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Public companies have a lot of options when choosing accounting treatments; so much so that sometimes there’s little comparability between companies’ financial statements due to differences in reporting.

To explain this to advisors, we developed the mnemonic CHOICE, which reflects the leeway management has.

Each letter represents a different area of concern, summing up issues that can have a material impact on target prices and the value of company shares (see “Spotting accounting problems,” this page).

For instance, the “O” stands for off-balance sheet liabilities. This includes many subsections of accounting, such as defined-benefit pension liabilities. Management has significant room in this area to make accounting assumptions that can sway the balance sheet by billions of dollars (see “Companies hide billions in pension liabilities Companies hide billions in pension liabilities,” Advisor’s Edge Report, July 2012, and “Accounting rules allow hidden liabilities,”).

The last letter, which stands for executive compensation, is key because it represents the potential motive for executives to manage accounting in a way that inflates results and, in turn, could ultimately harm investors.

Watch for warning signs. This includes using adjusted EBITDA (the acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization) as a basis for short-term executive compensation. For instance, Just Energy, a natural gas and electricity reseller, uses this non-standard compensation metric to determine annual bonuses for its top executives (see “Portfolio torpedoes,” Advisor’s Edge Report, October 2012).

And Aimia Inc., a loyalty points company best known for running the Aeroplan program, has also created its own version of adjusted EBITDA. Similar to Just Energy, it uses it as a basis for short-term and long-term management compensation.

Some companies use adjusted EBITDA in the traditional sense — to exclude one-time, non-operating gains and losses outside of management’s control. In these cases, adjusted EBITDA has just as much chance of being lower than non-adjusted EBITDA as it does of being higher.

But compare that to Just Energy and Aimia’s annual reports, which are examples of non-standard use. Both companies have invented their own metrics, which paint their results in a better light. The result in each case is not to normalize performance, but boost it.

Aimia includes deferred revenue — revenue that has not been earned by the company — in its adjusted EBITDA measure. Under standard accounting, this revenue belongs in future periods.

The company’s annual report doesn’t explain why it does this. It says, “Management believes adjusted EBITDA assists investors in comparing Aimia’s performance on a consistent basis without regard to depreciation and amortization and impairment charges, which are non-cash in nature and can vary significantly depending on accounting methods and non-operating factors such as historical cost.” But this statement just explains what normal EBITDA is.

What’s the motivation?

To examine potential motive, investors should ask what executives could gain by using a non-standard financial reporting metric like adjusted EBITDA. In the case of Aimia, the situation is straightforward. The company’s management outlines that adjusted EBITDA and adjusted net earnings are 50% of the basis for determining annual management bonuses.

Further, adjusted EBITDA is the only metric used to determine the vesting of performance share units under Aimia’s long-term incentive plan. According to the company’s disclosures, the board doesn’t take into account normal EBITDA or standard net income when assessing corporate performance or determining management bonuses.

Also, Aimia changed its definition of adjusted EBITDA in its latest annual report (a red flag that should be investigated). It now includes “distributions and dividends received from equity-accounted investments.”

The company is not recognizing its share of income or losses in adjusted EBITDA. It’s only recognizing distributions, which cannot be negative, and can only boost results.

Still, counting distributions are fine in theory if they represent recurring income. But this isn’t the case in Aimia’s latest annual results. In December 2012, the company received what it called a “distribution” of $15.7 million on its investment of $124 million in Club Premier, a loyalty company based in Mexico.

For audited financial reporting purposes, the $15.7 million distribution was applied to reduce Aimia’s investment in PLM to ~$108 million. Based on this, Aimia’s share of PLM did not have much cumulative income for the period after the company bought the interest. Thus, a reduction of the investment account, as opposed to recording income, is the appropriate method of accounting for the distribution.

Aimia did the opposite when computing its unaudited adjusted EBITDA, and the distribution was essentially categorized as income. Yet the aim of financial reporting is to separate income from capital. Income is what has been earned, not what has been borrowed or returned to the owner. Aimia’s adjusted EBITDA treatment seems to contravene this goal.

Why this happens

Companies are able to treat their financials this way because non-standard measures outside of the core financial statements are completely unregulated. They do not fall under the responsibility of the auditors or regulatory agencies.

We asked Aimia why it contradicted standard accounting and used the opposite treatment of the distribution for calculating adjusted EBITDA and annual bonuses. Its response was that both methods were disclosed and that our identification of the contradiction was proof.

The problem is that this depth of analysis is beyond what most advisors can commit to. The fact that most sell-side analysts accept the company’s method of adjusted EBITDA without question only compounds the problem for financial advisors.

Accounting rules allow hidden liabilities

Current accounting rules allow multi-employer pension plans to remain off balance sheets for companies. Multi-employer plans cover employees in an industry where there are multiple employers, or companies with employees that belong to the plan. The plans are extensions of the benefits provided by industry labour unions. Under accounting rules, companies can report these plans in a way that hides the liabilities from investors.

These plans tend to be in perpetual deficit, and companies that are responsible for funding those deficits aren’t reporting the associated obligations on their balance sheets.

In the Canadian grocery industry, for instance, the largest plan is the Canadian Commercial Workers Industry Pension Plan for members of the United Food and Commercial Workers (UFCW).

Major contributors to the plan, such as Loblaw Companies and Metro Inc., do not report their shares of the plan’s deficit on their balance sheets. Worse, they don’t quantify the deficit in their financial statement notes, making it difficult for investors to know the plans and associated debt obligations even exist.

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

Originally published in Advisor's Edge Report