Reading Financial Reports for Dummies (53 page)

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Revenue per employee (Revenue ÷ Number of employees):
If the annual report doesn’t mention the number of employees, you can call investor relations or find it in a company profile on one of the financial Web sites, such as Yahoo! Finance (finance.yahoo.com).

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Revenue per dollar value of property, plant, and equipment (Revenue

÷ Dollar value of property, plant, and equipment):
You can find the dollar value of property, plant, and equipment on the financial report’s balance sheet.

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Revenue per dollar value of total assets (Revenue ÷ Dollar value of
total assets):
You can find the number for total assets on the financial report’s balance sheet.

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Revenue per square foot of retail or rental space, if appropriate
(Revenue ÷ Square foot of retail space):
You can find details about retail or rental space in the managers’ discussion and analysis or the notes to the financial statements, or in the company’s profile on a financial Web site.

Compare these ratios for the past five quarters, and also compare the ratios to ones of similar companies and ones for the industry as a whole. If you see major differences from accounting period to accounting period or between similar companies, it may be a sign of a problem. For example, if revenue per employee is much higher, or if revenue per dollar value of property, plant, or equipment far exceeds that of similar companies or that of previous periods, this may be a sign of abusive revenue management.

Exploring Exploitations of Expenses

If a company is playing games with its expenses, the most likely place you’ll find evidence is in its capitalization or its amortization policies. You can find details about these policies in the notes to the financial statements. For further explanation of amortization, see Chapter 4.

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Part V: The Many Ways Companies Answer to Others

Companies that want their bottom lines to look better may shift the way that they report depreciation and amortization, which are the tools they use to account for an asset’s use and to show the decreasing value of that asset.

To make their net incomes look better, companies can play games with the amounts they write off. They do so by writing off less than they should and lowering expenses.

In addition to depreciation and amortization schedules, companies can play games with expenses when reporting some types of advertising, research and development costs, patents and licenses, asset impairments, and restructuring charges. In some cases, companies can capitalize (spread out) their expenses over a number of months, quarters, or years. Spreading out expenses can certainly improve a company’s bottom line because the expenses will be lower in the first year they’re incurred, and lower expenses mean more net income.

So the key question is whether a company is spreading its expenses out properly or improperly managing its bottom line. You can find details in the accounting-policies section in the annual report. I point out the key policies to review, but if the company is playing games, detecting anything out of the ordinary is difficult to do by using the annual reports. You have to depend on reports in the financial press or from the SEC to see if problems are detected or exposed by a whistle-blower.

Advertising expenses

Companies report most advertising expenses in the accounting period when they’re incurred; however, for some types of advertising, such as direct-response advertising, companies can spread the expense out over a number of quarters.
Direct-response advertising
is mailed directly to the consumer.

For example, when a business sends out an annual catalog, it can legitimately spread out the costs for that direct-mail piece over the year, as long as it can show that it receives orders from that catalog throughout the year. To find out a firm’s policy on advertising expenses, look in the notes to the financial statements.

Research and development costs

Companies are supposed to report research and development (R&D) costs in the current period being reported on the financial statements, but some companies try to stretch out those expenses over a number of quarters so the reduction in net income won’t be necessary all in the same year. If fewer expenses are subtracted from revenues, net income will be higher, which will make the company look more profitable. However, the SEC has ruled
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that because these expenditures are so high-risk and a company isn’t certain when the R&D activities may benefit its revenue, the company must immediately report R&D expenses rather than spread them out over months or years. One notable exception is when a company is developing new software, in which case it can spread its expenses over a number of periods until the software development is technically feasible.

To see how the company expenses its R&D, read the notes to the financial statements. If you’re uncertain about the accounting policies that the notes present, don’t hesitate to call investor relations and ask questions until you understand what you’re reading.

Patents and licenses

Understanding the accounting for patents and licenses can be difficult. Most times, the expenses a company incurs during the research and development phase — before it receives a patent or license — must be written off in the year when they occurred, and they can’t be capitalized (written off over a number of years). But the company
can
capitalize some expenses — for instance, those it incurs to register or defend a patent. The company can also list a patent or license it purchases as an asset at the purchase price and capitalize it. Companies like to capitalize a patent or license because such a large purchase can significantly reduce their net income, so most prefer to write it off over several years, if they can, to reduce the hit.

All patents and licenses that a company purchases are listed as assets on the balance sheet. In addition, the balance sheet lists the costs of registering patents or licenses for products developed in-house. The value of these patents and licenses is amortized over the time period for which they’re
economically
viable
(meaning for as long as the company benefits from owning that patent or license).

Companies can play games with the value of patents and licenses, as well as with the time periods for which they’ll be considered economically viable. To see what a company says about its patent and license accounting policies, read the notes to the financial statements. Compare its policies with those of similar companies to see whether they appear reasonable or if the company may be overstating its value or capitalizing its expenses in a way that differs from its competitors. For example, if Company A makes widgets and says the patent for its type of widget is good for 10 years, and Company B makes a different kind of widget and says its patent is economically viable for 20 years, you probably want to call investor relations and find out why Company B

believes it has an economically viable widget for so much longer than its competitor.

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Part V: The Many Ways Companies Answer to Others

Asset impairment

Tangible assets depreciate based on set schedules, but not all intangible assets face a rigid amortization schedule. For example, goodwill is an intangible asset that’s no longer amortized each year. This line item on the balance sheet has long had potential for creative accounting practitioners. Today, most companies have goodwill on their balance sheets because many large public companies are formed by buying smaller companies.

Any company that acquires another company can list goodwill on its balance sheet. A firm’s value of goodwill is based on the amount of money or stock that it pays for the acquisition, over and above what the net tangible assets were worth.

In the past, companies amortized goodwill and wrote off its expenses each year. Today, a company must prove that the value of its goodwill has been impaired (worth less than it was in a previous year) before it can write it off.

The SEC requires that companies test goodwill before they write off any value to see if any impairment to its value has occurred.

The value of goodwill is tested based on a number of factors, including

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Competition and the ability of competitors to negatively affect the profitability of the business that a company acquires

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The current or expected future levels of industry consolidation

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The impact that potential or expected changes in technology may have on profitability

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Legislative action that results in an uncertain or changing regulatory environment

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Loss of future revenue if certain key employees of the acquisition company aren’t retained

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The rate of customer turnover, or how fast old customers leave and new customers arrive

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The mobility of customers and employees

If you see that a company has written off goodwill or any other asset under the rules of impairment, look for an explanation about how it calculated that impairment in the notes to the financial statements. If you don’t understand the explanation, ask the investor relations office questions.

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Restructuring charges

Restructuring charges is one of the primary ways that companies can hide all sorts of accounting games. A company can
restructure
itself by combining divisions, having one division split off into two or more, or dismantling an entire division. Any major change in the way that a company manufactures or sells its products usually entails restructuring.

Whenever a company indicates restructuring charges on its financial statements, carefully scour the notes to the financial statements for reasons behind those charges and how the company determines how much it will write off. Find out what costs the firm allocated to the restructure, and carefully read the details for those costs. The restructuring method is a great way for a company to get rid of losses in one-time charges and clean out the books. Luckily, this is a red flag that the SEC closely watches for, and SEC

staff question company reports if they believe a company’s charges and its explanations seem fishy.

In the notes to the financial statements, you usually find a note specifically detailing the restructuring and its impact on the financial statements. You may also find mentions of restructuring charges or plans in the management’s discussion and analysis section of the financial report. Many times when a company restructures, it incurs costs for asset impairment, lease termination, plant and other closures, severance pay, benefits, relocation, and retraining, giving creative accountants a lot of room to fiddle with the numbers.

The company must specify costs not only for the current period but also costs for all future years in which the company anticipates additional costs and any related write-offs in periods prior to the one being reported. The SEC

watches these charges very closely, too, and tries to close any loopholes that allow companies to charge recurring operating expenses to their restructuring, which companies do to improve the appearance to outsiders of the earnings results from business operations.

Finding Funny Business in

Assets and Liabilities

Overvaluing assets or undervaluing liabilities can give a distorted view of a company’s earning power and financial position. These practices can have a devastating impact when the company must finally admit to its game-playing.

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Part V: The Many Ways Companies Answer to Others

Recognizing overstated assets

Overstated assets make a company look financially healthier to annual report readers than it truly is. The company may report that it has more cash due than it really does, or that it holds more inventory than is actually on its shelves. The company may also report that the value of its inventory is greater than it really is.

Accounts receivable

The accounts receivable section of the financial report is the place where you may find an indication of premature or fictitious revenue recognition. One way a company can overstate its accounts receivable is to post sales to customers who will return the items early the following month without paying for them. The dollar value of those goods reduces the accounts receivable during the next accounting period, but the deception makes the current period look like more revenues were received than should actually have been counted because the sales are premature or fictitious.

That’s not the only way that a company can overvalue its accounts receivable. Another account attached to accounts receivable is the allowance for doubtful accounts. At the end of each accounting period, the company identifies past-due accounts that probably won’t get paid and adds the value of these past-due accounts to the allowance for doubtful accounts, which reduces the value of accounts receivable.

A company that wants to play with its numbers and indicate that its financial position is actually better than it appears reduces the amount it sets aside for doubtful accounts. Gradually, the number of days the company takes to collect on its accounts receivable goes up as more and more late- or nonpayers are left in accounts receivable. Eventually, the number of days it takes for the company to collect on its accounts receivable goes up, and the amount of cash it takes in from customers who are paying off their purchase bought on credit slows down.

You can test the trend for accounts receivable by using formulas I explain in Chapter 16. Test the trend by calculating days in accounts receivable for the past three to five quarters. If you see the number of days in accounts receivable gradually rise, that’s a sign of a problem, and it may represent an attempt to recognize revenue prematurely or fictitiously. But it may also represent a problem of credit policies that are too liberal. I discuss that issue in greater detail in Chapter 16.