In the spring of 1997, the Supreme Court of Canada rendered a decision that took investors across Canada by surprise. The case in question involved an investment company, Hercules Managements Limited, and the accounting firm Ernst & Young. Investors claimed that they had suffered losses because they had relied on audited financial reports, which they maintained had been prepared negligently. However, the Supreme Court of Canada ruled that audited financial statements in annual reports are not produced to enable investors to make investment decisions. The Court said that, for the most part, auditors bear no duty of care to investors, meaning that investors have little chance of success in attempting to sue auditors who sign off on misleading financial statements. Only in regard to financial statements prepared expressly for investment purposes (e.g. in a prospectus) did the Court make an exception. In other words, investors who rely on audited financial statements to buy or sell shares or other securities have little recourse in law and auditors who approve misleading or bogus financial statements can (and do) defend themselves successfully against lawsuits by simply referring to Hercules. Successive Canadian and provincial governments have failed to create legislation to overcome the effects of this decision, leaving the public to invest at their peril.

…the Supreme Court of Canada ruled that audited financial statements in annual reports are not produced to enable investors to make investment decisions.

For forensic accountants Al Rosen and Mark Rosen, Hercules was in their words “the beginning of the end for Canadian investors,” giving auditors a free pass to bungle annual audits and allowing them to set self-serving auditing and accounting rules that allow managements to flatter themselves in their financial statements. In their very readable, well-argued book $windler$, they describe numerous instances of accounting failures that have damaged Canadian investors and warn that the adoption in 2011 of International Financial Reporting Standards (IFRS) will expose investors to even more aggressive and misleading accounting techniques and tricks. Importantly, they provide detailed advice to investors on how to protect themselves in a market where the figures can be deliberately misleading, the safeguards are too few and the enforcement of penalties is too weak. Moreover, they make specific government policy recommendations to protect investors.

While $windler$ covers some instances of basic scams, such as brass being passed off for gold and six inches of high-grade copper covering a barrel of low-grade scrap, the book’s value lies in its explanations of more subtle misrepresentations that comply with Canadian accounting and securities laws. The Rosens bring out the magnitude of the gap between how users believe accountants are reporting and auditing and how they are actually conducting these functions.

Problems with weak accounting rules

Problems occur most frequently when accounting rules are weak; in non-manufacturing, non-retail industries (especially financial, construction and resource businesses because of inadequate cash flow reporting and monitoring); when dealing with non-arm’s length transactions (usually poorly handled by auditors); when dealing with receivables, inventory and revenue; when corporate restructuring charges exist; and when capitalized expenses are present on the balance sheet.

To help investors understand the ways companies can manipulate accounting rules and the ways investors can misinterpret results, the authors use the acronym CHOICE for: capitalized expenses, hidden asset impairments, off-balance sheet liabilities, inflated revenue, cookie-jar liabilities (changes in reserves made to enhance earnings), and executive compensation (management incentive schemes based on targeting accounting numbers that can be manipulated).

Security regulators haven’t helped

One of the book’s thirty chapters and ten appendices is devoted to a frank discussion on how Canada’s securities regulators are “all talk, no action”, noting that they have taken virtually no enforcement action on the financial reporting front in well over a decade.

Criticism of business income trusts

In another chapter strong criticism is directed at the managers, accountants and underwriters of business income trusts for inflating the market for these securities by setting distribution levels far beyond sustainable levels and using so-called distributable cash, a misleading, unverifiable figure defined in various ways, as the primary basis of valuation in the sector.

Failings of IFRS

Other chapters identify areas of potential abuse in the banking and insurance industry but perhaps the most ominous chapter, entitled Stairway To Nowhere, warns that the adoption of IFRS in Canada will diminish comparability with U.S. companies that report according to more-stringent U.S. GAAP, as well as between Canadian companies owing to the wider choice of reporting practices permitted under IFRS, particularly with respect to valuing assets. They note that IFRS reopens loopholes and gaps that were plugged years ago under Canadian GAAP. Among important deficiencies are weaker revenue recognition standards and the hiding of the quality and adequacy of cash inflows by the netting of cash outflows with cash inflows. The shift to IFRS, which will bring very large additional fees to accountants, is described as likely to wreak considerable havoc on analysis.

Recommendations

The authors make several specific recommendations to raise Canada to the standards that the rest of the world applies to protect domestic and foreign investors. They call for the establishment of an independent Canadian accounting standards board, similar to the U.S. Financial Accounting Standards Board (FASB), and an independent Canadian auditing standards board that are both free from the financial control and influence of accounting practitioners in Canada. They also recommend that a national securities enforcement agency be created to act as the judicial counterpart to the currently proposed national securities regulator which would have the ability to overrule the Canadian accounting standards board on accounting issues (as in the U.S., where the SEC can overrule the FASB). They maintain that there should be an emphasis on prescribing accounting rules, not just principles, when setting accounting standards and a reduction of governments’ reliance on conflicted self-regulatory organizations to resolve problems in the financial industry by developing more independent sources of information and policy recommendations. And last, but by no means least, they urge that legislation be passed to fix the Supreme Court of Canada’s decision in Hercules.

Three decades of vigilance

Al Rosen is a Professor Emeritus of Accounting at the Schulich School of Business at York university where he taught for more than 30 years. He has been a member of the Canadian Institute of Chartered Accountants since 1960 and is chairman of the Canadian Justice Review Board. He and his work have been widely covered in the Canadian media and he has debated his views on numerous conference panels over the years. However, the confines of the sound bite have worked against full and broad public discussions of his arguments and the often devastatingly pointed criticisms directed at standard-setters and regulators have sometimes turned discussion into invective. Much of the appeal of the book lies in its uninterrupted, extensively documented presentation of arguments and proposed remedies. No one on the investment scene in Canada today is pursuing these vitally important issues with the same vigour and experience as Al and Mark Rosen. In the process they are doing the Canadian investing public a significant service. Investors, analysts and all other users of financial statements should do themselves a service and read $windler$. Whether they agree with the authors on each issue or not, their perspectives on financial statements, securities regulation and investing in Canada are almost certain to undergo some significant changes.