by Tom Slee
How new accounting rules are distorting financial results and reshaping company policies.
Two years ago, surrounded by the ruins of Enron and WorldCom, legislators promised us a fresh start, a level playing field. There would be new accounting rules that guaranteed small investors simple, transparent financial statements. Companies were going to provide numbers we could understand and trust. It sounded almost too good to be true and of course it was. The sad truth is that those new accounting requirements, now making their appearance in the second-quarter results, are creating as many problems as they solved. Transparency? Forget about it.
Take EnCana's second-quarter earnings, for example. The company reported its results on July 27 and the following day investors were greeted by conflicting headlines. The National Post trumpeted, in part: "Losses Slash Q2 Profit 69%." Across town, The Globe and Mail hailed the numbers as a "very good quarter", with "Company Reports Strong Sales And Cash Flow". So which newspaper had it right? Well, they both did! The only difference was that the Post focused on the new reporting guidelines while the Globe highlighted traditional numbers that, in this case, provided a more accurate picture. We seem to have traded deception for confusion.
In fact, EnCana turned in some impressive results, which is what you would expect with energy prices going through the roof. Operating profit amounted to $379 million or 82c a share in the second quarter, up from $275 million in 2003. That's a hefty 38% improvement. (Note that EnCana reports its results in U.S. dollars.)
Thanks to the post-Enron accounting rules, however, the company had to make some adjustments so that shareholders were better informed. Foreign debt was restated to reflect present currency values and unrealized profits and losses on future sales contracts were booked even though these are just hypothetical numbers. There were also provisions for income tax and, when the dust finally settled, EnCana reported a profit of $250 million compared to $807 million last year when there was a huge foreign exchange gain.
We have seen similarly distorted second-quarter earnings elsewhere, particularly in the oil patch. Petro-Canada, Imperial Oil, and Nexen all reported down earnings in the midst of an energy boom. However, the stocks have continued to perform well, so it seems as though investors were able to cut through all those supposedly helpful adjustments and focus on the fundamentals. Incidentally, we now have so many accounting changes that Petro-Canada provides a reconciliation table along with its earnings releases.
The problem may get worse before it gets better. Both U.S. and Canadian regulators are trying to clean up their acts but, as always, there is very little coordination. The SEC has probably gone overboard by enforcing a slew of mandatory requirements, regardless of whether they are really useful. U.S.-listed companies have little leeway and must conform even if the results are confusing. For instance, analysts expect General Motors to make about $7 a share this year but a proposed new, arcane treatment for the company's contingent convertible bonds could slash this to $6.25 and disappoint investors even if the company's new sales incentive program is a success.
Canadian legislators, on the other hand, are opting for the honour system. Instead of issuing sheets of precise instructions, they have allowed companies a lot of discretion and that is causing problems as well. Managements can choose how to account for pension surpluses, start up costs, goodwill, and a host of other major items. That makes it extremely difficult to compare corporate numbers as, understandably, CEOs cherry-pick their options and come up with some surprising results. For instance, one analyst has calculated that, based on the new U.S. accounting rules, BCE, an inter-listed stock no less, overstated its income by $335 million in 2003. Who are you going to believe?
It's disturbing. After all, accounting rules are supposed to provide continuity and a basis for comparisons but these days, thanks to the well-intentioned regulators, we seem to be on shifting sands, at least for a while. So my suggestion is that we remain cool and apply some common sense when apparently extraordinary results come down the pipe. As in the case of EnCana, there may be a rational explanation. Analysts, and particularly the media, will gradually become accustomed to the new reporting. We may even see fewer discrepancies between U.S. and Canadian results, especially as the number of inter-listed stocks grows. It's a learning process and, let's face it, too much information is a whole lot better than the sparse, misleading reporting that some companies were serving up a few years ago.
The danger is that the new policies may force ill-advised changes in the way companies do business. In this regard, it's worth taking a closer look at EnCana's second-quarter earnings because they highlight a major problem created by the new accounting guidelines.
In effect, because the company was required to value its foreign debt at prevailing exchange rates and write off unrealized hedging losses, EnCana understated its second-quarter results by $129 million. (Financial results in U.S. dollars.) That was so disheartening that CEO Gwyn Morgan said he was "rethinking" his risk management program. I find that alarming. Now we have a major company perhaps basing policy on bookkeeping requirements. Talk about the tail wagging the dog!
This is the situation. In order to establish some stability and continuity, EnCana hedges up to 50% of its production in the current year and 25% in the second year. In other words, the company sells future oil and gas output at prearranged prices in order to guarantee cash flow. Without the hedging, management would have to keep selling into the volatile spot market and earnings would be all over the place. A forward selling program makes a lot of sense in the oil business and, as a matter of fact, EnCana's hedging policy is one of the reasons why I have liked the company. But with the new reporting requirements if, for example, the company sold oil forward at $34 a barrel, making a huge profit in the process, and the spot price jumps to $43 a barrel, there is a bookkeeping, almost fictitious, loss of $9 a barrel. That may seem absurd but the fact is that EnCana has been forced to book $508 million of hedging losses so far this year for conducting its business in a prudent manner. You can understand Gwyn Morgan's concern.
Bookkeeping aside, EnCana continues to make good progress. The acquisition of U.S. gas producer Tom Brown Inc., tighter cost controls, and $6 billion in projected capital spending are going to underwrite future earnings growth. My only concern is that the company may reduce its hedging operations and become exposed to a sharp correction in oil prices.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada's top money experts. For more information about becoming an Internet Wealth Builder member, Click Here