How unaudited financial information could threaten Canadians' savings

More than 85 per cent of the information disclosed by public companies and used by investors to decide where to put their money hasn't been independently audited, posing a risk to investments and retirement savings.

It's a practice that can mislead investors by letting companies overstate their earning potential and push their share prices higher. That sounds good until the music stops and the stock price falls.

The problem is serious enough that Canadian regulators plan to raise it with their international peers at a conference in Toronto Nov. 1-2.

Company financial statements are externally audited using internationally approved practices. But many companies provide additional unaudited disclosures, according to institutional investors at a recent industry conference.

These disclosures regularly show more favourable results and trends, according to a global survey by the Chartered Financial Analyst (CFA) Institute of its 145,000 members in 2016.

And investors are placing their bets using that unaudited information.

The implosion in the price of Valeant Pharmaceuticals, from a high of $335.32 a share on July 31, 2015 in Toronto trading to a low of $11.20 a share in April, is a stark example of what can go wrong for investors.

Consistent definitions

At its peak, Valeant traded at a seemingly reasonable 22 times its "adjusted earnings" per share, in line with the overall S&P 500 market multiple of 24 times.

But this market measure is based on generally accepted accounting principles (GAAP) earnings for the companies in the S&P500 Index. On that same basis, Valeant was actually trading at an astonishing 440 times earnings.

According to Richard Talbot, former director of research for RBC Capital Markets and board member of the CFA Society Toronto (the second largest chapter in the world), to make non-GAAP information effective, consistent definitions and standards need to be applied:

• By a company to ensure its non-GAAP measures are clearly defined.
• By a company across all reporting periods.
• By all companies within the same industry.

"The first two are a must," he said. "The third would be a nice-to-have."

Securities regulators and auditors are on the case, actively seeking and including the voice of the investor in deciding how to address the risk.

The Canadian Securities Association (CSA) in Canada issued guidelines in early 2016 to companies on how to report financial non-GAAP measures, designed to make them reliable for investors.

Monitoring compliance

However, they remain only suggestions for now, rather than rules.

The CSA has been monitoring the track record of companies' compliance with these guidelines, and the news isn't good.

At an industry panel earlier this year, a representative of the CSA said that more than 80 per cent of issuers were falling short in implementing these suggestions.

Given this track record of non-compliance, the CSA recently said that next April it will begin transforming the guidelines into regulations, with enforcement actions and penalties for non-compliance.

Auditors are also concerned about reliance on non-GAAP measures and the implication for the relevance of audits themselves. If investors are using primarily non-GAAP measures to make decisions, how relevant are independent audits of financial statements based on GAAP?

Regulators and auditors are building a case for company boards to retain (and pay) auditors to check the process around non-GAAP measures. Not everyone, however, is persuaded of the need for enhanced auditing.

"I have been pitched by auditors on the need for an audit of non-GAAP financial measures, but haven't been convinced yet," said one experienced director and audit committee chair, who noted that non-GAAP financial measures are basically derived from the GAAP financial statements.

How did we get to a place where audited financial statements are no longer the primary financial inputs for shareholders to evaluate their holdings?

There are three components to a complete set of financial statements:

• Income statement.
• Balance sheet.
• Statement of cash flow.

The income statement measures the net earnings of a company and, until the past few decades, GAAP was primarily designed to ensure the accuracy of the income statement. This made sense, since earnings power is a primary input into traditional valuations (for example, price-earnings ratio).

However, financial reporting standards evolved over time to put increased emphasis on accurately measuring a company's balance sheet its assets and liabilities at a point in time with the income statement turning into a residual.

"This process really accelerated during the credit crisis of 2007-08," Linda Mezon, chair of the Canadian Accounting Standards Board, said in an interview.

This GAAP obsession with the balance sheet can result in plenty of volatility in a company's earnings from year to year, as swings in balance sheet values get flushed through the income statement.

We need to solve this together.- Linda Mezon, AcSB

This is no help to investors trying to judge a company's value and long-term prospects. So it's not surprising that companies and investors have sought to "normalize" for the volatility that GAAP produces in the bottom line by adopting non-GAAP financial measures.

Still, many professional investors start with the GAAP statements, especially the statement of cash flows, and work to estimate the "free cash flow" generated by the company as a means to value stocks.

This takes diligence, smarts and time, not all of which may be available to the typical investor.

In essence, a company's disclosure of non-GAAP measures such as "adjusted earnings" or "adjusted cash flow" is designed to level the playing field by providing figures that summarize this type of analysis.

But these measures need to be clear, consistent and reliable to make them safely usable and to remove the temptation for companies to present a biased picture of their performance in an effort to drive share prices (and management compensation) higher.

Achieving this isn't just a Canadian concern. Similar regulatory initiatives are underway in the U.S. and around the world.

Key opportunity

Consistency of regulatory approach across countries is critical, not only for investors, but especially for companies whose shares are listed on multiple exchanges and must meet multiple local reporting requirements.

A key opportunity for Canada to advance global co-ordination on this topic is the upcoming International Financial Reporting Standards (IFRS) annual conference Nov. 1-2 in Toronto.

Mezon has secured a rare joint appearance by both the chair of the International Accounting Standards Board and the chair of the Financial Accounting Standards Board in the U.S., which has a different, and sometimes conflicting, approach to accounting from the rest of the world.

They will join her in a roundtable discussion during which she intends to raise the issue of non-GAAP measures.

"We need to solve this together," said Mezon.