10-K Ford Motor Company Review Ford Motor Company's Form 10-K for 2012. Explain the purpose of a company?s 10-K and how it interprets the firm?s financial strength. Write a description of three important items, including their significance to stakeholders, that you learned from reading Ford Motors Company?s 10-K for 2012. Your paper must be two to three pages in length (not including the title and reference pages) and formatted according to APA style as outlined in the Ashford Writing Center. It must include citations and references for the text and at least two scholarly sources from the Ashford University Library. Carefully review the Grading Rubric for the criteria that will be used to evaluate your assignment.

1 What Are Financial Statements and How Can You Use Them? emily2k/iStock/Thinkstock Learning Objectives After reading this chapter, you should be able to: 1. List and explain the types of financial statements and the individuals who use them. 2. Describe the purpose of the annual report and the elements that it comprises. 3. Describe the purpose of the Form 10-K and the elements that it comprises. 4. Define the concept of generally accepted accounting principles (GAAP) and explain how they are used in practice. 5. Identify accounts that make up the annual report and Form 10-K. eps81356_01_c01_001-044.indd 1 3/25/14 3:07 PM Introduction Pre-Test 1. What are the key parts of an annual report? a. balance sheet, income statement, and cash flow statement b. revenues, expenses, assets, and liabilities c.\t\u0007 auditor's report, management's discussion and analysis, financial statements, and notes to the financial statements d.\t\u0007 highlights, president's or CEO's letter, key executive officers, and financial statements 2. Who reads financial reports? a. government agencies b.\tinvestors c.\tbankers d. all of the above 3. What rules must be followed when preparing a financial report? a.\tGAAP b. auditor's rules c. SEC rules d. rules set by executives 4. What are the key account groupings of financial statements? a. assets, liabilities, equity, revenue, cost of goods sold, and expenses b. cash, debt, stock, sales, expenses, and retained earnings c. sales, assets, liabilities, expenses, and costs d. sales, assets, equity, costs, and expenses 5. Who must receive a Form 10-K? a. the auditors b. the SEC c. the state treasurer d. the investors Answers can be found at the end of the chapter. Introduction You are probably at least a little familiar with financial statements, and you may have used or created them as part of your financial responsibilities as a manager or employee. But to be a truly effective manager, it's important to understand more than just the basics. And that's what this book is all about: understanding how you can use financial statements to make better and more informed decisions as a manager. One key responsibility for many managers is the regular preparation of a budget. In fact, all companies must plan a budget prior to the start of a new year. Most companies pick managers from various departments to spearhead the budget process. eps81356_01_c01_001-044.indd 2 3/25/14 3:07 PM Introduction In this text, we'll follow a fictional committee at the fictional Best General Company that was formed to create a budget for the coming fiscal year. Let's first meet the members of the committee: Bob, a financial analyst at the company, has been asked to form the budget committee. He chooses three other employees to join him: Susan, a marketing manager; Juan, a sales manager; and Mai, the purchasing manager. Together this group will need to review the year-to-date spending and compare it to the budget to analyze how well the company is doing. As part of their research, they will also need to compare their company's financial results to similar companies in the same sector. This will help them determine how they are performing against their competitors. After reviewing the previous year's results, they will also be able to determine areas where improvement is needed, or, conversely, identify areas in which their company excels. Using all of this information, committee members will be able to develop a framework that department heads can use to develop a budget for the next year. This will include a projection of revenuesthat is, whether revenues are expected to go up or down. Revenues drive the budget because resources the company can use during the next year will depend on the revenue that is expected to be generated. For example, if the budget committee projects an increase of 10% in revenues, it can instruct managers that they can increase their expenses by a certain percentage. On the other hand, if the economic conditions lead the budget committee to project lower revenue than the previous year, managers will be asked to reduce their expenses by a certain percentage. The profit goals will drive the percentage of budget increases and decreases as well. For example, if the company is expected to increase its revenue by 10%, the executive committee may want to increase expected net profit by a certain percentage. Therefore, managers will not be given leeway to increase expenses by the full 10% of expected revenues. The budget committee may also recommend to the executive committee expansion in certain divisions or departments that are producing the best resultsand possibly a reduction in resources to departments whose contribution to revenue is decreasing. In this book, we will follow the Best General Company budget committee and give examples of how it can use financial statements to determine how well the company is doing and make appropriate decisions. As part of this process, we will introduce financial statements and how they can be used to manage the finances of each department discussed. Along the way, we will explore who reads financial reports and what they hope to gain by reading them. By analyzing such reports, readers learn not only whether a company made money during a given period, but also how efficiently the company used its resources. Let's get started by discussing financial statements and why they are so important. eps81356_01_c01_001-044.indd 3 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 1.1\u0007 What Are Financial Statements and Why Are They Important? No manager or executive can develop plans to improve a company's financial performance and results without first analyzing what happened over the past year, or past several years. This is where financial statements come in; they provide a snapshot of the financial health of a company for a specific period of time, and give both internal and external readers information needed to make financial decisions about a company. Mid-level managers and supervisors, for example, can use financial reports to identify a trend. They can compare several years' worth of reports, and then make decisions about how to improve their department's results based on an analysis of these trends. Similarly, if a company's profits are dropping, managers, such as those participating on our Best General Company budget committee, can use financial reports to determine the contributing factors. Conversely, if managers spot an improving trend, they can use financial statements to identify the key products or services contributing to this improvement, and look for ways to grow their company's market share in the most profitable products or services. Managers should always be alert to trends that affect revenues or expenses, whether up or down. The sooner a changing trend is recognized, the quicker a fix can be put in place to meet or exceed year-end goals. Managers have access to two types of reports: external financial reports and internal financial reports. External financial reports are made available to the general public, including investors, bankers, vendors, and suppliers, and must be prepared according to strict accounting rules, which are discussed below. Internal financial reports, in contrast, are confidential and can only be shared with employees of the company or the company's board of directors. Let's review the key differences between these types of reports and the information found in each. External Reports All companies must prepare external reports for their bankers and investors. Companies that sell shares on the public stock markets (that is, public companies) must file these reports with the Securities and Exchange Commission (SEC), a federal agency that enforces securities law and regulates the securities industry, which includes the stock and option markets. eps81356_01_c01_001-044.indd 4 didecs/iStock/ThinkStock Companies that are publicly traded must file annual financial reports with the SEC. 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 Three Key Documents A standard set of financial statements consists of the following three key documents: The balance sheet (or statement of financial position): This statement shows a company's assets (what the company owns), its liabilities (what the company owes), and its equity (what claims investors have on the assets). It is essentially a snapshot of the company's financial position as of a particular date. We dig into this statement in Chapter 2. The income statement (or statement of earnings, or profit and loss statement): This statement provides information about a company's revenues and expenses. We explore this statement in Chapter 3. The statement of cash flows: This statement reveals how much cash flowed into and out of the business. The statement allows managers to determine whether the company received and spent more or less cash in the current year (versus the prior year) in each of the critical areas of operations. Operations include all the day-today activities in running the business. These activities will vary depending on the type of business that is being run. We explore this statement in Chapter 4. In addition, if the company is incorporated, the company's annual report will include a statement of shareholders' equity, which will detail the claims owners have against the company's assets. This can be found at the bottom of the income statement or on a separate page. We will explore the statement of shareholders' equity in the same chapter as the income statement. Using External Reports Let's say Juan, the sales manager at Best General Company, takes on the first task for the budget committee. Working with Susan, the marketing manager, he needs to determine what level of sales to project for the next year. This number is critical to the entire budgeting process because it sets the revenue goal, which will drive what financial resources will be available to every department. Juan and Susan need to analyze the sales trends for the current year and compare these results to previous years. They will then need to collect data that will enable them to project sales levels for the next year. They also need to compare Best General Company's sales to those of others in the industry. If Best General Company is doing better than the other companies, they need to identify what the company does differently to stay on top of the competition and plan strategies to keep Best General Company on top. If they find that their company is not doing as well, they need to analyze what the competition is doing to attain better results, and come up with a plan to improve their own performance. Suppose they discover that Best General Company's revenues are falling. How can the budget committee use the external financial statements to find out why? 1. From the income statement, they may find that revenues for the Best General Company have been falling for not just one year, but the past few years. eps81356_01_c01_001-044.indd 5 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 2. A second stop would be the balance sheet, which could reveal that the Best General Company's cash flow is threatened because of a rising trend in accounts receivable (an account that tracks money due from customers). This could mean customers are paying their bills more slowlyor not at all. 3. The third stop would be the statement of cash flows, which would enable them to determine whether the company received or spent more or less cash in the current year versus the prior year in each of the critical areas of its day-to-day operations. Someone examining a company's external reports would not be able to probe all that deeply into the company's finances because much of the needed detail would be in internal reports that are confidential and available only to insiders (which we discuss next). The budget committee will have access to the internal reports for the Best General Company but will not have access to the internal reports for their competitors. However, outsiders can find more about these key financial statements in the Notes to the Financial Statements, which are published publicly. These notes provide more detail about the numbers on the statements. We will explore these notes and their relationship to the financial statements as we delve into each of the statements in the chapters that follow. External financial report readers can also find out more information from a company's executives in another section of the reports filed with the SEC called the Management's Discussion and Analysis. In this section, executives discuss the prior year's results, as well as key plans for the company in the following year. This section of the external reports can be helpful for Juan and Susan to find out where their competitors are planning to focus their attention in the next year. The financial statements, notes to the financial statements, and the management's discussion and analysis are all parts of an annual report that must be sent to shareholders and filed with the SEC. (Quarterly reports that are not as detailed are sent to shareholders and are also filed with the SEC.) In addition to an annual report, a more formal financial reporting structure, called the SEC Form 10-K, must also be filed. Internal Reports As noted above, internal reports are released only to certain employees in the company to help executives and managers delve deeper into the numbers. Public companies prefer to release as little of their financial information as possible to minimize the information available to their competitors. Of course, public companies must divulge a certain amount of information because government regulators require it, but the devil is in the details. A financial report reader won't find many of the details needed to make business decisions in the public reports. Instead, such information is found in confidential reports prepared for internal audiences only. Confidential reports may detail the sales by product, the cost of goods purchased by product, and a summary of customers who are late paying their invoices, as well as a number of other details. There is no limit to the types of internal reports that can be developed. These reports do not have to meet any rules since they are for internal use only. eps81356_01_c01_001-044.indd 6 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 This book focuses primarily on public financial reporting. However, we will also explore common formats for internal reports that enable executives and managers to make decisions. The company's accounting department prepares both types of reports. As we explore the various financial statements, we will also discuss how these reports are prepared. Who Reads Financial Reports? Many people read a company's financial reports to get the information they need to (1) gauge the financial health of a company and (2) make decisions about the company. The following are examples of individuals who might be interested in these reports, and what they hope to learn by reading them: Executives and managers: These are the individuals who make financial decisions for the company. They base most of their decisions on the information found in both internal and external financial reports. If executives and managers see a major difference between what was budgeted versus the final result, they will investigate to find out why there is a difference; for example, they will talk to key managers and employees about their target goals. Non-accounting managers use these reports to determine whether they met their goals and, if they did not, to determine what happened. Employees: Employees also use financial reports to determine whether they met their goals. For example, salespeople depend on internal reports to determine their commissions and to be certain they received credit for all their sales. If the internal reports differ from what the salesperson believes he or she sold in the month, the salesperson will need to provide the evidence and determine what might be missing from the report. If the salesperson finds the internal report does not accurately reflect his or her sales, then all other reports based on these numbers may be wrong as well (or it may mean the wrong salesperson received credit for a sale and the rest of the reports are accurate). Employees may also make career and retirement investment decisions based on the financial reports. For example, if an employee is seeking an opportunity to move up in the company, he or she may use information from the financial reports to determine where the company is planning to grow and seek a position in one of the growth departments. Creditors: Creditors, such as banks or other lending institutions, use financial reports to determine whether to lend money to the company. A creditor who has already loaned money to the company may also use the reports to determine whether the company is meeting minimum loan requirements set in the agreement. Vendors: Vendors, such as suppliers or service providers, use financial reports to determine whether to extend credit. If a vendor does not think the company's finances are strong enough, it could require cash on delivery. Investors: Investors depend on financial reports to decide whether to invest in a company. Once they invest, they continue to analyze reports to decide whether to hold on to the investment or to sell it. Government agencies: Government agencies use financial reports to be sure that public companies comply with regulations set at both the state and federal levels. They also want to be sure that companies report their numbers accurately to inform the public about their financial position. eps81356_01_c01_001-044.indd 7 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 Analysts: Analysts use financial reports to develop analytical reviews and to prepare reports for investors or creditors. In addition to using the financial reports, analysts will question key executives about the financial results on an analyst call at the end of each reporting period. Financial reporters: Financial reporters use financial reports to write stories for their audience about a company's financial health. They may also participate in analyst calls to develop their news stories. Competitors: Competitors read each other's financial reports to make decisions about their own companies. That's why companies expose the least amount of detail possible in their financial statements. They hope to keep their competitors guessing about how they earn the results reported. Financial reports serve many purposes. For managers and employees, they can be an excellent resource for recommending growth opportunities. Employees who can understand and analyze financial reports become a very valuable resource to their employers. For example, suppose an operations employee notices that the expenses for shipping outgoing packages have increased dramatically and will result in exceeding the amount budgeted for this expense. She decides to investigate shipping alternatives and prepare a report for her manager that shows she can meet, or even reduce, budgeted expenses. She will impress the managerand if she works for a company that provides incentives for cost control, she may even receive a bonus. Public vs. Private Companies As noted earlier, only public companiesthose whose stocks are sold on the public stock marketsmust prepare financial reports for public consumption. Companies that do not sell their stock on the open market (rather, all shares are split among the company's founders, employees, investors, and select others) are private companies and do not need to reveal details about their finances. Most private companies are small businesses, but because of the advantages of remaining private, there are large corporations that choose to stay private as well (see Table 1.1). (For more information about one large private company, read the \"World of Business\" feature box on Mars, Inc.) Table 1.1: Forbes' 2013 top five private companies based on gross revenue Private company Gross revenue Industry (in billions of U.S. dollars) Cargill $137 Food, drink, and tobacco Koch Industries $115 Numerous industries (popular brands include Brawny and Quilted Northern) Dell $57 Technology hardware and equipment Bechtel $38 Construction Mars $33 Food, drink, and tobacco (primarily candy) Source: Murphy, A. (2013). America's largest private companies. Forbes. Retrieved from http://www.forbes.com/largest-private-companies/ eps81356_01_c01_001-044.indd 8 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 World of Business Mars: From Kitchen to Candy Titan M&M's, Twix, Dove Bars. You have no doubt tried a candy treat made by Mars, one of the most successful private companies in the United States. Since Mars is a private companystill owned and operated by the family that founded itit does not provide detailed financial reports to outsiders. However, the company does choose to share its gross earnings statements. And with gross earnings of more than $30 billion, it ranks in the top five of the Forbes list of biggest private companies (see Table 1.1). .Vincent Kessler/Reuters/Corbis Mars is one of the largest privately owned companies in the United States. Frank and Ethel Mars started the company in their kitchen in Tacoma, Washington, in 1911. The first candy bar that became a worldwide success was the Milky Way, which became known as the Mars bar in Europe in the 1920s. Today the company operates in over 50 countries and sells its products in more than 100 countries. In addition to candy, Mars manufactures pet food (Whiskas and Pedigree), rice products (Uncle Ben's), and prepared foods (Suzi Wan), as well as vending systems, electronics for automated payment systems, and other information technology related to its manufacturing operations. On its website, Mars explains why it stays private in one of its five principles: Freedom. The company states: \"Mars is one of the world's largest family-owned corporations. This family ownership is a deliberate choice. Many companies began as Mars did, but as they grew larger and required new sources of funds, they sold stocks or incurred restrictive debt to fuel their business. To extend their growth, they exchanged a portion of their freedom. We believe growth and prosperity can be achieved another way.\" Sources: Mars, Inc. (2012a). The five principles of Mars. Retrieved from http://www.mars.com/global/about-mars/thefive-principles-of-mars.aspx and Mars, Inc. (2012b). Mars business segments. Retrieved from http://www.mars.com/ global/about-mars/mars-pia/business-summaries.aspx Consider This: 1. 2. eps81356_01_c01_001-044.indd 9 If you were working for Mars or another private company, how might limited access to financial results impact your ability to do your job? Do you think there would be advantages to working for a private company that could take action without worrying about shareholders' reaction? If so, what might those advantages be? 3/25/14 3:07 PM What Are Financial Statements and Why Are They Important? Section 1.1 Private companies enjoy three key benefits: 1. Confidentiality: They do not need to file quarterly financial statements with the SEC and various state agencies. 2. Flexibility: They have greater leeway when it comes to compensating owners and executives. They don't have to worry about shareholders voicing concern about executive pay and bonuses. Co-owners can take out as much money as they want from the company without having to answer to shareholders. 3. Greater financial freedom: Private companies decide for themselves how to raise money for their business. Public companies have no control over who owns their stock once it is sold on the open market. However, private companies face some difficulties when they want to raise additional cash. They can't just issue more stock. Instead, they must arrange for a loan with a financial institution or sell additional shares of stock to existing owners. They can also seek help from a private investor, but they will need to provide extensive financial reporting to that investor before he or she will make a decision. Note that a private company must file financial reports with the SEC when it has more than 500 common shareholders and $10 million in assets. Such companies are considered semi-private. One such semi-private company is Publix Super Market. This company has more than 155,000 shareholders, but its stock is not sold on the open market. Rather, its public offerings are available only to its employees, former employees, their families, and non-employee members of the board of directors (Publix Super Market, Inc. Form 10-K, 2012). Where to Find Financial Reports The official repository of the financial reports of public companies is the SEC's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) website. EDGAR provides users with access to all reports filed with the SEC. Most public companies also provide downloads of their financial reports on their own websites, often in an \"Investor Relations\" or \"About Us\" section. These sections are usually accessed via a link at the bottom of the company's main page. Major financial news websites can be a reliable source of information about both public and private companies. Two excellent business news search engines are Google Business News and Yahoo Finance. Business magazine websites, such as Businessweek, Forbes, Fortune, Entrepreneur, Inc., and Fast Company can also be valuable resources, as can local business newspapers, particularly when seeking information about private companies. eps81356_01_c01_001-044.indd 10 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Task Box 1.1: Researching Public and Private Companies Pick one public and one private company, preferably in the same sector (service, retail, manufacturing, etc.) and develop a short summary of each company's revenue, expenses, and number of employees. Discuss any difficulties you may have experienced as you tried to find financial information about each company. Compare the information you were able to gather about the public company versus the private company. For example: Were you able to find out how many employees each company has? Were you able to find out how much each company earned in revenues? Were you able to find out how much each company spent on goods or services to be sold? Were you able to find out how much each company's net profit was for the year? How much more difficult was it to find out basic details about the private company versus the public company? 1.2 What Is an Annual Report? As we mentioned earlier, all public companies must provide their shareholders with an annual report of the company's activities, according to the Securities Act of 1933. The budget committee of Best General Company can investigate these annual reports to research where their competitors perform well; based on what they find, they can develop recommendations for improving Best General's financial results. Let's take a closer look at the information the budget committee can expect to find in an annual report. The SEC requires that this report include: an opening letter from the Chief Executive Officer (CEO), financial information, results from continuing operations, market segment information (information about where the company sells its products and to whom), new product plans, subsidiary activities (a subsidiary is a company that is completely or partially owned or controlled by another company), and research and development activities regarding future programs. The annual report must be provided to shareholders before the annual meeting to elect directors. Companies must post their annual report along with any issues to be voted on at the annual meeting on their website. They must also post proxy materials, which give shareholders information about the issues to be voted on at the annual meeting and a proxy with which they can vote on these issues. eps81356_01_c01_001-044.indd 11 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 The annual report does not have a required format. Generally companies include the following sections, but not necessarily in this order: Highlights Letter from the President or CEO Auditors' Report Management's Discussion and Analysis (MD&A) Management's Discussion of Financial Responsibility Financial Statements Notes to the Financial Statements Other Information Let's take a closer look at each of these sections. Highlights Companies put their best foot forward when they prepare the Highlights section of their annual report. If the company is doing well, this section usually includes glossy pictures and a good deal of positive news about what the company has done in the prior year and what it plans to do in the future. This section highlights the best performing subsidiaries, divisions, or departments and probably does not mention those that lost money. This section and the Letter from the President or Chief Executive Officer are usually presented in large, easily readable type with many pictures, while the rest of the report is often in small, harder-to-read type with no pictures. When reading the report for important information about the company's future, or key decisions that have recently been made, it's important to remember to read the fine print. Letter From the President or Chief Executive Officer (CEO) The letter tends to be a puff piece that highlights the successes of the past year and discusses future plans for the company. It may be officially from the President or CEO, but it's more likely that it was written by the public relations or marketing staff and approved by the executive. Auditors' Report All public companies must provide financial reports that have undergone an audit a process by which outside certified public accountants (CPAs) examine the books for accuracy and to ensure the company is maintaining its accounts according to generally accepted accounting principles (GAAP). (See Section 1.4 for more information about GAAP.) Audits are typically performed by outside auditors, such as those from a major certified public accounting firm. eps81356_01_c01_001-044.indd 12 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Auditors complete their audit under the guidelines set by the American Institute of Certified Public Accountants, called generally accepted auditing standards. These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatementsmeaning there are no errors that could have an impact on the value of the company. The auditors' report (or letter from the auditors) is usually located either before or after the financial statements in the annual report. The report reveals whether auditors raised any red flags about the financial reports. If they have, the auditors will specify the questions they have about how the financial information was collected or presented. When auditors examine a company's financial reporting, they don't check every transaction, so these reports can never provide 100% assurance that the information is accurate. Auditors instead review the accounting processes and make a statement about those processes. They also conduct spot checks on various transactions to be sure that company personnel are following the processes put in place. The auditors' report includes the following three paragraphs: Introductory paragraph: This includes information about the time period covered by the report and who is responsible for the financial statements. In most cases, you will see that management is responsible for the financial statements and that the auditors provide an opinion about the financial statements using information gathered during their audit. Scope paragraph: This includes information about how the auditors performed their audit, including a statement that they have used generally accepted auditing standards. Opinion paragraph: This includes the opinion of the auditors regarding the financial statements. If the auditors find no problems, they will simply state that the financial statements were prepared \"in conformity with generally accepted accounting principles\" (GAAP). As long as the auditors' report follows the above format, it's called a standard auditor's report. If there are no qualifiers or red flags that limit the auditors' opinions, the report is known as an unqualified audit report. If, on the other hand, the auditors find a problem, the report is known as a nonstandard auditors' report. In a nonstandard auditors' report, auditors must explain their opinions and note problem areas in a qualified audit report. In other words, the only difference between a standard and a nonstandard audit report is that the nonstandard report includes problems the auditors found in the opinion paragraph. Otherwise, the structure is the same. If the auditors' report denotes problems or raises questions, answers can be found in the Management's Discussion and Analysis section of the annual report. Some discussion may also be found in the Management's Discussion of Financial Responsibility section of the annual report. (We discuss both of those later in this chapter.) eps81356_01_c01_001-044.indd 13 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Common issues that may be raised in a nonstandard auditors' report include the following: Change in auditors: Whenever a new accounting firm handles the audit, it will note the change in auditors. This may or may not indicate a problem. The auditors will not explain why the change was made. If there was any hint of scandal, the coverage could be found in news stories. Change in accounting policies: The auditors will note if the company changed an accounting policy or accounting method. The change may or may not indicate a problem. If the auditors agree with the change, they will state that they agree and why. If the auditors question the change, a response will likely be found in the Management's Discussion and Analysis section. More information about the change and how it has affected the financial statements will also be found in the Notes to the Financial Statements. Material uncertainties: The auditors will note if there is an area of concern regarding an event that could have financial consequences but for which they cannot determine the full financial impact. An uncertainty can include damages the company must pay if they lose a pending lawsuit or the potential loss of market share because of a new competitor. They may also point out the potential loss of a major customer. If there is any uncertainty that might materially impact future earnings, the auditors will include a paragraph about the uncertainty and give a qualified opinion. Going-concern problems: If the auditors question whether the company will be able to stay in business, they will indicate that they have a going-concern problem. Such problems can include ongoing losses, cash deficiency, or a significant contract dispute. This is a major red flag and often indicates that the company is near bankruptcy. (We discuss General Motors' road to bankruptcy in \"World of Business.\" Auditors in 2008 questioned whether GM would continue as a going-concern.) Specific disclosures: Sometimes the auditors will discuss a financial concern but still give a company a nonqualified opinion. In a case like this, the auditors do not see signs of a significant problem, but they want the public to know about the issue. For example, if the company is doing business with another company that has officers involved in both firms, the auditors will note that. Qualified opinion: Any time the auditors issue a nonstandard report, they will issue a qualified opinion in the final paragraph of the report. A qualified opinion in the auditors' report should be researched further in other sections of the annual report, such as the Management's Discussion and Analysis and the Notes to the Financial Statements. Major issues may also be covered in external news reports. eps81356_01_c01_001-044.indd 14 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 World of Business A Going Concern: Hint of Bankruptcy in GM's Annual Report The world knew General Motors (GM), which filed for bankruptcy in 2009, was in trouble in 2008, and the final death knell was sounded when accounting firm Deloitte and Touche LLP placed this paragraph in the Auditors' Report of the 2008 GM annual report submitted to the SEC (General Motors Corporation, 2008): The accompanying consolidated financial statements for the year ended December 31, 2008, have been prepared assuming that the Corporation will continue as a going concern. As Bill Cobb/SuperStock discussed in Note 2 to the consolidated In 2009, General Motors filed for Chapter 11 financial statements, the Corporation's bankruptcy. recurring losses from operations, shareholders' deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also discussed in Note 2 to the consolidated financial statements. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. (p. 138) Also in that annual report, it was made clear that GM was pushing for a government bailout. In the risk factors section of another form filed with the SEC, GM management stated the following (General Motors Corporation, 2008): If we are not able to obtain adequate financing from the U.S. government or other sources or to execute our Viability Plan or if our Viability Plan does not result in an entity capable of sustaining itself over the long-term, or if we are unable to restructure our Series D convertible debentures prior to June 1, 2009, we could potentially be required to seek relief through a filing under the U.S. Bankruptcy Code, either through a prepackaged plan of reorganization or under an alternative plan, which could include liquidation. (p. 22) Note that Series D Convertible debentures are a type of debt that can be converted in equity (shares of stock). GM entered Chapter 11 bankruptcy on June 1, 2009. It was the fourth-largest bankruptcy filing in U.S. history. The company claimed $172.81 billion in debt and $89.29 billion in assets. The U.S. government gave GM $49.5 billion, and GM repaid $23.1 billion of that money. The U.S. government still owned 500 million shares of GM stock, or 32% of the company, as of this writing. If the government wants to recoup the rest of its investment in GM, the stock will need to sell for $52.80 per share. As of January 16, 2014, the stock closed at $39 per share. (Muller 2012) Source: Welch, D. (June 1, 2009). GM files for bankruptcy. Businessweek. Retrieved from http://www.businessweek .com/stories/2009-06-01/gm-files-for-bankruptcybusinessweek-business-news-stock-market-and-financial-advice Consider This: 1. 2. eps81356_01_c01_001-044.indd 15 When a company files for bankruptcy, employees lose jobs not only in the bankrupt company, but also in companies that service or supply that company. What types of other companies were likely impacted by GM's bankruptcy? If your company went bankrupt, what other companies would be impacted? How many people do you think could potentially lose their jobs? 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Management's Discussion and Analysis (MD&A) The Management's Discussion and Analysis (MD&A) section of the annual report contains many details about management's plans for the future of the company, as well as discussion of the successes and failures of the last year. The SEC reads the MD&A closely to be sure companies present all critical information about the current operations, capital (net worth of the company), and liquidity (ability to generate enough cash to pay the bills). Management must include forward-looking statements about known marketing conditions and economic trends that may impact the company's liquidity. It must also discuss material events as well as uncertainties that could affect future operations. For example, if the company manufactures a product in a country that faces political upheaval or a labor strike, it must discuss this possibility and the impact it may have on the company's ability to manufacture and sell this product at the same low cost. Companies focus on three key areas: Company operations: Companies will discuss sales and whether they increased or decreased, product line performance, how products are distributed, and product improvements. Companies will also discuss, without much detail, research and development projects. Capital resources: Companies will discuss acquisitions (companies they plan to buy or have recently bought) and expansions of existing operations. They will also discuss any major capital expenses incurred in the past year or planned for the future as well as their debt position and whether they plan to take on new debt. Liquidity: Companies will discuss their cash position and their ability to pay their bills. The SEC pays special attention to these key discussion points in the MD&A (U.S. Securities and Exchange Commission, 2003): Revenue recognition: A company can only add revenue to the books when it is earned, which means when a sale is completed and the goods or services have been delivered. This is known as the recognition of revenue. If the company operates retail stores, the recognition of revenue may be relatively straightforward: Revenue is recognized when a customer buys the product. However, revenue recognition is not as clearly defined for many businesses. For example, when a company buys a computer system from another company that includes hardware, software, training, and other services, revenue may not all be recognized at the same time. The company may recognize the revenue from the purchase of the hardware at the time it is delivered, but it will not be able to recognize the revenue from service and training until the obligation has been fulfilled. A contractor who is paid upfront for a project may not be able to recognize the revenue until it is earned. In the MD&A, management will discuss its revenue recognition methods and compare them to other companies. Discussion of revenue recognition may also be found in the Notes to the Financial Statements. Restructuring changes: If the company plans any type of restructuring, or has completed a restructuring plan, management will discuss these plans in the MD&A. This can include closing down factories, disbanding a major division, discontinuing operations, or any other major change in the way the company operates. eps81356_01_c01_001-044.indd 16 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Management will discuss the costs of employee severance, facility shutdowns, and any other expenses that will be incurred by the decision and how these costs will impact the financial statements. Losses of assets: The company must report any losses of assets in a timely manner to shareholders. For example, this can include the damage or destruction of a factory after a major storm. A company also may report impairment of an asset because of advancements in technology. Pension plans: Pension plans can be a major drain on a company's assets, and the methods for accounting for these plans require many assumptions that cannot be proven, such as the amount of interest or capital gains that will be earned on the investments. Also, the company must make educated guesses about how much will be needed to make payments to retired employees. If the company does have a pension plan, expect to find discussion about how the company finances that plan and if the company expects any difficulty meeting the requirements of that plan. Environmental and product liabilities: Most companies risk damage to the environment or other people's properties if products they sell fail to operate as expected. Some companies operate in industries, such as oil, gas, and chemicals, that regularly risk the potential of environmental damage if something goes wrong. For example, Exxon Mobil faces what could be millions of dollars in damages from the March 29, 2013, oil pipeline rupture in Arkansas. The United States Environmental Protection Agency (EPA) operates a Superfund to clean up the nation's hazardous waste sites, which were created by disposal of wastes by many different companies over many years. Companies that are identified as polluters must contribute to this fund. If a company is involved in negotiating a settlement with the EPA, it would discuss that involvement here. (Perpetua 2013 and U.S. Environmental Protection Agency 2013 and 2014) The discussion in this section of the annual report can get very technical. As the Best General Company budget committee is reviewing the external reports of their competitors, they can call the investor relations department of a company if they have any questions about what is discussed. The investor relations department is the primary department that answers questions from readers of the company's financial reports. Task Box 1.2: Using Financial Reports to Assess Risk Management To help you get started with reading financial reports, we will examine General Electric (GE), the sixth largest company on the Fortune 500 list, with more than $150 billion in revenue. GE operates in five major business segments: energy, technology, infrastructure, capital finance, and consumer and industrial goods. The company has won awards for its innovative financial reporting, which includes many interactive features. Its financial reports can be accessed here. To practice using financial reports to assess a company's competitors, download the MD&A for GE. Read the Global Risk Management section of the report. (We use GE as an example because it does an excellent job of laying out its risk management program.) How does GE manage its risks? Note how various aspects of risk management are assigned to key GE committees. Think about how your company manages risk and compare it to what GE does. eps81356_01_c01_001-044.indd 17 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Management's Discussion of Financial Responsibility This section of the annual report is relatively newit became a requirement after the financial reporting scandals of the late 1990s and early 2000s. Congress passed the Sarbanes-Oxley Act of 2002, and the new requirements are discussed in section 302, \"Corporate Responsibility for Financial Reports.\" (Read more about the Sarbanes-Oxley Act in \"The New World of Financial Report Oversight.\") Some companies call this the \"Management's Responsibility for Financial Statements\" letter. Officially, section 302 states that the CEO and chief financial officer (CFO) must each prepare a statement to accompany the audit report to certify that \"based on such officer's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report.\" While executives have been asked to provide financial reporting letters in the past, this new requirement stipulates that they must include a certified statement, signed, notarized, and available to the public, that indicates management takes full responsibility and can be held legally accountable for what's in the financial reports. Thanks to Sarbanes-Oxley (SOX), executives can now, in theory, be held personally responsible for their actions; they can face up to a five-year prison term, fines, and other disciplinary action if they are proven of wrongdoing. They could also face civil and criminal litigation, as well as be barred by the SEC from serving as a corporate officer or director. One net result of this change is that CEOs and CFOs are looking for ways to shield their money and property from shareholder lawsuits and federal prosecution. The key questions left to be answered are whether we will actually see this law enforced and whether it protects investors and the public from scandals like those we have seen in the past. (Marden, 2003) New World of Financial Report Oversight The Sarbanes-Oxley Act of 2002 (SOX), also known as the Public Company Accounting Reform and Investor Protection Act, set new or enhanced standards for external reporting. Thanks to SOX, top management must now individually certify the accuracy of financial report information. SOX also increased the independence of outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors. 1. 2. eps81356_01_c01_001-044.indd 18 Do you believe this new requirement has impacted how companies file their reports? How would you expect this law has impacted the role of the CEO and CFO? 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Financial Statements The main section of any annual report is the financial statements. These include the key documents introduced earlier in the chapter: the balance sheet, the income statement (which may include the statement of shareholders' equity), and the statement of cash flows. Notes to the Financial Statements The financial statements are a summary of numbers, but to really understand what they mean and how they were developed, one must read the Notes to the Financial Statements. These include information about such things as accounting methods, key financial commitments, mergers (two companies joining forces) and acquisitions (the purchase of one company by another), pension and retirement benefits, company segments, and significant events. Let's take a closer look at what you can expect to find in each note. Accounting Methods Most companies focus the first note on any changes to their accounting methods. Here they also outline the rules under which they developed their financial statements. The note is commonly called \"Summary of Significant Accounting Practices.\" If the company is large, and owns many affiliates, the note will likely discuss how the financial statements are a consolidation of its affiliates and how this impacts the financial statements. You can see an example of how a company presents its consolidation in General Electric's (n.d.) Notes to the Financial Statements in its 2012 annual report. GE goes on to discuss how it recognizes sales of goods and services, its depreciation and amortization, losses on financing receivables, investment securities, inventories, intangible assets, and a number of other specific methods related to its operations. The final section of the note discusses accounting changes. Other companies may include information about the accounting methods used for their pensions, employee stock incentive plans, and income taxes. Sales and Discontinued Operations If the company is involved in the sales of major assets or businesses it held, it will include a note detailing this information. If the company has closed or is planning to close a facility, this note will also detail the financial impacts of discontinued operations. GE presents the details of its sales and discontinued operations in Note 2. Investment Securities If a company holds investment securities, it will include a note detailing the information. GE details its investment securities in Note 3. You can see that GE holds debt (bonds) from other U.S. corporations, state and municipal governments, mortgage-backed securities, and other entities. Note that the balance sheet would only show a number for Marketable or Investment Securities. eps81356_01_c01_001-044.indd 19 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Current Receivables Any details about the Accounts or Current Receivables line item on the balance sheet will be found in a note. GE discusses its receivables in Note 4. This note usually includes details about a company's major customers. For example, GE details how much of its receivables come from which sectors. You can also read that GE revenues from the U.S. government dropped to 4% of GE sales of goods and services in 2012 and 2011, from 5% in 2010. GE details this information in Note 6. Major Assets The notes also contain line items about other key assets. For example, inventory held by the company will likely be in a separate note detailing that information. GE discusses its inventories in Note 5. There should also be a note about the Property, Plant, and Equipment (GE details that in Note 7) and Goodwill and Other Intangible Assets (GE details these in Note 8). Goodwill is an account used to track additional money paid for an acquisition over and above the actual value of the known assets. For example, say a company buys another company for $1 million. However, the known assets are only worth $900,000. The difference of $100,000 would be added to Goodwill. Goodwill usually reflects the value of nonassets, such as customer base or premium locations. Other Intangible Assets, such as patents and copyrights not included in their own line item, would be included in this line item of the balance sheet. Any major asset that doesn't have a separate note will be under a note called \"Other Assets\" (GE details them in Note 9). Key Financial Commitments You will also find details about a company's key financial commitments in the notes. For example, in Note 10, GE details its short-term and long-term borrowing. In Note 11, the company describes its investment contracts and insurance liabilities. Mergers and Acquisitions If a company is in the process of merging with another company or in the process of buying another company, there will be a note detailing the impact this transaction will have on the financial statements. GE did not mention merger or acquisition plans in the year being discussed. eps81356_01_c01_001-044.indd 20 3/25/14 3:07 PM What Is an Annual Report? Section 1.2 Pension and Retirement Benefits If a company provides a pension plan to its employees, it will provide details about its pension obligations in a note to the financial statements. GE details these obligations in Note 20. Included will be details about the number of employees covered, the cost of the pension plans, the actuarial assumptionsestimates of the value of an asset or person, used to help determine the value of future payments on retirement benefitsand a detailed projection of the benefit obligations. This note also details how the company invests its pension assets. Other Liabilities Any liability that doesn't have a note of its own will be detailed in an \"Other Liabilities\" note. GE uses Note 13 to discuss other liabilities. Details About Company Segments Most companies will also include a note that details their company segments. GE provides that information in Note 1. Company segments are used to group operating departments and divisions under a specific executive team. Notes to Financial Statements Companies tend to hide any problems they have in the Notes to the Financial Statements. When the Best General Company budget committee starts looking for details about their competitors' results, the notes to the financial statements should be one of their first sites to mine. As we discuss the parts of each of the financial statements in Chapters 2, 3, and 4, we will delve deeper into the information one can expect to find in the notes. Other Information In this section, you will find information about the backgrounds and qualifications of the company's key executives and managers, officers, board members, locations, and any new facilities they opened in the past year. eps81356_01_c01_001-044.indd 21 3/25/14 3:07 PM Section 1.3 What Is a Form 10-K? Task Box 1.3: Viewing a Full Annual Report General Electric is one of the most innovative companies when it comes to annual reports. Its annual report is highly interactive, letting readers explore topics of deeper interest. Few companies put as many resources into producing an interactive report for the public. Go to GE's website for its 2012 report. You'll find the highlights and CEO letter on that page. You'll also find the 2012 pro forma financial statements. Don't confuse these with the required financial statements. Pro forma statements tend to focus on what the company wants to highlight. Click on the word \"Downloads\" on the top right of the first page. You'll be able to download all the other parts of the annual report, as well as the company's Form 10-K and proxy statements; these give shareholders information about the items on which they will need to vote, such as new board members or company-specific issues. Download each section and review the information in each. 1. 2. 3. Based on what you read in these statements, what do you think are GE's top priorities for the future? What reorganizations are discussed in the Management's Discussion and Analysis? What accounting method was changed, according to the auditors' report? Explain the change after reading Note 1 in the Notes to the Financial Statements. 1.3 What Is a Form 10-K? While the annual report is published for the benefit of shareholders and investors, public companies must also submit a formal yearly update to the SEC. They do this using a form called the Form 10-K. The purpose of the Form 10-K is to provide comprehensive details of the company's business and financial condition. This report must include audited financial statements, and it must be filed in addition to the annual report. Much of the information in the Form 10-K is similar to that presented in the annual report, but the Form 10-K requires additional details in a specified format, and it is often more formal and technical in tone. Melanie Stetson Freeman/MACSM/Associated Press Table 1.2 compares the Form 10-K and the annual report. Often companies use the Form 10-K as part of the required financial statements within their annual report to shareholders. The portions from the Form 10-K are usually printed on thinner paper in smaller print, making it more difficult to read. Form 10-K is required by the SEC to insure that investors are receiving an accurate picture of a company's business and financial condition. eps81356_01_c01_001-044.indd 22 3/25/14 3:07 PM Section 1.3 What Is a Form 10-K? Table 1.2: Comparing the Form 10-K and the annual report Line item Form 10-K Annual report Item 1 - Business The company must include basic information about both positive and negative developments that impact the company since the beginning of the fiscal year. It will include much greater detail about each segment or division of the company. Companies will usually include some information about major changes in the previous year or planned changes for the next year, but in a less formal way and more for the purposes of promoting their successes. Rarely will companies highlight any failures. Item 1A - Risk Factors The company must detail risk factors in the industry segments in which it operates. While managers may discuss risk factors in general terms in the MD&A section, and provide some discussion in parts of the Notes to the Financial Statements, there is no formal risk factors section in the annual report. Item 1B - Unresolved Staff Comments Not required. If there are any comments from SEC staff that are unresolved, they will be discussed here. This will only be found in the Form 10-K. Item 2 - Properties Key property holdings will be discussed in detail. Some of this information may be found in the Notes to the Financial Statements. A company could discuss some key property additions in the narrative of the annual report, but it is not required. Item 3 - Legal Proceedings The company must detail information about significant pending lawsuits or other legal proceedings. This information can usually be found in the Notes to the Financial Statements. Item 4 - Mine Safety Disclosures Most companies leave this section blank. Only companies with mines must discuss safety issues here. Not required. Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Companies discuss details about any changes to their equity securities, the number of holders of shares of stock, and the dividends paid. If the company is repurchasing its stock and taking it off the market, the company will discuss this as well. Summary financial details about shareholder matters can be found on the income statement or statement of shareholders' equity. More details can be found in the Notes to the Financial Statements. Item 6 - Selected Financial Data Companies summarize their key finan- Companies will usually offer pro forma cial data over the last five years. financial statements that highlight the past five years, but the information will not be as complete as the Form 10-K. This part of the annual report usually conveys only the good news. Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations Company executives discuss their business results over the past year and discuss future plans. Similar information is found in the MD&A section, but the Form 10-K usually includes more detail. Item 7A - Quantitative and Qualitative Disclosures about Market Risk Companies discuss interest rate risk, foreign currency exchange risk, commodity price risk, and equity price risk. Companies will also discuss how they manage these market risk exposures. While there may be some discussion of risk in the MD&A section and the Notes to the Financial Statements, the information is usually more detailed in the Form 10-K. (continued) eps81356_01_c01_001-044.indd 23 3/25/14 3:07 PM Section 1.3 What Is a Form 10-K? Table 1.2: Comparing the Form 10-K and the annual report (continued) Line item Form 10-K Item 8 - Financial State- Includes the key financial statements, ments and Supplemen- such as the income statement, balance tary Data sheet, statement of cash flows, and any other relevant data. Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosures If there are any disagreements with accountants, they will be discussed in this section. Annual report Often companies use the statements filed with their Form 10-K in their annual report. Others may present the same information in a more graphically pleasing way. Usually information about disagreements with accountants can be found in the Auditor's Letter and the management's response to that letter (if there is one). Other disagreements may be discussed in the Notes to the Financial Statements in the section on accounting policy or accounting methods. Item 10 - Directors, Companies include information about Executives, Officers and the backgrounds and experience of Corporate Governance their directors and corporate officers. They also must include information about their code of ethics and how it is implemented. Information about a company's directors and corporate officers is often included in the annual report. Item 11 - Executive Compensation Companies provide details about how they compensate their executives, including information about salaries paid and incentives earned. This information is usually found in the proxy materials sent with the annual report to shareholders. Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Companies provide details of the holdings of key executives and major shareholders. This information is usually found in the proxy materials sent with the annual report to shareholders. Item 13 - Certain Rela- Companies provide details about rela- There is no comparable section in the tionships between the company and its annual report. tionships and Related Transactions, and Direc- directors, officers, and family. tor Independence Item 14 - Principal Accountant Fees and Services The company provides details about the fees paid to its accounting firm, as well as the services provided. There is no comparable section in the annual report. In the past, all companies could wait until 90 days after the end of the fiscal year to file a Form 10