The Hindu Business Line : How to write annual reports

READING the narrative element of an annual report in conjunction with the financial statements helps with their interpretation, but it can give a telling overview of the company even before these are examined. The chairman's statement (CS) is the most widely read section by the lay investor and it is also considered highly useful by analysts. Research shows that the content of the CS indicates performance changes or even whether a company is at risk of bankruptcy.

From a practical point of view, narrative also offers many opportunities. For example, Mr Andrew Lennard, technical director of the ASB, says that companies are likely to use the narrative sections to explain the effects of international financial reporting standards. Directors may consider smoothing out results by creatively narrating a bad year into a good year.

But there are several "red flag" practices that may point to fundamental problems with a company, and could therefore lead prudent investors to sell their shares. Equally, there are several "green flag" practices that may encourage investment.

Narrative can be improved through simplification wherever possible. Research has shown that more profitable companies use highly readable prose that uses few accounting terms. Readability can be tested by giving the narrative to employees to read before publication. If they can't follow it, then what chance does an outsider have? Equally, many word-processing programmes can now rate the readability of a document.

Warren Buffett, investment guru and chairman of Berkshire Hathaway, includes several jokes in his CS and gives the bad news up front. A straight-talking CS that shows accountability to investors is essential, as is maintaining consistency of reporting from year to year. A "line item" approach to disclosure — that is, a list of separate points — is not suitable for the CS. The structure and flow is critical, so it should not be treated as a long series of footnotes.

Quantified goals, along with a consistently applied metric for evaluating them, allow performance to be measured and compared year on year. Enron's CS, in the four out of five years that it discussed earnings, used a different financial item to represent this every year, choosing the metric that showed the result it wanted. Enron's stated desire in its 1996 CS "to generate 40 per cent of our net income 5 years from several now" from several new firms it was setting up was not mentioned in subsequent CSs. Similarly, the goal stated in its 1997 CS of growing earnings at 10 per cent a year was never mentioned again.

Many firms' CSs follow Enron's example and fail to cover whether the previous year's promises were met or not. By contrast,

Buffett's CS clearly defines his criteria for the assessment of his own performance as the increase in "per share book value" of his company by "a few points" in excess of the Standard & Poor's 500. The metric is unchanging and his performance history is easy to follow, because he shows his annual results against this key indicator going back to 1965. It is important that the narrative is not unduly optimistic. In the longer term, companies that report the lows as well as the highs will earn far more trust than those that do not. New products and services should not be overly hyped, since these usually take several years to convert into significant profits. For instance, in 2003 Microsoft could have boosted its operating income growth to 15 per cent by working on a pro-forma basis with a slightly different method of accounting for stock options, but it chose to show this only when required to do so in its annual report.

It also did not mention the 540 per cent increase in net earnings. The advantage of letting figures speak for themselves and downplaying good performance is that Microsoft's outlook will be seen as pessimistic. The market trusts a pessimist far more than an optimist, and trust will increase share prices.

Avoid using superfluous phrases such as "global presence", "market knowledge" and "financial strength" without quantification. Credible, informative and engaging statements are correlated with higher share prices. The opposite is true for those with more fluff and fewer facts.

Preparers should not be afraid of disclosure it is a sure warning sign when areas of concern go unmentioned or figures are missing. The Walt Disney Company's 2003 CS states that "we experienced solid earnings growth", but it does not include figures for earnings or the percentage increase. In fact, its earnings grew by 2.5 per cent. Is this really solid growth?

Directors should ensure that the CS talks about earnings, even when the news is bad. It can actually be beneficial if responsibility for poor performance can be taken, rather than attributed to external factors. It is important to use the narrative to "sell" the corporate vision, leadership goals and business model. Buffett uses his CS as an opportunity to promote not only his company but also its products. The provision of information on future projects, particularly spending plans — is highly prized by the market, since it is a rare practice.

It is important that directors do actually write most of the narrative. Using a PR firm or an accountant to produce the whole thing will destroy confidence in it as a communications medium and undermine people's faith in the company, although accountants will of course be highly involved in the process.

A recent study of the fortunes of companies using pro-forma earnings has found that they have lower future cash flows — 83 fewer cents of future cash flow for every dollar of exclusions, in fact. As Buffett says in his 2002 CS, "pro-forma earnings statements show `earnings' far in excess of those allowed by their auditors. In these presentations, the CEO tells his owners "don't count this, don't count that — just count what makes earnings fat.'"

(Edited extracts from Financial Management, a journal of CIMA London.)