Dr. Al Rosen, Ph.D., FCA, FCMA, CPA (USA), CFE, FHKSA, CIP, CA.IFA is the current chairman of the Canadian Justice Review Board.

Dr. Al Rosen is one of Canada's leading forensic accountants who has given expert accounting testimony in Canada's highest courts; is a fellow of the Chartered Accountants of Ontario and Alberta, a certified fraud examiner, and a specialist in investigative and forensic accounting. For 15 years he served as a technical advisor to three Auditors' General of Canada.

Dr. Rosen has taught accounting at universities across North America. He graduated from the University of British Columbia in 1957 and later earned his M.B.A. degree from the University of Washington. In 1966, he obtained his Ph.D. from the University of Washington. He founded Rosen & Associates Ltd. in 1990

LIE DETECTOR
If you base your investing decisions on what a company tells you, Al Rosen has bad news for you. Companies distort the truth. A lot

by David Berman

If you think accounting is incapable of generating passion, you haven't met Al Rosen. As he sits in his Toronto office, near a poster that reads, "Only an accountant could catch Al Capone," the 66-year-old with the hangdog face is outraged. He punctuates his sentences with words like "fraud," "rubbish" and "scum."

The source of his irritation? Financial statements that turn the stock market into a rigged game.
Rosen is Canada's best-known forensic accountant, a specialist in looking behind the official numbers on balance sheets and income statements to find out what companies are really doing. The way he sees it, an astonishing number of publicly traded companies are cooking the books, usually with the full knowledge and backing of senior management. Lost in a swamp of misinformation, investors have no compass to point them toward truth. All their traditional sources of information are suspect: auditors are ill-trained dupes who can't keep up with the cheats, financial analysts ignore even the most blatant problems, while journalists specialize in delivering misinformation to your doorstep. "You can churn out all sorts of rubbish in quarterly and annual reports," Rosen says.

"And guess what the newspapers do with their databases? They take this crap, they do all this analysis, and they're playing with bogus numbers."

In case you're wondering, Rosen is not a crackpot. He's a professor emeritus at York University's Schulich School of Business, where he teaches forensic accounting. He's also widely known and well-regarded among Canada's top tier of money managers and investment professionals. "I am impressed with him," says Bill Wheeler, president of Leith Wheeler Investment Counsel Ltd., a highly regarded money-management firm inVancouver. "He's made us more attuned to the problems out there."

Rosen's views on accounting reflect a growing sense of concern among accounting and investment professionals, who worry that financial statements are turning more and more into works of fiction. What's at stake in this seemingly academic debate over accounting standards is nothing less than the credibility of the entire corporate world. The outcome affects everyone from multibillion-dollar pension funds to small investors like you and me. After all, if you can't trust a company's financial numbers, how can you hope to choose stocks wisely? If most companies are playing games to artificially boost their earnings, will our capital markets eventually crash and burn, taking your money along with them?

Rosen thinks the bad guys are winning. Consider, for instance, the huge number of companies that now billboard their "pro forma earnings" or "operating earnings" in news releases and other public communications. These pro forma figures aren't like standard net earnings figures because they aren't governed by any accounting standards laid down by a professional body. Instead, they're figures that the company generates internally, based upon whatever assumptions it wants to make.

Pro forma earnings confuse unwary investors. For instance, JDS Uniphase initially reported a $67.4 million (U.S.) pro forma profit for the year ending June 30, 2001. That was a solid-sounding result and probably reassured many shareholders. What those investors may have missed is that the company's actual earnings, based upon the standards laid down by the accounting profession, was a gigantic $50.6-billion (U.S.) loss. By using its own accounting assumptions, JDS could airbrush out one of the largest losses in corporate history and turn it into a respectable profit.

One common practice is to exclude certain costs that the company has incurred in the past year, such as layoffs or inventory write-offs, on the grounds that these are one-time events and won't be repeated. By ignoring these supposedly temporary setbacks, management can inflate earnings. Conversely, if it's to the benefit of the bottom line, management might decide to jump the other way and include certain one-time gains from the sale of land or other investments, on the basis that these windfall profits give a truer sense of a company's potential. Either way, the pro forma earnings may not reflect the company's real level of success. "Financial statements are as trustworthy as the people behind them," says Wheeler, the Vancouver money manager. "Management has a lot of room to move these numbers around."

And they do. According to the Wall Street Journal, about 300 of the 500 companies in the S&P 500 are in the habit of reporting some form of operating or pro forma earnings. No wonder many investors are confused by what's real and what's not.

Consider Nortel Networks Corp., whose plunging stock sideswiped countless portfolios over the past year. In Rosen's eyes, Nortel is a poster child for what's wrong with the state of corporate financial reporting. While the company may still be on the leading edge of optical networking technology, much of its earnings growth over the past few years has turned out to be nothing but accounting legerdemain. In making its pro forma announcements, it conveniently ignored many of the costs associated with its numerous billion-dollar acquisitions. Also, it omitted making any deduction for the truly enormous cost of its generous stock option plan. "Nortel invented its own accounting," says Rosen.

The sad part? The company didn't break any rules. "In Canada, you don't have to call employee remunerations an expense if they are paid through options," says Rosen. And that raises the whole issue of cross-border accounting. Generally Accepted Accounting Principles (GAAP) in Canada ­ that is, the rules Canadian accountants must follow ­ can be very different from those in the U.S. If a multinational company has to comply with the rules of both countries, you can sometimes see startlingly different results.

Rosen cites BCE Inc., the Montreal-based telecommunications and media giant, as an example. Last year, BCE reported a profit of more than $7 a share under Canadian GAAP, mostly because the company was allowed to take the gains it made from selling investments and report them as earnings. Under U.S. GAAP, however, the company couldn't book its investment gains as earnings, so it was forced to report a small loss. Result: the same set of facts produced vastly different sets of results on either side of the border, depending upon the accounting system used.

While Rosen isn't accusing BCE of anything underhanded, he believes that Canadian GAAP does leave the door open to con artists. He calls the accounting rules in this country "a built-in Ponzi fraud," and says, "the American version at least fully recognizes that there are a bunch of scum in the world, and makes it harder for the scum to operate."

In Rosen's experience, it's common for companies to tailor financial statements to different audiences. One financial statement, aimed at prospective lenders, might show a big profit. A second statement, issued by the same company, might show only a small profit ­ that's for the government and it is designed to reduce the company's taxes. A third statement might show a loss. That's for the spouse the CEO is divorcing. "Same company, same period of time, but different purpose," says Rosen.

Perhaps the greatest motivation for creative accounting is pressure from the investment community, which demands good numbers each and every quarter. Executives know they must meet or exceed their earnings targets to keep their shares moving upward. If management misses its targets, share prices can plummet and so can careers.

Intelligent executives quickly get the message. "If a manager has the ability to influence the results and he's within a hair's breadth of the thresholds, it's very tempting to look for some way to get the numbers over the threshold," says Nick Hodson, a forensic accountant at Ernst & Young in Toronto.

In theory, financial analysts are another line of defence, but investors have been badly burned over the past two years by members of that profession. Some famous Wall Street analysts, like Henry Blodget and Mary Meeker ­ the so called "dot-com gurus" ­ were only too happy to tout the prospects of tech companies, even when financial statements looked anything but promising. They led investors willy-nilly into some of the most ill-considered share purchases in history.

Many other analysts, covering every sector in the economy, seem equally unreliable. Look at the Bre-X mining scandal, which unfolded with no warning from the analyst community, or the recent implosion at Enron Corp., the giant energy company, which took everyone by surprise. "The [accounting] abuses are outrageous and the analysts accept them hook, line and sinker," says David Dreman, chairman of Dreman Value Management in Jersey City, N.J. A Canadian by birth, Dreman is a Forbes magazine columnist, author and money manager who shares Rosen's blunt skepticism. "You'd think that after costing investors a few trillion dollars, analysts might start doing some real work and distinguishing earnings from phantom earnings," he says. "But nothing has changed."

Rosen suggests that any active investor should learn how to read financial statements. If you don't have time to develop this skill, stick to investing in a respectable mutual fund. His most useful advice is simply this: be skeptical. Don't take financial statements at their word.

Heed his advice, and you'll be miles ahead of other investors. "We interviewed a bunch of lenders a few weeks ago who had lost money," he says, "and their standard comment was, 'Well, I relied on the financial statements'. What are they thinking?"