Life in Canada

Sino-Forest Corp. [TRE.TO]has been a high-flying stock on the Toronto Stock Exchange. But investors who have been around the TSX for a while probably aren't surprised by the accounting scandal surrounding the widely held company.

Al Rosen, a prominent forensic accountant in Toronto, certainly isn't.He believes new international accounting rules known as the International Financial Reporting Standards, which have been adopted in Canada, probably mean there will be more balance sheets blowing up on Canadian investors — not less.

This isn't to say that Sino-Forest Corp. is guilty of anything, says Rosen. It's simply too early to say that.

Here's what we think we know so far:

A recent report from analyst Carson Block of the Muddy Waters hedge fund alleged that Sino-Forest had overstated the value of its assets, including the ownership of vast tracts of forest, triggering a huge price drop in the shares in late May and early June.

And shareholders were hurt again earlier this week when American hedge fund manager Paulson & Co. dumped 34.7 million Sino-Forest shares, representing a 14-per-cent stake in the company.

While Sino-Forest may yet be vindicated, the Muddy Waters complaint had a familiar ring to many Canada investors, especially people who once owned companies like Nortel or Garth Drabinsky's Livent.

Essentially, Muddy Waters alleges Sino had incorrectly stated the value of some of its assets and may have dealt improperly with companies with which it had relationships. As a result this may have made the company look far more valuable than it was.

Companies that tend to inflate their assets and profits often utilize weak "revenue recognition rules," says Rosen. Such asset inflation is commonplace in Canada and may or may not have occurred in Sino-Forest's case.

Revenue inflation was in large part the case with Nortel, where the value of some of accounts receivable assets on its balance sheet were inappropriately interpreted as being cash equivalents (but some were never collected in cash). The trouble is, those are the same assets and revenues that equity analysts use to value a company.

And unfortunately for investors, who believed what the analysts were telling them, their shares usually become worthless when the true value is revealed.

Rosen says under the new IFRS rules (applicable in 2011) it will become even easier for executives to create phantom assets values and phoney profits.

"It's a major, major step backwards in Canada," says Rosen. "It's a wide open field for crooks because you don't have to report as much relevant information to shareholders."
And some of the issues raised by Muddy Waters clearly involve questions of ownership and the value of assets.

That doesn't come as news to Rosen, who points out that under IFRS rules management has tremendous freedom to set the of value assets. For example, a property company could value a building at its original purchase price, revalue it each quarter or establish a one-time value increase.

Three companies in Canada could have three values for the same building. But investors have no way of knowing what the accurate value really is. "You can put any damn figure you want on a balance sheet," says Rosen. "And they are all in accordance with the IFRS rules. It's just sheer stupidity."

It's interesting to note the U.S., where Wall Street triggered the international financial crisis when markets were blindsided by worthless derivatives, doesn't want anything to do with the new IFRS rules that have been embraced by Canada.

"The U.S. has looked at the IFRS rules," says Rosen, "and they call it a race to the bottom, and they look at Canadians and think we're the stupidest people on earth."

Still, in Canada, major accounting firms have supported IFRS - which was developed by the European Union. But Rosen says this is because it lowers their liability when company audits turn out to be profoundly wrong.

"It pushes the responsibility onto the board of directors," said Rosen. "And the federal and provincial regulators go along with it."

One of the problems investors now face under IFRS is a lack of clarity. In the past, says Rosen, he was able to go to court and explain to a judge that a clear accounting rule had been violated and could not be misinterpreted.

But under the IFRS rules, Rosen says regulations are much more open to interpretation and therefore abuse.

Oddly, particularly in light of the Wall Street-inspired financial crisis, Canada has always trailed the U.S. when it comes to forcing companies to be truthful in their audits.

"We've always lagged the U.S. in accounting standards," says Rosen. "And it's a double-barrelled lag. It's a lag in accounting, in what you have to do, and it's a lag in auditing in what you have to check. Essentially, you audit in Canada by asking management to sign a letter saying that the crooked information they put on the financial statement is OK."

And, unfortunately for Canadian investors, they may increasingly find they are left with very little when someone like the Muddy Waters hedge fund comes looking for the truth.