ANNUAL REPORTS



Annual reports are public statements of an organization's financial performance that are distributed to company stockholders and other interested parties. An annual report assesses the preceding fiscal year's operations and discusses the management's view of the upcoming year. It may also contain limited comparative information about a company's competitors and the broader industry in which it operates. Both for-profit and nonprofit organizations produce annual reports, but this discussion concentrates on those of for-profit businesses.

THE BASICS

In the United States, the U.S. Securities and Exchange Commission (SEC) requires most publicly traded companies to file an annual report known as form 10-K. Other variant forms may also satisfy this requirement if a company is in special circumstances, such as being involved in a merger.

At its most basic, a 10-K report includes:

Some companies provide only this minimum amount of information. Annual reports of this type usually are only a few pages in length, printed in one color—black—and produced in an inexpensive fashion, often closely resembling photocopying. For these companies, the primary purpose of an annual report is simply to meet legal requirements.

DISCLOSURES.

Key to the legal requirements are financial disclosures and other information that investors may use to evaluate the company's fiscal health. This aspect is fundamental to the annual report's existence, and, in fact, if a company publishes in its report a statistical error of more than 10 percent, it is required to submit an adjusted report. Despite this and other regulations, investors continue to clamor for forthright information from companies, particularly about problems. These calls for better disclosures are especially poignant when a company suddenly is losing money or flirting with bankruptcy and investors feel they were in the dark about events leading to that situation.

Regulatory bodies in the accounting profession, such as the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB), have proposed broadening the scope of disclosures in annual reports. They seek to include not only financial data, but also other key measurements of the company's performance and internal stability. Much of this information is considered sensitive, and some is plainly negative. For example, the FASB has asked companies to provide such potentially damning information as their rates of product defects and employee turnover. Not surprisingly, a number of companies have balked at this request. Some accounting-standards advocates go further to demand information about corporate disputes with outside auditors and lawyers and even details about senior executives' criminal records. For the time being, however, these remained requests rather than requirements.

A MARKETING TOOL

A wider group of companies views the annual report as a marketing tool. It is a forum through which a company can relate, influence, preach, opine, and discuss any number of issues and topics. A "Letter to Shareholders" most often sets the tone of the annual report. The chairman of the board of directors, the chief executive officer, the president, the chief operating officer, or a combination of these four sign the letter on behalf of company management. The message of the letter will often focus on topics such as the past year's results, strategies, market conditions, new management and directors, and company initiatives. The letter sometimes is no more than a sounding board for the person leading the company. Some letters have run a dozen or more pages, contained several photos of the CEO in different poses and expounded on a wide variety of topics that apparently have some interest to the CEO, if not readers of annual reports. A letter that actually reads like a letter, and reads as if the person signing the letter may have actually penned it himself or herself, is one format known to appeal to readers. This contrasts with letters that read like an accounting treatise pieced together by an eclectic team.

Annual reports usually advance a theme or concept. Catch phrases such as "Poised for the Twenty-first Century" can unify a company's annual report message. In any year, a particular event or economic condition will create a theme adopted by a wide range of companies. For example, when the Berlin Wall fell in 1989, several reports focused on the opening of Eastern European markets. There was a similar response when the European Economic Community formed to unite Western Europe, when restructuring and reengineering dominated business, and, more recently, when the North American Free Trade Agreement (NAFTA) and General Agreement on Tariffs and Trade (GATT) opened previously restricted markets.

Companies also have used a milestone anniversary, such as 100 years of doing business, to unify a report. Promoting a long, successful track record can be appealing to shareholders and various audiences. Still other companies have developed a tried-and-true format that they use year after year with little change besides updating the data. Whatever the theme, concept, or format, Wall Street will consider the most successful reports those that clearly delineate a company's strategies for profitable growth.

AUDIENCES

Shareholders and potential shareholders remain the primary audiences for annual reports. Employees (who today are also likely to be shareholders), customers, suppliers, community leaders, and the community at large, however, are also targeted audiences. Companies will address other publics, depending on their objectives.

EMPLOYEES.

The annual report serves many purposes with employees. It often relates the company's goals. Employee innovation, quality, teamwork, and commitment are all critical to achieving company goals, so it is essential that employees and management share the same focus.

An annual report is also a vehicle for relating the company's successes—a new contract, a new product, cost-saving initiatives, new applications of products, expansions into new geographies—all of which have had employee involvement. Seeing a successful project or initiative profiled in the annual report gives reinforcement to the employee team, operating division, operating group, and/or operating company responsible for the success.

The annual report can help increase employee understanding of the different parts of the company. Many manufacturing locations are in remote areas, and an employee's understanding of the company often does not go beyond the facility where he or she works. An annual report can be a source for learning about each of a company's product lines, its operating locations, and who is leading the various operations. Other copy can relate success stories from each of the divisions. The annual report can show employees how they fit into the "big picture."

Employees also are often shareholders. So, like other shareholders, these employees can use the annual report to help gauge their investment in the company. In this case, they also realize that the work they are doing in making products or providing a service is having an impact on how Wall Street values the company's stock.

CUSTOMERS.

Customers want to work with quality suppliers, and an annual report can help a company promote its image with customers. Publishing management positions such as the company's mission and core values is one idea. Describing company initiatives such as projects to improve manufacturing processes, reduce costs, create quality, or enhance service can illustrate a company's customer orientation.

The annual report also will show the company's financial strength. Customers are reducing their number of suppliers, and one evaluation criterion is financial strength. They want committed and capable suppliers, and ones that are going to be around for the long term.

Often a supplier's annual report can be a marketing tool for the customer, as well. When a supplier highlights a customer in its annual report, it is giving the customer some free positive publicity.

SUPPLIERS.

A company's capability to meet its customers' requirements is only as good as its suppliers' capabilities. One hundred percent on-time delivery to customers is not possible if the company's suppliers are only responding with 60 percent on-time delivery. Therefore, successful companies today want to work with suppliers committed to the same quality standards. An annual report can help with this process by highlighting quality, innovation, and commitment. This will show a company leading by example and reinforce the type of response the company expects from its suppliers. Sometimes an annual report will even offer a profile of a supplier that the company has found exemplary so other suppliers have a better understanding of the level of service desired.

THE COMMUNITY.

Especially in the communities where it does business, a company wants to be perceived as a corporate citizen making a valued contribution. An annual report can help with this marketing. Many annual reports discuss companies' community initiatives such as community renovation projects, charitable contributions for human services organizations, and programs to help protect the environment. The objective is to present the company as a proactive member of the community.

This sort of publicity also can be valuable when a company is making plans to move into a new community. Companies seek warm welcomes in new communities (including tax breaks and other incentives). Communities will woo a company perceived as a "good" corporate citizen more zealously than one that is not. The good corporate citizen also will receive less resistance from local interest groups. The company's annual report will be one document that all affected parties will pour over in evaluating the company.

READING AN ANNUAL REPORT

The wide variety of audiences means people read annual reports for different purposes and at different levels. Generalizations, however, are difficult. The stockholder with five shares might be as careful and discriminate a reader of an annual report as the financial analyst representing a firm owning one million shares. Many readers find the following sections most useful.

COMPANY DESCRIPTION.

Most companies will include a description of their business segments that includes products and markets served. Formats vary from a separate fold-out descriptive section to a few words on the inside front cover. Reviewing this section gives at least a basic understanding of what the company does.

THE LETTER.

The "letter to shareholders," "chairman's message," or whatever a company may call it, should provide some informative data on how the past year went and what the prospects for the future are. As stated above, if the company has put in the time and thought, the language of the letter should be easy to follow and understand.

MANAGEMENT'S DISCUSSION AND ANALYSIS (MD&A).

This section can be dry, full of accounting jargon, and boring, but the MD&A gives, in a succinct package, an overview of what happened with the company over the past three years. It makes a comparison of the most recent year with the year previous, and then compares this latter year with the preceding year. It discusses sales, manufacturing income and margin, operating income, net income, and the things that led to the reported numbers. A section discusses capital expenditures, cash flow, changes in working capital, and anything "special" that happened during the years. The MD&A is also supposed to be forward-looking, discussing anything the company may be aware of that could negatively or positively affect results. An MD&A can be written at all different levels of comprehension, but with even a little accounting understanding, the reader can get valuable insights.

FINANCIAL SUMMARY.

Most companies will include either a 5-, 6-, 10-, or I1-year summary of financial data. Sales, income, dividends paid, shareholders' equity, number of employees, and many other line items may also be included. This section summarizes key data from the statements of income, financial position, and cash flow for a number of years.

MANAGEMENT/DIRECTORS.

A page or more of an annual report will list the management of the company and its board of directors. By reviewing the management list, one often can get a sense of the management team's background, diversity, and experience. The same is true of the director list. Number of directors, diversity, and the directors' positions within their respective companies all can help the reader evaluate the quality of company leadership.

INVESTOR INFORMATION.

There almost always is a page that lists the company's address and phone number, the stock transfer agent, dividend and stock price information, and the next annual meeting date. This information is helpful for anyone wanting additional data on the company or more information about stock ownership.

PLAIN-ENGLISH INITIATIVE

The language and presentation of annual reports has begun to change in response to SEC initiatives to make investment literature clearer and more accessible. In 1997 SEC chairman Arthur Levitt announced the commission's wish to move investment reporting away from highly technical, hard-to-read disclosures, including 10-K filings, based on pilot programs the commission was conducting with a number of companies. As Levitt described it, these disclosure documents should be in "plain English."

The SEC took several steps to encourage companies to abandon confusing and difficult writing, including publishing the 68-page A Plain English Handbook: How to Create Clear SEC Disclosure Documents. As its name suggests, the policy affected not only annual reports but all investment-related filings under the commission's purview. The handbook addressed such minute issues as avoiding the passive voice, formatting reports in easy-to-read typefaces, and ensuring that graphics are true to the underlying data. For parts of some disclosures, such as the front page of a prospectus, the plain English rule is mandatory.

PACKAGING THE ANNUAL REPORT

For most companies, the words and message are the most important aspect of an annual report. Companies also want to be sure, however, that their targeted audiences are going to read and understand the message. Thirty pages of monotonous, uninviting small type is not going to attract a lot of interest. At the same time, turning the message over to a designer who is more intent on creating a visual, aesthetic monument is likely to have a similarly negative effect.

The challenge is to attract the reader's interest and, once accomplished, to hold that interest long enough for the reader to get the company's message. Estimates are that the average annual report reader spends only a couple of minutes looking through a report. So the challenge is very real. Subheads, callouts, and other snippets are helpful in getting across concepts to the report skimmer. Visually appealing photography also can help gain reader attention. Combining an appealing photo that illustrates a strategy or initiative with a short narrative can be an even more effective tool.

A report designer can work with type styles, point sizes, and a variety of other techniques to enhance appearance, always cautious of overdesigning that can hinder interest and readability. To a certain extent, the kind of company will dictate the design format. For example, the design of an industrial company's annual report will probably differ from that of a fashion, entertainment, or trendy consumer services company. The key is choosing a design that will best convey the company's message.

Costs also influence the production of an annual report. Companies will weigh the printer it uses, contracting for new photography or using "pick-up" photos, whether to write in-house or out, and even the type of paper used for the report. All will affect whether the report costs a few thousand dollars or several hundred thousand dollars.

SUMMARY ANNUAL REPORTS

Few major trends have jarred the tradition of annual reports, but one is the "summary annual report." In 1987 the SEC eased its annual reporting requirements. It allowed companies to produce a summary annual report, rather than the traditional report with audited statements and footnotes. Full-blown financial data are still a requirement. Nevertheless, filing a Form 10-K containing this information and including audited financial data and other required material within a company's proxy statement—another SEC-mandated document for shareholders—met the requirement. Promoters of the summary annual report see it as a way to make the annual report a true marketing publication without the cumbersome, detailed financial data. Financial data is still included, but in a condensed form in a supporting role. Although several high-profile companies use this format, the summary annual report has not gained widespread support. In an analysis entitled Summary Annual Reporting, Deloitte & Touche estimated that in the late 1990s about 100 companies used a summary rather than a traditional report.

In some respects, annual reports are like fashions. Certain techniques, formats, and designs are popular for a few years and then new ideas displace the old. Several years later, the old ideas are back in vogue again. Other formats are "classic," never seeming to go out of style or lose their power. A key to a successful annual report is not getting caught up in a trend, and instead deciding what works best for conveying the message.

[ Richard Rump ]

FURTHER READING:

Petersen, Melody. "A New Rule to Turn the Annual Report into True Confessions." New York Times, 4 March 1998.

Securities and Exchange Commission. A Plain English Handbook: How to Create Clear SEC Disclosure Documents. Washington, August 1998. Available from www.sec.gov .

——. "Search the EDGAR Database." Available from edgar.sec.gov/edaux/searches.htm .



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