How to Read Company Accounts

Corporate accounts may be obtained from Companies House. Alternatively, larger companies will file financial results periodically throughout the year, which are generally available through their websites. On the day the figures are issued to the London Stock Exchange, via the Regulatory News Service, they are also available free online. If the company you are investigating is a charity, you are entitled to access financial data. Whichever way you obtain annual reports and accounting data, you need to know how to read certain key elements.

Larger companies will begin their annual report with a Chairman’s Statement; this can say anything as there is no legal requirement for truthfulness. By contrast, the Directors' Report will be checked for accuracy. These statements will generally put a positive spin on the previous year’s performance. As a rule, the more pertinent information will be contained towards the back of the report, in inverse proportion to the size of the type. Also look at the environmental statement and check it for consistency and accuracy. Any political donations and statements of corporate social responsibility may offer additional insight into a company. It is also a statutory requirement that larger companies state their directors’ salaries and share options.

Private and public companies differ markedly in their structure and their motivations when compiling accounts. Private companies, in which all the shares are held by a family or other private grouping rather than being on the stock market, tend to depress their earnings in order to minimise and delay the payment of taxes. Public companies, listed on the stock market, tend to enhance their earnings in order to elevate their share price and generate increased Earnings per Share (EPS) for investors. Public companies are required to predict their profits a year in advance, which contributes to a projected EPS figure; share prices, bonuses and directors’ reputations depend on the company having a high EPS. Artificial attempts to inflate the EPS have been at the basis of many recent corruption cases, which means that investigative researchers need to know how to spot this.

In order to exaggerate the EPS, earnings must be shown to have increased; this can be done in two main ways – by overstating revenue or by understating expenses. This always leads to assets that do not exist or are overvalued, or liabilities that are omitted or understated (both of which are examples of aggressive accountancy techniques aimed at increasing profits). This may be done clumsily, at the end of the financial quarter/year, or more stealthily throughout the accounting period; it may also involve transferring money from one part of the company to another and then back again, and every year it becomes harder to maintain the illusion of growth.

There is a particular order to accounts, as specified by Companies House. A financial statement includes the balance sheet, the income statement (profit and loss accounts), the cash flow statement and notes to the financial statement (which describes how figures in the balance sheet have been calculated). These terms are defined more fully here:

Balance sheet – this is everything a company owns balanced against everything it owes. Companies generally go bust because of a bad balance sheet, with debt outweighing credit. This is made up of three parts:

Assets – everything a company owns, in order of tangibility:

Fixed assets – includes property, plant and equipment which cannot readily be converted into cash.

Current assets – includes cash at the bank and stock that is expected to be sold within the accounting period.

Intangible assets – largely based on goodwill, this depends on the brand and the extent to which the company is a going concern.

Liabilities – everything a company owes including:

Current liabilities – that which is payable within the year, including wages, bank overdraft and debts to creditors.

Long-term liabilities – that which cannot reasonably be expected to be liquidated within the financial year, including bonds and pensions.

Net current assets – current assets less current liabilities; if this is a negative figure, the company is in trouble.

Creditors – the amount a company owes to another company, individual or institution, listed according to whether it falls due within or after one financial year.

Debtors – the amount owed to a company by its customers or others, listed according to whether it falls due within or after one financial year.

Called-up share capital – the amount the shareholders have put in, which appears initially as cash in the bank.

Profit and loss account – details the amount of money made in a financial year that has not yet been paid out to shareholders; anything that generates income or incurs a cost must appear in the profit and loss account. This breaks down into:

Turnover – that which has been sold (revenue).

Cost of sales – the cost of the items sold.

Gross profit – turnover minus cost of sales; this should not appear in brackets, which would represent a negative value (a gross loss).

Operating profit – gross profit minus all operating expenses (but before interest and tax). This figure is easier to manipulate than gross profit because operating expenses can be over-estimated.

Profit before tax – this is profit with all costs offset (including overheads, wages and interest) and is an indicator of efficiency. Compared to gross profit, this amount is also subject to control.

Net operating expenses – includes employees, directors, cars and depreciation (see below).

Depreciation – forms part of the net operating expenses of a company. Private companies may try to claim higher net operating expenses in order to minimise their tax charge, however in the UK depreciation is not a tax deductible expense. Depreciation is calculated according to the estimated lifespan of an asset, with a proportional amount being deducted against that asset’s value every year.3 So, for example, if an asset was valued at £1,000 and estimated to last 4 years, £250 would be listed as a depreciation expense every year. The recorded value of fixed assets diminishes accordingly, but the cash portion of the balance sheet is not affected.

Net cash inflows from operating activities = operating profit + depreciation

Dividend – that which is paid to shareholders; it may be related to profit and is often greater than the year before. Dividends can be paid in years hen losses are made but this is not sustainable in the long-term. It is good business practice to reinvest some of the profits in the company before paying the dividend.

Analysing Balance Sheets and Profit and Loss Accounts On the assets side of a balance sheet, called-up share capital has a cash value at the bank, as does the stock held by the company. If a loan has been taken out, this appears as cash at the bank but the borrowings (creditor) must also be included on the liabilities side; the same is true of mortgages used to buy property. If stock has been bought on credit, equivalent values appear within assets and amongst creditors. If stock has been sold on credit, the value appears in debtors on the balance sheet and in turnover in the profit and loss accounts. When stock is sold, its value is removed from assets and the relevant revenue and cost of sales moves over to the profit and loss account. Once a debt to the company has been repaid, or credit cleared off, it appears as cash and the relevant debtor is removed from the balance sheet.

Interest receivable has an equivalent value in the cash at bank and appears in both the balance sheet and profit and loss accounts. Conversely, interest payable is equivalent to the amount by which cash is reduced. The difference between turnover and profit after tax reflects the impact of any borrowing; this enables profitability to be calculated. It is the net profit that correlates to the Earnings per Share (EPS) and this appears in the balance sheet as profit and loss.

Any fiddling of the profit and loss account will always be reflected in the balance sheet, whereas the same is not true in reverse. Remember that one way in which profits are artificially inflated is by claiming sales (revenue) which do not exist. This may be evident in the debtors and cash columns of the balance sheet.

Reading the Cash Flow Statement This is a true indication of how much cash is in the business. The vast majority of companies that go out of business do so not because of profits drying up but because the cash fails to flow. This corresponds to the adage ‘turnover is vanity, profit is sanity but cash is reality’. Irregularities may be detected when different years are compared and profits are seen to increase but cash does not. Cash is what enables a company to live and, apart from cases where the company is a bank, the cash flow statement cannot be fiddled. Notwithstanding, the accounting team will seek to give the best possible impression, by making the company meet or even exceed expectations (by not paying suppliers, calling in debts etc.). If the net increase in cash and cash equivalents is negative, the company is in trouble. The first and last figures in the cash flow statement are the most important, the latter of which (cash and cash equivalents) shows whether or not the company is richer (in cash terms) than in the preceding year.

Reading the Notes to the Accounts These can be a useful indicator of irregularities. Compare notes word for word between two standard-bearing companies in the same sector. Of particular interest are:

Directors’ remuneration – look at how much the people running the company are paying themselves.

Pension liabilities – this will have a large note attached, the most interesting of which will be the figure in brackets, which represents the pension deficit. This may have arisen because the company took a pension contributions holiday (despite employees continuing to pay into the fund) in order to boost profits.

Post balance sheet events – this refers to any significant events that have taken place between the date accounts were finalised and the date they were filed. Public companies have six months to file their accounts and private companies have eight months. This item often comes towards the end of the notes to the accounts and relates to events which will have a bearing on the profitability of the company.

Taxation – analyse any tax charges or credits, including income or other company tax (adjusted for previous years), corporation tax and overseas tax. Study the calculation of how much the company was liable to pay and how much they actually paid (in cash flow statements), according to various allowances; the majority of US corporations pay no tax.

Related party transactions – this discloses the relationship between a parent company and its subsidiaries, which is compulsory in the UK. It is common to most frauds that these transactions will benefit parties related to the company.

Going concern – accounts are generally produced on the basis that a company will carry on trading for at least one more year. Auditors will occasionally express their concerns in this section, which is a sign of a company in trouble.

Exceptional items – these are considered to be one-off events that the company would like readers to ignore. As such, these items are segregated from other considerations, but they may only truly be considered exceptional if they do not occur repeatedly. Actual profits come after ‘profit before exceptional items’. Exceptional items tend to come in after operating costs because this is easy to fiddle. Researchers are perfectly entitled to ask companies about their exceptional items – if bad debts are listed in this section, question how they can be exceptional.

Goodwill – this is the notional value of a company minus its assets, which immediately disappears if a company ceases to be a going concern.

Ultimate ownership – in the UK, companies are required to disclose the ultimate owner of the company.

Contingent liabilities – this evaluates the impact of an event which may happen or is unlikely to happen.

Auditor’s report – the auditor must make a declaration which will normally be an unqualified opinion that this represents a true and fair reflection of the accounts. Occasionally, they may offer a qualified opinion and an explanation of their qualification, which may emphasise a particular matter or express uncertainty about the company’s status as a going concern. This should set alarm bells ringing. In the light of various accounting scandals, sceptical investigators might also ask about the extent to which auditors are independent. They are paid large fees and are generally well conditioned to suit the company’s purposes; it is in their financial interest not to draw attention to irregularities as they may be sued for not having spotted them in previous years. Auditors rarely leave a company but, if they do, they are required to file a letter, citing their reasons, which may be checked.

In summary, if undertaking a financial investigation:

• Look at political donations and statements of corporate social responsibility.
• Compare the level of directors’ remuneration with that of their employees.
• Examine the previous history of the management.
• Look at the pension deficit.
• Compare dividends paid out to shareholders with the amount of profit being made. Assess the degree to which profits have been overstated (by over-estimating assets and/or underestimating liabilities).
• Compare the turnover to the amount owed to creditors/by debtors and for evidence of fictitious sales.
• Look at how much cash there is in the company.
• Track both profits and cash flow over successive years – if profits seem to be increasing but cash does not, the company is in trouble.
• Analyse the quality of assets and not just their quantity.
• Compare the amount of tax the company actually paid with that which it was due to pay.
• Look at the exceptional items and evaluate how exceptional they really are.
• Check to see whether auditors have expressed any concerns.
• Ask yourself how independent the auditors are.

Based on a series of presentations by Raj Bairoliya

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