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This year will see growing concerns over public company accounting.The issue is underlined by a confluence of non-GAAP proliferation, key amendments to IFRS accounting rules and miscellaneous concerns from regulators.

In November 2016, the OSC issued a staff notice explaining areas to watch. The bulletin outlines issues the Commission may come calling about. Perhaps sending it out will cause companies to tighten things up voluntarily—but, since there’s not much enforcement heft behind the scenes, advisors would do well to watch for the reporting deficiencies themselves. In this article, we elaborate on the issues flagged by the OSC.

1. Non-GAAP reporting

We’ve warned about the expanding problem of non-GAAP financial reporting for many years, and in 2016, both the OSC and SEC became more vocal about the pervasive nature of non-GAAP measures reported by companies (especially when they improve earnings results).

It’s easy to say that most companies now use non-GAAP measures, but that misses the point entirely. It’s also wrong to assume that most companies benefit from the tactic. In reality, it’s useful to normalize earnings, given the many arcane requirements of IFRS. The key to identifying offside companies is to parse the types of adjustments being made.

Simply put, don’t use the non-GAAP measure if it deletes expenses instead of smoothing them out between reporting periods. Second, separate recurring cash costs of running the business (which can’t be ignored) from, say, one-off gains, or unrealized adjustments to the value of currency hedges (see “Why to watch a company’s adjusted earnings,” AER, January 2016).

2. Going concern notes

A going concern note in financial statements is usually included to explain that a company won’t be able to carry on operations unless it receives additional funds (either through financing or an operational turnaround).

The OSC is concerned about situations where management uses its own judgment (without any explanation) and decides not to provide a going concern note to investors—even though the company may be in financial difficulty.

In the absence of a going concern note, advisors should still be on the watch for companies that experience recent losses, report deficits or working capital deficiencies, or see continuing operating challenges.

3. Fair value adjustments

Management has significant latitude within the accounting rules to report “fair value adjustments” to their assets which, in turn, have a significant impact on their reported income. The adjustments can also sway the market’s perception of share value through measures like net asset value.

The OSC specifically highlighted real estate companies for their use of fair value adjustments, which can impact the majority of their assets. Companies might requisition an external appraisal of 30% to 40% of their properties each year, and the Commission is rightly concerned with the disclosure quality regarding that process. For instance, was the sample representative of the whole, and what method of valuation was used?

Left unsaid is the fact that the remaining 60% to 70% is valued internally by management based on their own assumptions. The OSC notes that some companies try to escape with boilerplate disclosures such as “investment properties are internally and externally valued.” But it’s worse than that. Some companies will claim they received an external appraisal by using a cap rate from a consulting firm and applying it to their own internal cash flow estimates. In the end, advisors should know that the notes to the financial statements can show the difference between a good and bad investment (see “Don’t fall into the NAV trap,” AER, May 2016).

4. New accounting rules for leases

The Commission highlighted that incoming changes to the accounting rules will have significant impacts on company results. The new standard for leases will bring almost all leases onto the balance sheet, effectively eliminating the off-balance-sheet separation of operating and capital leases. This will be a massive change for financial reporting and highly detrimental for investors, adding significant confusion to the analysis of balance sheet leverage, and operating and financing cash flows. The effect will not be seen until companies start reporting their results in 2019. As the date draws closer, companies will be required to disclose more detail about the expected financial statement impact and their choice of accounting method.

5. New accounting rules for revenue recognition

More relevant is the coming change in accounting rules for revenue recognition, specifically IFRS 15 Revenue from Contracts with Customers. The change, effective for financial years starting on or after January 1, 2018, will impact industries to varying degrees.

Companies feeling the biggest impacts have started to address the issue. Telus Corp., for instance, states that, “Like many other telecommunications companies, we currently expect to be materially affected by [IFRS 15]. […] The effects of the timing of revenue recognition and the classification of revenue are expected to be most pronounced in our wireless segment. […] Although the underlying transaction economics would not differ, during periods of sustained growth in the number of wireless subscriber connection additions, assuming comparable contract-lifetime per unit cash inflows, revenues would appear to be greater than under current practice.”

Translation: Revenues will show up faster than they used to, even though nothing has fundamentally changed.

Be your own watchdog

The Ontario Securities Commission has compiled a decent starting list of accounting concerns for 2017. Advisors should wonder why they don’t see these issues discussed often enough, given the impacts on share prices and portfolio values. But don’t expect the OSC to take care of it for you—the regulator’s notice is for investors as much as for companies. Start the year off right: use these tips to identify companies with weak financial reporting or industries at risk of accounting disruptions.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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