How Unaudited Financial Information Could Threaten Canadians' Savings
More than 85 per cent of the information disclosed by public companies and used by investors to decide where to put their money hasn't been independently audited, posing a risk to investments and retirement savings.
It's a practice that can mislead investors by letting companies overstate their earning potential and push their share prices higher. That sounds good — until the music stops and the stock price falls.
Company financial statements are externally audited using internationally approved practices. But many companies provide additional unaudited disclosures, according to institutional investors at a recent industry conference.
These disclosures regularly show more favourable results and trends, according to a global survey by the Chartered Financial Analyst (CFA) Institute of its 145,000 members in 2016.
And investors are placing their bets using that unaudited information.
The implosion in the price of Valeant Pharmaceuticals, from a high of $335.32 a share on July 31, 2015 in Toronto trading to a low of $11.20 a share in April, is a stark example of what can go wrong for investors.
At its peak, Valeant traded at a seemingly reasonable 22 times its "adjusted earnings" per share, in line with the overall S&P 500 market multiple of 24 times.
But this market measure is based on generally accepted accounting principles (GAAP) earnings for the companies in the S&P500 Index. On that same basis, Valeant was actually trading at an astonishing 440 times earnings.
According to Richard Talbot, former director of research for RBC Capital Markets and board member of the CFA Institute of Toronto (the second largest chapter in the world), to make non-GAAP information effective, consistent definitions and standards need to be applied:
"The first two are a must," he said. "The third would be a nice-to-have."
Securities regulators and auditors are on the case, actively seeking and including the voice of the investor in deciding how to address the risk.
The Canadian Securities Association (CSA) in Canada issued guidelines in early 2016 to companies on how to report financial non-GAAP measures, designed to make them reliable for investors.
However, they remain only suggestions for now, rather than rules.
The CSA has been monitoring the track record of companies' compliance with these guidelines, and the news isn't good.
At an industry panel earlier this year, a representative of the CSA said that more than 80 per cent of issuers were falling short in implementing these suggestions.
Given this track record of non-compliance, the CSA recently said that next April it will begin transforming the guidelines into regulations, with enforcement actions and penalties for non-compliance.
Auditors are also concerned about reliance on non-GAAP measures and the implication for the relevance of audits themselves. If investors are using primarily non-GAAP measures to make decisions, how relevant are independent audits of financial statements based on GAAP?
Regulators and auditors are building a case for company boards to retain (and pay) auditors to check the process around non-GAAP measures. Not everyone, however, is persuaded of the need for enhanced auditing.