IFRS issues recall the 2000 crash

First-quarter financial reports will deliver some strange and surprising results courtesy of the new IFRS accounting rules that came into effect for most companies on January 1. And some companies will be working hard to convince you that the new rules will have no adverse impact. That means advisors might have to contend with a certain amount of EBIFRS (earnings before IFRS).

Nobody wants to revisit the market crash of 2000, or any of the mindless practices that led to it. But we’re probably in store for some of that old-time nonsense again in 2011. A significant part of the tech crash can be pinned on foolish valuation practices by analysts and investors.

At the time, there was a preponderance of so-called pro-forma earnings being touted. Recall that Nortel used to report earnings from operations in order to justify a market cap that exceeded hundreds of billions back in the day. According to the bottom line of its financial statements, the company didn’t make any money. However, according to earnings from operations* the company made bundles.

Sadly, earnings from operations were nothing at all like the more time-tested concept of operating earnings, which ignore only truly one-time items like gains from asset sales. And worse, that nasty little asterisk excluded many day-to-day operating costs from the company’s hand-picked performance measure. And as if to guarantee that things would end badly, management bonuses were also based on the performance measure they themselves had made up, and were completely unique among their peers in the industry. Essentially, Nortel management ignored costs in plain black and white.

Lessons not learned

Unfortunately, investors didn’t learn their lesson with Nortel and the tech wreck. It was just a few short years before another management-created performance measure came along to prop up the valuation of a large part of the market. With many business income trusts (non-energy and non-real estate), investors were convinced they should ignore everyday costs of operating a business.

Some cyclical companies were shoehorned into the income trust model, promising cash payouts they couldn’t possibly hope to maintain over the longer term. Essentially, management got to make up a calculation for distributable cash that was specific to their company alone. Somehow, short-term cash budgets suddenly became the basis of valuation for long-term earnings power. It was akin to basing your personal earnings prowess on how much cash you’ll need to get through next week. Alas, the market got the better of itself once more, and it all ended badly.

Why dredge up such regrettable times? Because it seems too few investors recall past mistakes, especially when it comes to recycled financial reporting tricks. So keep in mind when dealing with IFRS that Nortel ignored its losses calculated in the conventional way, and made up a profit figure of its own. Likewise, many poor-quality business income trusts reported adequate profits, but not enough to attract the impressive valuations that a made-up distributable cash number could.

Incidentally, the key element of any Ponzi fraud is to fabricate a profit figure. As long as investors believe it, the fraudster can be well on his way. In a plain vanilla scam, the fake profit is simply pulled out of thin air — a return on capital of 15%, for instance.

If anyone asks to withdraw cash, the fraudster simply gives back a portion of what he has already collected. But with such impressive-looking investment returns, he can bring in more new cash than he needs to give back. Eventually though, the made-up figures can only cover reality for so long. With IFRS set to produce some unusual results this year, investors might fall victim to companies that try to convince the market to concentrate more on management pro-forma results instead of the bottom line as prescribed by sound accounting rules.

Out of thin air?

It’s not hard to find companies that dislike the impacts of IFRS, especially in places where the accounting rules are already in full swing. Take, for example, KfW Bankengruppe, a top-five German bank. In its latest quarterly release it refers to “consolidated profit before IFRS effects from hedging.” The bank came up with its own number because of what it calls the “economically unfounded effects” of the “rigid IFRS regulations.” For the first three quarters of 2010, profit before IFRS hedging effects was €2.2 billion compared to conventional consolidated profit of just €1.5 billion.

A more typical, non-financial example might be Adcorp Holdings, a South African staffing and outsourcing firm. It regularly refers to normalized EBITDA, which deducts depreciation, amortization and IFRS adjustments. Ignoring the negative impact of the IFRS adjustments alone boosted the company’s normalized EBITDA by 7% in 2010.

While there are many more instances in which IFRS will result in higher profits, it’s easy to see how some Canadian companies will be tempted to highlight normalized or adjusted figures in order to ignore those instances in which IFRS has a negative impact on results.

For example, IFRS has the ability to produce more asset impairment writedowns than Canadian generally accepted accounting principles (GAAP) did. Essentially, IFRS examines writedowns on a more granular level, breaking out asset components, allowing less grouping when it comes to testing for impairment. Under Canadian GAAP, some impairments went unrecognized because individually impaired assets were grouped with other assets that were carried on the books at less-than-fair value. Chances are that investors will be encouraged to ignore such impairments as so-called one-time or non-cash items.

Oil sands concerns

Turning to more industry-specific concerns, there is a greater requirement under IFRS for companies to recognize decommissioning costs (a.k.a. asset retirement obligations). The issue is especially prevalent in the mining and energy space.

In our equity research, we’ve zeroed in on many companies in the oil sands sector, which for years declined to recognize decommissioning costs because of a loophole in the Canadian accounting rules that allowed them to take a pass if they thought estimating the costs would be too hard. That passive stance won’t be allowed anymore, and the recognition of those future cash obligations has a direct impact on net asset value calculations and target prices.

Looking at the real estate sector, companies have the choice under IFRS of whether they want to mark-to-market the value of their property portfolio every quarter, with the difference hitting net income. Some companies might not be too happy with their choice if the market starts to turn the other way, and those portfolio gains suddenly become losses.

In another big change, certain resource companies will no longer be able to use full-cost accounting after switching to IFRS. Companies like Canadian Natural Resources, Canadian Oil Sands, and ARC Resources will see their EBITDA negatively impacted by the change, which naturally has an effect on stock prices. With the elimination of full-cost accounting, companies will not have the same ability to capitalize costs and defer them to future periods. This means they flow right into operating expenses which are above the EBITDA line. Previously, capitalized costs would flow through the income statement in future periods as depreciation and amortization expenses, below the EBITDA line.

And it might not be just income statement numbers that get adjusted and normalized by management. IFRS brings previously buried pension deficits onto the balance sheet, impacting the likes of BCE, Telus and other companies with large workforces and defined benefit pension plans.

Those companies’ balance sheets will take a hit, along with any associated leverage metrics, which can have an impact on everything from price/earnings multiples to discounted cash flow calculations. Odds are, investors will see some adjusted leverage metrics being bandied about as well.

Luckily, advisors have recent history to guide them in terms of how to deal with a potential deluge of adjusted earnings and other figures. Carefully consider any non-standard figures that corporate executives put forth. Indeed, alternative measures of a company’s performance can often shed light on the issue. But most importantly, never ignore the standard bottom line. Many an investor has been disappointed by ignoring time-tested convention and chasing the next new thing. Finally, if you see management bonus plans based on adjusted profit figures or EBIFRS, recall the lesson of Nortel, and run the other way.

DR. AL ROSEN, FCA, FCMA, CIP, CFE, CPA and MARK ROSEN, MBA, CFA run Accountability Research Corp., providing independent research to investment advisors across Canada.

Dr. Al Rosen, Mark Rosen