1
ARMING YOU WITH ESSENTIAL KNOWLEDGE

In past editions of this book, Chapter 1 dove right into the critical concept of gaining a clear understanding of how businesses produce and consume cash. In fact, we opened with this all-important statement:

Savvy business managers, owners, lenders, investors, and analysts pay a significant amount of attention to cash flows. Cash flows represent the heartbeat and pulse of every business, and without producing a steady heartbeat and healthy pulse of positive cash flows, a business would soon most likely end up on life support-or worse yet, die.

For this edition, I felt that I should begin by providing an explanation of the primary differences between what constitutes a financial report and the purpose and role of financial statements. While I touch on the elements of preparing financial reports, the primary focus of this book is how to read and understand financial statements, which make up the nerve center of the financial report. (Do not fret, as I will get to the critical concept of cash flows in Chapter 2 and again in Chapter 5.)

What Is a Financial Report?

To start, it would be helpful to clarify the difference between the purpose and function of financial statements and a company's financial reports. In this context, I am referring to publicly traded companies and other large businesses that are required, by regulatory bodies such as the SEC, or by third parties such as a large lender, to issue quarterly or annual financial reports. An important concept to keep in mind is that financial statements represent a part (albeit a critical part) of a company's financial report. Looking at it differently, it would be extremely difficult to produce a financial report without including financial statements, but financial statements can be produced and presented to third parties without a full financial report. In effect, financial statements by themselves are a financial report.

It is important to keep in mind that while a company's financial statements represent the backbone for analyzing and evaluating its financial performance, financial reports include extensive additional financial, business, legal, and regulatory material that accompany the financial statements. The actual financial statements may take up anywhere from three to six pages of an external business financial report, while the complete financial report may often exceed 100 pages (thanks to management providing their discussion and assessment of operating results, along with the required footnotes that accompany audited financial statements).

Although this book is about how to read and understand financial statements, understanding what additional content and data is most often included in financial reports, and why, makes sense because I focus on two primary tranches of additional information: management discretionary disclosures and financial statement footnotes (including supporting schedules). I describe these as follows:

1. Management discussion of operating results (MDOR): The MDOR, sometimes referred to as the MD&A (management discussion and analysis), is a section of a business's financial report that is generally reserved for management to provide an assessment or overview of key operating results, market trends, industry data, strategies, and so on that management believes would be beneficial to external parties to help them more fully understand the operating results of a business. The MDOR is usually located at the front of the financial report that is prepared periodically and externally distributed. Quite often, it starts with a shareholder or investor letter prepared by the company's board chair or CEO. There is no doubt that the MDOR can provide useful information to external parties, but it should be noted that, generally speaking, the information in the MDOR has not been audited by an independent CPA firm. Rather, it contains information that is presented by a company's management team. Translation: The MDOR tends to include a broader range of business information that has been internally prepared by the company and incorporates more opinions and perspectives than audited financial statements, which tend to stay factual in nature.
2. Financial statement footnotes and supporting schedules: In contrast to MDOR disclosures, financial statement footnotes and supporting schedules (sometimes referred to as supplemental reports) are part of the audited financial statements, prepared by an independent CPA firm with support from company financial executives and legal counsel. Often, these are located toward the back of the externally prepared financial report, just after the financial statements. The goal of financial statement footnotes is to provide additional clarity, support, and detail to validate and substantiate the information provided in the financial statements. For example, if a company has established a reserve for a potential liability due to uncertain legal actions brought against the company, the footnote will help shed additional light on the nature of the legal action and potential damages. Financial statement footnotes tend to avoid presenting management opinions and are more likely to stick to the facts. Yet, even here, I must point out an irony in the accounting and financial reporting world; that is, while the purpose of audited financial statements and associated footnotes is to present external financial reports that are prepared by independent, third-party CPAs and are factual in nature, almost all audited financial statements and associated footnotes rely heavily on the use of estimates when calculating operating results. This concept underscores the importance of remembering that accounting is often just as much an art as a science! In short, footnotes and supporting schedules represent an essential part of every CPA-prepared or CPA-audited financial report. Financial statements would be naked without their footnotes.

In summary, it is important to remember that this chapter refers to financial information as presented in external financial reports-those that circulate outside the business. These financial reports and communications are designed mainly for use by outside business shareowners, analysts, company lenders, governmental agencies, and the like, with the business shareowners, executive management team, and creditors (e.g., lenders, strategic partners and vendors, etc.) representing the three primary stakeholders in the business. Internal business executives, managers, and staff have access to significantly more information than that released in the company's external financial reports. This information is incredibly detailed in nature and is usually highly confidential, so external disclosure is tightly guarded. A more thorough discussion on internally generated business financial information appears in our sister book, How to Write a Financial Report, and is supported by the words of wisdom bestowed on us by Warren Buffett: When analyzing financial information, "the devil is in the details." It goes without saying that invaluable internal financial information is both highly sought after and closely guarded, given its importance.

Financial Information and the Big Three Financial Statements

It should be obvious that business managers, company lenders, investors, regulatory agencies, and countless other parties need to clearly understand an entity's financial performance, in a timely manner. This is common sense, no doubt, but you would be absolutely amazed at how often this basic concept is overlooked or, for lack of a better term, neglected by even the senior most internal company executive management teams.

Expanding on this thought, I would like to further note that all, yes all, businesses, organizations, non-for-profits, and governments (referred to as "entities" throughout this chapter), in one fashion or another, should produce reliable financial information on which business and economic decisions are made. Here again, this should be common sense, but I selectively used the term should because not all entities actually produce reliable financial information. Do not ask us how these entities prepare tax returns, execute financial management tasks, or make business and economic decisions, but in the spirit of full transparency, assuming all entities actually maintain accounting systems and produce reliable financial information can be a fatal error.

Focusing on entities that produce reliable financial information, I would like to note that financial information comes in all shapes, sizes, and forms ranging from something as small as preparing a flash report that summarizes the sales performance of a sales representative in a specific geographic region to something as large as Apple, Inc. producing its annual report for shareholders and other external readers to peruse.

The primary means of communicating an entity's financial information to external parties is via its financial statements, the preparation of which is one of the main functions performed by accountants. In a sense, accountants act as the financial scorekeepers of the entity as it is their job to ensure that complete, accurate, reliable, and timely (i.e., CART) financial statements are produced.

Financial statements are sent regularly by an entity to both internal and external parties including lenders, investors, financial analysts, regulatory bodies, internal management-and...