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Warren Buffett is investing in Canada, but you might want to read this before you follow his lead

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.

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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.

In addition, a 1997 decision by the Supreme Court of Canada has severely limited investors in suing company auditors for malpractice. Combined, these two factors generally make Canadian stocks a danger zone, Mr. Rosen said.

American investors often fail to recognize this, though, because they assume Canadian companies are abiding by American accounting standards. “I’ve been trying to alert investors in the U.S. to this,” Mr. Rosen said in an interview. “But there’s just that belief that Canada is following U.S. standards when it’s not.”

Mr. Rosen provides forensic accounting services and also works with his son Mark Rosen at the Accountability Research Corporation in Toronto. The two men recently published a book called “Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth.”

In Mr. Rosen’s view, the international accounting standards followed by Canadian companies allow managers to apply overly rosy assumptions to the financial figures they report to investors. For a while, these assumptions can propel stock prices — and executive bonuses — well beyond where they would be otherwise, he said.

Canadian accounting rules can also mask problems at a company. How else, Mr. Rosen asked, to explain the events leading up to the June 22 bankruptcy filing by Sears Canada? The company’s shares trade on both the Toronto Stock Exchange and the Nasdaq market in the United States.

Like many retailers, Sears Canada’s fiscal year ends in January. It compiled its 2016 annual financial statement in accordance with International Financial Reporting Standards, set by the International Accounting Standards Board, a group of experts from an array of countries.

Sears Canada’s numbers weren’t good. Both revenues and same-store sales had fallen, but it reported shareholders’ equity of 222 million Canadian dollars (about $171 million) and 1.24 billion Canadian dollars ($956 million) in total assets.

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.”

Canada is not alone in following the International Financial Reporting Standards, or I.F.R.S. Some 150 jurisdictions in Europe, Africa, Asia and elsewhere also use these rules. Many are underdeveloped nations whose previous accounting rules were none too stringent.

The international standards came about in 2002, when the European Union required adherence to them for all its listed companies beginning in 2005. The rules are 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.”

A spokeswoman for the I.F.R.S. Foundation, Kirstina Reitan, said its members disagree with Mr. Rosen’s take. “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.”

Still, the differences between the two standards can be significant. Consider, for example, the approach taken to recognizing revenue under the international standards.

Under these rules, companies can record revenues based on only a 50.001 percent probability of eventually collecting the money — something Mr. Rosen calls the “more-likely-than-not rule.” By contrast, under American guidelines, managers must have a reasonable assurance that they will generate the revenues before they can record them; companies generally interpret this as 70 percent to 80 percent certainty, he said.

Valuing assets is another problem with international standards, Mr. Rosen said. Under the generally accepted accounting principles used in Canada before 2011, a company would have to complete the sale of a property or building before recording the results of the transaction for financial reporting purposes.

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.

What can these differences mean to a particular company? In “Easy Prey Investors,” Mr. Rosen presents a side-by-side example of one public company’s 2011 financial results based on the previously applicable generally accepted accounting principles and the new international standards. The company, which owned rental properties, showed a $4 million loss under G.A.A.P. and an $82 million profit under the international standards.

“Many Canadian-traded stocks are trying to appear more financially adequate by utilizing the massive holes in I.F.R.S.,” Mr. Rosen wrote in his book. He calls financial reporting in Canada right now “the calm before the storm.”

The Toronto Stock Exchange index is up 6 percent over the past 52 weeks. Although that pales next to the Standard & Poor’s 500 return, it is nonetheless respectable.

Seems as good a time as any to heed a warning from an experienced investigator like Mr. Rosen.

Source: Investment Cnbc
Warren Buffett is investing in Canada, but you might want to read this before you follow his lead

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