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Capital Dynamics Sdn Bhd is the first independent investment adviser in Malaysia. It has been described as "one of the country's most iconoclastic and critical research outfits".

In February 2004, Capital Dynamics Sdn Bhd launched icapital education.

Since our inception in 1988, we have remained totally independent and have been providing objective advice on Stockmarkets and Economies through iCapital.

The iCapital newsletter is its flagship product. It has been around since 1989.

In 2002, icapital.biz, the online version of iCapital was launched.


Home > Articles > Reading Annual Reports Carefully

Reading Annual Reports Carefully


The Enron crisis is a disaster of gigantic proportions involving many dimensions. But like most crises, the victims are inevitably the many innocent ones. Imagine the many pensioners who lost almost all their hard-earned life savings. Whenever such disaster happens, we are often told that life is not fair, even as we preach to our children, our students and our fellow countrymen the virtues of fairness. Life is just an unfair irony.

We have been told that an Enron-type of crisis cannot happen in Malaysia. Having seen the social pain imparted by the collapse of the many deposit-taking cooperatives in 1985-1986, which once again involved many innocent victims, we just hope that our regulators are right. We just have to be very alert because the next crisis would not follow the exact pattern of Enron. It would most likely be something that is least expected by all of us.

However, as an investment adviser, what concerns Capital Dynamics most is how we can prepare ourselves against the serious corporate governance and transparency problems facing US now. They like to often claim that they have the best system. And yet, the US ended with such messy problems. For those of us who have to invest in emerging markets like the KLSE, what hope is there for us to ensure that we do not get sucked into such a quicksand ?

When investing in the stock market, whether it is the KLSE or anywhere else, the best defence is for the investor to do his or her homework. The underlying philosophy of such behaviour is best captured by the advice given to our managing director by his father and grandfather - do not blame the others for being smart, blame yourself for being foolish. So, how does one go about doing this ?

When The Malaysian Business featured our managing director as a top performing fund manager in the issue dated 1-15 Feb 2002, he told the surprised journalist that he reads all the annual reports of the listed companies on the KLSE. His reasoning is simple. The annual report is like a report card of a company. It tells us how the company and the management have performed in the last twelve months. It also tells us what the conditions of the company are at a certain date of the year. Admittedly, the quality of our annual reports is still very far from being satisfactory. One can still read an entire annual report and still do not have a reasonable idea of what the company does. But there is really no short cut and there is really no other choice.

To get to know the company, one must read the annual reports. To understand an annual report, an investor must be familiar with accounting. Accounting is the language of business. The modern system of double-entry bookkeeping was developed by Luca Pacioli, a Venetian monk and mathematician, in the 15th century. The principles have not changed much since then. For investors, the problems arise because annual reports or financial statements can be prepared in many ways, even though they have accounting standards to follow. So, when an investor reads the annual report, he or she has to be alert for accounting frauds, gimmickries and other forms of creative accounting.

Therefore, we would like to share with our subscribers some of the accounting practises that are commonly used. First, any annual report would contain 3 main statements : [1]. Profit and loss statement, [2], Balance sheet and [3]. Cash flow statement. Any gimmick or creative practise would centre on them.

The profit and loss statement is essentially sales minus expenses for the 12 months. The balance sheet is just a sheet showing the equality of assets and liabilities on a certain date. The cash flow statement is derived from these two. The accounting fraud or gimmick or creativity would then focus on playing with the figures relating to sales, expenses, assets and liabilities. When reading the annual report, it is important to read the notes.

For sales or revenue, the company can try to recognise sales too soon (that is, before it is earned) or record fictitious revenues. Premature sales could be due to goods ordered but not shipped or goods shipped but not yet ordered. The question of when sales or revenue should be recognised has troubled managers, accountants and regulators for a long time.

The appropriate timing of recognising sales or revenue can be a rather difficult matter to define. Selling a hamburger for cash is simple. But when a contract takes a few years to complete, recognising revenue can become troublesome and is vulnerable to creative accounting. This is one reason why we find the sales and earnings of construction companies less transparent than say a newspaper company. More complicated is the practise of trade loading or channel stuffing where a company ships its products to its distributors who are encouraged to overbuy under some short-term discounts. Sales or revenue from related parties can be another complication (subscribers may want to know that such transactions are now reported by the listed companies).

The company can also boost profit by one-time gains or non-recurring transactions. It can boost profits by selling undervalued assets or it may not segregate unusual or nonrecurring gains or losses from recurring income. The company can also hide losses under non-continuing operations. Broadly speaking, the investor has to adjust gains or losses from recurring and nonrecurring activities.

One common method to boost profit is for the company to shift current expenses to a later accounting period. It does this by resorting to either improperly capitalising expenses or depreciating too slowly or failing to write off worthless assets. The company can also shift current income to a later accounting period by creating reserves to shift revenue to a later period. The company does this believing it would benefit the company.

The company can also shift future expenses to the current period by accelerating discretionary expenses into the current period or writing off future years' depreciation.

The company can fail to record or disclose or undervalue liabilities or misreport assets. When cash is received, the company reports revenue rather than a liability. It fails to accrue expected or contingent liabilities or fails to disclose commitments and contingencies. It can of course engage in transactions that keep debts off its balance sheet.

With the many deficiencies found in the accrual accounting, many turn to the cash flow statement for enlightenment. While it also has deficiencies, analysing this statement together with the other statements would help the investor have a better picture of the company.

What we have presented here is only a very brief sketch of the accounting issues involved. There are many good books on creative accounting. So, start with the annual report, but do not stop there. It is only a starting point.


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