Skimming an annual report
An annual report often runs three hundred pages, of which about ten matter. Know which ones, and it takes half an hour.
Learning objective: After this lesson, you can quickly find the handful of sections in an annual report that actually matter for an assessment.
Start at the back, not the front. The first pages are marketing with smiling people. The substance sits in the management discussion, the notes, and the auditor's opinion.
Four spots are worth your attention. First, the risk report, where the company itself has to write down what could go wrong. Second, the cash flow statement, since it's harder to dress up than earnings.
Third, the notes on liabilities, showing when which debts come due. Fourth, the audit opinion: if it contains qualifications, or if an auditor was recently changed on short notice, that's a clear signal.
A practical trick for comparison: put last year's report next to this one and look for wording that changed. Companies rarely change their language without a reason.
The management discussion contains the outlook and risk reporting. Changes from the prior year in wording and the order of risks are revealing, since these sections are usually carried forward and updated. Newly added risks and changed probabilities are therefore more informative than the report as a whole.
The notes contain valuation methods and discretionary judgments. Changes in accounting and valuation methods must be disclosed and deserve attention, especially around revenue recognition, capitalization of development costs, and goodwill impairment testing. These three areas offer the greatest room for discretion.
The audit opinion has, for some years now, included the key audit matters, where the auditor names which areas carried the greatest discretion. This is a direct signal of where an independent third party saw the biggest risk of misstatement, and it's almost entirely overlooked by retail investors.
Summary
- Risk report, cash flow statement, maturities, audit opinion.
- Compare the wording against last year's report.
- Key audit matters show where the auditor saw risk.
Did you get it?
Why is the cash flow statement more revealing than earnings?
Because it leaves less room for discretion than reported earnings.
Which three areas offer the greatest accounting discretion?
Revenue recognition, capitalization of development costs, and goodwill impairment testing.
What are key audit matters?
Areas the auditor names as carrying the greatest discretion and risk of error.
Check your understanding
Sources and further reading
- The international auditing standard ISA 701 has required auditors of listed companies since 2016 to disclose the key audit matters in the auditor's report. View source ↗
Related
- Reading a balance sheetStage 3
- The key financial ratiosStage 3
- What a company is worthStage 3
- Matching questions for this stageQuestions