credit suisse - 10k checklist - accounting tells a story (1)
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A helpful checklist when reading 10KsTRANSCRIPT
DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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27 February 2015
Americas/United States
Equity Research
Accounting & Tax
10-K Checklist ACCOUNTING
Accounting Tells A Story, Is it Fact or Fiction?
Source: With permission from CartoonStock.com
■ It's the language of financial reporting, but in some cases the
accounting is more like hieroglyphics than Plain English, making it
difficult to dig through the accounting and uncover the underlying economics
of the companies that you own. But have no fear the 10-K Checklist is here
and it could provide some help. So pull on a pair of cabin socks, load up on
the Hot Cocoa and keep our 10-K Checklist handy as you trek through that
pile of annual reports you've been meaning to read.
■ Wanna stay warm put on a hat, wanna read a 10-K grab our 10-K
Checklist. It includes things to keep an eye on, questions to consider,
common sense tips and potential red flags (it's the stuff that we look for
when reading a 10-K). To give you a head start, taxes, FX, and pensions are
areas that warrant some extra time this year. The 10-K Checklist has three
main sections, Management Discussion & Analysis (MD&A), Financial
Statements and Footnotes (in Exhibit 2 we include a list of all the items that
show up in a 10-K and our quick take on each).
■ 10-Ks are due on Monday March 2nd
for large (over $700 million public
float) calendar year-end companies and as of yesterday about one-third of
the S&P 500 calendar year companies had not yet filed.
Research Analysts
David Zion, CFA, CPA
212 538 4837
Ravi Gomatam, CFA
212 538 8137
Ron Graziano, CPA
312 345 6169
27 February 2015
10-K Checklist 2
10-K Checklist Management Discussion and Analysis (MD&A)
As the name implies management is expected to discuss and analyze what's going on
with the business, focusing on known trends, demands, commitments, events and
uncertainties facing the company, it’s the most forward looking section of the 10-K. It's
also where management should be answering the question, why? Why are the numbers
changing, why did revenue increase, why did cash flow drop, etc.? This is where
management gets to tell its story, not the accountants or the lawyers (the MD&A is not
even audited). As a result we suggest paying attention to the tone that management uses,
is it overly optimistic, evasive, etc. If management wants a premium valuation it should
provide premium disclosures, less boilerplate and more meaningful transparent
information.
Results of Operations
What’s driving the reported results (revenues and costs)? Is it volume, pricing, product
mix, acquisitions, foreign currency, new contracts, inflation, labor costs, raw material
costs, creative accounting, etc. Try to distinguish between those drivers that are
sustainable and those that aren't. Be very careful if a company isn't clear about what's
driving the results.
Liquidity and Capital Resources
Look for how much cash is parked overseas. The balance sheet may not be as liquid
as it appears if a company doesn't have ready access to all of its cash.
What are the main sources of liquidity? Can the company cover immediate liquidity
needs? Is cash restricted in any way? Does the company generate enough cash to
pay the bills? Do they have unused lines of credit, do they factor receivables?
You can also find information on covenants, what are the key ratios and is the
company in danger of tripping over them? What are the consequences?
How does intraperiod borrowing match up with what shows up on the balance sheet at
the end of period? Is the company prettying up the balance sheet for quarter end?
What is driving cash flows, what are the main sources and uses of cash? If a company
tries to answer that question by just referring to what you can plainly see on the cash
flow statement (that's poor disclosure). The company needs to answer, why? (e.g.,
why did working capital increase)?
Are there any known trends or uncertainties that could impact liquidity, like higher
costs, changes in credit terms, maturing product lines, pricing changes, etc.? How
much cash will the company spend on capex and how will it be funded?
Contractual Obligations and Commitments
Look for a table that lays out the timing and amounts due under contractual obligation
(i.e., cash that's contractually obligated to go out the door in the future). It includes
long-term debt, leases (both on and off-balance-sheet), purchase obligations and
other long-term liabilities. Don't forget to read the footnotes to the table that's where
you'll find out if there’s some uncertainty about the amounts due. The balance sheet
may not be as healthy as it appears after factoring in the stuff that's off-balance-sheet.
Compare the contractual obligations with cash on hand to see how much of a cash
cushion the company has (see our May 31, 2011 report, How Big is the Cash
Cushion? Cash Vs. Contractual Obligations).
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10-K Checklist 3
Look out for balloon payments and potential refinancing risks. How have you factored
these cash outflows into your model? Are the contractual obligations a leading
indicator of forward capex and/or revenue (spend money to make money)?
Critical Accounting Estimates
On the lookout for accounting red flags? You should pay close attention to
management judgment calls; the more judgment involved the more room for
manipulation. This disclosure is a good start, it's supposed to be where management
discusses the handful of accounting estimates that involve the greatest degree of
management judgment and that if changed would have the biggest impact on the
financial statements.
What are the significant estimates, assumptions? Do they make any sense? Are they
aggressive or conservative? How do they compare with other companies, historically,
your own view, etc.? How would the results have changed if you plugged in a different
set of assumptions? If the assumptions changed what impact did it have on results
(look for sensitivity analyses)? What's driving the results, the underlying business
(high quality) or aggressive assumptions (low quality)?
Financial Statements
Do the financial statements properly reflect the underlying economics of the business?
That’s a question you should ask every time you pop open a balance sheet. Remember
there’s lots of room around what's acceptable under GAAP, some companies might lean
more conservative and others might be more aggressive. In the worst case, the company
is committing financial reporting fraud, that’s “any intentional or reckless conduct whether
by act or omission that results in materially misleading financial statements.”
How can you tell whether the accounting is more aggressive or conservative? Since it's
rare to find the "smoking gun" we suggest, as a starting point, good old fashioned financial
statement analysis, monitoring financial statement relationships over time and versus
other companies. Some of our favorites include common size financial statements (e.g.,
expressing each line item in the income statement as a percentage of revenue), free cash
flow to earnings ratio (be careful, it’s probably inflated for a growth by acquisition story and
for companies that rely on stock based comp), working capital growth (especially inventory
and accounts receivable) versus revenue growth, margin trends, debt-to-equity, interest
coverage etc.
As you’re going through the financial statements be on the lookout for any changes versus
last year, which nowadays you don't even have to find on your own, a number of services
will underline the changes for you. If the line items are changing over time and a company
is providing less information, that's a red flag. If items are being reclassified look to see
what impact the reclass had on metrics like sales growth, margins, etc.
Take a peek at the audit opinion. Look for anything that’s not the standard boilerplate
clean opinion. Did the auditor change (that’s a red flag for the SEC)? Were there any
problems with internal controls, material weaknesses, significant deficiencies, etc.?
Balance Sheet
How has the company financed itself, how much leverage has it taken on? How
complex is the capital structure, if it’s complicated, why? Is the balance sheet really as
liquid as it appears? How much cash is parked overseas, restricted? Are they using
converts, how big is the claim (if the conversion option is in the money the claim may
be much larger than what shows up on balance sheet)?
Ask yourself, do the assets and liabilities appear fairly stated (remember some are
carried at fair value, some at historical cost and others at some amount in-between)?
What portion of the assets is hard to value or involve significant management
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10-K Checklist 4
judgment (e.g., intangibles, level 3 financial assets, etc.)? Watch out for off-balance-
sheet liabilities, including contingencies.
Keep an eye out for asset liability mismatches too (they can be especially painful
come crisis time), when you find them make sure to factor the risks into your analysis.
Income Statement
Be wary of non-GAAP results (e.g., Cash EPS). Compare what you see on the income
statement with the non-GAAP results that you get from the earnings release, how
many adjustments are made, are the adjustments consistent over time and with peers,
what’s the spread between the GAAP and non-GAAP numbers, are the “non-cash”
costs really non-cash, why are the non-recurring items recurring, does the non-GAAP
number better reflect the underlying economics or is management just trying to paint a
prettier picture? How have you factored the costs being excluded into your analysis?
Focus on earnings quality, lower quality usually means a lower multiple. Try to figure
out what’s driving earnings: is it the core business or something else like a lower tax
rate, drop in interest expense, increased share buyback, non-recurring income or
some twist or tweak in the accounting (that might not be the highest quality, most
sustainable source of earnings). Is the smooth consistent earnings stream, really
smooth and consistent? How much of the earnings does the company turn into cash?
Don't expect to see as many discontinued ops starting this year, the FASB issued new
guidance last year (ASU 2014-08, Reporting Discontinued Operations and
Disclosures of Disposals of Components of an Entity) that raised the bar so only
disposals that represent a "strategic shift" (i.e., getting rid of a major part of the
business) and have a material impact on operations/results will be considered
discontinued ops.
Statement of Comprehensive Income
Includes net income and the four components of other comprehensive income (OCI),
(1) unrealized gains and losses on available for sale securities, (2) foreign currency
translation, (3) cash flow hedges and (4) the once a year pension/OPEB mark-to-
market. These are all economic gains and losses that bypass the income statement
temporarily. How have you factored them into your analysis? Try to get a sense for
when they might hit earnings.
Cash Flow Statement
What’s driving cash flows, is it sustainable and from the core business or is it
temporary, for example, the company has put off paying its bills?
Is the company really generating free cash flow, how does it look after adjusting for
cash paid for acquisitions and the cost of buying back stock to offset earnings dilution
from stock based comp?
Keep in mind that capex doesn’t necessarily include all additions to PP&E, for
example, assets acquired under capital lease are excluded from capex, and so is
PP&E purchased but not yet paid for, though both tend to be provided in supplemental
cash flow disclosures.
Are you adjusting cash flows to strip out the piece that doesn’t belong to you but
belongs to the non-controlling interests instead?
Statement of Changes in Shareholders’ Equity
If you want to know what’s going on with book value look here. Includes information
on share issuance, buybacks, option exercise, etc.
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10-K Checklist 5
Footnotes
The topics covered below are the ones that we tend to get the most questions on from
investors (and are the most fun). How much time you spend on each will depend upon
how big an issue they are for the companies that you own and follow. For example, if you
follow the tech sector, you'll probably spend a lot less time on OPEB plans than you would
on taxes or stock based comp (unless you ignore that too). The more management
judgment involved the more you need to pay attention.
Taxes
The key question: Is the tax rate sustainable? If the tax rate seems to be driven by
aggressive tax planning, watch out. Especially with tax risk on the rise as a result of
potential changes both here and abroad on profit shifting and tax avoidance (tax
reform, OECD effort, etc.). Look for disconnects between where a company is booking
its profits (which you can find in the tax footnote) and where value is being created
(e.g., where are the sales taking place). The SEC has been asking companies to
provide more information if the tax rate is driven by countries with very low tax rates,
especially when the profits booked in those countries are large relative to revenue.
How much of a boost did lower taxes provide to earnings and cash flows, what were
the key drivers of a lower tax rate, is that sustainable?
What’s the total amount of earnings parked overseas, how has it changed? What
amount of taxes would the company have to pay to bring the earnings to the U.S.? It's
usually an off-balance-sheet liability and most companies don't disclose an estimate.
How does that compare with the tax bill if there were some type of repatriation
holiday? How much cash does the company need in the U.S. (to pay dividends, pay
down debt, etc.), can it continue to keep the earnings parked overseas?
Don't sleep on those deferred tax liabilities, they may not be perpetual, think about
what could cause them to come due? Like a slowdown in capex or if bonus
depreciation were to stay expired. How big of a drag would that be on cash flows (our
Bonus Depreciation Model could help you figure that out)?
Just because the balance sheet ignores time value when it comes to deferred tax
assets (and deferred tax liabilities) doesn’t mean that you should too. For example,
when valuing DTAs take into account when you expect the company will be profitable
enough to utilize them and when the tax assets expire. If the company is an M&A
target, you’ll also want to factor in the Section 382 limitation when valuing NOLs (give
us a call and we’ll run you through it). Remember, that if we get a reduction in the
corporate tax rate (through tax reform) the value of DTA's and DTL's will drop.
If the company has run into a rough patch (like a three year cumulative loss) will it
have to set up a deferred tax valuation allowance (reducing deferred tax assets on the
balance sheet)? If you expect the company to turn things around then there's an off-
balance-sheet asset that you should factor into your valuation. If things are getting
better when might the valuation allowance be released, boosting earnings and book
value? As with other reserves, keep an eye on whether the valuation allowance is
being used to manage earnings.
Check out the disclosures on uncertain tax positions (i.e., unrecognized tax benefits).
It may give you an indication of how much tax risk a company is taking on. Remember
that unrecognized tax benefits can turn into real cash obligations for back taxes,
penalties and interest (keep an eye on the status of IRS audits and whether the IRS or
another tax authority is proposing a tax increase). Are you willing to pay for a
company to take on tax risk? To get a sense for how the unrecognized tax benefit
affects earnings look for disclosure of the amount that would impact the effective tax
rate (is it being used as a cookie jar)? See our May 18, 2007 report, Peeking Behind
the Tax Curtain, FIN 48 Reveals Tax Risk.
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10-K Checklist 6
Foreign Currency
Which currencies does the company have the most exposure too? What are the most
significant currency related asset/liability, revenue/expense mismatches? That's
where currency risks will hit the hardest. What impact has foreign currency had on
revenues, costs, etc.?
How are the currency risks managed, especially on a go forward basis? What amount
of currency risk is hedged/unhedged? As a result of the stronger dollar you should see
big FX hedging gains, how and when will those gains impact earnings, margins,
revenues, etc.?
Remember the key to accounting for FX is the functional currency (i.e., main currency
for cash inflows and outflows) as it determines whether you are dealing with FX
transaction or translation gains and losses. For example, if the functional currency of a
foreign subsidiary of a U.S. company is the Euro and the dollar strengthens against it,
that will drive down the assets, liabilities, revenues and expenses of the foreign sub
when translated into dollars and will result in an FX translation loss (assuming assets
are greater than liabilities) reported on the balance sheet. Give us a call if you need a
refresher on how it all works.
Venezuela and its multiple exchange rates are a nightmare for accountants, they tell
companies to ask their lawyers for advice on which exchange rates to use for which
transactions. For companies with Venezuela subsidiaries we'd suggest that you
estimate the impact of switching to a more conservative exchange rate (if the
company hasn’t already done it for you). Another thing to consider, if the exchange
controls become so bad and the companies are stuck with Bolivar cash balances that
they can't exchange, we may see Venezuela subsidiaries get deconsolidated as the
parent may no longer be able to claim that they are in control of it.
Derivatives
How much of a particular risk is hedged / unhedged, how has that changed over time,
do they have the same level of protection going forward? How does that compare with
peers? Is the company speculating? This is tough to figure out as the disclosure is
pretty weak. However, with the fall in oil prices and currency volatility this can be an
important factor for many companies.
What types of derivatives is the company using? How are they being used and why is
the company using them?
How are derivatives being accounted for, hedge accounting or not, as this choice can
have significant impacts on results and distort comparability across companies? How
have derivatives impacted the income statement and balance sheet, where are the
amounts reported? What amount of unrealized gains/losses on cash flow hedges will
move to the income statement over the next 12 months (that’s a required disclosure)?
Do companies suggest that you ignore hedge ineffectiveness, why, isn’t that a cost of
hedging? Are the costs of hedging justified?
How would the balance sheet change if you were to gross up derivatives, similar to
how derivatives are reported under IFRS (remember, derivatives are generally
reported net by counterparty under U.S. GAAP)?
M&A
How much of the growth is by acquisition? For a "growth by acquisition" story does it
make sense to ignore restructuring costs and amortization expense, aren’t those costs
of doing business?
Does the allocation of purchase price make any sense? When you see a large portion
of the purchase price going to goodwill ask why? Is it because the company under
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10-K Checklist 7
allocated to other assets to make the deal look more accretive, did they overpay or is
that simply what was purchased? Is the goodwill tax deductible?
Also keep an eye on whether the purchase price allocation changed from the original
estimate and what impact that had on earnings/margins. Remember, a company has
one year to make changes.
How was the acquisition financed, is there refinancing risk? Does the present value of
the target’s cash flows plus expected synergies exceed the price paid?
Is there any contingent consideration, what would cause it to come due? Does the
company have a history of overstating the amount of contingent consideration initially
and then eventually reversing it to provide a boost to earnings? Remember any
contingent consideration paid over and above the liability originally recognized on the
balance sheet hits cash flow from operations.
Switching gears, when it comes to the standalone financial statements of an acquired
company, a new rule from the FASB (ASU 2014-17, Pushdown Accounting) makes
pushdown accounting a choice as long as the acquirer gets control of the target. In the
past the SEC allowed pushdown accounting only if 80% or more of a company were
acquired and required it if 95% or more was acquired. As a reminder pushdown
accounting is when the target uses the acquirer's new basis in the target's assets and
liabilities as its own. Will companies choose pushdown if it paints a prettier picture?
Revenue Recognition
Follow the money; do you understand the step by step process from when the order is
taken to when the cash is collected? Does the revenue recognition policy reflect how
the company does business with its customers? Has the policy changed? How does it
stack up against peers? How much judgment is involved, are the
assumptions/estimates aggressive or conservative?
Compare revenues to the balance sheet (e.g., DSO’s). If accounts receivable are
growing faster than sales does that indicate lower quality sales?
On May 28, 2014 the FASB and IASB released, Revenue from Contracts with
Customers, which replaces all of the existing revenue recognition guidance under U.S.
GAAP and IFRS with one accounting standard. The new rule could have a big impact
on revenue recognition for complex, multi-year, multi-element arrangements with
customers especially where industry specific guidance exists today (e.g., software).
On the other hand revenue recognition for plain vanilla transactions (e.g., retail)
shouldn't change much. The new rules don't go into effect until 2017 (a one year delay
is possible). There won't be much disclosure about the new rule this 10-K season,
other than companies telling you it's been issued (look for references to ASU 2014-09)
and that they are still evaluating the impact. But as we move closer to implementation
of the standard companies will provide more and more information about its impact.
Pensions
The Society of Actuaries released new mortality tables (RP-2014) last year with some
bad news for pensions: people are living longer. As a result pension obligations are
increasing. Keep in mind that companies are not required to use the new mortality
tables; however, the SEC has made clear that ignoring the new data when the
company comes up with its own estimate on mortality might not be such a great idea.
Companies should disclose the impact of mortality changes on the pension obligation.
You might want to start thinking about what it would cost the company to shut down its
pension plan, as we expect to see more companies try to get out of the pension
business (through annuities from insurance companies or lump sum payments to plan
participants). The new mortality tables might even provide a spark, since the spread
between corporate and insurance pricing of pension obligations will shrink (insurance
companies were already using updated mortality assumptions) and that may help to
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alleviate some of the sticker shock from pricing a pension closeout. There's also a
temporary arbitrage between the mortality tables used for accounting and those used
to determine a lump sum.
Most pension plans took a hit last year, the combination of lower discount rates and
the new mortality tables outweighed decent asset returns and the benefit of a stronger
dollar, as a result pension funded status deteriorated in many cases. Weaker pension
plans could mean higher pension costs and a drag on earnings, have you estimated
the impact on earnings/margins (if not, you might want to try our Pension Model)?
We suggest a three step process to working a pension plan into your model, (1) treat
the pension underfunding like a net debt (though you might want to gross up the asset
and liability sides of the balance sheet to get a better sense for how levered the
company is to the pension plan), (2) treat service cost (new pension benefits earned
each year) as an ongoing cost of doing business and (3) try to capture pension risk
(run different scenarios).
Pension risk comes in lots of flavors, for example, there’s the asset liability mismatch
so you might want to be on the lookout for changes in asset allocation (is it risk-on or
risk-off?). Another risk is that the pension obligation is mispriced (assumptions are too
aggressive or conservative). Ask yourself if the assumptions make sense, especially
the discount rate (compare it to yields on high grade bonds) and expected rate of
return (judge it against the asset allocation)?
Don’t forget about multiemployer pensions. Keep an eye on company contributions
(which are collectively bargained), that’s the cost recognized on the income statement.
In most cases nothing is reported on the balance sheet. Because of all the strange
rules around these plans companies probably contribute less than they should (in
theory) and as a result overstate their earnings. See our March 26, 2012 report,
Crawling Out of the Shadows, Shining a Light on Multiemployer Pension Plans.
OPEB – Other Postretirement Employee Benefits
OPEB can be a cash flow issue for companies, check to see whether there are any
assets to pay OPEB benefits (e.g., retiree healthcare). If not, companies disclose ten
years of future benefit payments, how does that compare with the cash flow
projections for the company? As with pensions, do the assumptions make sense? The
new mortality tables will drive OPEB obligations higher too.
Stock Based Compensation
Keep an eye on the performance metrics used to drive incentive comp; they might tell
you a lot about how management will run the business.
Does management back out stock comp when providing earnings guidance? No
surprise, the companies with the most stock comp would prefer that you ignore it
(claiming that it's double counting or non-cash, etc.). How have you factored stock
based comp into your model?
Funny, those same companies that ask you to ignore stock comp are more than
happy to recognize it as a cost on their tax return to cut their tax bill (we think the tax
code has it right when it comes to stock comp, the cost is based on the value on
exercise/vesting).
When it comes to stock comp you should at least capture two things in your analysis,
(1) stock based comp outstanding (treat it like a debt claim or include it in the share
count) and (2) future grants (it’s a cost of doing business, compare the fair value of
stock comp granted to revenue to estimate the ongoing cost). See our January 20,
2006 report, The Cost of Employee Stock Options, Part II.
How has stock based comp impacted cash flows, both inflows (proceeds received on
option exercise and tax benefit) and outflows (cash used to buy back stock to offset
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stock comp related earnings dilution, remember real economic dilution still takes place
in most cases)? Should you adjust free cash flows? How much of the growth in cash
is due to stock comp, are the employees financing the business?
How does the stock comp hitting the income statement compare with the true
economic cost, the wealth transfer from you to the employees (e.g., how much the
options are in the money when exercised)?
Are the option pricing assumptions aggressive or conservative?
Earnings Per Share
What’s in the diluted share count, converts, stock options, etc.? How might the share
count change if the stock price heads higher? Remember with convertible note
hedges the diluted share count only picks up the dilutive effects (where additional
shares would need to be issued) not the other side of the hedge (purchased
calls/warrants) that would be anti-dilutive (i.e., could reduce the share count).
Inventory
Keep on the lookout for inventory impairments, especially for commodity based
companies. Remember, inventory is held at lower of cost or market, so that when the
market value of the inventory slips below cost, inventory is written down and a charge
is reported in COGS. That will result in a new (lower) cost basis for the inventory,
which could boost margins in the future when the inventory is eventually sold (see our
January 17, 2008 report, Impairments, Not All Write-Offs Are Created Equal).
If the inventory balance is growing does that indicate less demand for the company’s
products or is the company ramping up for a projected surge in demand? Compare
inventory growth to sales growth. How has the mix of inventory changed, raw
materials, work in process and finished goods?
Does the company use LIFO or FIFO? If it’s LIFO, take a look at the LIFO reserve, it
could signal a future tax hit if LIFO goes away as part of tax reform.
Don’t be so quick to ignore a LIFO charge, it’s telling you that the company
underestimated price inflation and as a result it overstated prior period results.
Therefore you might want to go back and spread the charge over time to get a better
reflection of the true margins.
What costs are capitalized as part of inventory? Has that changed?
Intangibles
Don’t ignore impairment charges (even goodwill) they could change your expectations
about future cash flows. See our July 10, 2008 report, Goodwill Impairments, Goodwill
Going Bad.
What amortization period is the company using? Do they provide a weighted average
or a range (be careful with ranges)? How does the amortization period on recent
transactions compare with what was used in the past and against peers? How are
intangibles being amortized straight line / accelerated?
Have you worked the expected amortization schedule into your model, or are you
asked to ignore intangible amortization because its “non-cash” (but they paid cash to
buy the assets)? To include or not include that is the question when it comes to the
amortization of intangibles; it's a growing cost that many companies pro-forma away.
PP&E
Over what period are assets being depreciated, does the company provide a weighted
average depreciable life or just a range? If a wide range is provided test what
depreciation would look like at each end of the range. What impact has a change in
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depreciable lives had on earnings, you might be surprised? Compare depreciable
lives with peers.
What costs are capitalized versus expensed? Has that changed?
Keep an eye out for impairment charges, are they telling you anything about the future
cash flow generating ability of the assets that you didn’t already know? If there’s an
impairment should prior years’ depreciation have been adjusted upward (i.e., earnings
were overstated)? Or is the company just taking a big bath charge to clean the decks,
to drive future depreciation expense lower and earnings higher? Does the impairment
indicate that depreciable lives should be shortened going forward?
Reserves
Watch out for reserves (there’s plenty of management judgment involved) including
the deferred tax valuation allowance, allowance for doubtful accounts, loan loss
reserve, inventory valuation allowance, reserve for returns and allowances,
restructuring reserve, warranty reserve, unrecognized tax benefit, etc. etc.
We suggest monitoring the change in the reserve, compare cash payments with
charges. Are companies using it as a cookie jar to manage earnings? What impact did
changes in the reserve have on earnings?
Don’t just focus on the absolute level of the reserve; you also need to think about it in
relation to other line items. For example, what's the impact to earnings, margins,
growth rates, etc. if the same relationships had been maintained (e.g., warranty
reserve as a percent of sales, allowance for doubtful accounts as a percent of
receivables)?
Financial Instruments
Are you comfortable with the loan loss reserve, how has it changed and what impact
did it have on earnings? Don’t forget to take a look at the disclosure on loan credit
quality including the aging schedule and loans on nonaccrual status.
What were realized gains/losses, how did that impact earnings? Did the company
cherry pick gains?
How old are the unrealized losses (more/less than a year)? The older the unrealized
losses the less likely it is that the company would recover its investment which could
trigger an other-than-temporary impairment.
How much of the balance sheet is at fair value? How have fair values changed over
time? How reliable are the valuations, what’s in Level 3 (hard to value)? What are the
key assumptions used for Level 3? Does the company provide a weighted average or
just a range?
Other Income / Assets
Keep a close watch on "other", what's included and how it changes over time. You
never know what can get dumped in here; companies might be hiding operating costs
by capitalizing them or putting off paying their bills.
Commitments and Contingencies
Do you have enough information to price in these potential claims on cash flow or are
you staring at a black box of legal gobbledygook? The SEC has been pushing
companies to at least provide a range of possible losses instead of hiding behind the
“we can’t estimate” excuse.
Look for triggers that could cause a commitment/contingency to turn into a real cash
outflow.
Does the company self-insure? If so, against what type of risk, what’s the liability on
the balance sheet and the exposure to potential losses?
27 February 2015
10-K Checklist 11
Segments
Is the company providing enough segment information (probably not); ask yourself if
this is how the company breaks down its business in other communications with
investors (or how you’d like them to break it down)? This is an area that the SEC is
focused on and a result we could start seeing companies disaggregate their results
into more segments.
Does the company dump all the bad stuff in corporate/other to make the remaining
segments look better? What’s in the unallocated items (this is where some companies
put stock based comp), how has it changed? Does the growth in unallocated
expenses combined with a change in how segment profitability is being reported
indicate that a company might be trying to hide deteriorating segment results?
Leases
Operating leases might actually come on balance sheet one day; the FASB and IASB
are expected to put out a new rule later this year (we'll believe it when we see it). In
the meantime, you might want to take a crack at estimating off-balance-sheet lease
liabilities (or you might not). See our August 17, 2010 report, Leases Landing on
Balance Sheet, Proposed Major Changes to Lease Accounting. Also check out the
HOLT model as they capitalize operating leases for every company around the world.
When thinking about how much a company is investing in the business don't forget to
factor in assets "acquired" through both operating and capital lease even though there
is no impact on capex.
For lessors, if a company is using sales-type leases, you can use changes in the
lease receivable to estimate the amount of gain on sale that the company is booking.
10-K Filing Deadline
The 10-K’s are due 60 days after year-end for large accelerated filers (companies with a
public float over $700 million). For calendar year companies 60 days after the year end will
fall on March 1 this year, since that's a Sunday (and the Fairfield Stags are playing the
Niagara Purple Eagles) the 10-Ks are due on Monday, March 2. Smaller companies get
more time, calendar year accelerated filers have until March 16 (just in time for St.
Patrick’s Day) and non-accelerated filers have until March 31 (the last of the 10-Ks will
trickle in and the Final Four teams will be all set).
Exhibit 1: 10-K and 10-Q Filing Deadlines
Type of Filer Public Float 10-K 10-Q
Large Accelerated Filer $700 million or more 60 40
Accelerated Filer $75 million or more and less than $700 million 75 40
Non-Accelerated Filer Less than $75 million 90 45
Filing Deadline
(# of days from fiscal period end)
Source: U.S. Securities and Exchange Commission
To get an automatic 15 day extension of the 10-K filing deadline, companies must file a
notice of late filing with the SEC on form NT 10-K. If companies don’t file within the 15 day
window they eventually run the risk of delisting, running afoul of debt covenants and the
market’s fear of uncertainty.
27 February 2015
10-K Checklist 12
Everything that’s in the 10-K and More
Here’s a list of all the stuff that’s required in a 10-K and our take on each item.
Exhibit 2: The Anatomy of a 10-K Item # Item Name Our Thoughts
Part I
1 Business Picking up coverage of a company for the first time? Want to know what they do for a living,
how they make money? Start here, it provides an overview of the business, you might also find
customer/supplier concentrations.
1A Risk Factors Have you factored these risks into your model, maybe run a sensitivity analysis? Keep an eye
out for how risks are managed, new risks and for a change in the order (top of the list should be
most important).
1B Unresolved Staff Comments Open items from the SEC staff, are something to watch out for. SEC comment letters are a
good place to unearth accounting red flags (they can be a source for SEC investigations). You
can find them wherever it is that you get your hands on SEC filings, the comment letter from
the SEC is labeled UPLOAD and the company response is CORRESP.
2 Properties How many properties the company has, where they are, sq. feet it occupies, own vs lease.
3 Legal Proceedings Who is suing the company and why (including the IRS).
4 Mine Safety Disclosures You can find mining problems here, like safety violations and mining-related fatalities.
Part II
5 Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of
Equity Securities
Good source for information on share buybacks, including how many shares were bought back
during each month of the quarter and the price paid. Did those buybacks add value? You might
find the rationale for the buyback, e.g., to offset "dilution" from stock comp or converts.
6 Selected Financial Data The five year summary includes income statement and balance sheet metrics.
7 Management’s Discussion and Analysis of
Financial Condition and Results of Operations
Where management is supposed to discuss and analyze what's going on at the company
(discussed above).
7A Quantitative and Qualitative Disclosures About
Market Risk
What's the impact of a change in interest rates, FX rates and commodity prices.
8 Financial Statements and Supplementary Data The fun stuff: financial statements and footnotes (discussed above), audit opinion too.
9 Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure
If the company and its accountants disagree, the dirty laundry is aired here. (Rarely used)
9A Controls and Procedures Changes in internal controls, material weaknesses and management’s evaluation of disclosure
controls are all provided here.
9B Other Information Companies can disclose something here and avoid filing an 8-K, you should have a look.
Part III
10 Directors, Executive Officers and Corporate
Governance
Find out who’s in charge. Most times it will refer you to the proxy.
11 Executive Compensation Look here to discover what the named executives are getting paid. Keep an eye on the
performance metrics used to drive incentive comp, are the targets too easy, have the
metrics/targets changed (will that shift how management runs the business), if the targets are
met will that drive up shareholder value, is the right peer group being used, if the formula is so
complex that you need to read the employment agreement to figure it out that might be a
problem. Will most likely point you to the proxy.
12 Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters
Find out how many shares are held by the "insiders" CEO, CFO, top three highest paid
officers, board of directors and more than 5% holders.
13 Certain Relationships and Related Transactions,
and Director Independence
Related party transactions over $120,000 are disclosed here, we suggest taking a peek. Lots of
frauds have had related party elements.
14 Principal Accounting Fees and Services What are the accountants getting paid for the audit versus all of the other stuff that they do
(tax, consulting, etc.).
Part IV
15 Exhibits, Financial Statement Schedules Laundry list, including list of subsidiaries, Schedule II valuation and qualifying accounts (e.g.,
allowance for doubtful accounts, inventory valuation allowance, etc.), indentures, employment
agreements, deferred comp plan, earnings to fixed charge ratio, CEO/CFO certifications, etc.
See Exhibit 3 for more detail.
Signatures Last but not least, find out who signs off on this thing.
Source: U.S. Securities and Exchange Commission, Credit Suisse Accounting & Tax Research
On the next page find a list of the exhibits that are attached to a 10-K and our thoughts.
27 February 2015
10-K Checklist 13
Exhibit 3: Exhibits (Attached to the 10-K)
Exhibit # Exhibit Name Our Thoughts
2 Plan of Acquisition, Reorganization, Arrangement,
Liquidation or Succession
Look here for the finer details of a company’s acquisitions, dispositions, reorganizations, etc.
3(i) Articles of Incorporation Contains the official name of the company, state of incorporation, and details of the classes and series of shares (the number of shares authorized, shareholder rights, preferences and limitations, etc.)
3(ii) By-Laws Has corporate governance details such as the composition of the board, length of a director’s term, when and where annual meetings are to be held, officer job descriptions, how to amend by-laws, etc.
4 Instruments Defining the Rights of Security
Holders, Including Indentures
These agreements contain the details related to debt and equity security rights which are especially important if the company has a complex capital structure and/or it’s in distress.
9 Voting Trust Agreement Describes a trust that holds a company’s shares in another company and how the trustee is to oversee/manage/vote them.
10 Material Contracts Fun legalese reading of contracts that are outside the ordinary course of business including: bridge loans, employment, joint ventures, leases, and equity awards.
11 Statement re: Computation of Per Share
Earnings
If companies don’t provide a detailed computation of basic and diluted EPS in their footnotes, look here.
12 Statement re: Computation of Ratios Look here for the computation of earnings to fixed charges ratios and other ratios.
13 Annual Report to Security Holders Our favorite exhibit, it’s where you’ll find the financial statements.
14 Code of Ethics Just how ethical is that management team?
16 Letter re: Change in Certifying Accountant A letter from the replaced auditor that notes any disagreements with the company. Companies don’t change auditors often so this exhibit might be worth a look if it’s filed.
18 Letter re: Change in Accounting Principles When you see a change in accounting, ask yourself whether the new policy is aggressive / conservative, how it compares with peers, and how it will impact results.
21 Subsidiaries of the Registrant A list of subsidiaries and their jurisdiction of incorporation. Are the subs domiciled in countries where the company sells/manufactures its product or in tax havens? Some companies seem to list all of their subs others don't.
22 Report on Matters Submitted to Vote of
Shareholders
Items that shareholders are going to vote on
23 Consent of Experts and Counsel Permission to use an outside expert’s statement, document, or opinion (e.g., a valuation expert’s consent to use their valuations in the company’s annual report). Are the “experts” reputable? How much does the company rely on third party experts and counsel in the preparation of their financial statements?
24 Power of Attorney This document gives a few officers the authority to sign on behalf of all the individual directors. More of a procedural document.
31(i)/32 (i) Rule 13a-14(a)/ 15d-14(a) Certifications Certifications by the CEO and CFO that the financial statements and internal controls are kosher.
31(ii) (ii) Rule 13a-14(d)/ 15d-14(d) Certifications Asset-backed securities issuers certify the documents filed regarding servicing, distribution, and performance of the assets are true.
33 Report on Assessment of Compliance with
Servicing Criteria for Asset-Backed Issuers
If not compliant, what does this mean for rest of the company?
34 Attestation Report on Assessment of Compliance
with Servicing Criteria for Asset-Backed Securities
An auditor’s report that agrees/disagrees with management’s assessment of their compliance with the servicing of asset backed securities.
35 Servicer Compliance Statement Applies only to a servicer and states that it has fulfilled its servicing agreement obligations and it is compliant.
95 Mine safety disclosure How safe are those mines.
99 Additional Exhibits Any other exhibits the company wants to file.
100/101 XBRL-Related Documents/ Interactive Data File The financial statements written in XBRL (eXtensible Business Reporting Language). The full power of this bar-coding for financial information will be realized when the tagging is more consistent.
Source: U.S. Securities and Exchange Commission, Credit Suisse Accounting & Tax Research