The Securities and Exchange Commission (SEC) requires that every stockholder of a publicly-traded U.S. corporation be given a copy of its annual report, a formal document describing the corporation's performance over the past year. However, besides being required by law, annual reports can also serve as vital sources of company information-information that should be a part of your investment decisions.
Like many individual investors, perhaps you feel you just don't have the time to teach yourself all you need to know about the annual reports that arrive in your mailbox. In the hopes of making these important documents more accessible, this three-part article will take a brief look at some (but not all) of the main sections contained in a typical annual report. Of course, not all reports will contain every one of these sections; nor will they all offer the same degree of information. But, as you familiarize yourself with their contents, you may find them significantly less intimidating than when you began.
Notes to the Financial StatementsLooking only at the numbers contained in an annual report's financial statements rarely tells the whole story. Because the notes explain how the company arrived at its "numbers," they are often as important as the statements themselves. In general, the notes cover such items as:
- accounting methods
- commitments
- lease obligations
- contingencies
- pensions
Accounting methods. Corporations can often choose from among a number of different accounting methods when preparing their annual reports. When this occurs, the notes must disclose the method used-usually in Note 1. Such disclosures are important because different accounting methods can have different effects on such key elements as balance sheets and computations of net income. (For example, some methods of depreciation permit higher expense deductions than others.)
Keep in mind, however, that a company's financial statements cannot be directly compared from one year to the next unless the same valuation methods were used each year. Similarly, financial statements from different companies are not directly comparable unless they've been prepared using the same method(s).
Commitments. A "commitment," for purposes of corporate financial statements, is a contractual agreement by the company to do something. All significant commitments must be disclosed in the notes. These commonly include long-term purchase agreements, loan agreements and employee pension plans. Of course, every commitment has some effect on a company's financial future, but be especially wary of those that add significantly to the existing debt structure or that increase the amount of capital required to meet current obligations.
Lease obligations. Financial statements treat leases as a type of commitment, as defined above. In general, capital leases (a variety of noncancellable long-term lease) transfer ownership risks to the lessee, who then assumes responsibility for paying all property taxes, insurance fees and maintenance/repair costs. Short- term leases and leases where ownership risks are not transferred are known as operating leases. Whether short- or long-term, however, all leases represent a future obligation that must be met with cash.
Contingencies. Contingencies arise whenever some event might cause a financial gain or loss to the company. The exact amount of this gain or loss may in turn depend (or be contingent upon) the happening of some second event. Lawsuits for damages are one common type of contingency. The plaintiff's alleged injury gives rise to a possible loss, while the size of the award is contingent upon the final settlement or ruling.
Contingencies are usually classified as being either remote, possible or likely. Remote contingencies are generally not disclosed in the financial statements. Possible contingencies are disclosed, along with an estimate of the company's future gain or loss. Any contingency that the company believes likely to result in a loss must be accrued (recorded as a loss) and include a loss estimate. If the contingency is believed likely to result in a gain, it too is to be disclosed and described, but generally not accrued.
Investors should carefully examine any note that mentions contingencies, since contingency losses have the potential to seriously damage the financial future of an otherwise healthy company. And, when calculating contingency risks, be sure to weigh their possible effects on cash flow, current debt and overall liquidity.
Pensions. As listed in corporate financial statements, pension expenses represent the amount of money a company invests each year in order to cover the pension benefits its employees earned during that year. In order to remain solvent over the long-term, a pension fund's investment returns must be able to meet these future obligations.
It should be noted, however, that pension calculations are never exact. Instead, they represent a "best guess" estimate as to what the actual costs will be. Differences among employees in terms of years of service, salaries and projected life expectancies, along with varying rates of return on the pension fund's investments, combine to paint an uncertain picture.
Employers can legally contribute less (or more) each year to their employee pension fund than is necessary to meet the current year's obligation. As a result, pension costs are often spread over future accounting periods. When more than the current year's pension expense is being funded, the excess is listed as a "Prepaid Pension Cost." When the funded amount is less than the current year's expense, the difference is listed as an "Unfunded Accrued Pension Cost." Since most pension funds are administered by an outside trustee, their performance records are not included in annual reports. Those records are maintained by the trustee.
Be on the lookout for a major red flag-"Unfunded Projected Benefit Obligations." It warns you that, given its current rate of return, the company's pension fund investments are incapable of covering future benefit payments. Left uncorrected, the negative effects of this shortfall may seriously affect other areas of the business.
