The Numbers Game: David Milstead

'It's gotten out of control': How accounting games are boosting the bottom lines of TSX stocks -… Page 2 of 19
THE NUMBERS GAME
In an attempt to burnish their image with investors and

drive stock prices higher, companies are offering up a
host of gerrymandered measures to make their costs
appear lower, and their profitability higher. The use of
these customized earnings measures that do not adhere
to generally accepted accounting principles is growing in
Canada, posing a quandary for both regulators and the
investors they’re charged to protect.
DAVID MILSTEAD
Special to The Globe and Mail Last updated: Sunday, Sep. 25, 2016 9:59AM EDT
• • • • • • 0 Shares • 11 Comments
http://www.theglobeandmail.com/globe-investor/inside-the-market/boost-earnings-manipulate-a… 2016-09-25
I magine, if you will, something terrible: A fire begins in your home and rages,
uncontrolled. No one is hurt, thankfully, because you’re away from the house at the
time. But the structure is ruined and, financially, you’ve just taken a huge blow – because
you failed to renew your home insurance policy.
You are devastated. But your accountant advises you not to worry. After all, the
destruction of your house is merely a non-cash loss.
The example may seem extreme, but the accountant’s words are not unlike the message
being offered to shareholders by many large public companies in Canada when they report
sales and profits each quarter. In an attempt to burnish their image with investors and
drive their stock prices higher, companies are offering up a host of gerrymandered
measures to make their costs appear lower, to ignore real losses, and to make their
profitability seem higher.
Restructuring costs, stock payments to executives, writeoffs from deals that went badly –
all of these are being removed by corporate accountants who use “adjusted” measures of
earnings. Company management justifies hiding some of these costs because, just like an
uninsured house that burns down, they do not involve an immediate outflow of cash.
But the effect is often to deceive investors and to make many Toronto Stock Exchange-
listed companies look healthier than they really are. Sometimes, the adjustments change
the entire picture of a company’s profitability. In the first quarter this year, for instance,
BlackBerry Ltd. presented a number to investors that showed it broke even. But that figure
excluded a litany of costs, including share payments to staff, some administrative costs,
and writedowns of royalty agreements that were no longer as valuable as the company
first thought.
The real bottom line for BlackBerry? Not break even. A loss of $670-million (U.S.).
(BlackBerry tells investors it believes that presenting its earnings this way “enables it and
its shareholders to better assess the company’s operating performance … and improves the
comparability of the information presented.”)
The use by companies of customized earnings measures, called “non-GAAP” because they
do not adhere to generally accepted accounting principles, is growing in Canada, as more
companies cast aside tried-and-true accounting conventions. According to a new report
from Veritas Investment Research Corp. provided exclusively to The Globe and Mail, 70 per
cent of the members of the S&P/TSX 60 stock index of large public companies used some
form of non-GAAP metric in their results as compiled by Bloomberg. In the United States,
63 per cent of companies in the Standard & Poor’s 500 do so.
Firms that include non-GAAP net income in their regulatory filings
In 2004, just a handful of companies in the S&P/TSX 60 used non-GAAP measures

somewhere in their annual reports. Today, 59 do. The only exception: Imperial Oil Ltd.
The majority of the accounting adjustments by TSX companies – at least 80 per cent –
served to put a positive spin on the numbers, mostly by boosting measures of profitability.
“Management isn’t going to adjust numbers to make themselves look bad,” says Jerome
Hass, a partner at Lightwater Partners Ltd., a Toronto-based hedge fund.
And, in Veritas’s view, about 35 per cent of the members of the S&P/TSX 60 may not be
following the guidelines of Canadian securities regulators about how they should present
financial numbers. For example, the Canadian Securities Administrators calls on companies
to present their GAAP earnings figures with at least as much prominence as their non-
GAAP measures – something a number of companies seem to be failing to do.
The new report from Veritas presents a quandary for both Canadian regulators and the
investors they’re charged to protect. In the United States, the Securities and Exchange
Commission is cracking down on abuses in non-GAAP reporting. In Canada, securities
commissions have been more lax, offering “guidance” instead of firm rules, reminding
companies of what to do – and weighing whether more action is needed.
Further reading:
Securities regulators warn
against misleading earnings
statements
In the meantime, investors must navigate an ocean of conflicting and contradictory

measures that typically serve to inflate companies’ earnings – and, as a result, the stocks’
valuation. After all, investors are paying for companies’ earnings, now and in the future.
And if the companies can convince investors and analysts that their earnings are higher
than what accounting rules require, their stock prices will follow – at least for a while.
“Valuations are attached to inflated earnings, so valuations are higher than average
investors believe them to be,” Mr. Hass says.
“This is the root of all evil, the current No. 1 problem in financial reporting,” says Anthony
Scilipoti, Veritas’s chief executive officer and a co-author of the report. “The regulators,
investors, the auditors – this is a challenge for everyone involved. … It’s gotten out of
control, and investors can’t assess what the truth is.”
The use of non-GAAP measures is not brand new. The trend began in earnest during the
technology-driven stock market boom of the late 1990s. The bursting of the bubble, as well
as the Enron and WorldCom accounting scandals that followed, brought greater scrutiny to
the use of “pro forma” earnings, or what has also been called “earnings before bad stuff.”
While the SEC took action against companies for abuses in earnings announcements – the
first major case, in 2002, was against Trump Hotels & Casino Resorts Inc. – the Sarbanes-
Oxley Act in the U.S. later that year codified their regulation. Rather than ban the use of
these measures, however, the United States allowed them, as long as certain rules
were followed.
Chief among them was the regulation that the GAAP measure be at least as prominent as
the non-GAAP measure, as well as the rule that companies must provide a clear
explanation of how they calculated the latter. (This is known as a reconciliation.)
Canadian regulators’ guidance is markedly similar.
Once companies received the blessing of regulators to use their own accounting metrics,
however, the predictable happened: More and more companies used them, and used them
to exclude more and more expenses.
Latitude
Latitude
15 500015 5000
Series with
Seriesa with
6th gen
a There's never Intel Inside ®.
to give your
with powerful
Built to ®
Intel Core™
6th gen i5Intel® Core™
been a better Powerful
outperform.
Dell products. processor.
i5 processor. business
Shop Nowan edge
Productivity
time Outside.
In a study published earlier this year, Jack Ciesielski of the Analyst’s Accounting Observer
found that 401 members of S&P 500 firms were reporting earnings on a non-GAAP basis;
of those, just 269 were using such figures in 2009.
All told, the 380 firms that also existed in 2009 collectively reported $804-billion in non-
GAAP income in 2015. But using standard accounting rules, the real profit figure was $562-
billion.
For investors, the difference is a significant one. While the companies’ customized
measures allowed them to show a gain in profits of 6.6 per cent last year, their net income,
if measured conventionally, actually fell by 10.9 per cent over the same period. “Call it
‘Wonder Bread,’” Mr. Ciesielski says. “The firms make their bread, but you should
wonder how.”
What kinds of things are companies leaving out? Canadian companies are making the
same fundamental choices as U.S. companies, Veritas has found. Some of the
major categories:
Asset impairments: Investors in energy or mining companies are well versed in this
expense item. When a company has an asset on the books that has suffered a decline in
value, it must write down its value, with the amount of the writedown charged directly
to earnings.
Since there’s no cash used at the time of the writedown, companies often exclude the
charge from their quarterly numbers. Kinross Gold Corp. is an example. In 2010, it acquired
Red Back Mining Inc., creating what it billed as a “gold growth powerhouse.” But the deal
proved to be a disaster and Kinross has now taken $7.5-billion in writedowns on its
purchase, a number that exceeds its $5.6-billion market capitalization on the New York
Stock Exchange.
Stock option compensation expenses: Companies that were heavy users of stock options,
as well as industry trade groups, engaged in a multiyear battle to keep stock options from
appearing on the income statement as an expense. They lost, and the cost of options began
to hit the bottom line in 2005.
Since then, many companies adjust their quarterly earnings to exclude their cost. Agnico
Eagle Mines Ltd. had $24.6-million in 2015 net income using International Financial
Reporting Standards. But it added back $19.5-million in stock options expenses, along with
other items, to get to $93-million in “adjusted net income.”
Restructuring or other “non-recurring” expenses: Companies argue that severance

payments and other costs associated with buying another firm are one-time in nature, so
they leave them out of quarterly earnings – but then, the next quarter, they announce
another acquisition, and another batch of one-time charges appears, only to be excluded
again. BCE Inc. has adjusted for “severance, acquisition and other costs” each year for the
past five years.
“One of the more common justifications for many earnings adjustments is that they are
‘non-cash expenses’ and therefore should be excluded,” Mr. Scilipoti wrote in the Veritas
report. “This line of reasoning falls down for two reasons: One, earnings are not a cash
metric and are not supposed to be. Two, investors interested in cash generation can and
should look at the cash flow statement.”
Adjusting for items that are non-cash “simply produces earnings metrics that management
has created without giving investors a clear picture of either earnings or cash flow,” he
writes. In other words, these adjusted profit figures are sometimes designed to confuse or
obfuscate, instead of clarify matters.
Further reading:
How five companies are
playing the numbers game
Some institutional investors are so unimpressed with the accounting games that they
simply ignore profitability measures that are being promoted by management. Take one of
the most widely used non-GAAP measures, EBITDA, which stands for earnings before
interest, taxes, depreciation and amortization. “It is shocking to me how many companies
in heavy capital-expenditure-required industries are touting EBITDA. For them, depreciation
is a real expense,” says Barry Schwartz, chief investment officer at Baskin Wealth
Management in Toronto. “We generally skip the income statement” and focus on how
much cash flow the company is producing – since that’s harder to manipulate than
earnings disclosures.
'It's gotten out of control': How accounting games are boosting the bottom lines of TSX stocks… Page 10 of 19
One of the poster children for non-GAAP earnings – although surely the rest of the
S&P/TSX 60 will dislike the comparison – is Valeant Pharmaceuticals International Inc., a
company that Veritas put in its crosshairs several years ago.
The Laval, Que.-based company had an explicit business model of shunning research and
development costs, instead buying other companies or specific drugs that it thought it
could make more profitable from cost-cutting or price increases. However, in its earnings
report, Valeant removed the cost of amortizing the assets it had acquired, saying these
“non-cash” expenses didn’t reflect the company’s earnings power.
This made it nearly impossible to compare Valeant’s earnings figures to those reported by
other pharmaceutical companies that included research and development costs every
quarter. And it had the effect of allowing Valeant’s preferred earnings measure to balloon,
even as it posted losses. Investors bought into the growth story and Valeant briefly became
the largest company on the Toronto Stock Exchange – until its share prices collapsed
under the weight of questions about its sales practices and accounting. It’s now under
investigation by the U.S. Securities and Exchange Commission and the U.S. Department of
Justice (and the company has acknowledged it had a “tone at the top” problem with its
now-departed management).
Further reading:
How BlackBerry turned a
$670-million loss into break-
even performance
The widespread use of these adjustments, however, suggests a belief among management
that standard accounting rules – International Financial Reporting Standards for most
Canadian public companies, U.S. GAAP for others – are not flexible enough to completely
reflect how a company is actually performing.
“We believe that GAAP, and having a set of standards that everyone has to follow as a
basis, is very important – it sets a level playing field,” says Susan Campbell, the chair of the
Committee on Corporate Reporting at Financial Executive International, a group for chief
financial officers and other finance professionals.
“However, there are many different industries, and many different things that can impact a
specific company or industry that is not captured within IFRS … so a non-GAAP measure
gives a company the ability to tell more of the business story of the specific entity,
something that explains its performance a little more clearly than just the strict GAAP
statements do.”
Regardless of the merits of the non-GAAP metrics, companies are supposed to make clear
to investors exactly what they’re doing – and in this, Veritas argues that many of Canada’s
largest public companies are falling short.
The most frequent problem, Veritas says, is that companies are failing to show how they
change their GAAP numbers to the non-GAAP ones: They’re supposed to provide a clear
reconciliation between the two. They’re also supposed to tip off investors the very first
time the non-GAAP number is used that there’s a place where they can find that
reconciliation. Veritas found 14 members of the S&P/TSX 60 with this potential issue.
A less frequent, but also problematic, issue is companies’ failure to name their non-GAAP
measure in a way that distinguishes it from a similar earnings metric. One company tagged
by Veritas for this problem is Pembina Pipeline Corp., which in its 2015 annual report
defined EBITDA as excluding not just interest, taxes, depreciation and amortization, but
also unrealized losses on derivatives. (A Pembina spokesman notes the company
abandoned the practice this year and says his company should not be used as an example
of this problem.)
Veritas has some recommendations for how Canadian regulators should deal with the
wave of new accounting measures being crafted, and some practices companies could
engage in to make them better. One may be counterintuitive: Veritas believes a company’s
auditors should not be responsible for reviewing any measures that don’t comply with
generally accepted accounting principles. When an auditor signs off on “adjusted net
income” that pumps up a company’s profitability, it “has the potential to create a false
sense of security,” Veritas writes. If the auditor reviews the metric, Veritas says, investors
may view the number as correct. Instead, the firm says, “adjustments proposed by
management should be carefully considered by investors.”
Further reading:
Investors need to stop blindly
accepting non-standard
financial metrics
Veritas also believes regulators should step in and explicitly prohibit companies from
playing certain games with the numbers – such as excluding stock-based compensation
expenses. Stock options and share units are just like salaries: a way of paying employees,
and a real cost of doing business. Also, says Veritas, companies that present a metric that
deviates from a standard definition, such as EBITDA, should have to refer to it as “adjusted”
so as to avoid investor confusion.
While regulators may react to the widespread use of non-GAAP earnings, the greater risk is
that investors will take the lead and react sharply to the broad use of non-GAAP metrics, as
they ultimately did with Valeant, which plunged 90 per cent from its all-time high.
“Last time we saw frequent, extensive use of non-GAAP measures was in the late 1990s,
and it was used to support high valuations for companies that were not generating
sufficient profits, or any profits at all, to support their valuations,” says Lynn Turner, who
was the chief accountant at the SEC in that period.
“At that point in time, the executives were saying the exact same thing as they’re saying
today, that ‘GAAP doesn’t really present our company as it should.’ We know how that
story ended: It had a very bad outcome. Investors lost something like $7-trillion [in stock
market capitalization] by the time the dot-com explosion ended and the corporate scandals
came to light. It’s a classic story of history repeating itself, and this time isn’t going to be
any different.”
(Return to the story)
The difference between non-GAAP and GAAP earnings metrics for S&P/TSX
60 members
The absolute percentage difference for each company between their non-GAAP and GAAP
earnings, calculated by Veritas. Veritas cautions that investors should not make any conclusions
about the individual companies based on this table. “Investors need to focus on the rationale for
adjustments made by each company and, if the rationale is legitimate, than the scale is
irrelevant,” it says.
! Report Typo/Error
Next story | Learn More
Trial of accused in Surrey Six slayings delayed more than a decade

FRIDAY, SEP. 23, 2016, 9:29PM EDT
Canada advances to World Cup of Hockey final after

beating Russian rivals
SATURDAY, SEP. 24, 2016, 10:02PM EDT
How data journalists missed the truth about Trump

SATURDAY, SEP. 24, 2016, 8:00AM EDT
•
•
•
• connect with us
•
•
•
Products
The Globe and Mail Newspaper
Newspaper delivered to your doorstep. Subscribe to the newspaper
Globe Unlimited
Digital all access pass across devices. Subscribe to Globe Unlimited
Globe2Go
The digital replica of our newspaper. Subscribe to Globe2Go
Globe Email Newsletters
Get top Globe stories sent to your inbox. Subscribe to email newsletters
Globe eBooks
A collection of articles by the Globe. View the library
Advertise with us
GlobeLink.ca
Your number one partner for reaching Canada's Influential Achievers.
• Or go directly to:
• Newspaper
• Magazine
• Digital
• Globe Alliance: extend your reach
• Globe Edge: custom content
• Classifieds
The Globe at your Workplace
Globe Corporate Sales
Globe Unlimited digital edition and Globe2Go e-paper group discounts available. Learn more
Corporate financial data and content licensing for your organization. Learn more
• Or go directly to:
• Report On Business Top 1000
• DataStore essential business intelligence
Our Company
• About us
• Work at The Globe
• Staff
Secure Services
• Secure Drop
• Staff PGP Directory

The Numbers Game: David Milstead

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Numbers Game: David Milstead

Uploaded by

Copyright:

Available Formats

'It's gotten out of control': How accounting games are boosting the bottom lines of TSX stocks -… Page 2 of 19

THE NUMBERS GAME

In an attempt to burnish their image with investors and

Firms that include non-GAAP net income in their regulatory filings

In 2004, just a handful of companies in the S&P/TSX 60 used non-GAAP measures

In the meantime, investors must navigate an ocean of conflicting and contradictory

Restructuring or other “non-recurring” expenses: Companies argue that severance

(Return to the story)

Next story | Learn More

Trial of accused in Surrey Six slayings delayed more than a decade

Canada advances to World Cup of Hockey final after

How data journalists missed the truth about Trump

The Globe and Mail Newspaper

Newspaper delivered to your doorstep. Subscribe to the newspaper

Digital all access pass across devices. Subscribe to Globe Unlimited

The digital replica of our newspaper. Subscribe to Globe2Go

Globe Email Newsletters

A collection of articles by the Globe. View the library

Your number one partner for reaching Canada's Influential Achievers.

The Globe at your Workplace

Globe Corporate Sales

You might also like