QUALIPORT
What To Spot In An Annual Report

By Maynard Paton (TMFMayn)
March 1, 2005

 

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) in 2003, Safeway 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 2004 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

High-profile bookkeeping scandals continue to bring 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 last year 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 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 corporation 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 £20.1m, tax of £4.0m and hence a tax rate of 20%. Within the notes of the engineer's 2004 report, the effects of 'different tax rates applicable to overseas subsidiaries', 'research and development tax credits' and 'companies with brought forward tax loss relieved in the year' were among the items 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 really address this particular issue.

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?

Take Churchill China (LSE: CHH), the crockery manufacture. After years of disclosing sales and operating profits for its 'Dining In' and 'Dining Out' divisions, shareholders were greeted with this statement tucked away in the 2001 accounts:

"The Directors now consider that the Group's activities are a single class of business. The previously disclosed segmental analysis is now no longer appropriate. However for additional shareholder information turnover is analysed as follows:

Analysis by market sector	2001 £000	2000 £000
Dining Out	21,323	20,602
Dining In	30,662	29,311

Why divisional sales could still be disclosed -- but not operating profits -- wasn't made clear. Funnily enough, the 'Dining Out' division has proved troublesome ever since and annual group profits at Churchill have yet to recover to the levels recorded in 2001.

Where next? Companyreporting.com | Motley Fool's FREE Annual Report Service.

A version of this article was first published in February 2004.

Portfolio value

Holding	Number of shares	Closing price 28/02/05 (p)	Value (£)
Associated British Ports	681	476.5	3,244.97
Emap	372	844	3,139.68
Halma	1,920	160.75	3,086.40
Johnston Press	1,608	565	9,085.20
London Stock Exchange	2,018	539	10,877.02
Cash			207.07
Total			29,640.34