Advisor: Don’t trust financial reports

Every once in a while I come across an item important enough to pass on to CARP members and readers. This time it appeared in the form of a contribution by Tom Slee to Gordon Pape’s Internet Wealth Builder in July.

The Wealth Builder is a weekly Internet newsletter written by Pape and distributed to paid subscribers.

Slee’s message confirms what we have written before but goes even further: Investors can no longer trust financial reports from either accounting firms or securities analysts. Conflicts of interest have become too great, argues Slee, a regular writer for the letter. As both a chartered financial analyst (CFA) and an accountant (CGA), he knows the subject well.

Deceptive practice
He focuses on the high-tech companies whose operations – and stock prices – came crashing to earth recently, pointing to the deceptive practice of leaving stock options out of the equations on their balance sheets. As well, he deplores the complicity of both auditors and analysts.

Companies grant options to key employees and executives to top up their cash salaries and motivate them to increase profits and stock prices. Options allow holders acquire shares in the company at a predetermined price during a fixed future period.

This way, companies get talented help without necessarily making a huge monetary commitment upfront and employees get a chance at greater compensation in the future should the company be successful.

But Tom Slee’s point is that outstanding options have a real impact on a company’s bottom line. In short, by not reporting the cost of options to shareholders (there is an industry-accepted method of making such a calculation), a company’s profits can look a whole lot better than they really are.

Acting for business
“A lot of the numbers we were fed last year were downright wrong,” he says. Companies misrepresented their profitability and financial health, auditors certified these deceptive numbers, and analysts used them in reports to investors. All involved acted for the good of their own businesses, rather than that of the general investing public.

The situation is becoming intolerable. This is the second time this year I have felt the need to bring such troubling conflicts of interest to your attention. My June column dealt with the many professionals in the securities business who conveniently ignored the warning signals regarding Nortel.

Conflicts of interest
It’s not enough to tell the investing public to protect themselves by being informed investors (as regulators and commentators on the industry do persistently). Aside from news, rumours and hype, a company’s financial statements are essentially all we investors have to go on.

We look to the auditor’s signature on a company’s financial report and analysts’ interpretations to help us. But as they now stand, conflicts of interest between companies, brokerage firms and auditors leave us high and dry.

Such conflicts arise, for example:

  • When an auditing firm is also being paid as a management consultant to the same firm.
  • When the securities analysts of a brokerage firm help their investment banking departments win stock underwriting deals by participating in road shows to drum up investor interest
  • When they also initiate research coverage in prospective banking clients.

These practices were reported as being “widespread” by the U.S. Securities and Exchange Commission (SEC) in August of this year.

What can we do?
First, change will come only if we let the people in charge know that we know. Tom Slee urges us to inform our brokers about our displeasure.

Go further-to the top brass at your brokerage firm. Also, contact securities regulators in your province.

Second, “Take all earnings reports with a grain of salt,” Slee says.

Do the published figures make sense? Remember that the overall direction of a company’s results is more important than the actual numbers.

“Above all,” he urges, “be skeptical about results from new-economy companies over the next year or so”-no matter who certifies or reports on them.