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Money: Beginners Guide to Investing in Shares - Another account between the lines

Annual reports can be very revealing. Magnus Grimond looks at what lies behind the jargon
Accountants traditionally come second only to actuaries in the ranking of the world's most boring people, but they and their jargon populate the world of investment. Get used to this - accounts are vital to the investor, who needs to have at least a rudimentary understanding of how to read them.

A small shareholder will find that a company's accounts provide the most intimate knowledge of the investment. Indeed, they may be the only source. Shareholders in Antofagasta Holdings, a copper-mining to banking conglomerate, for instance, have little chance of becoming personally acquainted with the company - unless they happen to live in Chile.

Most UK quoted companies issue accounts in some form twice a year. After the first six months - which may not start on 1 January - a half-term report known as the "interim" statement comes out. Soon after the full year ends the company publishes full-year figures, known as the "prelims", followed by a detailed annual report and accounts. Most importantly, these final figures are the only ones to be closely scrutinised by independent experts - the auditors, usually a firm of accountants.

How independent and investigative these accountants are is moot. Because they are subject to annual reappointment and are well paid for their auditing and other spin-offs, they clearly have an interest in keeping the client relationship sweet.

Even when it is a question of uncovering problems the company itself has missed, the system is by no means foolproof, as even the biggest companies find. Last year Pearson, the publishing group and FT-SE 100 index member, uncovered a pounds 100m hole in its accounts stretching back for years. Nobody, auditors included, had noticed that a relatively junior member of staff had been giving unauthorised discounts to customers.

Assuming the auditor has done his job, the accounts can be highly revealing. The figures split into three main parts: the profit and loss account, the balance sheet and the cash flow statement. Daunting documents all, the best way to think of them is in terms of time. The profit and loss account, probably the most straightforward, is a financial record of all the company's business over the full year. The turnover figure at the top of the page represents all the income the company received from trading in that period. Apart from certain so-called non-trading income - perhaps rents or interest received - the other items as you go down the column represent costs and expenses payable out of that first gross income figure.

The key items for investors are the pre-tax profits and earnings per share. These measures are generally used to compare the company's performance both with the previous year's figures - usually given alongside the current year's - and earlier periods. But interpretation is crucial.

Since the creation in 1990 of the Financial Reporting Council, an accounting watchdog, the auditing industry has had to accept more stringent standards. The main result is that profit and earnings figures can now fluctuate wildly from year to year. Every time a company sells or closes a business, it must include gains or losses in its profit and loss account. Stockbrokers now often restate profits or earnings to exclude one-offs.

The balance sheet might seem totally baffling. Think of it in terms of time, like a freeze-frame view of the company on just one day of its year, and it becomes much more comprehensible. The basic principle is that the firm's assets should match - or balance - its liabilities.

In summary, the top half of the accounts ascribes values to "fixed assets", such as property and plant, and "current assets", such as stocks, debts owed to the company and cash, often known collectively as working capital. Offsetting these will be a series of liabilities that must be paid back over progressively longer periods of time. Trade creditors and overdrafts are, in theory, payable immediately, while bonds and other longer-term borrowings have a fixed date for repayment. All being well, this huge piece of expensive arithmetic should still leave a surplus - the company's net assets.

Balancing this figure are a number of different types of capital and reserves, in the bottom half of the balance sheet. They add up to the net assets figure, although in this case the resulting number is described as shareholders' funds - the value of the business to the owners.

Finally, the cash flow statement is not unlike the sort of bank statement most people receive every month. On it can be found all the important payments made by the company, and all the important receipts it has been paid. Its beauty is that it is free of subjective judgements, which the company is entitled to make, but which can artificially inflate or depress profits to make the presentation look better.

The best way to understand this jumble of jargon is to get hold of a real set of accounts and take a look at them. But remember, while most investors tend to look at the general trends of profits and earnings over one to five years, horrors are often lurking in the detail, in that sea of tedious notes to the accounts. Investigation there often pays dividends, or at least helps avoid losses. Happy hunting.