describe, but basically unrelated auditors test transactions, along with the internal control system, to arrive at a conclusion as to the validity and completeness of information being presented to both management and shareholders. Audits don’t find every little mistake, but they are supposed to be designed to catch the big ones that would affect an investor’s judgment on the performance of the company.
The Audit Committee of the company’s board of directors is charged with evaluating the qualifications of an audit firm, its fees and its integrity to make certain the auditors will be working for the investor and not management. The process involved in finding an auditor can be cumbersome, but one thing you can be certain of is that the resulting audit will be expensive by the standards of most investors, but overall, it’s probably a fair fee.
These auditors will design tests to give them comfort that the company has sufficient controls to prevent misappropriation of the company’s assets. Based on the results of the tests, the auditors will then design tests to ascertain whether the recorded balances in the financial statements are properly recorded and that all required financial information on those balances is complete. The bottom line for an auditor is to be able to issue a report that the financial statements are "fairly presented in conformity with generally accepted accounting principles." The audit report is basically there to provide shareholders comfort that they are not being deceived.
At about the same time as the auditors are looking at the numbers, company personnel are trying to word the rest of the document (including the financial statements and notes) so they will cast the best possible light on the company’s situation without lying. Typically, a company’s lawyer and accountant will get involved in the process to make sure there is nothing false or misleading in the information presented by management.
Once the auditors and management are satisfied with the numbers, the earnings are "released" to the public. This basically entails a conference call where analysts and others get to hear an announcement on the results of company operations. The public, and analysts, will then start evaluating those results in light of how much earnings were expected versus actual results.
Next comes the filing of an annual report with the Securities Exchange Commission. At a minimum, this involves preparing and submitting Form 10-K based on SEC requirements. It can provide a wealth of information not normally found in the "public" annual report, but can also be confusing depending on how well the company’s writers do their jobs.
Next comes the annual report. Based on the information in audited statements and other non-financial information management prepares narrative information about the results of the company’s preceding year. The auditors must sign off on the information presented in the annual report, primarily to provide assurance to the public that the information in the entire document really is the truth.
Once everyone is happy with the package, the annual report goes to the SEC to ensure the information is consistent with actual financial results.
This month was a foundation to tell you where we are headed and also to introduce the annual report. If you are looking at purchasing stock and are poring over the annual report, don’t let it confuse you. Simply pick up the telephone and give us a call. We will be happy to try and explain the annual report elements in a clear and concise manner.
Happy New Year to one and all!