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Five steps to safeguard your savings from investment losses.

In recent years, we have seen numerous high-profile examples of how loose accounting rules can make easy prey of uninformed investors. Managers have proven adept at using accounting gimmicks to con investors into exchanging their hard-earned savings for investment losses. So how can you protect yourself from unscrupulous managers? You could stuff your money into a mattress, but that won't help you in the long run and it's not something we recommend. The only way to protect yourself is to be informed. To help you get started, we have outlined five steps you can take to detect misleading financial statements and provided some illustrated examples of accounting games to watch out for in 2005.

Step 1:

Before investing in any firm, force yourself to read completely the company's quarterly and annual financial statements, including all the notes and the management discussion and analysis. That may seem obvious, but discipline is required to work with financial statements, because the accounting terminology can seem foreign and the concepts confusing. However, the payoff will be worth it, because quite often the competence and integrity levels of management are on paper right in front of you.

Step 2:

Watch out for too-good-to-be-true situations. Look for inexplicable changes in numbers from quarter to quarter. Are most of the income statement figures moving in tandem, or is one item in particular contributing disproportionately to the results? So-called “breakout” numbers should have a clear catalyst behind them, such as increasing commodity prices. If the reason for improved results doesn't seem intuitive or even obvious in hindsight, it could be a sign that questionable accounting is taking place.

Step 3:

Be careful who you trust. It should go without saying that you have to dig deeper than the rah-rah press releases the companies themselves issue. As well, you cannot simply read a few brokerage reports and think your homework is done. Investment research is worth what you pay for it. The worst mistake is to base a decision on a few EPS or EBITDA numbers, which can be easily manipulated over a few quarters.

Step 4:

Watch for specific accounting games and poor financial statement disclosures. Some of the shenanigans we are likely to see in 2005 include the manipulation of income and EBITDA through: understated pension expenses; the juggling of tax asset valuation allowances; restructuring charges; lowball stock option expenses; delayed writedowns of goodwill, intangibles and long-lived assets; overstated revenues; hidden one-time gains; and expenses that are transferred to the balance sheet as assets. Some of these topics are covered below.

Step 5:

Look out for executive compensation schemes that base management performance bonuses on slippery accounting figures. For instance, companies that base their bonuses on proprietary and incomparable figures like distributable cash or EBITDA should be watched closely. As well, bonuses based solely on meeting short-term goals, or on singular accounting numbers, almost always spell trouble for long-term investors. Accounting standards are just too easy and tempting to manipulate in the hands of a manager who can determine his own bonus.

Although loose accounting rules can produce any number of games, only a few are needed to produce dramatically misleading financial statements. If investors catch the presence of two or three gimmicks in a single company, it's probably time to move on in search of more worthy investments.

We'll now outline some specific accounting tricks to watch for this year. The first shows how a company can change its reported EPS figures by deciding to revalue its so-called tax assets. The second trick illustrates how managers can influence the bottom line through their assumptions concerning the company pension plan. In both cases, the accounting and auditing rules in Canada leave the timing of these important decisions up to the whims of management. Remember: the vast majority of accounting games are fully audited in Canada.

Trick 1:

Manipulation of income tax assets. Most investors ignore the income tax note in the financial statements because some of the underlying accounting concepts are confusing. Investors also tend to overlook the income tax asset and liability entries on the balance sheet. However, instead of remaining in the dark, one would do well to understand the significance of these items, especially the impact they can have on reported EPS figures.

Many Canadian companies have subsidiaries in various countries, and some of these subsidiaries produce losses. Such losses can reduce taxable income (and thus income taxes) in future years. Whether and when these losses can be used has an impact on their value, because many of them eventually expire. The accounting rules governing tax assets give considerable freedom to management in establishing their reported value on the balance sheet. Likewise, management has the ability to change the value from quarter to quarter, directly impacting reported income.

The easiest way to detect tax asset shenanigans is to study the income tax note in the financial statements. We will use Gerdau Ameristeel Corp. (TSX: GNA) as an example. In its recent third-quarter 2004 report, the Toronto-based steel company reported US$154.1 million of income before tax, but only US$9.8 million in income tax expense. That's an effective tax rate of only 6.4%, which is the first red flag for investors. By going to the income tax note, investors can see a reconciliation between the company's reported tax expense of US$9.8 million and the US$54.7 million the company would have normally reported under Canadian statutory tax rates. The difference of US$44.9 million, which reduced the company's reported tax expense, is entirely attributable to an unusual entry called “purchase price valuation adjustment.”

When Gerdau SA of Brazil combined its North American operations with Co-Steel in October 2002 to form Gerdau Ameristeel, the subsidiary did not record any value for some of Co-Steel's tax assets, because under the loose accounting rules, management estimated it was likely that Gerdau would not be able to make use of the assets. In the third quarter of 2004, management changed its mind. The company eliminated the valuation allowance, and the balancing entry boosted reported income by US$45 million, or 20¢US per share.

Trick 2:

Underestimating pension plan expenses. Reported pension expenses are important because, unlike regular wages, the amounts are highly susceptible to management estimates. However, just like wages, pension expenses represent a critical cost of earning revenue. As well, pension expenses are included everywhere that wage expenses appear on the income statement. They can be buried in selling, general and administrative costs, and even the cost of goods sold.

The reason this is so troubling is that pension expenses can be severely underestimated and end up boosting reported EBITDA numbers. In fact, accounting rules permit pension expenses to be estimated at less than zero. In other words, management can even wipe out a portion of regular wage expenses by estimating that there should be a pension credit (instead of an expense).

In recent years, several Canadian companies have reported pension credits, thereby boosting reported profits. Many tricks have been used, including overstating the expected return on pension plan assets, understating liabilities and ignoring the impact of large pension plan deficits. In many cases, non-existent pension plan surpluses were pulled into profit at the same time that pension plan asset values were collapsing.

The pension plan note in a company's financial statements is a must-read for investors. For illustrative purposes, we have chosen Calgary-based Canadian Pacific Railway (TSX: CP). CP Rail reported a pension credit in 2002 and was thereby able to boost its income for the year. The calculation of pension expense is strange, to say the least, so hold on to your hats. A company will start by calculating the interest and service costs for the year, which were $387.1 million and $61.7 million, respectively, for CP in 2002. The company then subtracted what it thought it should have earned on its pension plan assets for the year, or $450 million. Even though the company actually lost $95.6 million on the plan, it is allowed to use a management estimate of what it might have earned. This estimate is calculated using management's 8% expected rate of return on plan assets, which happens to be on the high end for large companies. The company then also subtracted $15.6 million for the amortization of a transitional asset, which is nothing more than an arcane accounting adjustment that should be ignored by investors and added back to the pension expense. In the end, the result is a net income statement gain of $4.7 million. That's right–a gain where you would expect to see an employment expense.

Looking to 2003, we see more of the same. Although the company has now started to report a small expense of $9.2 million, it is easy to make a case that it is severely understated. If we simply lower the expected rate of return to 7.75%, to be more in line with other companies, ignore the transitional asset as permitted by the accounting rules and amortize the actuarial loss in line with the expected level for 2004, we can estimate the company's pension expense to be $73.5 million. Investors should take notice that all it took was a few reasonable changes in accounting assumptions to increase the company's estimated pension expense by nearly eightfold.

Unfortunately, the TSX is a place where you can be conned into exchanging your hard-earned savings for investment losses. Your only defence is to get educated about accounting games so you can detect misleading financial statements, hopefully before any damage is done.