Reading Financial Reports for Dummies (44 page)

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Item 4 — Submissions of matters to a vote of security holders:
Anytime a company takes a vote of the shareholders during the quarter being reported, it must report the date and place of the meeting, as well as whether the meeting was annual or special. The company must give a brief description of all matters voted on at the meeting and also detail the votes cast for or against and report the number of abstentions and nonvoters. If the company elects directors at the meeting, it must list those elected, as well as those who remain on the board and their terms of office.

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Item 5 — Other information:
This item is a catchall for any issue that hasn’t been previously reported on Form 8-K but needs to be reported. I discuss the requirements of Form 8-K in a later section called

“Uncovering the Ways Companies Keep in Compliance.” A company doesn’t have to file an 8-K for an issue reported on a 10-Q.

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Item 6 — Exhibits and reports on Form 8-K:
Any compliance reports filed during the quarter must be attached as an
exhibit
(additional pages that provide this information) on the 10-Q.

Introducing the 10-K

Form 10-K is the official annual report form required by the SEC, and it’s the report you’re most likely to see as part of the glossy annual report that companies send out to investors. The 10-K includes four parts, which I discuss in this section.

Business operations

In Part I of the 10-K, you find the following details about business operations:

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Item 1 — Business:
This section describes the company’s operations with discussions about product lines, major classes of customers, industries in which the company operates, and details about domestic and foreign operations. “Risk factors” (Item 1A) and “Unresolved staff comments” (Item 1B) are also discussed in this section.

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Item 2 — Properties:
This section describes the property the company owns.

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Item 3 — Legal proceedings:
This section discusses any legal proceedings the company is involved in and the material impact the lawsuits may have on the company.

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Item 4 — Submission of matters to a vote of security holders:
Any matters voted on by the shareholders are detailed in this section.

Financial data

Part II of the 10-K includes information related to any matters that impact the company’s financial health. In this part, you find the following items:

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Item 5 — Market for registrant’s common equity, related shareholder
matters, and issuer purchases of equity securities:
In this section, you find information about the market for the company’s stock, which stock exchange the company is traded on, the quarterly low and high stock
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prices for the past two years, the approximate number of shareholders, the amount paid in cash dividends for the past two years, and discussion of any restrictions on the company’s ability to pay future dividends.

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Item 6 — Selected financial data:
In this section, you find a five-year summary of selected financial data, including net sales, income or loss from
continuing operations
(company activities that go on each year to make and sell products or services) on a per-share basis, total assets, long-term debt, cash dividends per share of common stock, and information about any redeemable
preferred stock
(stock that can be converted to debt).

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Item 7 — Management’s discussion and analysis of financial condition and results of operations:
In this section, management discusses the company’s financial condition and any changes to its condition that have occurred in the past year. Management also discusses the results of operations and analyzes the company’s liquidity, resources, and operations. If any major changes in the financial statements took place during the year being reported, the company also discusses those changes in this section.

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Item 7A — Quantitative and qualitative disclosures about market risk:
This section is where you find management’s discussion of external economic factors that impacted the company’s operations, such as the effects of inflation. You also find discussion about the company’s competition and any major risks to the industry as a whole.

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Item 8 — Financial statements and supplementary data:
Here’s where you find the balance sheet, income statement, and statement of cash flows, as well as all supplementary information for these documents, such as the notes to the financial statements (see Chapter 9) and the auditors’ report (see Chapter 5).

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Item 9 — Changes in and disagreements with accountants on accounting and financial disclosure:
If the company has any disagreements with the auditors about what information must be presented on the financial statements and how to present it, this section is where you find discussion of the differences.

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Item 9A — Controls and procedures:
This section is where you find information about the company’s internal controls and procedures to avoid fraud and ensure accuracy in the financial statements. I discuss these requirements in greater detail in the section “Investigating Internal Controls.”

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Item 9B — Other Information:
This includes any items that aren’t reported on an 8-K during the year, as well as items that are reported on an 8-K but aren’t reported elsewhere in the 10-K.

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Part V: The Many Ways Companies Answer to Others

Information about directors and executives

Part III of the 10-K takes you behind the scenes of company operations and gives you information about the directors and top executives, including any special compensation packages they receive. Following are the items you can expect to find:

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Item 10 — Directors and executive officers of the registrant:
Here’s where you find out who sits on the company’s board of directors, as well as who serves as the company’s top executive officers.

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Item 11 — Executive compensation:
The company must report the compensation packages for all its top executives in this section.

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Item 12 — Security ownership of certain beneficial owners and management and related stockholder matters:
Here you find details about the stock owned by top executives, board members, senior managers, and any other major shareholders of the company.

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Item 13 — Certain relationships and related transactions and director
independence:
This section is where you find out about large related-party transactions, such as any transactions between the company and its top management team. Information about significant transactions between the company and its subsidiaries or major shareholders must also be listed in this section.

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Item 14 — Principal accounting fees and services:
Here’s where you find details about the relationship between the company and its accountants. The company must report the fees billed for each of the past two fiscal years for professional services by the principal accountant for the audit of the company’s financial statements, as well as for any services related to the audit. The company must also disclose fees for tax services by professional accountants for tax compliance, tax advice, and tax planning, as well as fees for any additional services that the principal accountant provides. In addition, the company must disclose the audit committee’s pre-approved policies and procedures related to the work of the principal accountant.

The extras

Part IV of the 10-K is the catchall for additional exhibits, including any financial statement schedules and any reports the company filed throughout the year and reported on Form 8-K.

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Investigating Internal Controls

When filing Form 10-K with the SEC, companies must also include the management’s report on internal controls (which includes rules for how company staff should do their work to avoid theft and fraud). This requirement was added as part of the sweeping changes mandated by the Sarbanes-Oxley Act of 2002, which I discuss in greater detail in Chapter 3.

The management’s report on internal controls requires that companies provide the following:

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Statement of management’s responsibility for designing, establishing, and maintaining an adequate internal control structure over financial reporting for the company

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Statement identifying the framework used by management to evaluate the effectiveness of its internal controls

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Management’s assessment, as of the end of the fiscal year being reported, of the effectiveness of the company’s internal control structure and procedures for financial reporting

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Attestation report from the company’s auditor regarding management’s assessment of the internal controls’ effectiveness, which assures the 10-K

reader that the auditor reviewed the assessment and found it effective Management must report any weaknesses it finds in its internal controls over financial reporting. If management finds one or more material weaknesses within the company’s internal control system, the company can’t conclude that its internal controls are effective. The following are some of the key points management must guarantee for its internal control process:

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Maintenance of records that accurately detail and fairly reflect the transactions and dispositions of the company’s assets

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Assurance that transactions are recorded as necessary to permit the company to prepare financial statements in accordance with generally accepted accounting principles

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Assurance that receipts and expenditures are made only in accordance with authorizations from management and company directors

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Assurance that management has controls in place to detect and prevent unauthorized acquisition, use, or disposition of company assets that could have a material effect on the financial statements 254
Part V: The Many Ways Companies Answer to Others

You may be thinking, “Shouldn’t a company have all these controls in place and not need the government to tell it to put them there?” Well, investors who lost billions because of the financial shenanigans at companies like Enron, MCI, and others during the early 2000s sure wish these internal controls were more strongly enforced by the SEC before they took their losses.

Uncovering the Ways Companies

Keep in Compliance

Sometimes, significant changes in a company’s financial position occur between the times the company files its financial reports. When that happens, the company must file a special report called an 8-K, which reports any
material changes
(changes that could have a significant financial impact on the company’s earnings) that happen between the times of the quarterly or annual reports.

The Sarbanes-Oxley Act of 2002 (see Chapter 3) mandates that the SEC review all its compliance requirements regarding financial reporting. In response to the legislation, the SEC issued new rules for Form 8-K, requiring companies to report any material changes within four days of the event. Critical events to be reported on Form 8-K include

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Business combination:
Any agreement related to a
business combination
(such as a merger combining two companies or consolidating two major divisions into one) or other extraordinary corporate transaction that could be material to the company’s financial position. This report must include

• Date of execution

•

Parties

involved

• Material relationship between the company or its affiliates and any other party involved in the agreement

• Brief description of the terms and conditions of this agreement Companies don’t need to disclose any nonbinding agreements or letters of intent, provided that they aren’t material to the company.

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Agreement termination:
Any termination of an agreement that was previously reported, such as the cancellation of a signed contract to provide a significant amount of the company’s product to another company if this cancellation means a loss of significant future earnings.

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Bankruptcy or receivership:
Any plans to declare bankruptcy or enter into
receivership,
a type of bankruptcy in which the company can avoid liquidating itself and instead work with a court-appointed trustee to restructure its debt with the intention of emerging from bankruptcy.

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Acquisition or disposition:
Any acquisition or sale of major assets outside the course of ordinary business operations. For example, the acquisition of a new company fits the reporting requirement, but the acquisition of new equipment for continuing operations doesn’t need a special report on Form 8-K.

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Financial results:
Any earnings results related to earnings, company operations, or financial conditions that occurred between the quarterly or annual reports and were distributed by press releases or other public means.

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Financial obligations:
Any direct financial obligations that are material to the company, such as the signing of a long-term debt or lease obligation. The company must include a brief description of the transaction and agreement.

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Disposal of assets:
Any costs related to the disposal of long-held assets when the company enters into an agreement (usually called an
exit
agreement
) to get rid of those assets. Termination of employees under an exit plan must also be disclosed.

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Impairment of asset value:
Any conclusion by the board or an authorized company officer that the value of an asset is significantly impaired — for example, when the value of goodwill is determined to be significantly less than what’s reported on the balance sheet.