Accounting: The Language of Business - Vol. 2 (Intermediate: Part 78)

If you are hired to shake up the system, do it. No one will believe you're the boss until you do one or more of the following: 1. Add a new division; 2. Lop off a present department; 3. Add new people or reassign and reward present employees; 4. Get rid of deadwood; 5. Change the method of accounting; 6. Change lawyers, accountants, or other outside services; 7. Ask a lot of questions, and demand answers by a certain date; 8. Get in touch with key people in your industry or city and arrange personal meetings; 9. Improve working conditions; 10. Update present benefit plans.

Lois Wyse

Statements of Financial Position and Cash Flows and the Annual Report (Part P)

by

Charles Lamson

The Annual Report

The financial statements are included in an annual report that provides a comprehensive picture of a company's operations, the risks it faces, and its operating and financial performance. A country's security regulators usually determine the form and content of the annual report. In the United States, the Securities and Exchange Commission (SEC) has the authority to promulgate standards that establish the structure of the financial report called the 10-K. (For IFRS reporters, the content of the annual report varies with the country and the regulator in which the company operates. The IASB has issued a statement describing important disclosures in a management commentary that companies can voluntarily follow.) The U.S. annual report contains detailed information on 15 major areas. The financial statements and the notes to the financial statements are included in the 10-K. In addition, we discuss the following areas that are most relevant to this analysis:

• Management discussion and analysis

• Auditors report

• Management's report

• Board of directors

We use the Johnson & Johnson annual report for fiscal year 2016 ending January 1, 2017, to illustrate the contents of a company's annual report. Companies can also voluntarily provide other disclosures and discussions in a variety of other areas. For example, Johnson & Johnson prepares a report on sustainability and corporate responsibility that includes areas such as quality and safety of products, climate, water, governance, transparency, and stockholder engagement. Companies report many of these other items in the investor relations part of their websites. 

Management Discussions and Analysis

 Management's discussion and analysis of the financial condition and results of operations (typically referred to as the MD&A) is a required part of the annual report. The MD&A section provides the information necessary to understand the entity's financial condition, changes in financial condition, and results of operations (SEC Rule 240. 14a-d(b)(5)(ii). Item 303 of SEC Regulation S-K and SEC Interpretive Guidance). The SEC specifies the topics discussed including:

1. Liquidity

2. Capital resources

3. Results of operations

4. Off-balance sheet arrangements

5. Disclosure of contractual obligations

6. Critical accounting policies (Items 303 of SEC Regulation S-K requires that these topics be discussed but does not mandate the level of detail to be provided within each topic.) 

The MD&A section focuses on material events and uncertainties known to management that could affect the faithful representation of the financial information reported elsewhere in the annual report. Examples include trends, events, and uncertainties that did not impact the entity in the past but could affect future financial position, operating results, and cash flows. Conversely, the MD&A provides information related to prior trends and events and uncertainties that may not occur in future reporting.

The MD&A section allows top management to provide the reader with an extensive analysis related to the firm's future performance. Although the discussion may contain some management bias, auditors are required to read the MD&A to ensure consistency with all the information provided throughout the financial statements. Thus, although it is not part of the audited financial statements and should be viewed with some degree of caution, there are some assurances that the information is accurate. 

Johnson & Johnson's MD&A on pages 14 to 32 of its 2016 10-K begins with a description of the company, business segments, and management objectives. The MD&A then reviews the results of operations and provides an analysis of consolidated sales. This analysis addresses multiple dimensions, such as U.S. versus international results, performance by geographic region, and performances across the company's three business segments (consumer, pharmaceutical, and medical devices and diagnostics). The MD&A section also presents a combined discussion of Johnson & Johnson's liquidity and capital resources with a breakdown of its contractual obligations and commitments.

Critical accounting policies involve estimates and assumptions that could have a material impact on the company's financial condition or operating performance. These are areas with high levels of subjectivity and judgment necessary to account for uncertain matters or matters subject to change. Company disclosure supplements rather than duplicates the description of accounting policies that are already disclosed in the notes to the financial statements. Johnson & Johnson begins its discussion of critical accounting policies on page 26. Johnson & Johnson identifies the following critical areas: revenue recognition, income taxes, legal and self-insurance contingencies, valuation of long lived assets, assumptions used to determine the amounts recorded for pensions, and other employee benefit plans and accounting for stock-based awards. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 262-263*

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