Annual Report

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Annual Report

A document published by public corporations on a yearly basis to provide stockholders, the public, and the government with financial data, a summary of ownership, and the accounting practices used to prepare the report.

Annual reports measure a corporation's financial health. They focus on past and present financial performance, and make predictions about future prospects. By law, any corporation that holds an annual meeting for stockholders or security holders is required to issue an annual report. Regulations set down by the Securities and Exchange Commission (SEC) specify in detail what information the report must include about the corporation's finances, markets, and management. The rules are strict: the SEC can levy stiff penalties if corporations fail to comply.

Traditionally a rather dry and factual document, the annual report has acquired a larger audience in recent years as corporations increasingly treat it as not merely a legal obligation but also a public relations opportunity. Yet, even as annual reports take on the appearance of glossy magazines, promote corporate public relations, and make political arguments, they remain bound by legal concerns about completeness and accuracy, and sometimes expose corporations to lawsuits when they fall short.

Although federal law governing the financial industry is quite old, its application to annual reports grew in complexity from the mid-1970s to the mid-1990s. This authority derives from two laws: the Securities Act of 1933 (15 U.S.C.A. § 77a et seq.) and the Securities Exchange Act of 1934 (15 U.S.C.A. § 78a–78jj). The 1933 law requires issuers of securities to file financial information with the federal government; the 1934 law authorizes the SEC to act as a regulatory body over the financial industry. In 1974, the SEC tightened requirements on annual reports by specifying a broad range of information that must be provided, and it frequently amended them in subsequent years. Corporations have consequently made greater efforts to scrutinize their reports for compliance with the law, increasing the role of lawyers in producing what was once the work of accountants.

These requirements address financial and general information. An annual report must include a balance sheet reflecting changes in the corporation's financial worth, an income and cash flow statement, and other relevant documentation, all of which must be reviewed first by outside auditors. A statement by management must analyze past performance as well as discuss prospects for the following years; if circumstances change, corporations have a duty to issue corrected information. In addition, they must make public details about products and services, domestic and foreign markets, and the backgrounds of directors and executive officers.

Corporations that fail to comply with all the requirements can face enforcement proceedings. In such cases, the commission has the power to invalidate the election of directors and decisions made at the shareholders' meeting, which can necessitate issuing a revised annual report. Administrative remedies also exist. Under the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (15 U.S.C.A. § 77g et seq.), the SEC can use violations of any securities laws to force corporations to make full disclosures in their reports. Corporations that are in the process of registering for the first time with the SEC are particularly scrutinized for overly optimistic projections.

Besides federal penalties, wishful thinking in annual reports can lead to lawsuits. Hoping to put the best spin possible on their achievements and prospects, corporations sometimes attract Class Action suits from shareholders who allege that the corporations have exaggerated or misled the public. One of many examples is a suit brought against Pizza Time Theatre (In re Pizza Time Theatre, 112 F.R.D. 15 [N.D. Cal. 1986]). Its 1982 annual report had cartoon characters bragging, "We're going full speed ahead!" And so they were: nine months later, Pizza Time Theatre declared Bankruptcy. Shareholders brought a class action suit against the corporation and its directors, citing the report's overly optimistic tone, but the suit was discharged in bankruptcy.

Beyond requiring that annual reports meet financial and general information regulations, the law says nothing about the rest of their contents. Corporations are free to package their reports as they please, and the form itself is constantly evolving: current annual reports borrow from the flashy graphic styles of magazines, can be released on videodisc and computer disk, and sometimes even include gifts. Particularly interesting is a trend toward using these reports—usually via the president's letter—to address political issues. As powerful forces in the body politic, corporations rarely refuse an opportunity to make their influence felt on government, especially when pending legislation may affect their interests. In the early 1990s, for example, some annual reports from the medical industry targeted the ill-fated health care reform proposals of the Clinton administration.

Annual reports became a source of widespread public interest after the sudden collapse in 2002 of Enron, the seventh largest U.S. corporation. Within a few months other major corporations disclosed major financial difficulties, which came as a surprise to shareholders and regulators that had relied on upbeat financial information contained in these corporations' annual reports. The credibility and legitimacy of corporate financial data quickly became a topic of political debate.

The collapse of Enron was predicated on fraudulent accounting practices that concealed the amount of debt the corporation had accumulated. Federal prosecutors accused the major accounting firm of Arthur Andersen of aiding Enron's corporate officers in this enterprise and successfully won a conviction against the firm for its actions, including the destruction of documents. A careful review of Enron's annual reports revealed that certain transactions were buried in obscure footnotes or were not reported at all.

During 2002, the SEC and Congress examined the shortcomings of annual reports and other corporate reporting practices. In a bipartisan effort, Congress passed and President george w. bush signed the sarbanes-oxley act, also known as the Accounting Industry Reform Act, in July 2002 (Pub. L. 107-204, 116 Stat. 745, [2002]). The act seeks to address Corporate Fraud by, among other things, requiring chief executive and chief financial officers to personally certify the accuracy of the financial information contained in quarterly and annual reports. The certification must state that the officers have read the report, and must confirm it contains no misstatements or omissions and that it is a fair presentation. An officer who knowingly makes a false certification will be subject to fines of up to $5 million and a prison sentence of up to 20 years. In addition, officers will be forced to repay bonuses that were based on inaccurate financial earnings.

The SEC also responded by demanding that all major U.S. corporations recertify the accuracy of their 2002 annual reports or risk prosecution. A number of corporations took the opportunity to change their financial statements. In the wake of the 2002 scandals, the expectation is that annual reports will be more accurate in detailing the financial health of corporations.

Further readings

Malveaux, Suzanne. July 31, 2002. "Bush Signs Bill to Stop 'Book Cooking'." CNN.com: Inside Politics. Available online at <www.cnn.com/2002/ALLPOLITICS/07/30/bush.corporate.reform> (accessed May 30, 2003).

Monks, Robert A. G., and Nell Minow, eds. 2001. Corporate Governance. 2d ed. New York: Blackwell.

Practising Law Institute. 1994a. The Annual Report to Shareholders. Corporate Law and Practice Course Handbook Series, January–February.

——. 1994b. Annual Reports to Securityholders and Disclosure in Annual Reports. October–November.

Winkler, Carol. December 26, 2002. "Weighing SEC Ability to Fight Fraud." Boston Globe.

Cross-references

Board of Directors; Financial Statement.

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