Veteran accountant tells of perils in investing in Canada
When Warren Buffett acts, investors notice. And after he took a roughly $300 million position last month in Home Capital Group, a troubled Canadian mortgage underwriter, some investors saw it as a vote of confidence not only in that company, but also in Canadian stocks overall.
Al Rosen takes a different view. A veteran forensic accountant and independent equity analyst who predicted the collapse of Nortel Networks two years before its 2009 demise, Rosen has a message for people investing in Canadian stocks: be wary.
It is a mystery to Rosen why Buffett bought into Home Capital, a company that has been the subject of a titanic battle between the investors who believe in the company and other investors — short sellers — who do not. Certainly, Buffett expects to make money on his deal. But in an interview, Rosen said he thought there was more to the story than the markets yet know.
Rosen is certain of this: International accounting rules followed by Canadian companies since 2011 are putting investors in Canadian stocks — not just Home Capital’s — at peril. Canada’s rules, which are substantially different from the generally accepted accounting principles (GAAP) governing American companies, give much more leeway to corporate managers when it comes to valuing assets and recording cash flows.
In addition, a 1997 decision by the Supreme Court of Canada has severely limited investors in suing company auditors for malpractice. Combined, these two factors generally make Canadian stocks a danger zone, Rosen said.
American investors often fail to recognize this, though, because they assume Canadian companies are abiding by American accounting standards. “I’ve been trying to alert investors in the U.S. to this,” Rosen said in an interview. “But there’s just that belief that Canada is following U.S. standards when it’s not.”
Rosen provides forensic accounting services and also works with his son Mark Rosen at the Accountability Research Corp. in Toronto. The two men recently published a book called “Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth.”
In Rosen’s view, the international accounting standards followed by Canadian companies allow managers to apply overly rosy assumptions to the financial figures they report to investors. For a while, these assumptions can propel stock prices — and executive bonuses — well beyond where they would be otherwise, he said.
Canadian accounting rules can also mask problems at a company. How else, Rosen asked, to explain the events leading up to the June 22 bankruptcy filing by Sears Canada? The company’s shares trade on both the Toronto Stock Exchange and the Nasdaq market in the U.S.
Like many retailers, Sears Canada’s fiscal year ends in January. It compiled its 2016 annual financial statement in accordance with International Financial Reporting Standards, set by the International Accounting Standards Board, a group of experts from an array of countries.
Sears Canada’s numbers weren’t good. Both revenues and same-store sales had fallen, but it reported shareholders’ equity of $222 million and $1.24 billion in total assets.
In the report, company management characterized Sears Canada as a going concern. In accounting parlance, that meant the business was expected to operate without the threat of liquidation for the next 12 months.
The auditor for Sears Canada did not challenge this view and assigned the company an unqualified — or “clean” — opinion on April 26. The report fairly represented Sears Canada’s financial position, the opinion said. And that opinion may well have been justified under Canadian rules.
Less than two months later, Sears Canada was insolvent.
“What are the auditing and accounting rules in Canada that allow you to give this totally clean opinion on a company and you can’t even look beyond six weeks?” Rosen asked. “That’s the scary situation with Sears, and we’re just seeing it more and more on other cases coming forward.”
Canada is not alone in following the International Financial Reporting Standards, or IFRS. Some 150 jurisdictions in Europe, Africa, Asia and elsewhere also use these rules. The international standards came about in 2002, when the European Union required adherence to them for all its listed companies beginning in 2005.
A spokesperson for the IFRS Foundation, Kirstina Reitan, said its members disagree with Rosen’s take. “The success of accounting standards depends on companies applying them properly and exercising sound judgment,” she said. “Both U.S. GAAP and IFRS are high-quality standards, and one is not more prone to abuse than the other.”