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Late last year, Artis Real Estate Investment Trust told its investors it had made an accounting mistake and announced it would correct its financials – a "restatement" – saying it had understated its profits by a factor of three.

Earlier in 2016, Northview Apartment Real Estate Investment Trust said it would restate its financials for the third time in less than five years. Two of the errors related to the accounting for its financing costs.

However, when it came time to tell investors whether there were any weaknesses in their "internal controls" – the systems that are supposed to help produce robust, accurate financial statements and prevent such accounting errors – the companies said no, there were no weaknesses to report.

These two companies are more the norm than the exception, according to a new study by Robert Pozen, a senior lecturer at Massachusetts Institute of Technology's Sloan School of Management, and Olga Usvyatsky, vice-president of research at Audit Analytics. They found 78 restatements between 2009 and 2016 among Canadian-listed companies with a market capitalization above $75-million. Of those 78 companies, only 18 disclosed a material weakness in its internal controls.

To narrow the field to the most significant restatements, and whether companies disclosed a controls weakness in those cases, Dr. Pozen and Audit Analytics judged whether they were material, which very simply defined means they were significant enough that an investor or user of the financial statements would consider them important in evaluating the company's performance. Out of the 78 restatements, they found 43 material. Of those 43, 14 led to a disclosure of internal controls weakness – but 29 did not.

Serious questions

"That suggests management isn't focused enough on these internal controls issues and the obligation to disclose to the public they had a problem they've fixed, or they have a problem they're going to fix," says Dr. Pozen, who has also worked at the U.S. Securities and Exchange Commission, served as an executive at mutual-fund companies including Fidelity Investments, and served on the board of BCE Inc. prior to its failed 2008 buyout by a group including Ontario Teachers' Pension Plan.

"There are serious questions about whether there are enough disclosures for investors, and in the end, that's the critical issue: Investors should be concerned if there's an internal controls problem that hasn't been fixed, or if they say it's been fixed, and you get a second or third restatement," Dr. Pozen says.

The disclosure bar is lower in Canada than in the United States because of a conscious choice made by regulators and capital-markets players over a decade ago. In the U.S., the Sarbanes-Oxley Act, passed in the wake of the Enron Corp. and WorldCom Inc. collapses, required a company's outside auditors to "attest" to the strength of the company's internal controls and place that attestation in a distinct place in financial reports. All companies above $75-million (U.S.) in market capitalization are subject to the rules.

Canada, which did not see the scope of accounting scandals the United States did, opted not to make companies bring in their auditors to that discussion, allowing management to make its own decision about whether controls were weak. The disclosure occurs in the management discussion and analysis, in a location at the company's discretion.

"The consensus view was that management should attest, and requiring the auditor to attest on internal controls was an unjustified imposition of cost," says Ed Waitzer, a partner at Stikeman Elliott LLP and former chair of the Ontario Securities Commission.

Management's judgment

Canadian securities laws do say any public company with a material weakness in its internal controls is required to publicly disclose the nature of the weakness, its impact on the company and its plan for remediation, Dr. Pozen says. And yet, a 2010 Staff Notice from the Canadian Securities Administrators noted that after discussions with companies that had done restatements in 2009, "we concluded that issuers did not always consider if the misstatement in the financial statements related to a material weakness in the issuer's [internal controls]."

"I don't think we've seen the improvement they called for," Dr. Pozen says. "I think if you don't have an external check, it takes away some of the discipline of the process. Management can make its own judgment, and there's really no external review to say whether that judgment is reasonable."

Shivaram Rajgopal, a professor of accounting and auditing at Columbia University in New York, says having an auditor involved in the attestation process could potentially identify companies at risk of a restatement before the restatement occurred. "And [it] would have helped the shareholders who bought stock between such identification and the actual restatement," he says.

Dr. Pozen says a restatement, "next to fraud, is the biggest indicator of a material weakness in internal controls." Yet it is not definitive proof. Indeed, Dushyant Vyas, an assistant professor in accounting at the University of Toronto Mississauga, says that a company can respond to changes in the interpretations of an accounting rule, or simply disagree with its outside auditor. "While restatements in general and material/multiple restatements in particular raise a red flag that an internal controls weakness may exist, they do not necessarily imply [the existence of] internal controls weakness."

In a number of cases in the study by Dr. Pozen and Audit Analytics, the companies may not be disclosing an internal controls weakness because they believe that the restatements or errors themselves, even though seemingly large, are not material.

After discovering an error in translating foreign currency, Artis reduced a loss of $25.97-million in the second quarter of 2016 to $4.01-million, a difference of nearly $22-million, or 85 per cent of the previous net loss. But Artis chief financial officer Jim Green says "we … discussed [this] with our external auditors and they agreed with our assessment that it would not represent a control weakness and would not be material to a reader of the financial statements."

Mr. Green says the restatement had no impact on the balance sheet, cash flow statement or on any of the non-GAAP measures commonly looked at for REITs such as funds from operations or various debt metrics. He also claims the absolute dollar amount of the change was immaterial when compared with the company's revenue, which was just under $135-million in the quarter.

That might be the most insight we get into what the companies are thinking. Starting in mid-June, The Globe and Mail contacted three other companies of interest in the study that did not disclose internal controls weaknesses, and was unable to get responses as to how they arrived at their conclusions.

New Flyer Industries, a Winnipeg bus maker, announced restatements or financial errors in May, 2011, March, 2013, and March, 2014, related to valuing a derivative, recognizing revenue from warranty contracts, and recording the value of tax benefits. In its securities filings, the company said none of the errors were material, although the correction of the tax issue reduced 2011 earnings per share from 98 cents to 81 cents.

Miner Orca Exploration announced a restatement in April, 2015, owing to an incorrect computation of Tanzania income tax that spanned roughly 10 years' worth of financial statements, as well as errors in finance costs and income in 2013 and 2014. Just for fiscal 2013, the company said a net loss of $5.47-million increased by $2.39-million, or by more than 40 per cent.

For more on Dr. Pozen's prescriptions, see the opinion piece here. However, it remains to be seen whether the internal controls issue will move up on the list of regulatory to-dos in the Canadian capital markets. (An Ontario Securities Commission spokeswoman says regulators keep an eye on the issue because companies' disclosures on internal controls weaknesses are part of the OSC's annual continuous disclosure review program.)

"Bob's basic thesis is right, which is you want to have more transparency around weaknesses in internal controls," Mr. Waitzer says. "But I'd be very surprised if this was viewed as a priority issue on the Canadian agenda right now, not because it's not important, but because it was debated extensively a decade ago and there are other issues that are perceived to be more important."


No weakness to report

In a study of 78 restatements between 2009 and 2016 among Canadian listed companies with a market capitalization above $75-million, Robert Pozen and the firm Audit Analytics found 29, shown here, where the restatement was, in their judgment, material, yet the company did not later disclose any weakness in  its internal controls, the systems designed to minimize the risk of financial statement errors.

NameRestatement DateRestatement Reason Original Income Restated Income Net Income Effect
Artis Real Estate Investment Trust11/3/2016|Comprehensive income issues| 8,617,000 30,577,000 21,960,000
Orca Exploration Group Inc. (formerly EastCoast Energy Corporation)4/17/2015|Accounts/loans receivable, investments & cash issues|Foreign currency/inflation |Tax expense/benefit/deferral/other (FAS 109) issues| (5,465,000) (7,640,000) (2,175,000)
Toscana Energy Income Corporation5/30/2014|Debt and/or equity classification issues|-2,479,562 - 2,479,562
Veresen Inc.5/8/2013|Investment in subs./affiliate issues| 38,900,000 43,600,000 4,700,000
Crombie Real Estate Investment Trust4/2/2013|Debt and/or equity classification issues| (23,068,000) (31,712,000) (8,644,000)
Uni-Sélect Inc.2/28/2013|Inventory, vendor and/or cost of sales issues| 55,980,000 53,323,000 (2,657,000)
Endeavour Mining Corporation3/13/2012|Acquisitions, mergers| 9,612,000 8,112,000.00 (1,500,000)
Northview Apartment Real Estate Investment Trust3/13/2012|Investment in subs./affiliate issues| (21,880,000) (23,948,000) (2,068,000)
Altus Group Limited1/23/2012|Liabilities, payables, reserves and accrual estimate failures|Tax expense/benefit/deferral/other (FAS 109) issues| (10,574,000) (12,250,000) (1,676,000)
Parkland Fuel Corporation11/2/2011|Tax expense/benefit/deferral/other (FAS 109) issues| 31,928,000 26,828,000 (5,100,000)
Freehold Royalties Ltd.8/10/2011|Tax expense/benefit/deferral/other (FAS 109) issues| 15,313,000 11,219,000 (5,099,999)
African Minerals Limited6/30/2011|Accounts/loans receivable, investments & cash issues|Balance sheet classification of assets issues|Capitalization of expenditures issues|Foreign currency/inflation |Debt and/or equity classification issues|Deferred, stock-based and/or executive comp issues|EPS, ratio and classification of income statement issues|PPE/Intangible assets, goodwill issues| (13,876,000) (2,727,000) 11,149,000
GMP Capital Inc.3/18/2011|EPS, ratio and classification of income statement issues| 40,279,000 32,716,000 (7,563,000)
Pacific Exploration & Production Corporation3/10/2011|Liabilities, payables, reserves and accrual estimate failures| (153,574,000) (125,793,000) 27,781,000
Hana Mining Ltd.2/25/2011|Acquisitions, mergers| (6,865,604) (7,734,151) (868,547)
Mercator Minerals Ltd.11/26/2010|Revenue recognition issues| 10,680,000 (75,882,000) (86,562,000)
China Gold International Resources Corp. Ltd.3/17/2010|Capitalization of expenditures issues|Inventory, vendor and/or cost of sales issues| (5,125,262) (2,214,561) 2,910,701
Martinrea International Inc.3/31/2014|Capitalization of expenditures issues|Inventory, vendor and/or cost of sales issues| 38,782,000 37,075,000 (1,707,000)
Aspen Group Resources Corporation4/1/2009|Expense (payroll, SGA, other) recording issues|Revenue recognition issues|Unspecified (amounts or accounts) restatement adjustments|
Northview Apartment Real Estate Investment Trust3/24/2016|Depreciation, depletion or amortization errors| 87,070,000 87,070,000 -
Northview Apartment Real Estate Investment Trust5/13/2014|Liabilities, payables, reserves and accrual estimate failures|
New Flyer Industries Inc.3/19/2014|Revenue recognition issues|
Superior Plus Corp.10/31/2013|Expense (payroll, SGA, other) recording issues|Liabilities, payables, reserves and accrual estimate failures|
New Flyer Industries Inc.3/20/2013|Tax expense/benefit/deferral/other (FAS 109) issues|
goeasy Ltd. (formerly, easyhome Ltd.)3/6/2012|Liabilities, payables, reserves and accrual estimate failures|
Parkland Fuel Corporation11/2/2011|Tax expense/benefit/deferral/other (FAS 109) issues|
Boston Pizza Royalties Income Fund5/11/2011|Depreciation, depletion or amortization errors|
E-L Financial Corporation Limited3/16/2011|Pension and other post-retirement benefit issues| (184,535,000) (184,908,000) (373,000)
ADF Group Inc.4/30/2010|Gain or loss recognition issues|PPE /fixed asset (value/diminution) issues|

Source: Robert Pozen and Audit Analytics

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