Effective 1 January 2011, the International Financial Reporting Standards (IFRS) became mandatory for Canadian public companies. Proponents of IFRS adoption argued that it would enhance global comparability of financial statements. The authors of Swindlers: Cons & Cheats and How to Protect Your Investments from Them argue, on the contrary, that “differences in laws, regulations, taxes, cultures, education, ethics, training, traditions, enforcement, and optimism make uniformity an opium dream.”
Al Rosen, professor emeritus of accounting at York University, and his son, Mark Rosen, CFA, a partner at Accountability Research Corporation, further claim that IFRS will not even ensure comparability among Canadian companies. Certain provisions are overpermissive, they say, meaning that some companies will take liberties that overstate their profits and balance sheet strength relative to their peers. One example of the wide discretion afforded by IFRS is allowing assets to be reported on the basis of historical cost, fair value, or something in between.
Although the authors acknowledge that IFRS represents an improvement in accounting quality for some countries, Canada has taken a step backward in their judgment. Reviewing files from their forensic accounting practice, they find that in cases in which their plaintiff clients received financial settlements, convictions or settlements would have been either impossible or highly unlikely if IFRS had been in force.
None of this is to suggest that the previous Canadian accounting standards protected investors particularly well. One weakness widely exploited by issuers of financial statements involved minimal requirements for reporting related-party transactions. Unscrupulous executives perfected such abuses as arranging for private companies they owned to buy goods and resell them to the public corporations they managed “at cost.” The so-called cost included overhead charges that consisted largely of salaries for the executives and their relatives. The IFRS rules for related-party transactions are even looser than Canada’s old rules.
The authors list several institutional factors that underlie Canadian investors’ heavy exposure to financial reporting manipulation. For one thing, Canada has no national securities regulator, unlike the United States, which created the Securities and Exchange Commission in 1934. Canada has begun moving toward setting up a national regulator but has put in charge of the project a former provincial regulator who argued against the need for national regulation until shortly before his appointment.
Second, the Supreme Court of Canada ruled in 1997 that the purpose of audited financial statements does not include helping investors make informed stock purchase decisions. Rather, the justices decided that financial statements are intended only to enable existing shareholders to evaluate management’s performance. The Supreme Court thereby determined that auditors have no duty of care to prospective new investors. This ruling encouraged auditors to cater to corporations, which hope to inflate their share prices, with little fear of being sued by investors who relied on misleading financial statements in buying shares.
The authors catalog a number of outlandish flimflams perpetrated in an environment they see as inadequately policing financial disclosure. VisuaLABS, a company based in Calgary, Alberta, Canada, rose to a C$300 million market capitalization on the basis of technologies that included combining several plasma television screens to form a larger viewing surface. The prototype turned out to be one large screen that had been etched with a glass cutter to make it look as though it had been assembled from smaller screens.
Cross Pacific Pearls claimed to have a proprietary technique for growing pearls in mussels. When the mussels it had transported from the southern United States to California failed to produce a single pearl by the scheduled date, the company claimed that the bivalves had fallen asleep in the cold waters of a northern California lake and were hibernating. Eventually, it emerged that Cross Pacific had lent much of the proceeds of its debt and equity financing to two Panamanian companies that disappeared.
In addition to describing classic scams in such businesses as energy exploration, mining, and scrap yards, Swindlers details many telltale warning signs of financial reporting irregularities and deceptions. Particularly helpful is the discussion of cash flow, which some investors regard as inherently more reliable than net income. The authors show how companies can mislead readers of financial statements by netting items on the cash flow statement.
The authors also list a number of classic techniques for overstating revenues. One involves overcharging on shipments to a customer and then rebating the excess to the customer’s employees in the form of expensive dinners or sports excursions. Another gambit consists of booking essentially uncollectible fees for the renegotiation of loans to failing companies.
Because these ruses can be used anywhere in the world, Canadians are not alone in benefiting from reading Swindlers. In addition, with more than 100 countries now permitting or requiring the International Financial Reporting Standards, it behooves investors everywhere to know how the good intentions behind the new rules might be subverted. Al and Mark Rosen deliver the goods with clarity and surprisingly high entertainment value for a book on a subject commonly thought to be dull.