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Introduction
When I open an annual financial report today, one of the first questions I ask myself is, “Can I believe the numbers I'm seeing?” I never used to think that way. I used to think that any corporate financial report audited by a certified public accountant truly was prepared with the public's interests in mind.
The financial scandals of the late 1990s and early 2000s destroyed my confidence in those numbers, as they did for millions of other U.S. investors who lost billions in the stock market crash that followed those scandals. Sure, a stock bubble (a period of rising stock prices that stems from a buying frenzy) had burst, but financial reports that hid companies’ financial problems fueled the bubble and helped companies put on a bright, smiling face for the public. After these financial reporting scandals came to light, more than 1,800 public companies had to restate their earnings. Yet in almost a repeat of the scandals, the mortgage mess of 2007 showed how financial institutions were still using the same tricks of keeping key financial information off the books to hide financial troubles.
I still wonder what government regulators and public accountants were thinking and doing during these fiascos. How did the system break down so dramatically and so quickly? Although a few voices raised red flags, their pleas were drowned out by the euphoria of the building stock market bubble of the early 1990s and the housing market bubble of the mid-2000s.
These financial scandals occurred partly because Wall Street measures success based on a company's quarterly results. Many analysts on Wall Street are more concerned about whether a company meets its quarterly expectations than they are about a company's long-term prospects for future growth. Companies that fail to meet their quarterly expectations find their stock quickly beaten down on the market. To avoid the fall, companies massage their numbers. This shortsighted race to meet the numbers each quarter is a big reason these scandals happen in the first place.
Since the scandals broke, legislators have enacted new laws and regulations to attempt to correct the problems. In this book, I discuss these regulations and show you how to read financial reports with an ounce of skepticism and a set of tools that can help you determine whether the numbers make sense. I help you see how companies can play games with their numbers and show you how to analyze the numbers in a financial report so you can determine a company's true financial health.
About This Book
This book provides detailed information on how to read a financial report's key statements — the balance sheet, the income statement, and the statement of cash flows — as well as how to discover and scour a report's other important parts.
When you finish reading this book, you'll understand what makes up the parts of financial statements and how to read between their lines, using the fine print to increase your understanding of a company's financial position. You'll also be familiar with the company outsiders who are responsible for certifying the accuracy of financial reports, and you'll know how the rules have changed since the corporate scandals broke. Although I can't promise that you'll be able to detect every type of fraud, I can promise that your antennae will be up and you'll be more aware of how to spot possible problems. And most important, you'll get a good understanding of how to use these reports to make informed decisions about whether a company is a sound investment. If you work inside a company, you'll have a better understanding of how to use the reports to manage your company or your department for success.
Conventions Used in This Book
I use the words corporation and company almost interchangeably. Just so we're on the same page, all corporations are companies, but not all companies are corporations. The key difference between them is whether a company has gone through incorporation, which is the rather complicated legal process by which a company gets a state charter to operate as a business. To find out more about company structure and incorporation, see Chapter 2.
To help you practice the tools I show you in this book, I use the annual reports of the two largest toy companies, Mattel and Hasbro, and dissect their reports throughout various chapters. You can download a full copy of the reports by visiting the investor relations section of the companies’ websites: www.hasbro.com and www.mattel.com.
What You're Not to Read
Many of the topics I discuss in this book are, by nature, technical — dealing with finances can hardly be otherwise. But in some cases, I provide details that offer more than the basic stuff you need to know to understand the big picture. Because these explanations may not be up your alley, I mark them with a Technical Stuff icon (see the upcoming section “Icons Used in This Book”) and invite you to skip them without even the slightest regret. Even if you skip them, you still get all the information you need. On the other hand, if you savor every financial detail or fancy yourself the bravest of all financial report readers, then dig in!
I've also added some sidebars to give you more detail about a topic or some financial history. You can skip those, too, and still be able to understand how to read financial reports.
Foolish Assumptions
To write this book, I made some basic assumptions about who you are. I assume that you
Want to know more about the information in financial reports and how you can use it.
Want to know the basics of financial reporting.
Need to gather some analytical tools to more effectively use financial reports for your own investing or career goals.
Need a better understanding of the financial reports you receive from the company you work for to analyze the results of your department or division.
Want to get a better handle on what goes into financial reports, how they're developed, and how to use the information to measure the financial success of your own company.
Both investors and company insiders who aren't familiar with the ins and outs of financial reports can benefit from the information and tools I include in this book.
Icons Used in This Book
Throughout the book, I use icons to flag parts of the text that you'll want to notice. Here's a list of the icons and what they mean.
