Corporations Supersize Annual Reports

Companies pump up the volume -- but will investors be satisfied?


Talk about putting a new face on financials. General Electric Co.'s 2001 annual report contains no fewer than 84 pictures of people's faces, most of them employees. IBM's annual report has 46 — plus snapshots of 16 eclectically shod pairs of feet. "It kind of opens up the company in a way if people are photographed looking right at you," says GE spokesman David Frail.

Smiles and shoes aside, what really opened up GE, IBM, and other companies this year was an Enron-inspired slew of new or expanded disclosures in the latest crop of annual reports. IBM trumpeted its added disclosures in a press release issued 10 days before the report mailed. GE pointed out that it added 16 pages to its report — 8 in the financial statement — and changed its layout to accommodate more text. "There was about 30 percent more [than in 2000] in terms of word count," says Frail.

Energy company Aquila Inc., a competitor of Enron's, added four pages to its report and borrowed additional space for financial disclosures from the front section. "The bottom line is, the disclosure part of the book grew by six or seven pages," says Ethan Hirsh, vice president of corporate communications for the Kansas City, Missouri-based company. When Hirsh called to order more paper and another print run for the new pages, he recalls, "my printer said three out of four of his clients were doing the same thing. Scheduling was very tight for everybody."

One reason companies are bulking up their financial reports stems from the comments issued last January by the Securities and Exchange Commission on how management discussion and analysis (MD&A) should deal with liquidity, off-balance-sheet arrangements, derivatives, and transactions with related parties — all issues raised by Enron's collapse. But, most companies were more worried about the backlash from jittery investors than any regulatory edict. "Companies are increasing disclosure not because they are necessarily altruistic or scared they are going to be put in jail, but because the market is demanding it now," declares Ken Shea, head of equity research at Standard & Poor's.

Isn't That Special

No surprise, then, that companies whose capital structure contained items similar to Enron's — such as special-purpose entities (SPEs) — took great pains to explain how they were different. "SPE really isn't a dirty word," says Aquila CFO Dan Streek. "It depends on the business purpose." Aquila uses two SPEs — run by Citibank and CIBC, respectively — to securitize its accounts receivable, and its 2001 MD&A expands at some length on the footnote explanation found in previous reports. Although Aquila doesn't own the SPEs, as Enron did, "I want to be up-front about the dang thing," says Streek. (Aquila does own a third SPE as part of a synthetic lease arrangement.)

One-fourth of the new ink in GE's annual report also is devoted to explaining its use of SPEs, which, unlike Aquila's, are sponsored — that is, created and supported by the company. "I think CP [commercial paper] conduits are completely different vehicles" than the SPEs used by Enron, argues CFO Keith Sherin, who is quick to point out that GE has long used such entities to participate in the commercial-paper market.

Nonetheless, GE has announced plans to cut the liquidity support that it offers to its SPEs anywhere from 25 percent to 50 percent. "We want a triple-A rating, and we don't want to have investor concerns about liquidity," says Sherin. "We don't think there are any concerns with these SPEs anyway, but having less of them is better than having more of them."

Opening the Black Box

For Aquila, which mentioned the "collapse of our biggest wholesale competitor" on the cover of its annual report, distinguishing itself from Enron also meant more explanation of accounting for trading contracts. "We are disappointed with our valuation," says Streek. "People think our earnings model in this industry is a black box. If there are ways to reduce the mystery, we are in favor of it."

Thus, mark-to-market accounting is explained not only in the MD&A but also in the chairman's letter to shareholders. "One thing Enron has done is highlight the naïveté of some of the investing public in [the energy] industry," notes Streek. Aquila wants to set those investors straight. "We'd like to clear the air," states the report. "Mark-to-market accounting is not an option — it's required by accounting standards."

Streek concedes that mark-to-market accounting of long trades does involve estimates of their value. But, he adds, 550,000 of Aquila's 600,000 transactions closed the same year, and most of the rest settled the following year, meaning that most of the mark-to-market valuations used by Aquila are based on market quotes. "There are just a few that start to reach out into the future a long way," says Streek. This year's report includes a chart of the fair value of contracts maturing in each of the next four years.

No matter how straightforward their financial statements, many companies felt the need to actively affirm that their finances do not resemble Enron's. "We have the world's simplest balance sheet — it's boring, even," says CFO Harlan B. Plumley of Burlington, Massachusetts-based Lightbridge Inc., a $177 million (2001 revenues) supplier of services to telecom providers. Nonetheless, Lightbridge's 2001 annual report carries a new disclaimer asserting, "The company has no off-balance-sheet entities and is not a party to any material transactions involving related persons or entities."

"This whole Enron debacle has made a pretty challenging job even tougher," complains Plumley. He now regularly rattles off a laundry list of accounting techniques that his company doesn't use. "I spend a fair portion of my time trying to convince investors that we have no capitalized software, that our deferred revenue is all associated with maintenance contracts, we have no FX risk, no special-purpose entities, no leases, and no intercompany transactions."

Is Longer Better?

Despite the changes, some financial-statement consumers were unimpressed. "We were amused by all the ballyhoo surrounding IBM's 10-K, promising new, improved disclosure," wrote Carol Levenson, director of research at New York-based Gimme Credit research service. "Well, it was longer." Most of the supposedly new information, Levenson argued, simply repeated existing footnote disclosures in the MD&A.

Others felt the changes did not go far enough. Asked recently by the SEC for his disclosure wish list, Howard Schilit, president of the Rockville, Maryland-based Center for Financial Research & Analysis Inc. and author of Financial Shenanigans, proposed that any company taking a restructuring charge be required each quarter to indicate how much of the resulting reserve had flowed back onto the income statement. And, in addition to total balance-sheet debt, he suggested that companies detail their total obligations — off-balance-sheet debt, liquidity support, convertibles, options, and so on.

"All considered," says S&P's Shea, "I think [IBM and GE] did a good job and raised the bar a bit." Nonetheless, he would like to see disclosure of how options would affect earnings per share if the stock were treated as cash. "Companies that issue a lot of options are posting artificially high gross operating margins," he says. "Is that a realistic barometer of how expensive their business is? Probably not." Today, only one company in the Fortune 500, Boeing, expenses its options.

But investors may change some of these practices. "In the past 10 years," says Schilit, "the good guys haven't been rewarded for good behavior. That is changing. Substantial capital is flowing away from companies that are seen as just not playing fair."

Tim Reason is a staff writer at CFO.

Thinner and Phatter

In lieu of lavish annual reports, many smaller companies issue so-called 10-K wraps, consisting of merely the 10-K document with a chairman's letter attached. On the heels of its dismal performance in 2001, Natick, Massachusetts-based Cognex Corp. — famous for its irreverent annual reports — produced its "10K Rap," replete with hip-hop phrases and photos of CEO Robert Shillman dressed as a gangsta rapper. "Yo, Yo, Yo," began Shillman's letter to shareholders, "why spend a whole lot of money just to report to you that we lost a whole lot of money? It just don't make cents!"

Although incurably tongue-in-cheek, Shillman is serious about cutting costs. At $28,000, this year's report cost about a dollar per copy to produce (although Cognex's puckish reports have become something of a collector's item, forcing the company to print many more copies than their shareholders would need). A few years ago, Cognex spent just 21 cents per copy on what it proudly billed as "The World's Cheapest Annual Report."

"An annual report is a waste of time," says Shillman, who notes that the information usually has been posted on the Web for months by the time the report mails. How does CFO Richard Morin feel about Cognex's take on the annual report? "He's a starchy kind of guy," says Shillman, "but his sense of humor has improved since he has joined Cognex." —T.R.


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