To say that Al and Mark Rosen have a dim view of securities regulators and investor protection law in Canada is putting it mildly. The father-and-son forensic accounting duo, who co-founded Accountability Research Corp. in Toronto, lay out an alarming picture of the Canadian investing landscape in a new book, Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth. In short, the book explains how companies can present misleading financial statements that are approved by auditors, and then used by equity analysts to talk up shares in those companies. Under International Financial Reporting Standards (IFRS), a set of accounting guidelines adopted in Canada and in other countries, figures are especially prone to manipulation. Regulators and lawmakers, meanwhile, have shirked off their duties to protect investors. Ultimately, the Rosens argue, investors have to watch their own backs. In this excerpt, they outline the most common traps investors fall into.
We are often asked to identify the most troublesome situations that we encounter in our forensic investigations. Some of these problem areas can be difficult to detect, especially in their early stages. It doesn’t help that Canadians often get lulled into a sense of complacency, unwisely believing that we live in a country that protects investors through laws and regulations, when in fact the opposite is the case. That’s how Canadians fall into deceptive traps, such as Ponzi-like business income trusts.
Having said that, we’ve listed below some of the most common ways in which Canadians get duped.
Trick 1: Yield Worship
Canadians are attracted to dividend yields, but often ignore many other factors occurring in the company. For how long will the dividend rate be maintained? In an era of low interest rates, yield traps play into the hands of financial cheats who can cook the books by inventing revenue, altering expenses and creating assets. Then, the company deceptively increases the dividend rate. Mesmerized by the yield, Canadians will buy the shares, and the price will tend to rise beyond its worth.
The deceptive company then borrows money to pay for the increased dividend while personally selling shares at the inflated price. Given the silence of regulators on this type of trap, it’s no wonder that manipulators continue to use it with impunity.
A high yield that may exist for only a year or two is all too common in Canada. The source of cash to pay the dividend must be traced very carefully. Lenders will not finance Pyramid schemes forever. Good collateral to be pledged against bank loans eventually gets exhausted.
Trick 2: Nortel Clone Variations
Companies like Nortel and their clones get away with this trick by claiming in their annual and quarterly reports that typical financial reporting does not do justice to the company’s so-called potential. The company then invents its own reporting rules “to better reflect the company’s value”. As the company emphasizes its own version of reality, the media accepts the story, referring to fabricated figures such as adjusted EBITDA or adjusted earnings. Using such figures, companies ignore many expense categories, such as selling and administrative expenses. They may also incorporate future hoped-for revenue into the current year’s figures. The overall effect is to produce an inflated picture of profit that does not exist under conventional reporting methods.
As gullible investors buy the stock, the share price rises. Company insiders may receive bonuses based upon the company’s phony profits. They might also exercise their stock options, acquiring shares at a low price and selling them at grossly inflated prices. International Financial Reporting Standards (IFRS) makes this trick even easier to prolong because management has more ability to cook the books.
Trick 3: Resuscitating Declining Companies
Companies that are falling out of favour with customers and are experiencing declining sales and profits will often cook the books for a while. But, eventually they have to make major organizational changes. To buy time for a possible turnaround, a company might embark on a program of buying other companies. Sometimes, they’re seeking additional revenue; at other times, they seek the strong cash flow of the target company. They may acquire one or more private companies to take advantage of higher earnings multiples that apply when these companies are swallowed into public entities. Investors have to determine whether a company is expanding for legitimate reasons or to cover up its own deficiencies. Under IFRS, temporary resuscitation of weak companies through timely acquisitions has become like child’s play.
As explained, this trick works for the cheat who pays an excessive purchase price for the acquired company, then buries the excess as an intangible asset such as goodwill in the financial statements. Reporting rules are so loose that the scam can be hidden for several years in an IFRS-bloated balance sheet. Income statement results improve, but only because the reporting rules permit postponing the recording of write-downs of intangibles-based assets. Since reporting rules don’t require companies to expense goodwill on a systematic basis, companies may choose to not write down bloated goodwill until the hot-air balloon of inflated value pops, leaving investors to deal with the losses.
Trick 4: Related Ownerships
Related-party arrangements can be productive and honest. They can also be outrageous diversions of shareholder money into the pockets of undeserving people. Once again, IFRS makes this trick easier to execute.
Transactions between related businesses should be recorded at fair market value. But under IFRS, a company can bury in notes to the financial statements the details about a company’s related parties, including corporate executives, directors, joint venture partners and family members. As we’ve discussed, investors can sometimes find these details by scouring numerous corporate financial disclosure statements. As an alternative, investors should simply walk away from such dubious companies and look elsewhere for better investment opportunities.
Trick 5: Believing the Company’s Numbers
In our experience, investors in Canada place far too much reliance on published numbers. As we have stated previously, US GAAP tends to hold companies to a higher standard of reporting than IFRS and gives investors more reliable figures. But, US GAAP also has deficiencies. Under either system, investors should not place their complete faith in a company’s published numbers.
Experienced financial cheats test the water by starting with elementary games such as using cookie jars to increase or decrease current liabilities and to alter revenue. If such games are not noticed, the manipulation escalates to much larger amounts, usually with a different trick.
Even if they get caught, financial cheats are often penalized by securities commissions with nothing more than a no-contest settlement. Sometimes, in exchange for a relatively small payment, the accused just walks away. By agreeing to settle the matter, the manipulator reduces the commission’s expenses, eliminating the requirements of a hearing and all the bureaucratic red tape that goes with it. But the investing public remains unaware of important details about the nature of the scam, and the cheat knows that he or she can do it again, facing only a minor penalty if they get caught.
Canadians need to be aware of the games that are being played by financial cheats, especially under IFRS. Persistence is necessary in analyzing financial statements to uncover these tricks. Canadians have to be more willing to judge certain management actions and to call into question the deficiencies behind a company’s reported results. Just because a stock rises in price, investors should not believe that it reflects a company’s appropriate value. Stocks rise on hype and rumour as much as performance sometimes. The best advice is to sell when you feel suspicious, and uncomfortable, even if the price continues to rise.
The worst decision to make is to fall back into a belief that the situation “cannot be that bad, because authorities would have acted to stop the financial tricks.” A long line of Canadian cases tells us that authorities did not act, time after time. You have to learn to protect yourself.
Easy Prey Investors is published by McGill-Queen’s University Press.