QUALIPORT
What To Spot In An Annual Report

By Maynard Paton (TMFMayn)
February 9, 2004

Annual reports are essential reading for all investors. Though results issued via the Regulatory News Service provide the main profit and loss, balance sheet and cash flow statements, the accounting notes always provide the full -- and sometimes not so pretty -- picture.

As well as inspecting working capital movements, debt levels, pension deficits, boardroom pay and employee productivity, shareholders may also wish to consider these five points when perusing a company's report:

1. Undervalued assets

The nuances of accounting can sometimes undervalue assets on the balance sheet. Prime examples are supermarkets. Weeks after it received a bid from William Morrison (LSE: MRW) last year, Safeway (LSE: SFW) announced a 'store portfolio' revaluation had generated a £2b surplus to the amount recorded in its books.

J Sainsbury (LSE: SBRY) is another. In its 2003 annual report, the company declared land and building assets of £6b. However, closer inspection reveals the last group store revaluation took place in 1973. No wonder "the Directors believe that the aggregate open market value of Group properties exceeds the net book value of £6 billion by a considerable margin."

Company directors, unfortunately, never hint at overvalued assets until they issue a hefty write off.

2. Auditor's non-audit fees

Recent bookkeeping scandals have brought auditor independence and objectivity to the fore. The theory goes that large auditor fees for non-audit services could generate a conflict of interest.

The excellent Companyreporting.com recently discovered the fees auditors receive for non-audit work outweigh the fees for audit work on average by 1.6:1. For example, the website highlighted the 2002 annual report of mining group Xstrata (LSE: XTA), which revealed audit costs of $1.2m and non-audit costs of $14.9m paid to Ernst & Young. According to Companyreporting.com, auditor fee questions could also be asked at William Hill (LSE: WMH), British Sky Broadcasting (LSE: BSY), N Brown (LSE: BWNG) and Brittanic (LSE: BRT).

3. Declining deferred income

Deferred income represents payments received for goods or services that have not been 'earned' during the accounting period. For example, a publisher with a December year-end would recognise just three months of an annual magazine subscription, paid upfront at the start of October, as earned revenue. The balance would be deemed deferred income and recorded on the balance sheet as a creditor item.

The beauty of deferred income is the visibility it gives to forthcoming revenues. But significant changes can be a forewarning of near-term sales difficulties. After peering into the firm's balance sheet notes, the Qualiport discovered deferred income difficulties at Misys (LSE: MSY) well before the inevitable profit warning. Read more.

4. Low tax rates

The Inland Revenue rarely allows companies to pay less tax than is normal. Businesses with taxation rates well below the standard 30% should therefore prompt some annual report investigation.

Full-year results from portfolio watch list share Renishaw (LSE: RSW) showed pre-tax profits of £17.8m, tax of £3.4m and hence a tax rate of 19%. Within the notes of the engineer's 2002 report, the effects of 'different tax rates applicable to overseas subsidiaries', 'research and development tax credits' and 'tax relating to pension fund liabilities' were found to cause the abnormal rate. Investors have to decide for themselves whether the benefits will sustain a sub-standard charge into the future. Sad to say, but Renishaw's report doesn't address this particular worry.

5. Reclassifications

Always be highly suspicious when a company reports less or different information to what it did last year. Ask yourself: is there good reason, or is it a cover-up?

The book Interpreting Company Reports and Accounts cites Body Shop  (LSE: BOS) as an example. In the retailer's 1999 annual report, the segmental turnover analysis was changed, with sales from the USA and Americas being merged. In 1998, Body Shop USA had continued to rack up losses while Body Shop Americas produced operating margins of 27%, which prompted some suspicion. The authors of ICRaA wrote: "Our immediate reaction to the combining of the 'USA' and 'Americas (excluding USA)', with their very different margins, was 'naughty, naughty!'.

As it happened, Body Shop's USA operation eventually turned around, but the reclassification could so easily have swept further losses under the carpet.

Where next? Companyreporting.com | Interpreting Company Reports and Accounts | Motley Fool's FREE Annual Report Service.