Interpreting Company Reports For Dummies E-Book

Ken Langdon

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 595

Veröffentlichungsjahr: 2011

Beschreibung

Company financial reports are a key resource for investors, helping them uncover priceless information about a company's profitability, or lack thereof, from the figures as well as through other non-monetary indicators. Details of lawsuits, changes in accounting methods, liquidations, and mergers and acquisitions can all be ways of detecting red flags if you know where to look. However the jargon and financial footnotes in financial reports can be difficult to decipher, and this For Dummies guide on the subject will help readers to understand company reports and make sensible investment choices based on publicly held information. Taking you step-by-step through the finer points of financial reports, this straightforward guide will help you get to grips with the most accurate way to wade through the numbers, judge a company's performance, and make profitable investment decisions. This UK Adaptation focuses on the UK financial market, with the FTSE index as the focus of the book.

Leseprobe

Interpreting Company Reports For Dummies

by Alan Bonham, Ken Langdon, and Lita Epstein

Interpreting Company Reports For Dummies®

Published by John Wiley & Sons, Ltd The Atrium Southern Gate Chichester West Sussex PO19 8SQ England

E-mail (for orders and customer service enquires): [email protected]

Visit our Home Page on www.wiley.com

Copyright © 2008 John Wiley & Sons, Ltd, Chichester, West Sussex, England

Published by John Wiley & Sons, Ltd, Chichester, West Sussex

All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, England, or emailed to [email protected], or faxed to (44) 1243 770620.

Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book.

LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: The publisher, the author, AND ANYONE ELSE INVOLVED IN PREPARING THIS WORK make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose. No warranty may be created or extended by sales or promotional materials. The advice and strategies contained herein may not be suitable for every situation. This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If professional assistance is required, the services of a competent professional person should be sought. Neither the publisher nor the author shall be liable for damages arising herefrom. The fact that an organization or Website is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Website may provide or recommendations it may make. Further, readers should be aware that Internet Websites listed in this work may have changed or disappeared between when this work was written and when it is read.

For general information on our other products and services, please contact our Customer Care Department within the U.S. at 800-762-2974, outside the U.S. at 317-572-3993, or fax [phone].

For technical support, please visit www.wiley.com/techsupport.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books.

British Library Cataloguing in Publication Data: A catalogue record for this book is available from the British Library

ISBN: 978-0-470-51906-6

Printed and bound in Great Britain by Bell & Bain Ltd., Glasgow

10 9 8 7 6 5 4 3 2 1

About the Authors

Alan Bonham: Since qualifying as a Chartered Accountant, most of Alan’s time has been spent training others. He was a Director at Anderson’s Tutors Limited where he prepared students for ICAEW exams. From there, he joined Neville Russell where he became Training Manager. He then spent 16 years as a freelance lecturer and training consultant specialising in audit and accounting topics.

Most recently, Alan was Director of Training for SWAT Ltd. As part of his role, he was responsible for the development of SWAT’s national programme of CPD training as well as presenting a number of courses himself. Alan had been Managing Director of Pentagon Training Ltd until the company was acquired by SWAT in October 2005.

Alan is now working again as a freelance lecturer – he is one of the few lecturers who can make auditing interesting. He also advises firms on their audit procedures and offers practical help in achieving compliance in a cost-effective manner. He has also worked with non-accountants, and is the co-author with Ken Langdon of Smart Things to Know about Business Finance which also demystifies the language of finance.

Ken Langdon: With a background in technology, Ken has been a trainer and consultant to many of the computer majors around the world. He has lectured in the USA, Australia, and all over the Far East and Europe.

In particular he has taught finance for non-financial managers and worked hard on explaining how the slightly esoteric world of finance reflects the real life world of businesses.

He is the author of a number of books on this and related topics.

Lita Epstein ran the financial accounting lab when she worked as a teaching assistant as she completed her MBA programme at Emory University’s Goizueta Business School. After receiving her MBA, she managed finances for a small, non-profit organisation, and the facilities management section of a large medical clinic.

Now she enjoys helping people develop good financial, investing, and tax planning skills. She designs and teaches online courses on topics such as investing for retirement, getting ready for tax time, and finance and investing for women. She is the author of Streetwise Crash Course MBA and Streetwise Retirement Planning (Adams Media Corporation).Lita is the co-author of Trading For Dummies (Wiley), and Teach Yourself Retirement Planning in 24 Hours (Penguin Putnam).

Lita was the content director for a financial services Web site, MostChoice.com and managed the Web site Investing for Women. She also wrote TipWorld’s Mutual Fund Tip of the Day in addition to columns about mutual fund trends for numerous Web sites. As a Congressional press secretary, Lita gained first-hand knowledge about how to work within and around the federal bureaucracy, which gives her great insight into how government programmes work. In the past, Lita has been a daily newspaper reporter, a magazine editor, and an associate director for development at The Carter Center.

For fun, Lita enjoys scuba diving and is certified as an underwater photographer. She hikes, canoes, and enjoys surfing the Web to find its hidden treasures.

Dedication

Alan and Ken: We would like to acknowledge the loyal support of our good friends Britney and Sol.

Lita: I would like to thank my father, Jerome Kirschbrown, an auditor and savings and loan examiner, who helped to hone my financial skills and taught me to be leery of what I see in financial reports.

Authors’ Acknowledgements

Alan and Ken: We would like to thank our acquisitions editor, Samantha Spickernell, our development editor, Simon Bell, and the team at Wiley for the huge contribution they have made to this book. We would also like to thank our Technical Reviewer, Paul Gee of Smith & Williamson Solomon Hare LLP, for his help and suggestions.

Lita: I would like to thank all the people at Wiley who helped to make this book possible, especially my acquisitions editor, Stacy Kennedy, who first discussed this topic with me; my project editor, Traci Cumbay, who did a wonderful job of steering this book through the entire process and was always available to help me with any problems; and my copy editors, Michelle Dzurny and Trisha Strietelmeier, for their excellent work cleaning up the copy.

I also want to thank my agent, Jessica Faust, who finds all these great projects for me, and my outstanding technical editor, Shellie Moore, who helped keep all the technical accounting stuff accurate for this book. This is third time we’ve worked together on a book. And a special thank you to HG Wolpin who puts up with all my craziness as I rush to meet deadlines.

Publisher’s Acknowledgements

We’re proud of this book; please send us your comments through our Dummies online registration form located at www.dummies.com/register/.

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and Media Development

Acquisitions Editor: Samantha Spickernell

Development Editor: Simon Bell

Content Editor: Nicole Burnett

Developer: Kelly Ewing

Copy Editor: Martin Key

Proofreader: Christine Lea

Technical Reviewer: Paul Gee, Technical Director Smith & Williamson Solomon Hare LLP

Publisher: Jason Dunne

Assistant Production Manager: Daniel Mersey

Cover Photos: © PhotoAlto / Alamy

Cartoons: Ed McLachlan

Composition Services

Project Coordinator: Erin Smith

Layout and Graphics: Reuben W. Davis, Alissa D. Ellet, Melissa K. Jester, Christine Williams

Indexer: Claudia Bourbeau

Brand Reviewer: Janet Sims

Contents

Title

Introduction

About This Book

Conventions Used in This Book

What You’re Not to Read

Foolish Assumptions

How This Book Is Organised

Icons Used in This Book

Where to Go from Here

Part I : Getting Down to Financial Reporting Basics

Chapter 1: Discovering What Reports Reveal

Finding Out What Financial Reporting Is For

Looking at Different Types of Reporting

Dissecting the Annual Report for Shareholders

Understanding How the Number Crunchers Are Kept in Line

Chapter 2: Recognising Different Business Types

Flying Solo: Sole Traders

Joining Forces: Partnerships

Shielding Your Assets: Public and Private Limited Companies

Seeking Protection with Limited Liability Partnerships

Chapter 3: Discovering How Company Structure Affects the Books

Investigating Private Companies

Understanding Public (Listed) Companies

A Whole New World: How a Company Goes from Private to Public

Chapter 4: Digging into Accounting Basics

Making Sense of the Accounting Method

Understanding Debits and Credits

Digging into Depreciation and Amortisation

Checking Out the Chart of Accounts

Differentiating Profit Types

Part II : Understanding Published Information: Annual Reports

Chapter 5: Exploring the Anatomy of an Annual Report

Meeting the Basic Parts of an Annual Report

Everything but the Numbers

Presenting the Financial Picture

Summarising the Financial Data

Chapter 6: Balancing Assets against Liabilities and Equity

Understanding the Balance Equation

Introducing the Balance Sheet

Assessing Assets

Looking at Liabilities

Navigating the Equity Maze

Chapter 7: Using the Income Statement

Introducing the Income Statement

Delving into the Tricky Business of Revenues

Acknowledging Expenses

Sorting Out the Profit and Loss Types

Calculating Earnings Per Share

Chapter 8: The Statement of Cash Flows

Digging into the Statement of Cash Flows

Checking Out Operating Activities

Investigating Investing Activities

Understanding Financing Activities

Recognising Special Line Items

Adding It All Up

Chapter 9: Scouring the Notes to the Financial Statements

Deciphering the Small Print

Accounting Policies Note: Laying Out the Rules of the Road

Working Out Financial Borrowings and Other Liabilities

Accounting for Share-Based Payment: Something New in the Accountants’ World

Mergers and Acquisitions: Noteworthy Information

Pondering Pension and Retirement Benefits

Breaking Down Business Breakdowns

Reviewing Significant Events

Finding the Red Flags

Chapter 10: Considering Consolidated Financial Statements

Getting a Grip on Consolidation

Looking at Methods of Buying Up Companies

Reading Consolidated Financial Statements

Looking to the Notes

Part III : Analysing the Numbers

Chapter 11: Testing the Profits and Market Value

The Price/Earnings Ratio

Dividend Yield and Cover

Return on Sales

Return on Assets

Return on Equity

The Big Three: Margins

Chapter 12: Looking at Liquidity

Finding the Current Ratio

Determining the Quick Ratio

Investigating Income Gearing

Comparing Debt to Shareholders’ Equity

Determining Debt-to-Capital Ratio

Chapter 13: Making Sure the Company Has Cash to Carry On

Measuring Income Success

Checking Out Debt

Calculating Cash-Flow Coverage

Part IV : Understanding How Companies Optimise Operations

Chapter 14: Using Basic Budgeting

Peering Into the Budgeting Process

Building Budgets

Providing Monthly Budget Reports

Using Internal Reports

Chapter 15: Turning Up Clues in Turnover and Assets

Exploring Inventory Valuation Methods

Applying Inventory Valuation Methods

Determining Inventory Turnover

Investigating Tangible Fixed Assets Turnover

Tracking Total Asset Turnover

Chapter 16: Examining Cash Inflow and Outflow

Assessing Trade-Receivable Turnover and Average Collection Period

Taking a Close Look at Customer Accounts

Finding the Accounts-Payable Turnover Ratio

Determining the Number of Days in Accounts-Payable Ratio

Deciding Whether Discount Offers Make Good Financial Sense

Chapter 17: How Companies Keep the Cash Flowing

Slowing Down Bill Payments

Collecting Accounts Receivables Faster

Borrowing on Receivables

Reducing Inventory

Getting Cash More Quickly

Part V : The Many Ways Companies Answer to Stakeholders

Chapter 18: Finding Out How Companies Find Errors: The Auditing Process

Meeting Mr or Ms Auditor

Delving Into the Auditing Process

Filling the GAAP

Chapter 19: Checking Out the Analyst–Company Connection

Typecasting the Analysts

Regarding Bond Rating Agencies

Delving Into Share Rating

Looking at How Companies Talk to Analysts

Chapter 20: How Companies Soothe the Shareholders

Knowing What to Expect from an Annual General Meeting

Culling Information from the Annual General Meeting

Checking Out How the Board Runs the Company

Speaking Out at Meetings: Proxy Votes

Catching Up on Corporate Actions

Staying Up-to-Date Using Company Web Sites

Chapter 21: Keeping Score When Companies Play Games with Numbers

Getting to the Bottom of Creative Accounting

Unearthing the Games Played with Earnings

Exploring Exploitations of Expenses

Finding Funny Business in Assets and Liabilities

Playing Detective with Cash Flow

Part VI : The Part of Tens

Chapter 22: Ten Financial Crises That Rocked the World

Enron: Be Cautious of Explosive Growth

Adelphia and Hollinger: Be Wary of Lavish Lifestyles

WorldCom/MCI: If It Looks too Good to Be True . . .

Parmalat: Keep It Simple

Independent Insurance: Unreliable Info, Higher Risk

Versailles: Don’t Follow the Money-Go-Round

Barings Bank: Security, Accuracy, and Incompetence

Equitable Life: Spread Your Pension Bets

Robert Maxwell: Unfit to Lead

Northern Rock: Financial Problems Without Wrongdoing

Chapter 23: Ten Signs That a Company’s in Trouble

Lower Liquidity

Low Cash Flow

Disappearing Profit Margins

Revenue Game-Playing

Too Much Debt

Unrealistic Values for Assets and Liabilities

A Change in Accounting Methods

Questionable Mergers and Acquisitions

Slow Inventory Turnover

Slow-Paying Customers

Chapter 24: Ten Top-Notch Online Resources

Companies House

IASB

Yahoo! Finance UK

Standard & Poor’s

Biz/ed

Financial Times

Accounting Web: ICC

Find

Department of Business, Enterprise and Regulatory Reform

Reuters

Part VII : Appendixes

Appendix A: Financial Statements

Appendix B: Glossary

: Further Reading

Introduction

When you open an annual financial report today, one of the first things you ask yourself is, ‘Can I believe the numbers that I’m seeing?’ At one time no one doubted the numbers. Everyone believed that any corporate financial report, audited by a certified public accountant, was truly prepared with the public’s interests in mind.

However, the financial scandals of the late 1990s and early 2000s destroyed public confidence in those numbers, including millions of investors who lost billions in the stock market crash that followed after many of those scandals came to light. Sure, a stock market bubble (a period of rising stock prices that stems from a buying frenzy) had burst, but financial reports that hid companies’ financial problems fuelled the bubble and helped companies put on a bright, smiling face for the public. After these financial reporting scandals came to light, more than 400 public companies in the US alone had to restate their earnings.

Many people still wonder what government regulators and public accountants were thinking and doing during this entire fiasco. How did the system break down so dramatically and so quickly? Although a few voices raised the red flags, their pleas were drowned out by the euphoria of a building stock market bubble.

These financial scandals occurred partly because the City measures success based on a company’s periodic results. Many in the City are more concerned about whether or not a company meets its short-term expectations than they are about a company’s long-term prospects for future growth. Companies that fail to meet their expectations find their shares quickly beaten down on the market. To avoid the fall, companies ‘massage’ their numbers. And this short-sighted race to meet the numbers each period is a big reason why these scandals occurred in the first place.

Since the scandals broke, legislators and regulatory bodies have enacted new laws and regulations to attempt to correct the problems. In this book, we discuss these new regulations and show you how to read financial reports with an ounce of scepticism. We also give you a bunch of tools that can help you determine whether or not the numbers make sense. We help you see how companies can play games with their numbers and show you how to analyse the figures in a financial report so that you can determine the financial health of a company.

About This Book

In this book, you find detailed information about how to read the key financial statements – the balance sheet, the income statement, and the statement of cash flows – in a financial report as well as discover the other key parts of the report that you should scour. (Turn to Chapters 6, 7, and 8 to find out more about these important statements.)

Many people skim or skip over three crucial parts of annual reports – the auditor’s report, the notes to the financial statements, and management’s discussion and analysis. (See Chapters 5 and 9 for more info on these parts.) In fact, in these parts, you find most of the juiciest information. Unlike the fancy, glossy coloured pages that lead off the report and give only the information that a company wants you to know, these less graphically appealing black-and-white pages give the key data that you need to know.

Although we can’t promise that you’ll be able to detect every type of company problem or fraud, we can promise that your antennae will be up and you’ll be more aware of how to spot possible problems. When you finish reading this book, you’ll understand what makes up the parts of a financial statement and how to read between the lines, using the fine print to increase your understanding of a company’s financial position. You’ll find out about who regulates the companies and certifies the truth and fairness of financial reports and how the rules have changed since the corporate scandals broke.

Conventions Used in This Book

Our principle concern here is with public limited companies that you may choose to invest in. But we also include some information on different types of company, small as well as large. (To find out more about company types and structure, see Chapter 2.)

To help you practise the tools we show you in this book, we use the annual reports of two large retailers, Tesco and Marks and Spencer, and dissect their annual reports in various chapters throughout the book. We also include their financial statements in Appendix A so that you can practise with the actual reports. You can download a full copy of the reports by visiting the investor-relations section of the companies’ Web sites: www.tesco.com and www.marksandspencer.com.

What You’re Not to Read

Many of the topics discussed in this book are, by nature, technical. Dealing with finances can hardly be otherwise. But in some cases, we provide details that offer more than the basic stuff you need to know to understand the big picture. Because these explanations may not be up your alley, we mark them with a Technical Stuff icon (see the section ‘Icons Used in This Book’ later in this chapter) and invite you to skip them without even the slightest regret.

If you want, you can also skip over the sidebars (the grey shaded boxes) as these cover only example material or anecdotes. They’re interesting to read through, but you won’t miss the meat and veg by skipping them.

Even if you skip these items, you still get all the information you need. On the other hand, if you savour every financial detail or fancy yourself the bravest of all financial report readers, then dig in!

Foolish Assumptions

To write this book, we made some basic assumptions about who you are. We assume that you:

Want to know more about the information in financial reports and how you can use it.

Want to know the basics of financial reporting.

Need to gather some analytical tools to more effectively use financial reports for your own investing or career goals.

Need a better understanding of the financial reports that you receive from the company you work for to analyse the results of your department or division.

Want to get a better handle on what goes into financial reports, how they’re developed, and how to use the information to measure the financial success of your own company.

Both investors and company insiders who aren’t familiar with the ins and outs of financial reports can benefit from the information and tools included in this book.

How This Book Is Organised

This book is organised into seven parts. After introducing the basics, we carefully dissect what goes into financial reports, giving you the tools you need to analyse those reports. We introduce you to the company outsiders who are involved in the financial reporting process and show you how to find red flags that might indicate deceptive or fraudulent reporting.

Part I: Getting Down to Financial Reporting Basics

Part I discusses the basics of accounting and financial reporting. If you need an introduction to these basics, or just a simple refresher course, you may want to begin here. In this part, you find information about the types of business structures, the differences between public and private companies, and the accounting basics necessary to understand financial reports.

Part II: Understanding Published Information: Annual Reports

This part introduces you to the key elements of an annual financial report. The first chapter in this part reviews the key sections of an annual report; the chapters that follow focus on each of these parts individually, explaining what you’ll find in a financial report and how to use that information. Another chapter explains in more detail what you can expect to find in the notes to the financial statements and what all that small print means. In the last chapter of this part, we discuss consolidated statements and the information that goes into them.

Part III: Analysing the Numbers

In this part, we give you the tools you need to analyse the numbers in financial statements. We show you how to test profitability, liquidity, and cash flow. These tools help you determine whether or not the company is a good investment.

Part IV: Understanding How Companies Optimise Operations

This part focuses on using financial statements to measure how efficiently management is using its resources. We review the basics of budgeting and how to use financial reports in the budgeting process. You also find tools for testing how efficiently companies manage their assets and keep cash flowing.

Part V: The Many Ways Companies Answer to Stakeholders

In this part, we focus on the outsiders involved in the financial reporting process. We review the role of auditors and the accounting rules and look at the role analysts play in the world of financial reporting. We also talk about shareholders and what they should expect from the companies that they invest in. In addition, we discuss how some companies ‘massage’ the numbers when they compile their financial reports.

Part VI: The Part of Tens

In the Part of Tens, we give you quick-reference lists pointing out the top-ten online resources you can use to do your financial research about companies and the top-ten signs that indicate that a company is in financial trouble. We also outline some of the juicier financial reporting scandals of the past several years.

Part VII: Appendixes

Appendix A includes two actual financial reports from the retailers Tesco and Marks and Spencer. We refer to these reports throughout the text. Appendix A also contains the results of the analysis carried out in the chapters. And, because much of the language of financial reporting may be new to you, we include a glossary in Appendix B.

Icons Used in This Book

Throughout the book, we use icons to flag parts of the text that you’ll want to notice. Here’s a list of the icons and what they mean.

This icon points out ideas for improving your financial report reading skills. In these paragraphs, you find useful financial resources, too.

This icon highlights information you definitely want to remember.

This icon points out a critical piece of information that can help you identify the dangers and perils in financial reports. We also use this icon to emphasise information you definitely don’t want to skip or skim when reading a financial report.

This icon highlights information that may explain the numbers in more detail than you care to know. Don’t worry – you can skip these points without missing the big picture!

Throughout the book, we give examples from financial reports of real companies, particularly Tesco and Marks and Spencer, whose reports are featured in Appendix A of this book. We highlight these examples with the icon you see here.

From time-to-time we use this icon to show you differences in nomenclature or systems that apply to small companies after text in which we have discussed their equivalent big brother companies. In this context, when we use the term small company, we are referring to companies that are not listed on the stock market.

Where to Go from Here

You can start reading anywhere in this book, but if you’re totally new to financial reports, start with Part I so you can get a good handle on the basics before delving into the financial information. If you already know the basics, turn to Part II to start dissecting the parts of a financial report. If you’re ready to get started on the road to analysing the numbers, turn to Part III. If your priority is tools for optimising company operation, you might want to start in Part IV. Those of you who want to know more about company outsiders involved in the financial reporting process may want to start at Part V.

Part I

Getting Down to Financial Reporting Basics

In this part . . .

If you’re a complete novice to the world of financial reports, this part gives you the background you need to understand this complex world, which has a language and rules of its own. In this part, we discuss the key types of financial reports, both internal and external, as well as what you should expect to find in those reports. We also explore different types of business structures and talk about the differences between a public and a private company. Finally, we review the accounting basics you need to understand in order to read financial reports.

Chapter 1

Discovering What Reports Reveal

In This Chapter

Reviewing the importance of financial reports

Exploring the different types of financial reporting

Discovering the key financial statements

Financial reports give a snapshot of a company’s worth at the end of a particular period, as well as a view of the company’s operations and whether it made a profit. In the modern business world it’s unthinkable that public, and some would say private, limited companies do not give the public some way to gauge their financial performance. Many stakeholders depend on this information.

Right now, nothing could possibly replace financial reports. Nothing could be substituted that’d give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the people who work for a company wouldn’t know how to make the company more efficient and profitable because they wouldn’t have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures, and help them make plans for future improvements.

This chapter introduces you to the many facets of financial reports and how internal and external stakeholders use them to evaluate a company’s financial health.

Finding Out What Financial Reporting Is For

Financial reporting gives readers a summary of what happened in a company based purely on the numbers. The numbers that tell the tale include the following:

Assets: The cash, amounts receivable from customers, stock awaiting sale, investments, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business that the company owns or has the use of.

Liabilities: Money a company owes to outsiders, such as loans and unpaid bills.

Equity: Shareholders’money invested in the company.

Sales: Products or services sold to customers.

Costs and expenses: Money spent to operate the business, such as money used for production, employee remuneration, and costs of operating the buildings and factories and supplies to run the offices.

Profit or loss: The amount by which the revenue from sales exceeds (or is less than) the costs and expenses.

Cash flow: The amount of money that flowed into and out of the business during the time period being reported.

Without financial reporting, nobody would have any idea where a company stands financially. Sure, the managers of the company would know how much money the company had in its bank accounts but even they wouldn’t know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much the company owes, or what the company owns. As an investor, if you don’t know those details, you can’t make an objective decision about whether the company is making money and whether it’s worth investing in the future of the company.

Many people rely on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:

Executives and managers: They need information to know how well the company is doing financially and to get information about problem areas so they can make changes to improve the company’s performance.

Employees: Employees need to know how well they’re meeting or exceeding their goals and to know where they need to improve. For example, if a salesperson has to make £30,000 in sales every month, they need a financial report at the end of each month to gauge how well they did in meeting that goal. If they believe that they met their goal, but the financial report doesn’t show that they did, they’d have to provide details to defend their level of productivity. Most salespeople are paid according to the level of their sales. Without financial reports, there would be nothing to base their bonuses on.

Employees also make career and pension decisions based on financial reports released by the company. If a company’s financial reports are misleading or false, employees could lose most, if not all, of their pensions and their long-term financial futures could be at risk.

Creditors: Suppliers need to understand a company’s financial results to determine whether they should supply goods and services to the company. Banks and other lenders need to decide whether to risk lending more money to the company and to find out whether the company is meeting the minimum requirements of any existing loans. To find out how companies meet creditors’ requirements, see Chapters 9 and 12.

If a company’s financial reports are false or misleading, banks might lend money at an interest rate that doesn’t truly reflect the risks being taken. They could miss out on a better opportunity because they trusted the information released in the financial reports.

Investors: Investors need information to judge whether or not the company is a good investment. If investors think that a company is on a growth path because of the financial information it reports, but those reports turn out to be false, investors can make large losses. They may buy shares at inflated prices, risking the loss of capital as the truth comes out or missing out on better investment opportunities.

Government agencies: These agencies need to be sure that the company is complying with regulations. They also need to be satisfied that the company is accurately informing the public about its financial position.

Analysts: Analysts need information to develop analytical reviews for clients who are considering the company for investment or additional loans.

Financial reporters: Financial reporters need to provide accurate coverage about a company’s operations to the general public. Their commentaries help investors to be aware of the critical financial issues facing a company and any changes the company makes in its operations.

Competitors: Every company’s top people read the financial reports of their competitors. If these reports are based on false numbers, it distorts the financial playing field. A well-run company could make a bad decision to keep up with the false numbers of a competitor and end up reducing its own profitability.

Looking at Different Types of Reporting

Under UK company law, every company must prepare accounts for shareholders and file information on the public record at Companies House.

Small private companies will usually prepare one set of accounts for their shareholders but will file a simplified set of accounts known as abbreviated accounts at Companies House. In most cases, neither of these sets of accounts will need to be audited.

Medium-sized private companies require to have their accounts audited. Some minor concessions, to make things simpler, are available for the set of accounts which are filed.

Larger private companies receive no concessions.

Public limited companies, or PLCs, are not necessarily listed on the stock market. A PLC has the right to issue shares to the public but does not necessarily have to exercise that right. All PLCs are subject to more detailed reporting requirements than private companies but, except for listed entities, the extra requirements are minor.

There are three markets for trading shares in the UK. The full market is subject to very detailed listing rules which are considered briefly below and in more detail in Chapter 3. AIM (Alternative Investment Market) provides a lighter touch for companies seeking a listing for the first time. As AIM companies grow, they may progress to the full market. The third market is known as the Plus market (formerly OFEX) which exists to permit arranged (matched) deals between buyers and sellers as distinct from the open market dealings in shares for companies on the AIM or full markets.

All public companies and private companies (other than small private companies) require an audit by a firm of registered auditors which are firms of accountants regulated by the various professional bodies. More details about auditors and the audit are included in Chapter 18.

Keeping everyone informed

One big change to a company’s operations after it decides to sell shares to the public is that the company must report publicly on a regular basis to its shareholders and the major financial institutions that help fund their operations through loans or bonds. As well as an annual report, listed companies in the UK currently need to produce the following:

Interim reports (currently at the 6 month stage).

Preliminary announcements (these are advance notices of the profit and other key information which will appear in the annual accounts).

Notification of material events such as indications that the profit is going to fall significantly short of the previously announced expectations. These notifications would also include other matters such as proposed take overs, mergers, and so on.

Notification of major changes in shareholdings.

Most major companies put a lot of money into producing glossy reports filled with information and pictures to make a good impression on the public. The marketing or public relations department, rather than the financial or accounting departments, writes much of the summary information. Too often, annual reports are puff pieces that carefully hide any negative information in the notes to the financial statements, which is the section that offers additional detail about the figures provided in those statements (see Chapter 9). Find out how to read between the lines – especially the tiny print at the back of the report – to get some critical information about the accounting methods used, any pending lawsuits, or other information that could negatively impact results in the future.

You can access reports filed with Companies House online at the Companies House Web site www.companieshouse.gov.uk.

Staying within the walls of the company: Internal reporting

Not all the finance department’s reporting is done for public consumption. In fact, companies usually produce many more internal reports than external ones to keep management informed. Companies can design their internal reports in whatever way makes sense to their operations.

These internal reports help managers to:

Find out which of the business’s operations are producing a profit and which are operating at a loss.

Determine which departments or divisions should receive additional resources to encourage growth.

Identify unsuccessful departments or divisions and make needed changes to turn the troubled section around or, for example, kill a project.

Determine the staff and inventory level they need to respond to customer demand.

Review customer accounts to identify slow-paying or non-paying customers in order to devise the best collection methods and to develop guidelines for when a customer should be cut off from future orders.

Prepare production schedules and review production levels.

Each department head usually receives a report from the top managers showing the department’s expenses and revenues, sometimes called sales or turnover, and whether it’s meeting its budget. If the department’s numbers vary significantly from budget, the report indicates red flags. The department head usually needs to investigate the differences, or variations on budget, 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 still needs to know why the difference exists because an error in the data input may have occurred. We talk more about reports and budgeting in Chapter 14.

Reports on inventory are critical not only for managing the products in hand, but also for knowing when to order more inventory. We talk more about inventory controls and financial reporting in Chapter 15.

Tracking cash is vital to the day-to-day operations of any company. Some large companies actually provide cash reporting to their managers daily. The frequency of a company’s reporting depends on the volatility of its cash status. The more volatile the cash, the more the company needs frequent reporting to make sure that it has cash in hand to pay its bills. We talk more about cash reporting in Chapters 16 and 17; Chapter 16 focuses on incoming cash, and Chapter 17 deals with outgoing cash.

These are just a few of the many uses companies have for their internal financial reports. The list is endless and is limited only by the imaginations of the executives and managers who want to find ways to use the numbers to make better business decisions. We talk more about using internal reports to optimise results in Chapters 14, 15, and 16.

Preparing the reports

The finance department is the key source of financial reports. This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called double-entry bookkeeping, which requires a company to record resources and the assets it used to get those resources. For example, if you buy a chair you must spend another asset probably cash. An entry in the double-entry system would show both sides of that transaction. The cash account would be reduced by the cost of the chair and the furniture account value would be increased by the cost of that chair.

This crucial method of accounting gives companies the ability to record and track business activity in a standardised way. The principles of double-entry bookkeeping have stood the test of time, remaining unchanged for centuries but accounting standards are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry bookkeeping, turn to Chapter 4.

Dissecting the Annual Report for Shareholders

The annual report gives more detail about the company’s business and financial activities than any other report. This report is primarily for shareholders, although any member of the general public can request a copy or look at it online. 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.

The annual report is broken into the following parts (We summarise the key points of each of these parts in Chapter 5):

Mission statement: Many companies put their statement of intent, or their mission statement, on the front cover, or in a key position on the first page. This succinct statement explains the company’s key vision and strategy.

Financial highlights: The inside cover and first page normally contain the company’s view of their financial performance last year compared to the year before. This comparison is interesting, but carefully selected, information.

The chairman’s statement: This is always a key description of the intentions of the company. Whilst predicting what will be in any particular statement is impossible, in this section the chairman is expected to pick out the critical issues in the recent past and in the future.

Reports of the chief executive and directors: These reports contain a number of matters required by law as well as describing the principal activities of the company.

A recent development in the directors’ report now requires the directors to state that they are not aware of any information of which the auditors are unaware (Yes! That is exactly what it says). A review of the business, including financial and non-financial key performance indicators, is also required to be included in the directors’ report as a substitute for the information which would have been required in the OFR (see below).

Review of operations – also known as the operating and financial review (OFR): This section has always been an important voluntary statement from which we can derive the company’s strategy. The detection of the overall strategy should not be too difficult.

Recently, the government got in a right pickle when it decided to make the OFR compulsory but then changed its mind soon after in order to cut red tape. In the meantime the Accounting Standards Board had written rules for the OFR and many companies had done so much work in gathering the necessary information that they went ahead and published their OFR’s on a voluntary basis!

Directors’ responsibilities: This section covers a number of issues including the responsibilities of the directors in relation to the publishing of financial information.

Auditors report: This statement is also nearly a standard with few particular variations. It’s here to record the fact that the auditors have done their job, how they did the job, and what their considered opinion is of the prepared accounts.

The financial statement: For those who want to know how well the company has done financially, the financial statement is the most critical part of the annual report as it includes the balance sheet, the income statement (also known as the profit and loss account), and the cash-flow statement.

• The balance sheet gives a snapshot of a 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 total equity (which in itself is a liability of the company). For more on the balance sheet, see Chapter 6.

• The income statement, also known as the profit and loss account (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of an entire year or any other period. Many companies prepare income statements on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: sales revenue, net income, and earnings per share. To find out more about the information you can find in an income statement, go to Chapter 7.

• The cash-flow statement is relatively new to the financial reporting game. The Accounting Standards Board didn’t require companies to publish it with the other financial reports until 1991 – previous to that there was a requirement for a rather convoluted document known as the ‘Source and Application of Funds’. Basically, the cash-flow statement is similar to the income statement in that it reports a company’s performance over time. But instead of focusing on profit or loss, it focuses on how cash flowed through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. We talk more about the statement of cash flows in Chapter 8.

Understanding How the Number Crunchers Are Kept in Line

Every public company’s internal accounting team, as well as its external auditors, must answer to government. The primary government entity responsible for overseeing corporate reporting and making sure that reporting is accurate is the Financial Reporting Council (FRC). Reports filed with Companies House may be reviewed by the Financial Reporting Review Panel which is a subsidiary body of the FRC. The Review Panel will also investigate complaints from members of the public concerning financial reports.

Another subsidiary body of the FRC is the Accounting Standards Board (ASB) which, as its name suggests, is responsible for setting accounting standards in the UK. The ASB’s power has been reduced in recent years since UK listed companies are now required to prepare their consolidated accounts in accordance with International Accounting Standards as adopted by the European Community. There is much more about this regulatory hiatus in Chapter 18.

Finally, auditors of listed companies are visited by the Audit Inspection Unit – yet another public body answerable to the FRC. We now have the answer to the question ‘Who audits the auditors?’

Financial statements filed at Companies House must adhere to Generally Accepted Accounting Principles(GAAP). To meet the demands of these rules, financial reporting must be understandable, relevant, reliable, and comparable with the financial reports of other similar entities. To find out more about GAAP, turn to Chapter 18.

You may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years with GAAP in place. Filing statements according to GAAP rules has become a game for many companies. Unfortunately, investors and regulators find that companies don’t always engage in transactions for the economic benefit of the shareholders but to make their reports look better and to meet the expectations of the City. Many times, companies look financially stronger than they actually are. For example, as scandals have come to light, companies have been found to overstate income, equity, and cash flows while understating debt. We talk more about reporting problems in Chapter 21.

Chapter 2

Recognising Different Business Types

In This Chapter

Exploring sole traders

Taking a look at partnerships

Figuring out the advantages of limited liability partnerships

Discovering the differences between types of limited companies

All businesses need to prepare key financial statements, but some businesses can make less formal statements than others can. The way in which a business is legally organised greatly impacts on the way it must report to the public and the depth of that reporting. For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and more and more outsiders such as investors and creditors become involved, financial reporting becomes more formalised until the company reaches the point where audited financial statements are required.

Each business structure also follows a specific set of rules about what financial information the business must file with government agencies. In this chapter, we review the basics about how each type of business structure is organised, how taxation differs, what must be filed, and what types of financial reports are required.

Flying Solo: Sole Traders

The simplest business structure is the sole trader – a business owned and run by an individual. Most new businesses with only one owner start out as sole traders. Some never grow into anything larger. Others start adding partners and staff and may realise that incorporating is a wise decision for legal purposes. (Check out ‘Seeking Protection with Limited Liability Partnerships’ and ‘Shielding Your Assets: Public and Private Limited Companies’ later in this chapter to find out more about incorporating.)

Anyone who wants to start a business as a sole trader must inform Her Majesty’s Revenue and Customs (HMRC) within three months. Weekly National Insurance Contributions (NICs) will need to be paid and, at the end of the tax year, the sole trader completes a self-assessment tax return. If turnover is expected to exceed the threshold for Value Added Tax (VAT) (currently £64,000 per annum), then VAT registration is also required.

The biggest risk for a sole trader is that the business isn’t a separate legal entity. All debts or claims against the business are filed against the sole trader’s personal property. If you are the owner of a sole tradership and are sued, then insurance is the only form of protection against losing everything you own.

Keeping taxes personal

Sole traders aren’t taxable entities, and sole traders don’t have to fill out separate tax forms for their businesses. Instead, sole traders simply add the self-employment forms about the business entity to their personal tax returns, and this is the only financial reporting they must do.

Sole traders will pay weekly National Insurance Contributions (NICs). NICs are fixed in amount (currently £2.20 per week) and are known as Class 2 National Insurance Contributions. If the trader’s annual profits exceed a set amount (currently £5,225), then additional contributions known as Class 4 Contributions will be payable. These are calculated from the self-assessment tax return and collected along with income tax.

Reviewing requirements for reporting

Financial reporting requirements don’t exist for sole traders. However, if they want to seek funding from outside sources, such as a bank, then the lender is likely to demand financial information. The lender is likely to need a statement of assets and liabilities and a basic profit and loss statement. Depending on the size of the loan, a sole trader may even have to submit a formal business plan stating goals, objectives, and implementation plans.

Even though financial reports aren’t required for a sole trader who isn’t seeking outside funding, completing periodic profit and loss statements lets you keep tabs on how well the business is doing and helps you find any problems before they become too huge to fix. These reports don’t have to adhere to formal Generally Accepted Accounting Principles (GAAP; see Chapter 18), but honesty is the best policy. The only person being fooled is you if you decide to make your financial condition look better on paper.

Joining Forces: Partnerships

Any business started by more than one person is a partnership. The partners share the risks and rewards of being in business but, because more than one person is involved, the business set-up is more complicated than that of a sole trader. Partners have the same requirement to inform HMRC as the sole trader. A useful online interactive tool exists which you can access from the HMRC Web site to identify what you need to do when starting a business. See www.hmrc.gov.uk. Partners have to sort out the following legal issues:

How they will divide profits.

How they can sell the business.

What happens if one of the partners becomes sick or dies.

How the partnership will dissolve if one of the partners wants out.

Because of the number of options, a partnership is the most flexible business structure for a business that involves more than one person. But to avoid future problems that can destroy an otherwise successful business, partners should decide on all these issues before opening their business’s doors.

The biggest risk for a partnership is that all the partners are jointly liable for the debts of the partnership and so are equally responsible for paying off the whole debt. If your partners disappear, you can end up picking up the entire tab.

Partnering up on taxes

Partnerships aren’t taxable entities. Partners are self-employed in exactly the same way as sole traders. Therefore, they will each pay Class 2 and Class 4 NICs. Each individual partner must report their share of the partnership profit in their personal tax return.

Meeting reporting requirements

Similar to the sole trader, a partnership does not have to present its financial reports in any special way because it doesn’t have to satisfy anyone but the partners. Partnerships do need reports to monitor the success or failure of business operations, but they don’t have to be completed to meet GAAP standards (see Chapter 18). Usually, when more than one person is involved, the partners decide among themselves what type of financial reporting is required and who is responsible for preparing those reports.

Shielding Your Assets: Public and Private Limited Companies

Business owners seeking the greatest level of protection may choose to incorporate their businesses as limited companies. The courts have clearly determined that limited companies are separate legal entities, and their owners are protected from claims filed against the company’s activities. An owner (shareholder) in a company can’t get sued because of actions taken by the company.

Two types of limited company structure exist:

Private companies: Whilst there is no limit to the number of shareholders in a private company, there will normally be just a handful. Typically, the private company is owned by a small number of people who are all involved in the day-to-day management of the business.

Public companies (PLCs): A company that wishes to offer shares to the public must register as a PLC.All companies listed on the stock exchange are PLCs, but some owner-managed companies are also PLCs. That is, a company does not have to issue shares to the public just because it’s a PLC.

Before incorporating, the first thing a business must do is form a board of directors, even if that board includes spouses and grown-up children on the board. (In a new rule brought in by the Companies Act 2006, directors must be at least 16 years of age.) Boards can be made up of both owners and non-owners. In private companies, the shareholders and directors are likely to be one and the same people but, as a company grows bigger, it often needs to raise money from outsiders.

Before incorporating, a company must also decide how many shares each of the shareholders will have. Private companies aren’t allowed to sell their shares on an open exchange. Even selling shares privately to friends and investors may fall foul of the strict rules that exist in this area.

A limited company’s veil of protection makes a powerful case in favour of incorporating. However, certain obligations come with incorporating, and the required legal and accounting services can be costly. Many businesses don’t incorporate and choose instead to stay as sole traders or partnerships to avoid these additional costs.

When a company is first set up, its constitution is laid down in its Memorandum and Articles, which must be placed on public record at Companies House. Model Articles exist, and they can be adopted by any new company. The Articles set out the rules for the internal management of the company and cover matters such as rights of shareholders, rules for transfer of shares, rules for conducting meetings, and the appointment and removal of directors.

Paying taxes the corporate way

Limited companies are separate tax entities, so they must file tax returns and pay taxes or try to find ways to reduce them by using deductions.

You sometimes hear that company profits are taxed twice – once through the corporate entity and once as dividends paid to its owners. This is not true. If the shareholder is a basic rate tax payer then there is no further tax to pay when he receives his dividends. A higher rate tax payer will pay the extra tax – as is right and just!

Getting familiar with reporting requirements

Public reporting is achieved by placing records on file at Companies House. All companies must file an Annual Return giving:

The address of the company’s registered office

The type of company it is and its principal business activities

Details about the directors and company secretary

A statement of capital

Details about names and addresses of the members (shareholders) of the company

Companies must also keep Companies House informed about a range of matters such as a change in the directors or the Articles of the company or if a charge is given over the assets of the company.

Companies must also file a copy of their Financial Statements drawn up in accordance with the rules appropriate for their business. (For more details, see Chapter 3.)

The records at Companies House are available to be searched by the public. The easiest way to do this is to log on to the Companies House Web site www.companieshouse.gov.uk. Basic details of registered address and nature of business are available free of charge. Alternatively for a small fee, you can get copies of the Annual Return and/or the latest financial statements. While most of this information is available from the Investor Relations pages of the Web sites of large companies, Companies House is the only source of this information when dealing with smaller companies.

Seeking Protection with Limited Liability Partnerships

A partnership or sole proprietorship can limit its liability by using an entity called a limited liability partnership, or LLP. This business form actually falls somewhere between a limited company and a partnership or sole trader in terms of protection by the law. (For more on these business forms, see the sections earlier in this chapter.)

LLPs are quite a new business vehicle in the UK. Created by the Limited Liability Partnerships Act 2000, LLPs are growing rapidly in popularity. LLPs have a number of the benefits of the limited company – the partners (or, more properly, the members) are taxed in the same way as the partners in a partnership.

The benefits of the LLP stem from the fact that it is a separate legal entity; the LLP is treated like a single person. It can enter into contracts and hold property and continues in existence despite a change of membership, such as through the death of a member. A third party enters into a contract with the LLP rather than with an individual member. By contrast, in a partnership, the third party contracts with a partner as principal and on behalf of the other partners.

The upshot of this is that, in the traditional partnership, negligent advice by an individual partner will result in all the partners suffering their share of the loss arising from a court action – even to the extent that they can lose their homes and personal possessions. In the LLP, the members who were not party to the giving of the advice are protected. It is the LLP itself which will be sued – although the individual member who gave the negligent advice can still suffer an action under the law of tort.

Taking stock of taxes

LLPs have their cake and eat it, too: They get the same legal protection from liability as a limited company, but don’t have to pay corporate taxes. In fact, HMRC treats LLPs as partnerships. (See the earlier section ‘Shielding Your Assets: Public and Private Limited Companies’ for more on these topics.)

Reviewing reporting requirements

Reporting requirements for LLPs are broadly similar to those of limited companies with some slight differences in the format of the main performance statements. LLPs classified as small enjoy the same exemptions as limited companies. We cover these matters in more detail in Chapter 3.

To shield themselves from liability, many large legal and accounting firms incorporate as LLPs rather than as limited companies.