Warren Buffett invests in Canada, but should you?, asks a recent New York Times column
Here’s how it starts off:
- 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 over all.
- Al Rosen takes a different view. A veteran forensic accountant and independent equity analyst who predicted the collapse of Nortel Networks, the Canadian telecom company, two years before its 2009 demise, Mr. Rosen has a message for people investing in Canadian stocks: be wary.
- It is a mystery to Mr. Rosen why Mr. Buffett bought into Home Capital Group, 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, Mr. Buffett expects to make money on his deal. But in an interview, Mr. Rosen said he thought there was more to the story than the markets yet know.
- Mr. Rosen is certain of this: International accounting rules followed by Canadian companies since 2011 are putting investors in Canadian stocks — not just Home Capital Group’s — at peril. Canada’s rules, which are substantially different from the generally accepted accounting principles (G.A.A.P.) governing American companies, give much more leeway to corporate managers when it comes to valuing assets and recording cash flows….
And from there on, those of us familiar with the Rosen perspective on IFRS will have little difficulty in anticipating the rest of the article – it reads pretty much as if the author, the usually interesting Gretchen Morgenson, was off for the week and just gave him the keys to her office. I wrote about Rosen not long ago and there’s no point rehashing any of that material, so I’ll just restate my admiration for his persistent success in attaining visibility, and in using that to stimulating deeper engagement with the limitations and complexities of financial reporting than readers might otherwise have exercised. The article does require some commentary on its own terms though. Note above the vague segue from Home Capital into IFRS, certainly seeming to imply that the problems afflicting that company are at least to some degree attributable to the nature of its financial reporting. As far as I’m aware, that’s an extreme minority view, if it even exists at all, and so seems like a bumpy start to the article at best.
From there on, most of what’s in the article seems – again, at best – overly summarized. For example:
- (IFRS is) designed to “bring transparency, accountability and efficiency to financial markets,” the I.F.R.S. Foundation says in a mission statement on its website.
- But that’s not the outcome, Mr. Rosen said. In practice, the rules allow company executives to inflate their revenues and hide excessive acquisition costs. They also let managers overstate assets and understate liabilities, he said.
- Not all managers will do so, of course. But Mr. Rosen’s forensic accounting work has taught him that “for every honest manager, there’s a cheat waiting to pounce.”
This essentially says – and the article’s overall tenor, even its very existence, doesn’t contradict this impression – that something like half the entities reporting under IFRS will be afflicted by the problems summarized there. Such a broad, damaging assertion should surely require some statistical or other support, but of course none is provided. Instead, a spokesperson for the IFRS Foundation is quoted as follows:
- “The success of accounting standards depends on companies applying them properly and exercising sound judgment,” she said in an emailed statement. “Both U.S. G.A.A.P. and I.F.R.S. are high-quality standards, and one is not more prone to abuse than the other.”
But of course, in the context of what surrounds it, this will strike many readers as defensive stonewalling. The article goes on to highlight other “problems,” such as:
- Because the international standards instead focus on current value accounting, executives have much more freedom to assign value to assets that may or may not be real.
- Mr. Rosen presents a hypothetical example in his book. Say a company owns a building that may sell for $10 million. But based on medium-term contracts, the company’s managers assess the building’s current value at $18 million. In Canada, the managers can use the higher figure in the company’s financial statements.
Well of course the $18 million may “not be real” (if we take it that nothing is completely real until it’s realized in cash or financial assets), but then in what sense is the $10 million more real (if it’s merely another amount for which the building “may sell”)? In what sense would the building’s depreciated cost amount (presumably less than the $10 million?) be more real? Again, such a summarized example hardly allows even a hint of the issues attaching to selecting reliable and relevant measurement models.
The article’s most interesting portion perhaps relates to Sears Canada. The company filed for bankruptcy on June 22 of this year, less than two months after issuing its audited financial statements:
- 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 bankrupt.
- “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?” Mr. Rosen asked. “That’s the scary situation with Sears, and we’re just seeing it more and more on other cases coming forward.”
It’s true that the auditors issued an unqualified opinion on the statements, and that the statements asserted that “the Company expects to end with a positive cash balance and continue as a going concern for 12 months from the issuance of the Fiscal 2016 financial statements.” At the same time though, the first page of the notes contains some 900 words on why this constituted a significant judgment and on the challenges and risks applying to that judgment; this, of course, is an inherent aspect of the basis on which Sears Canada’s financial position was judged to be fairly presented. I’m not saying the case may not warrant some reflection; only that the nature of the “scary situation” seems to require further clarification (not least because the same basic fact pattern doesn’t seem to be unthinkable under US GAAP). Among other things, it may illustrate the danger of placing too much weight on going concern uncertainty disclosure or its absence as providing some generalized stamp of relative health, as I’ve addressed before.
So should you invest in Canada? Well, there are always plenty of reasons not to do anything. Rosen concludes by saying that Canadian financial reporting is currently in a state of “the calm before the storm.” But even he would surely concede that he’s been predicting the storm for a long time. I don’t doubt it’ll arrive eventually, in one form or another. But will it be such a hurricane that it will justify years of never having ventured outside…?
The opinions expressed are solely those of the author