Quarterly, Annual & Auditor's Reports, Management Discussion & Analysis
The Quarterly and Annual Reports
We find most historical data in the annual and quarterly reports released by the management. These can be found over the Internet or in physical form, which is usually a glossy and colorful publication.
Financial statements are required by law and must include a balance sheet, an income statement, a statement of cash flows, an auditor's report, and a relatively detailed description of the company's operations and prospects for the upcoming year.
The following information is presented in most financial reports, note that the order in which these are presented might vary:
- Summary of the previous year.
- Information about the company in general, its history, products and line of business.
- Letter to shareholders from the President or the CEO.
- Auditor's report telling you that the results are accurate.
- An in-depth discussion about the financial results and other factors within the business.
- The complete set of financial statements (balance sheet, income statement, statement of retained earnings, and cash flow statement)
- Notes to the Financial Statements.
- Other information on the company's management, officers, offices, new locations, etc.
How you read the financial statements really depends on who you are and what your interest in the company is. Management, creditors/lenders, partners, and investors utilize financial statements. Each group is interested in different things. For example, an investor might assess profitability, growth, stability, and the rate of dividends. On the other hand, a creditor is much more interested in the amount of debt that a company currently has and whether it has the ability to make repayments.
Let's take a tour through some of the most important sections of financial statements, looking more closely at what each section means.
Management Discussion & Analysis
As a preface to the financial statements, a company's management will typically spend a few pages talking about the recent year (or quarter) and give a background on the company. While this is not the guts of the financial statements, it does give investors a clearer picture of what the company does. It also points out some key areas where the company has performed well.
Don't expect the letter from management to delve into all the juicy details affecting the company's performance. The management's analysis is at their discretion, so take it for what it's worth. Things to look out for are:
- How candid and accurate are the managers' comments?
- Does the manager discuss significant financial trends over past couple years?
- How clear are the managers comments? If they try to confuse you with big words and jargon then perhaps they are trying to hide something.
- Do they mention potential risks or uncertainties moving forward?
Disclosure is the name of the game. If a company gives a decent amount of information in the MD&A, it's likely that management is being upfront and honest. It should raise a red flag if the MD&A portion of the financial statement ignores serious problems that the company has been facing. A good example would be a company that is known to have large portions of outstanding debt but fails mention anything about it in the MD&A. Withholding important information not only deceives those who read the financial statements, but in extreme cases also makes the company liable for lack of disclosure.
The Auditor's Report
If you had a large sum of money invested in a company, wouldn't you feel better if there was someone outside of management keeping an eye on things? This is the purpose behind the auditor's report, which is sometimes called the " Report of Independent Accountants." The job of the auditors is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure.
By law, every public company with stocks or bonds trading on an exchange must have their annual reports audited by a Chartered Accountant firm (or a Certified Public Accountant firm, for American companies). An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements.
The typical auditor's report is almost always broken into three paragraphs and written in the following fashion:
Independent Auditor's Report
- Paragraph 1
- The first tells the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited.
- Paragraph 2
- This paragraph lists how the GAAP (generally accepted accounting principles) were applied, and what areas of the company were assessed.
- Paragraph 3
- The third paragraph gives the auditor's opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy.
Generally, the auditor's report won't uncover any big nuggets of information on a company. However, it is crucial that you at least ensure that the financial statements have been audited. Audits give credibility to the figures reported by the management. Financial statements that have not been audited are essentially worthless. Unaudited financial statements have a higher probability of being misleading and fraudulent, and therefore completely useless to the investor who is trying to make an educated decision.