Archives: Financial Analysis
Serious Limitations of Financial StatementsL.S. (Al) Rosen*
1.
Introduction
Most of the educational material available on the topic of Canadian financial reporting is written from the self-serving point of view of the company and its auditors. Comments that haven’t been valid for up to 25 years are still being published in Canada.
Quite often, simplistic and often misleading financial statement ratios are explained in books and courses. What is usually missing in explanations is how the preparers, and perhaps auditors, have chosen to print only a particularly glowing point of view. This “Introduction” has to serve as a vital awakening for understanding financial analysis and its many pitfalls. Yesterday’s approach usually will not work anymore.
Canada has never accepted the concept of mandating financial reporting that balances between the interests of creditors/investors and those of corporate management. That is one main reason why we see so many actual or alleged delayed financial failures in Canada: Nortel, Castor Holdings, Confederation Life, Crocus Investment, Northland Bank, Canadian Commercial Bank, Victoria Mortgage, Hercules Managements, Standard Trust, and much more.
The recent wave of income trust failures in Canada (now totaling well over $13 Billion in investor losses) has been inappropriately blamed on income tax changes. Some losses have arisen by tax alterations. But, the real causes are the pyramid schemes that were being employed by the “trust” promoters. Return on investment “yields” that included cash returns of the investor’s own capital contribution were, simply, outrageously false financial reporting. Basically unprofitable companies were being sold as income trusts, even though investors could not “trust” the “income” or the fictitious hype scenarios.
Yet, here we are today, again facing the same circumstances where you cannot believe the financial statements of large numbers of Canadian companies. Neither the Provincial securities commissions nor our auditors have taken any recent worthwhile actions to protect investors and creditors from massive financial reporting trickery. Actions taken typically do not solve the problems.
Several uniquely-Canadian factors have combined to produce what should be regarded as an unbalanced anti-investor, anti-creditor bias within Canadian financial reporting. First, the Supreme Court of Canada (SCC) has ruled that annual, audited financial statements are not being legislated for the purposes of investor decision-making. Hence, if the financial statements contain bogus figures and explanations, investors have little recourse against auditors, and probably also against directors and officers for falsehoods. One exception exists to this SCC posture, and that occurs when the misleading financial statements are included as part of a prospectus or offering document.
Second, Canada is nearly the very last country in the world to allow its auditors to write the country’s accounting, reporting and auditing rules. Most other nations have independent, non-conflicted rule-setting bodies that prescribe the quality of accounting and auditing. Canada permits corporate management considerable freedom of financial reporting choice. The consequence is that management is unlikely to choose those particular accounting policies that make itself look bad.
In essence, Canada is backwoods or obsolete in its present-day financial reporting philosophy. A proposed change for 2011 to adopt portions or much of international accounting rules is unlikely to alter matters. Still existing will be the freedom of management to report what it believes is flattering, and helpful for calculating executive bonuses. Canada has never caught up to the U.S. and its securities regulations that were passed into U.S. law in 1933 and 1934. We are far, far behind in investor protection, despite what some writers may state.
Third, our Provincial securities commissions do not have the leadership, talent, experience and resources to detect and prosecute even the most flagrant of financial reporting scams. We saw the U.S. versus Canadian comparisons in cases involving Nortel, Bre-X, Hollinger, Livent and many, many more.
As a consequence, those who are inclined to “cook the books” in Canada have little to fear. Investigations and prosecutions are rare. Convictions for financial reporting shenanigans are almost non-existent. In short, our tricksters seriously have nothing to lose.
When we do the math, by adding up the above Canadian peculiarities, credit analysts certainly face a huge task. If a company uses U.S. accounting rules and files in the U.S., the financial statements are likely to be more comprehensive and more trustworthy. But, those companies that use only Canadian rules and file only in Canada can be scary. You just don’t know what to expect.
We recently saw the degree of shock with our batch of incredible income trusts. Many “trusts” calculated profit in frightening, grossly misleading and inconsistent ways, and distributed cash that was not earned. Yet, the financial statements were fully audited, and the regulators and auditors said close to nothing to the public.
The above warnings have to be kept in mind at all times when financial statements are being analyzed. Numbers have to be adjusted before they are used for ratio analysis. Otherwise, your ratios and conclusions can easily be misleading.
Ratios and analysis that do not adjust the reported financial numbers are all too often seen in stock brokers’ reports. Maybe the company is a rarity and no adjustments are needed. More likely, however, the financial analysis is worthless, or misleading.
2. What to Look For
What are the most serious Canadian financial reporting tricks in use today? Much depends on whether we consider Canadian-listed companies that report only under Canadian GAAP, or perhaps just private companies. Also, the industry and stage of “life cycle” (e.g., start-up; mid-life; near-bankruptcy; or somewhere in-between) have to be considered when performing analysis. The tricks can differ.
Let’s start with private companies in a manufacturing industry. Our forensic accounting practice has encountered hundreds of cases where accounts receivable, inventory and accounts payable have been deliberately and grossly misstated. In the case of receivables, the typical problems are: premature recognition of revenue, uncollectible amounts, unrecorded credit notes or allowances for returns, contorted aging to “freshen-up” when-due invoice dates, and non-existent customers. The reported figures may be audited, or “reviewed” or compiled/notice to reader; it doesn’t seem to matter, because the result is the same: overstated or bogus assets.
The usual signs of uncollectible receivables are that they are too high in relation to sales (e.g., year-end inclusion of fake sales) and have been falsely growing over the years. Usually, a bank will be lending based on the under-90-day receivables; hence, look at the balance sheet and notes for credit term details. Theoretically, receivables should be recorded at net realizable or cash value. Practice can be another story.
Inventory is a further much-abused asset. It should be recorded under Canadian rules (GAAP) at the “lower of cost and market”. Unfortunately, the terms cost and market are too vaguely defined, so that almost anything can be expected to appear on financial statements.
Overstated inventory commonly occurs because of overstocked, obsolete and otherwise overvalued items. Too much overhead gets packed into “cost”, especially with slow-moving items. Apparently, (based on our Court cases) auditors are easily fooled at physical inventory count time. Junior auditors cannot tell different ratings or qualities of inventory (e.g., grades of copper, brass vs. gold, ore vs. slag, oil vs. water and much more). Yet, each year they trudge to clients’ warehouses on inventory count day to again prove their unawareness.
Detection of overstated inventory is possible through comparisons of average inventory to cost of goods sold, and to purchases. Raw materials and work in progress have to be separated from finished goods when comparing to cost of sales. Currency differences and fluctuations have to be adjusted as does seasonality and commodity price changes. Growing dollar amounts compared to several previous years, and lowered turnover ratios on finished goods, must be followed up. It is not unusual for spare long-lived asset parts to be called inventory when the company has had a bad sales and profit year.
Accounts payable increases are always a huge red flag. Cash from operations, an interesting indicator, but one that requires adjustments, increases when delayed payables exist. Thus, it becomes essential to separate when a company has serious cash flow problems and can’t pay their payables, versus their wanting to manipulate cash from operations by merely delaying payment of payables. Sometimes the situation can be temporary because of contract payments that come due after the balance sheet date. But, the composition of the income and cash flow statements must be studied, as well as the whole current liability section of a balance sheet, to pin down causes. Deferred revenue build-ups or reductions often need careful investigation.
Receivables, inventory and payables may turn out to only be starting points in analysis if unevenness in operating cash flow becomes a concern. It is not unusual to discover that one-time gains (e.g., favorable settlement of a lawsuit; currency exchange or translation gains, or gains on disposal of long-lived assets) find their way into revenue, or as reductions to management compensation expense. Excessive netting of unlike items seemingly is accepted in Canada. The losers of such financial reporting are the creditors and investors.
Obviously, much more can be said about analyzing the financial statements of private companies. For instance, non-arm’s length or related party disclosures can be grossly inadequate, yet still get audited.
Note that these same tricks can occur in public companies. Using EBIT or EBITDA or similar ratios does not catch the trickery.
3. Public, Canadian GAAP, Companies
One of the most frequently-asked questions for a forensic accountant is: “what causes profitable companies to suddenly fail”? Huge bad luck can be a reason. But, when we dig deeper into most sudden-failure situations, the typical answer is that the companies weren’t really profitable. The looseness of Canadian GAAP (i.e., Canadian auditors have been permitted to set their own weak rules) has allowed non-income to be reported as audited income. Fake profits are common in Canada. Cash flow and GAAP can be material dollars apart.
In the past five years we have seen endless situations where maintenance costs have been curtailed. Other standard expense accruals also have not been recorded at full amounts (e.g., environmental accruals). Basic GAAP rule changes made four to seven years ago (e.g., involving income tax, and intangibles) are now coming back to haunt us. Matching of expenses to revenue has been downgraded, thereby opening the door to a variety of scams.
In essence, Canada has opted to call as income today, transactions that would not have been permitted to be income 10 years ago. We are inflating profits so as to drive-up stock prices. Eventually, the bubble bursts. When reported income does not produce equivalent cash inflow, greater borrowing or selling of the company’s shares becomes necessary. When the creditors and investors clue-in, and stop providing money, the realistically-unprofitable company goes bankrupt.
Thus, as analysts, searching for fake profits and overblown “cash from operations” becomes our top priority. The task is not easy because we (as users of financial statements) have neglected to bitterly complain about the poor financial disclosure that exists in Canada. Silence about bad rules does not lead to improvements.
Quite basically, Canadian financial reporting rules are an excellent cover-up device for all sorts of management shenanigans. The fact that the cover-up nature has not been grasped by most analysts is at the heart of continuing pathetic reporting under Canadian GAAP. Bad management stays in office for additional years, making further bad decisions.
Meanwhile, what do we look for? An exceedingly popular game in Canada is the purchasing of other companies. Additional profit and cash flow becomes the result, giving the false impression of growth and success. What has made this game nasty since 2001 is that any excess paid to acquire these other companies can be hidden in goodwill and intangibles. The next step is to not expense any of the goodwill by calling upon one or more of GAAP’s horrendous goodwill loopholes. The result is enhanced cash flow from the purchased companies and no additional expense for goodwill wear and tear. Some companies have bought one after the other of their competitors or other cash producers. The balloon eventually will break.
The income tax expense/recovery line has been mangled this decade by allowing management to fiddle with their own optimism about possible recovery of tax losses. Hence, when times get tough for a company, look for sudden optimism about tax recoveries. In some companies, swings back and forth have been absurd.
Related party transactions are another growing problem in Canada. Many public companies are engaging in trading with companies that are really owned by the corporation’s executives. Analysts therefore have to ascertain the ownership of companies that are mentioned in financial reports (e.g., in MD&A disclosures). All too often transactions are not at fair market value. “Cost recovery” is often stated as the price being charged. But, cost can include all sorts of overheads and executive compensation. Shareholders become the losers.
Our auditors have conveniently set up the related party reporting rules so that they don’t have to assure transfers at fair market value. They also don’t have to search for situations that often give rise to related party dealings.
Many more tricks are currently being carried out in Canada. The foregoing is a good start. Footnotes must be studied in considerable detail to acquire clues.
4. Silence is Not Golden
To say that Canadian financial reporting is a mess is simply being too kind. Readers of financial statements have allowed the reporting situation to deteriorate badly, by not speaking up. All an analyst has to do is review the recent financial reporting of income trusts. Billions of savings were donated to financial reporting tricksters. Yet, very few analysts confronted the perpetrators. Governments were also not forced to deal with the major loss of credibility of financial statements. Serious reform is long overdue in Canada.
*Al Rosen is a forensic accountant at Accountability Research Corporation in Toronto, Canada. His regular columns can be seen in the National Post/Financial Post on the second Wednesday of each month, plus in every second issue of Canadian Business magazine, “Between The Lines”.