Reading Financial Reports for Dummies (26 page)

When a company discusses lawsuits and potential environmental liability cases in the notes, it commonly indicates that in the opinion of management, the matter in question won’t result in a material loss. Use your own judgment after reading the details that management provides. If you think the company may be facing bigger problems than it mentions, do your own research on the matter before investing in that company.

A company facing a lawsuit isn’t necessarily a matter of great concern. Given the litigious nature of society, most major corporations face lawsuits annually.

But sometimes these suits do raise red flags.

Finding the Red Flags

As you probably know by now, companies love hiding their dirty laundry in the small print of the notes to the financial statements. As you read through the notes, keep an eye out for possible red flags.

Whenever you see notes titled “Restructuring,” “Discontinued operations,”

and “Accounting changes,” look for red flags that could mean continuing expenses for a number of years. The company will detail the costs of any of these changes. Be sure to consider long-term financial impacts that could be a drain on the company’s future earnings — which may mean stock prices will suffer.

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Also be on the lookout for potential lawsuits that could result in huge settle-ments. If you see that a lawsuit has been filed against the company, search for stories in the financial press that discuss the lawsuit in greater detail than what’s included in the notes.

Significant events aren’t the only things that can raise red flags. You may also see signs of trouble in the way that the company values assets or in decisions it makes to change accounting policies. The notes involving the long-term obligations the company has to its retirees may also be a good spot to find some potential red flags.

The financial press often mentions red flags that analysts spot in companies’

financial reports. Read the financial press to pick up the potential problem spots and look for the details in the financial statements and the notes to those statements.

Finding out about valuing

assets and liabilities

Valuing assets and liabilities leaves room for accounting creativity. If assets are overvalued, you may be led to believe that the company owns more than it actually does. If liabilities are undervalued, you may think the company owes less than it actually does. Either way, you get a false impression about the company’s financial position.

When you don’t understand something, ask questions of the firm’s investor relations staff until they present the information in a manner that you understand. If you’re confused about the presentation of asset or liability valuation, I guarantee that other financial readers are confused as well. I often find that the more convoluted a company’s explanation is, the more likely you are to find out that the company is hiding something.

Considering changes in

accounting policies

How a company puts together its numbers is just as critical as the numbers themselves. The accounting policies adopted by the company drive these numbers. Whenever a firm indicates in the notes to the financial statements that it’s changing accounting policies, your red flag should go up. I discuss the key accounting policies and how they can impact income in the section

“Accounting Policies Note: Laying Out the Rules of the Road,” earlier in this chapter. You can find more details about accounting policies in Chapter 4.

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Changes in accounting policies aren’t always a sign of a problem. In fact, many times the change is related to requirements specified by the Financial Accounting Standards Board (FASB) or the SEC. No matter what the reason for the change, be sure you understand how that change impacts your ability to compare year-to-year or quarter-to-quarter results.

If you see a change in accounting methods but you don’t see an indication that the FASB or SEC required it, dig deeper into the reasons for the change and find out how the change impacts the valuation of assets and liabilities or the company’s net income. You can find some explanation in the accounting policies note, but if you don’t understand the explanation there, call the investor relations department and ask questions.

Decoding obligations to retirees

and future retirees

As noted in the “Pondering Pension and Retirement Benefits” section earlier in this chapter, obligations to retirees and future retirees can be a bigger drain on a company’s resources than debt obligations. The note to the financial statements related to pension benefits is probably one of the most difficult to understand. Look specifically at the charts that show the company’s long-term payment obligations to retirees and the cash available to pay those obligations. If you find any indication that the company may have difficulty meeting the obligations mentioned in either the text of this note or the charts, this could be a sign of a major cash-flow problem in the future. Don’t hesitate to call and ask questions if you don’t understand the presentation.

Chapter 10

Considering Consolidated

Financial Statements

In This Chapter

▶ Understanding consolidation

▶ Seeing how companies buy companies

▶ Exploring consolidated financial statements

▶ Turning to the notes for details

Like couples who marry and work to combine two incomes, two sets of financial obligations, and two ways of managing money, things get complicated when companies decide to join forces or buy other companies and their financial statements become one. This new arrangement can make it much harder for you to find out how each of the pieces of this new entity performs financially. In this chapter, I discuss how to read the more complex financial reports that arise when companies consolidate.

Getting a Grip on Consolidation

One of the ways businesses grow is by buying or merging with other companies. When a company is bought by another, it gets gobbled up in the new company and loses its identity. But when firms decide to merge, they usually decide jointly how the new company will operate and how the financial statements will be presented.

Major corporations that own more than 50 percent of a company create financial reports for each division. These entities include subsidiaries, joint ventures, and associates. Here’s how they stack up:

✓

Subsidiaries
are entities controlled by a larger entity, usually a corporation. The corporation controlling the subsidiary is called the
parent company
. I discuss the various ways a company can become a subsidiary in the next section, “Looking at Methods of Buying Up Companies.”

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✓

Joint ventures
are entities in which
venturers
(usually two or more corporations) share joint control over the economic activity.

✓

Associates
are entities over which the parent company has significant influence but not the level of control it has over a subsidiary.

If a company’s financial report mentions these entities in any detail at all, you find it in the notes to the financial statements. Most times, you know only that a company has subsidiaries or associates, or participates in joint ventures, if you see “Consolidated” noted at the top of the page on the balance sheet (see Chapter 6) or income statement (see Chapter 7).

If you look at Mattel’s or Hasbro’s statements online (www.mattel.com; www.hasbro.com), you see that each statement indicates that it represents the financial results of the parent company and its subsidiaries.

However, you don’t see any listing of what those subsidiaries are on the balance sheet or income statement. In fact, unless a company discusses a merger, acquisition, or sale of a subsidiary, associate, or joint venture in the notes to the financial statements, you probably won’t see them mentioned individually in the current year’s financial report. If no financial transactions occur in the year being reported, the company may only highlight some of its subsidiaries’ successes in the narrative pages in the front of the financial report.

General Electric is one of the few companies that handles one of its subsidiaries — General Electric Capital Services (GECS) — differently.

Because this subsidiary’s financial activities and reporting are significantly different from its other business activities, as well as from its other subsidiaries, associates, and joint ventures (which it groups under the title

“Affiliates”), GECS gets its own column on the balance sheet (Financial Position) and income statement (Earnings), as Figures 10-1 and 10-2 show.

Although most of GE’s activities are in the manufacturing realm, GECS is a financial services subsidiary that has very different financial operations.

I chose GE as an example for this chapter because the Association for Investment Management and Research (AIMR) has cited it as having one of the best practices for presenting financial information. In addition to separating GECS from the rest of the GE fold, GE makes reading the financial report easier by carefully indicating which note to the financial statements is relevant to a particular line item on the balance sheet or income statement.

You can see GE’s complete annual report online at www.ge.com/ar2007/

index.jsp. You even find active links to the relevant notes as you read through the financial statements online.

Chapter 10: Considering Consolidated Financial Statements
141

Statement of Financial Position

General Electric Company

and consolidated affiliates

At December 31 (In millions, except share amounts)

2007

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