Too much smog in annual reports?

In 1978, Gulf & Western Industries Inc. spent $3 million reprinting its annual report in Time magazine. A corporate gadfly, however, Lewis D. Gilbert, criticized the company for using small type for the financial footnotes, thus making it physically difficult for him to find out that, among other items the company had investment losses of $3,912,000.

Mr. Gilbert's criticism highlights one of the chief problems of the financial section of annual reports: They are often unreadable.

Not only are the footnotes set in small type in some of the reports, but they are also written in such a manner that the investor has difficulty ferreting out exactly what a company means by a footnote.

For example, in the latest annual report by Pan American World Airways Inc., there is a statement by the company under "Dividend Restrictions" that says, "Under the most restrictive of the covenants relating to dividends or other stock payments, as defined, in various indentures to loan agreements to which the Company is a party, at December 31, 1979, retained earnings of $289,831,000 were available for dividends or other stock payments."

Since Pan Am did not pay a dividend last year, a shareholder, reading the annual report, may have wondered what the company meant. Acoording to a Pan Am spokeswoman, "The statement speaks for itself." As one writer of corporate annual reports suggested, however, it might have been clearer to he shareholder if Pan Am had further stated that the company used that $289,831,000 to reinvest in itself, since the company did not pay any dividends last year.

This type of smog in annual reports is referrred to as "compliance information," which is inserted in a report because the company's lawyers feel it must be there. Unfortunately, says Edward A. Weinstein, a partner at Touche Ross & Co., a major accounting firm, the investor must wade through this "chaff" to find the real "kernels" that will give an inkling of what is going on at a company. For example, Mr. Weinstein suggests that the important items an investor should look for in the financial footnotes are:

* Hidden information that might reveal any unusual transactions. For example , the accountant says, look for provisions for plant closings and any new financing agreements or sales arrangements. "Sometimes," he says "companies will use the footnotes to disclose a major transaction."

* Sometimes there are important disclosures on taxes."Many companies don't pay the standard rate on taxes," he explains, "and their effective tax rate is lower. Now they must explain why."

* On occasion a company will change its quarterly financial data. If the earnings have been restated, it will show up in the financial footnotes to the annual report.

* If a company has a major customer, or has just lost a major customer, this can sometimes appear in the financial footnotes. Conversely, if it is dependent on one supplier, this can also be considered material information which should appear in the footnotes.

William Dunk, the president of Corpcom Services Inc., a company that specializes in writing and producing annual reports, notes that some companies also disclose their financial policy in a footnote. "They say, 'Gee, here's our future dividend policy,'" he says. Still others, he has found, will include a footnote on the company's capital spending and a statement on the expected rate of return on such projects. This becomes a good test for investors, he says, "to ask if the company's officers are managers or just a bunch of bean counters."

Mr. Dunk has also observed that some companies are working to put their footnotes into readable English. he points out, however, that ever since the financial sections of the report have been expanded, the trend has been toward disclosure instead of communication. In fact, some companies have sent the investor a copy of the 10K, a document that must under law be filed with the Securities and Exchange Commission, in an effort to "bury the investor with information." Ideally, Mr. Dunk says, companies, should combine both disclosure and communication functions in their annual report.

He says that one way to make the financial reports more readable is by enlivening the section with five-year charts and graphs. In fact, J. C. Penny this year merged the formal notes with the text and wrote them in understandable English.

Mr. Dunk says it is that the average shareholder doesn't read the financial footnotes. But he hardly faults the shareholder, since they are so often unreadable. Likewise, Mr. Weinstein decries the murkiness in footnotes, because "they sometimes contain all kinds of interesting information."