Last year was generally a bad year for American business. This year has started off worse. Yet you would hardly know it from reading some corporate reports.
For example, Joe L. Allbritton, chairman of Riggs National Corp., wrote in the 1981 annual report that Riggs "is strongly positioned to maintain and expand our traditional role of preeminence in Washington banking." It was not until page 24 that the reader learned that "nonperforming assets" (problem loans) had increased threefold, that the bank lost $4 million in interest due from those loans and that, partly as a result, profits increased by only $11,000 despite a $550 million growth in the amount of money it manages.
Roger B. Smith, chairman of General Motors, declared in the automaker's annual report that "intensified and extraordinary efforts to improve operating performance and record financing and insurance income helped GM earn a profit despite a lower unit volume" than in 1980, when it had a loss. What Smith didn't say was that almost $90 million, or 27 percent of the company's 1981 profit, was attributable to an accounting maneuver: liquidation of certain inventories carried at lower costs compared with costs of current purchases.
Richard P. Sullivan, president of Easco Corp., a Baltimore manufacturer of hand tools, aluminum and industrial products, called 1982 first-quarter results "gratifying" in reporting "slightly higher sales and net income from continuing operations." What Sullivan didn't say was that net income--the bottom line--actually dropped 27 percent; earnings per share declined from $1.03 in the 1981 quarter to 66 cents. The reason for this seeming contradiction is that profits for the first quarter of 1981 were pumped up by a one-time windfall from discontinued operations.
Like individuals, many corporations put their best face forward in adversity. There is a natural tendency to disguise, dismiss or disregard bad news so as not to discourage existing or prospective stockholders and sometimes even lenders. This can be done in a number of ways--all legal.
The chief executive officer's report can make selective use of financial data or bury the unfavorable data in averages. Santa Fe's report states: "The economic recession of 1981 was largely responsible for a break in Santa Fe's string of record earnings which had run for five consecutive years and which produced the cumulative effect of tripling net income from 1975 to 1980, but the 1981 results were still the second best in our history."
Instead of talking about the past, a more popular ploy for not talking about the present recession is talking about the future. The leitmotifs in the 1981 crop of annual reports are " 'long-term strategy,' 'redeployment of assets,' and 'response to world markets,' " according to William P. Dunk, president of Corpcom Services, Inc., a New York consulting firm that handles hundreds of annual reports each year. Borden, Inc. tells shareholders: "The divestiture phase of our redeployment program is complete. Our priority now is to get maximum results in coming years from the reinvestment of the funds generated."
A third choice is to talk about how the recession has affected the entire economy, how forces essentially beyond the company's control, such as high interest rates, are responsible for for the company's bad performance. In other words, yes, the company had a lousy year, but so did everybody else. If the economy improves next year and the company's profits do as well, you can be sure the company will take credit for the upturn, Dunk added.
Another school of thought holds that in a severe recession a company will make its picture as bleak as possible, so the rebound looks brighter. In the words of Bert T. Edwards of Arthur Anderson & Co., one of the Big Eight accounting firms, "If you're going to take a bath, you fill the tub." Or, as John A. Tracy, an accounting professor in the College of Business Administration at the University of Colorado, Boulder, put it, "Shareholders don't care if you lose $10 million or $100 million. It's all the same to them."
The average shareholder spends 10 minutes reading an annual report, according to Dunk, and therefore rarely gets beyond what he characterizes as the "soporific rhetoric" of the letter to shareholders. So long as the chairman's message does not grossly misstate the evidence in the financial tables that follow, the Securities and Exchange Commission is not concerned about it. Therefore, a company's accounting firm will let the chairman say pretty much what he wants, to determine the tone of the report.
Beyond the opening message lie reams of figures and footnotes that, again in Dunk's words, "disclose but do not communicate." That is, they fulfill the SEC's requirements for publicly traded corporations without being comprehensible to the non-accountant. As Tracy put it, "They say, 'Here are the facts; draw your own conclusions.' "
Take this example from Insilco Corp.: "Since the divestiture in 1975 of International Graphics, Inc, a former subsidiary, the company approved deferral of payments on the original note of sale . . . Management believes an impairment in the realizability of such receivables became probable in the current year and wrote down the receivables to estimate net realizable value of $4,000." Corpcom's translation: "Sorry, folks, but we made a bad loan."
In a speech to the U.S. Chamber of Commerce this spring, the SEC's enforcement chief, John M. Fedders, warned that "periods of fiscal turmoil and economic difficulties historically spawn new abuses and new deceptions. During periods of economic stress and business stagnation, managements have engaged in acts designed to create an appearance of fiscal stability and prosperity." Judging from the 1981 reports he has seen, Fedders added later, companies are running true to form.
Fedders emphasized the need for corporations to explain liquidity problems resulting from trouble in collecting from customers or inabilty to get credit, to present "an objective discussion of poor financial results," and report problem loans. He warned against deceptive and fraudulent accounting practices, such as recognizing income in advance of actual realization, inflated inventory by improper application of LIFO (last-in, first-out) accounting, improperly deferred costs and artificially structured year-end transactions to boost earnings. All of these practices are illegal under SEC rules. However, there is as large a gray area in accounting practices as there is between legal avoidance and illegal evasion of taxes.
In the past 2 1/2 years, the SEC has taken action against 10 corporations in financial reporting cases. Fedders admits the SEC's experts have difficulty finding deceptions, so the average stockholder doesn't stand a chance. Annual reports are really written by professionals for professionals. Industry Week magazine recently cited a study showing that it takes 16 years of education to be able to comprehend the typical annual report, yet nearly 60 percent of all shareholders are not college graduates.
However, Tracy's book, "How to Read a Financial Report," does provide some clues for the amateur.
Though few wade through to the end of the tables and notes, it is generally there that one finds, the accountant's sign-off. The boilerplate language states that, in the examiner's opinion, the statements fairly present the financial position of the company. However, if the reader finds a qualified opinion containing the words "except for," it is a red flag that the company may be in trouble, that the CEO's glowing phrases in the letter to stockholders are suspect. At other times, the accountants Co.'s report on Continental Airlines contains the language, "These factors . . . indicate that the company may be unable to continue in existence."
Footnotes are required by the SEC, but there is no requirement that they be understandable. Fuzzy footnotes are a tipoff, says Tracy. "Poor writing seems more prevalent in footnotes on sensitive matters, such as law suits lost or still in progress, or ventures the business has abandoned with heavy losses."
Interpreting the tables is more difficult because, as the author warns, permissible accounting methods range from conservative to liberal. It is management's duty, he writes, to "manipulate the profit numbers as well as the asset and liability numbers. The manager has to decide which 'look' of the financial statements is in the best interest of the company. . . . The best you can do is to determine whether the business is being conservative or not so conservative in its financial statements, and then to make lending investment decisions with this in mind."
Tracy does suggest scrutiny of the cash flow statement, as well as the income statement and balance sheet. Cash flows are apt to be affected in adverse economic conditions. Moreover, cash flows directly affect the ability of a company to pay debts and dividends. He also recommends looking at the method of accounting used for inventories. "The manager can cause a partial LIFO liquidation in a given year that would give an arbitrary boost to reported profit for the year." That is what General Motors did.
The SEC's requirements for more disclosure to protect investors have often succeeded in increasing the quantity rather than the quality of annual reports. Tracy suggested recently that a surrogate of the average stockholder, an accounting expert, be invited to participate in their preparation. Another solution cited by Industry Week was adopted by some education-minded companies, including Macmillan Publishing. They put out annual reports for children in simple language. The demand was so great the company had 100,000 copies printed, 40,000 more than its regular annual report.