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This article appeared in the December 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Make the most of this evolving shareholder document.

Photo of Michael Kemp By Michael Kemp, author

The annual report is the principal document for conveying information on the activities and financial state of a company and is of interest to many groups -shareholders, potential shareholders, creditors, employees, government bodies, and social and environmental organisations. This article focuses on the information provided and how it can be best interpreted to achieve good investment outcomes.

There are two principal forces working against full disclosure in the reports. First, while the intention is to provide shareholders with the best possible view on the company's prospects, there is equally a reluctance to supply any commercially sensitive information to competitors. Second, the annual report is often seen as a comment on management's performance, and if performance has been lacking there could be a temptation to undertake some creative accounting.

In an effort to provide consistency and sincerity, governments and accounting bodies throughout the world have found it necessary to establish standards governing the production of financial reports. Consistency facilitates inter-company comparisons within a period and intra-company comparisons between periods.

Sincerity simply means keeping everyone honest. Australian accounting standards are set by the Australian Accounting Standards Board (AASB). They define minimum disclosure requirements and how accounting measures must be undertaken.

But the standards introduce an irony: objective methods of measurement can lead us away from economic reality, one of the very reasons they were put forward in the first place. They result in balance-sheet distortions because of the use of historical cost, defined rates of depreciation, and different treatment of organically grown goodwill versus acquired goodwill. They also result in earnings distortions, again because of defined depreciation rates but also the use of accrual accounting and "once off" forms of income and expense. For a fuller discussion of these distortions refer to the November ASX Newsletter article, Hidden Value.

As a practical example, consider how Coca-Cola Amatil was affected by the adoption of Australian International Financial Reporting Standards (AIFRS) several years ago. Despite the obvious commercial benefit of its exclusive distribution licences, Coca-Cola was required to remove the estimated value from its balance sheet. This was deemed an internally generated intangible asset. Overnight, the gearing ratios and return on equity doubled. The former would seem to be bad. The latter would seem to be good. In reality, the company was unchanged.

There's an elephant in the room

Investors and accountants have long known that when it comes to financial reporting, there is a very large elephant in the room. Double-entry book-keeping is supposed to provide us with the following equation:

Assets = Liabilities + Equity (A=L+E).

The financial stake put up by shareholders is represented by the equity component of the formula. Equity can be broken down into two further components: contributed capital and retained profits. Retained profits are recorded as the accumulation of net profit after tax (NPAT) less annual dividends paid. As they accumulate, book value grows (all other things being equal).

But if there are distortions in the earnings and book values shown in the annual report, should investors be using these figures for the purpose of selecting share investments? Accountants acknowledge the problem but their hands are tied by convention and regulation. Investors struggle with the necessary adjustments because the adjustment process requires an intimate knowledge of the business. And simplistic books on the subject of valuation just ignore the problem altogether.

We are so used to the appearance and format of the annual report that it seems strange to ask whether there is another way this information could be presented. But there have been enough books on the subject of security analysis to fill a library, and they almost invariably discuss the need to adjust the information provided in the accounts as the first step in analysis.

This includes adjustments to both the income statement and balance sheet figures. So, for the benefit of investors, why are the changes not made before inclusion in the accounts? There are many reasons, but the principal ones - consistency, sincerity and the concept of full disclosure - have already been discussed.

Making the adjustments

In an effort to resolve these issues, two economists, Edgar Edwards and Philip Bell, proposed in 1961 that financial reports be presented in a manner that was compatible with present value analysis (a commonly used method of intrinsic value calculation). They suggested an alternative means of measuring balance-sheet items and defining profit. Based on their work, an American academic, James Ohlson, further developed and later popularised a valuation technique called Residual Income Valuation (RIV).

Following Ohlson's description of RIV, in 1995, it has become widely adopted as a valuation tool. RIV demands that the accounting equation (A=L+E) is upheld. This relationship is commonly referred to as the Clean Surplus Relationship. Although Edwards and Bell's proposal to change the way accounts are presented was not adopted, analysts acknowledge the principles underlying their proposal and commonly adjust the earnings and book value figures before their input to the RIV formula.

A figure that is more representative of annual shareholders income requires a redefinition of annual expenses as those expenditures necessary to maintain the economic integrity of the business. In other words, the sum total of expenditures required for the company to maintain its ability to grow and earn at the same rate. If these costs are not truly represented in the accounts, the investor needs to consider what they are.

An obvious example is plant and equipment. An airline that is slow to replace its ageing fleet might appear to be making good profits, when in reality it is not. This is because the depreciation expense understates the true cost of maintaining its planes. However, the economic reality of an ageing fleet will ultimately bite, with the airline either having to sign some big cheques or lose customers. The inevitable fleet upgrade is an expense that should have been recognised by the analyst in earlier years. Under these circumstances, the depreciation figure would have been added back to net profit and the appropriate annual cost of maintaining the fleet would have been deducted.

In reconsidering the balance sheet, a fundamental question is whether the figure shown for shareholders equity (book value) is a true reflection of the cost of reproducing the business. Under or overstatement of balance sheet items need to be adjusted in an effort to produce the best possible representation of worth.

Since earnings and balance sheet items are used as inputs in both ratio analysis and valuation, formulae investors always need to consider how representative of economic reality the figures are. For example, a commonly used metric is return on equity (ROE). It is used both as a measure of managerial capability and as input to intrinsic value formulae. ROE is traditionally calculated by dividing NPAT by book value, with both figures taken directly from the accounts. But given the preceding discussion, the analyst might prefer to use adjusted earnings and adjusted book value instead.

Annual report as an evolving document

Cash Flow Statement: The Income Statement is based on the concept of accrual accounting in which revenues and expenses are matched at the time transactions occur, not when payments are made or received. However, the Cash Flow Statement recognises cash flows when they actually occur. It contains three sections: cash flow from investing, financing, and operating activities. It is useful in providing a check on the Income Statement because the figures it presents are less subject to manipulation and interpretation.

Sustainability report: Increasingly, annual reports are including non-financial information. Many companies now include an annual sustainability report that focuses on environmental and social issues. There are several reasons for this. First, there is a growing global awareness of the need for companies to behave in a socially and environmentally responsible manner. Second, it is in a company's best interests to be seen as responding to these concerns. Third, governments and regulatory bodies around the world are producing guidelines and legislation requiring companies to respond to these concerns.

Digital delivery: More recently, annual reports have become available via the internet, resulting in multiple benefits. Annual reports are now more accessible, cheaper to produce and distribute, and have less impact on the environment.

About the author

Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer.

From ASX

ASX glossary of sharemarket terms helps investors understand the language of investing in listed products. Use it to learn more about unfamiliar terms or descriptions.

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