Latest / How Canadian Markets Work / Episode 73: The Notes and the Auditor's Report (Where the Truth Lives)

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Episode 73: The Notes and the Auditor's Report (Where the Truth Lives) · How Canadian Markets Work

0:00
I mean, imagine you are walking into a beautifully
0:02
staged open house, like the lighting is absolutely
0:05
perfect, testing this warm, inviting glow over
0:08
everything. The furniture is modern, minimalist,
0:11
chic. It even smells like freshly baked cookies.
0:15
Oh, yeah, the classic cookie trick. It really
0:16
works, though. It totally works. You take one
0:19
look at this pristine living room and you think,
0:20
you know, this is it. This is the perfect place.
0:22
I'm ready to make an offer right now. Right,
0:24
because it feels incredibly safe. It feels like
0:27
a really solid investment. because everything
0:30
that is visible on the surface has been polished
0:34
to total perfection. I mean, the staging is doing
0:36
exactly what it was designed to do, right? It's
0:38
selling you on a feeling. Exactly. But hidden
0:42
away in a kitchen drawer somewhere, maybe under
0:45
a stack of old takeout menus, there is a 100
0:48
-page home inspector's report. And that report
0:51
tells a very different story. A much scarier
0:53
story. Oh, absolutely terrifying. It mentions
0:55
the termites eating through the load -bearing
0:57
walls. It details the severe crack in the foundation.
1:01
It even notes that the roof is basically guaranteed
1:03
to cave in after the next heavy rain. Well, the
1:06
catch, of course, is that most prospective buyers
1:09
are simply never going to open that drawer. No,
1:11
never. They're completely mesmerized by the staging
1:14
and the seller is banking on that. They are banking
1:16
on the sheer friction of reading a hundred page
1:19
technical document to keep all that bad news
1:21
safely out of sight. Right. And today we're opening
1:24
that drawer. we are looking at the corporate
1:26
equivalent of that cracked foundation. We're
1:28
talking about the back pages of financial reports.
1:31
And look, you don't need to be a CPA to read
1:33
them because today we're taking a deep dive into
1:36
Canadian market mechanics and financial reporting
1:38
standards to give you a shortcut. Yeah, a literal
1:42
five -word cheat code. Exactly, a cheat code
1:44
to extract the unvarnished truth from CEDAR plus
1:47
DUA, which is the National Electronic Filing
1:50
System. Our mission today is to prove to you
1:53
that the short financial statements everyone
1:56
obsesses over. Or just the opening act. Yes.
1:59
The real story lives in the dense notes that
2:01
almost nobody reads and in the auditor's report
2:04
sitting at the very back. You know, what really
2:06
stands out when you look at how these corporate
2:08
filings are structured is how the system manages
2:11
to be entirely transparent yet completely opaque
2:15
at the exact same time. Oh, totally. I mean,
2:18
the disclosure is right there. It is legally
2:20
available to anyone who pulls up the document
2:23
on Cedar Plus What It, but it is buried. It's
2:27
buried under a mountain of measured, highly technical
2:30
legal language. So let's unpack this illusion,
2:33
starting with those glossy front pages. When
2:36
you pull up a company's annual report, the actual
2:39
financial statements like the balance sheet,
2:41
the income statement, the cash flow statement,
2:43
they are maybe four pages long in total. barely
2:46
a skim. Right. You look at them, you see the
2:49
revenue numbers, you calculate a couple of quick
2:51
profit margins, and you genuinely feel like you
2:53
understand the business. But those four pages
2:56
are merely summaries. I mean, they give you the
2:58
final numbers, but they do not tell you what
3:00
those numbers actually mean. Which is the most
3:02
important part. Exactly. They don't explain the
3:05
underlying assumptions management made to produce
3:08
those numbers. And crucially, they do not tell
3:12
you what is missing from the page entirely. Wait,
3:14
hold on. How can something just be missing? Like,
3:17
if a company owes money or if there's this massive
3:20
threat to the business, doesn't that have to
3:22
be on the balance sheet as, you know, a giant
3:24
red number? You would think so. Right. Let's
3:26
say a company is facing a massive business ending
3:29
lawsuit. If they lose, the company is completely
3:33
bankrupt. Surely that shows up on the front page.
3:36
It often doesn't. And the wild part is that is
3:39
not concealment or fraud. That is simply how
3:42
the reporting rules work. Wait, really? Yeah.
3:45
The accounting standards, they hinge on probability.
3:48
So if an outflow of cash is like losing that
3:50
massive lawsuit, if that isn't considered probable
3:53
by management and their lawyers, it does not
3:55
get a line item on the balance sheet. So where
3:57
does it go? It gets a paragraph buried deep in
3:59
the notes. Oh, wow. So management knows the vast
4:02
majority of retail investors will simply never
4:05
read to page 65 to find that one paragraph. They
4:08
rely on the sheer exhaustion of reading a hundred
4:11
page document to keep the bad news quiet. That
4:14
is the exact mechanism at play. I mean, the cracked
4:18
foundation is disclosed. Legally speaking, the
4:21
company is completely covered. But you, as the
4:25
investor, have to be the one to actually go digging
4:27
for it. OK, well, since we know we have to go
4:29
digging, we need a map. Instead of wandering
4:31
aimlessly through 100 pages of fine print, let's
4:34
break down the five specific notes you absolutely
4:37
have to understand. This is where it gets really
4:38
practical. Right. So let's start with how the
4:41
numbers are even calculated in the first place,
4:42
which is the accounting policies note. Right.
4:45
So this note is foundational. It explains why
4:48
two companies in the exact same industry, doing
4:50
the exact same amount of business, can report
4:53
vastly different profits completely legitimately.
4:56
Because they're using different rules. Exactly.
4:58
It outlines the rules of the specific game that
5:01
a particular management team has decided to play.
5:03
Okay, let me see if I have this straight. Say
5:05
you have two manufacturing companies. They both
5:07
buy the exact same piece of heavy machinery for
5:10
a million dollars. Okay. Company A decides to
5:14
depreciate that equipment over 10 years, but
5:17
Company B decides to stretch that depreciation
5:19
out over 20 years. Because Company B is spreading
5:22
that cost over a much longer timeline, their
5:25
expenses look significantly lower today. Yep,
5:28
you've got it. Which means they will report higher
5:31
profits right now from the exact same million
5:34
-dollar asset. That is the exact dynamic. And
5:37
there is nothing fraudulent about either choice
5:40
provided the company can justify the estimate
5:42
as reasonable to their auditor. Right, reasonable
5:45
being the key word. But if you are trying to
5:47
decide which company is a better investment,
5:50
you can only compare them fairly if you know
5:52
they are keeping score differently. The accounting
5:54
policies note tells you if a company is using
5:56
aggressive assumptions to make today's profits
5:59
look better at the expense of tomorrow. Okay,
6:01
so that covers the basic rules of the game. But
6:04
what about the surprises? You know, the things
6:06
that aren't neatly factored into depreciation
6:09
schedules? That brings us to the second keynote,
6:13
and honestly, the one that is the most terrifying
6:15
to me. Contingent liabilities. Yes, contingent
6:20
liabilities. This is where that lawsuit example
6:22
we talked about lives. Contingent liabilities
6:24
are potential future obligations. We're talking
6:27
about major litigation, massive environmental
6:30
cleanup costs, or like bruising tax disputes
6:33
with the government. And you mentioned earlier
6:35
that this hinges entirely on vocabulary, like
6:38
whether a loss is probable or not. So a business
6:41
-ending threat can just be a paragraph if management
6:44
decides it's merely possible but not probable.
6:47
Exactly. Doesn't that mean a tiny shift in vocabulary
6:50
between years is a massive red flag? Oh, it is
6:52
the ultimate red flag. Yeah. Because the language
6:55
used in these documents is not casual. It's all
6:57
lawyers. It is intensely negotiated by teens
7:01
of lawyers and auditors. Let's say last year,
7:04
a lawsuit was described in this note as without
7:06
merit. The company was just brushing it off.
7:08
Right. Nothing to see here. But this year, the
7:11
description of that exact same lawsuit changes
7:14
to Possible, but not probable. Boom. Management's
7:18
assessment of their own survival just dropped.
7:21
And that subtle shift in text is often the earliest
7:24
public indication that something is going very,
7:27
very wrong long before the financial numbers
7:29
reflect the damage. They are signaling to the
7:32
market that they might actually lose without
7:35
having to take the hit on their balance sheet
7:36
yet. Wow. OK, so contingent liabilities cover
7:39
threats from the outside lawsuits, regulators,
7:41
that kind of thing. But what if the threat is
7:43
coming from inside the house? What if management
7:46
is making deals with themselves? Oh, yeah. That
7:49
leads us to the third crucial area, which is
7:52
related party transactions. Right. So this note
7:54
covers any business the company conducts with
7:56
connected people. That means directors, major
7:59
shareholders, or other entities that those insiders
8:01
control. Give me a real -world scenario of how
8:04
this actually plays out. Let's say the CEO of
8:07
a publicly traded company is leasing the company's
8:09
head office building from a real estate firm
8:12
that the CEO personally owns. A classic example.
8:15
Hold on, I mean, how is that even legal? Doesn't
8:18
that immediately scream corruption? One person
8:20
is essentially sitting on both sides of the negotiating
8:23
table. It definitely raises alarm bells. But
8:26
it isn't automatically illegal. In fact, in family
8:29
-controlled businesses or smaller public companies,
8:32
these arrangements happen constantly. Really?
8:34
Constantly. Yeah. The CEO might argue that they're
8:37
giving the company a perfectly fair market rate
8:39
on the lease. The danger, however, is obvious.
8:44
In an arm's -length transaction, two independent
8:46
parties fight for their own best interests. Right.
8:48
To get the best deal. But in a related party
8:51
transaction, the CEO has a massive incentive
8:53
to overcharge the public company to enrich their
8:56
own private real estate firm. So if you see a
8:59
massive volume of related party activity like
9:01
loans to directors or massive consulting fees
9:05
paid to a board member's private firm, you really
9:08
have to ask yourself if the company exists to
9:10
serve the shareholders or if it exists to funnel
9:13
money to the insider side projects. And disclosure
9:16
is your only protection here. If you don't read
9:18
that note, you have absolutely no idea who is
9:20
actually getting paid. All right, so we are looking
9:23
for hidden deals. But what about hidden performance?
9:26
Like, how does a company hide the fact that a
9:28
huge part of their business is basically failing
9:31
while the overall numbers still look OK? That's
9:34
where the fourth note comes in. Segment reporting.
9:36
Segment reporting. OK, break this down for us.
9:38
This is where we learn why looking at a consolidated
9:41
total number can completely blind you to reality.
9:45
A consolidated income statement mashes the entire
9:48
company together into one big revenue figure
9:51
and one big profit figure. Right, the headline
9:53
number. Exactly. The segment reporting note breaks
9:57
those figures down by division, product line,
10:00
or geography. I see. So imagine a tech company
10:02
reports a total revenue growth of 5%. You read
10:05
the front page and think, great, nice, steady,
10:07
stable growth, I'll invest. Seems perfectly healthy.
10:10
But then you dig into the segment note and you
10:12
realize this company basically has two divisions.
10:14
Division A is their cloud software, and it is
10:16
absolutely exploding, growing at like 25%. Huge
10:19
growth. Yeah. But Division B is their legacy
10:22
hardware business making physical servers and
10:25
it is completely dying. It's shrinking by 15
10:28
percent a year. And if you just look at the five
10:30
percent total on page one, you miss the entire
10:33
story of the business. You miss that they are
10:35
rapidly transitioning away from their historical
10:37
core product and that the legacy business is
10:40
in a total death spiral. And the booming division
10:42
is just propping up the dying one. Exactly. The
10:46
booming software division is currently subsidizing
10:48
the failing hardware division. Very often the
10:52
segment note is the single most illuminating
10:54
page in the entire document because it shows
10:56
you the internal engines of the company Wow,
10:58
okay, but it feels like we are always looking
11:00
at the past though Like these annual reports
11:02
cover a year that has already ended Is there
11:05
anywhere in this hundred page brick that actually
11:08
talks about what is happening right now? There
11:10
is and it is usually sitting near the very back
11:13
of the document where almost nobody looks it
11:15
is the fifth Keynote which is subsequent events.
11:17
Okay, so subsequent events This covers major
11:21
disasters or shifts that happened after the financial
11:24
period ended, but before the statements were
11:27
officially published. Correct. Let's say a company's
11:29
fiscal year ends on December 31st. The financial
11:33
statements only capture events up to that exact
11:35
date, but the actual annual report might not
11:39
be published and filed on Cedar Plus until, say,
11:43
March. Which means if their primary manufacturing
11:46
factory burns to the ground in February, or if
11:49
they acquire a massive competitor in late January,
11:52
none of that is in the December numbers. None
11:54
of it. The balance sheet from December 31st will
11:57
show a perfectly intact factory. But the subsequent
12:00
events note will disclose the fire. That's wild.
12:03
It is literally the most current up -to -date
12:05
information in the entire filing. It bridges
12:08
the gap between the end of the year and the day
12:10
you are actually reading the report. Okay, so
12:13
we've mapped out the five crucial notes for management.
12:15
We've got accounting policies, contingent liabilities,
12:18
related party transactions, segment reporting,
12:20
and subsequent events. That's the core map. But
12:22
management wrote those notes. They have every
12:25
incentive to spin them, right? So, we need to
12:27
talk about the independent referee who actually
12:29
signs off on all of this, which is the auditor.
12:32
Ah, yes. The auditor's report is where retail
12:35
investor expectations and legal reality violently
12:39
collide. Violently collide. I love that. Because
12:41
when you see that a massive independent auditing
12:44
firm has signed off on the financials, you naturally
12:47
assume, great. This is safe. They checked every
12:49
single receipt. There is zero fraud here, and
12:52
the experts think this is a fantastic, healthy
12:54
business. Which raises the critical question,
12:57
what does an audit actually guarantee? And the
13:00
answer is vastly narrower than people assume.
13:03
Really? How so? Well, the auditor is merely expressing
13:06
an opinion on whether the financial statements
13:08
present fairly in all material respects according
13:10
to the accounting rules. Present fairly? That
13:13
feels like a very carefully chosen legal phrase.
13:15
It is the entire threshold. I mean, an audit
13:17
is not a guarantee against fraud. Management
13:20
can absolutely lie to the auditors. It is not
13:22
an opinion on whether the management team is
13:24
competent. And it certainly is not an opinion
13:27
on whether the company's stock is a good investment.
13:30
It simply means the numbers follow the rulebook
13:32
closely enough that they aren't materially misleading.
13:35
That is a huge distinction. Let's break down
13:38
the types of opinions the auditor can actually
13:40
give. Because I imagine most of the time, they
13:43
just give it a passing grade, right? Yeah. The
13:45
standard outcome, the one you always want to
13:47
see, is called an unqualified or clean opinion.
13:50
It means everything presented fairly. Anything
13:52
other than a clean opinion is rare and highly
13:55
serious. What happens if the auditor catches
13:57
management breaking a rule, but management just
14:00
refuses to fix it? Then you see what's called
14:03
a qualified opinion. The auditor is essentially
14:05
saying, everything is fine, except for this one
14:08
specific issue. It is a major red flag. But worse
14:12
than that is an adverse opinion, which means
14:14
the statements outright do not present fairly.
14:17
They are deeply misleading. That sounds like
14:19
a disaster. It is. And finally, there is a disclaimer
14:24
of opinion, which means the auditor couldn't
14:27
even form an opinion, usually because management
14:29
withheld vital information. If you see an adverse
14:32
opinion or a disclaimer, you shouldn't just walk
14:35
away, you should sprint. Exactly. Run. But there's
14:38
another major warning sign in the auditor's report,
14:40
and it's written in plain, blunt English, going
14:44
concern. What exactly triggers that phrase? Well,
14:47
if the auditor looks at the cash flow, the debt,
14:50
and the lawsuits, and they have a substantial
14:53
doubt about the company's ability to even survive
14:55
the next 12 months, they're required by rule
14:58
to flag it. And they just say it outright. They
15:00
use that exact phrase, going concern. If you
15:03
see a paragraph titled material uncertainty related
15:06
to going concern. The auditor is blowing a massive
15:09
blaring siren that bankruptcy is a very real
15:11
possibility. And recently there has been this
15:14
fascinating addition to these reports called
15:15
Key Audit Matters, or Canams. The auditor actually
15:19
writes out a description of the specific areas
15:21
that required their most intense attention during
15:23
the audit. It is a remarkable level of transparency.
15:27
You are literally getting a window into the actual
15:31
friction between the auditor and the CFO. I saw
15:34
a term pop up in our sources regarding this friction.
15:37
It was goodwill impairment. What does that actually
15:41
mean in the context of an audit? Is it essentially
15:44
a company overpaying for a competitor and having
15:46
to admit it later? That is exactly what it is.
15:49
Let's say a company buys a competitor for $50
15:51
million. But the physical assets are only worth
15:54
10 million. Right. That extra 40 million goes
15:58
on the balance sheet as an intangible asset called
16:00
goodwill. It represents the brand value, the
16:03
customer loyalty, things like that. OK, makes
16:05
sense. But if that acquired business starts failing,
16:08
the rules say you have to write down or impair
16:11
that goodwill. You have to admit it's no longer
16:13
worth 40 million. And I can see why that causes
16:15
massive friction. Management desperately wants
16:18
to avoid writing that number down because it
16:20
wipes out their profit for the entire year and
16:23
likely wipes out their bonuses, too. Oh, absolutely.
16:25
But the auditor wants them to write it down to
16:27
reflect reality so the auditing firm doesn't
16:29
get sued by angry investors later. Precisely.
16:33
That tension is what creates a key audit matter.
16:36
If they spend 80 % of their time locked in a
16:38
boardroom arguing with management about whether
16:41
to impair that goodwill, the auditor will list
16:44
goodwill impairment as a key audit matter. So
16:47
the auditor is essentially handing you a treasure
16:49
map. They are pointing directly at the most subjective,
16:52
highly contested numbers on the entire balance
16:54
sheet and whispering, hey, look right here, we
16:57
fought about this for a month. They are telling
16:59
you exactly where the bodies are buried. So we've
17:02
covered the illusion of the statements, the mechanics
17:04
of the five keynotes, and the intense reality
17:07
of the auditor's report. It is a lot of dense
17:09
accounting theory. And let's be honest, nobody
17:12
wants to spend their weekend reading a hundred
17:14
page PDF. No, nobody does. But you can distill
17:17
all of this into a highly actionable toolkit.
17:20
A literal cheat code for SIDR plus M. Right,
17:23
you do not need to read the full document to
17:25
find the red flags. You can let the technology
17:27
do the heavy lifting for you. Okay, here's how
17:29
you do it. If you were looking at a Canadian
17:32
public company, you pull up their filings for
17:35
free on SIDR plus E, you download the annual
17:38
report, You hit CCHEL plus F on your keyboard
17:42
to open the search function, and you use a simple
17:44
five -word search checklist. Just five words.
17:47
You just type in these five phrases, read the
17:49
paragraphs that pop up, and you will have 90
17:51
% of the vital context in about 10 minutes. The
17:54
five words are related party, contingent, going
17:58
concern, subsequent, and impairment. Let's give
18:02
this the weight it deserves because this totally
18:04
levels the playing field for retail investors.
18:07
You search related party to see if the CEO is
18:10
leasing buildings to themselves or if the board
18:13
of directors is funneling consulting fees to
18:14
their friends. Yep. You search contingent to
18:17
bypass the front pages and jump straight to the
18:19
business ending lawsuits and environmental disasters
18:22
that management decided were only possible but
18:24
not probable. You search going concern to see
18:26
if the independent auditor thinks the company
18:28
is going to drop dead before the next annual
18:30
report even comes out. You search subsequent
18:33
to find the freshest data. The factories that
18:36
burned down or the massive acquisitions that
18:38
happened after the fiscal year ended but before
18:40
the ink was even dry on the report. And you search
18:42
impairment to find out if they are quietly admitting
18:45
that past acquisitions were terrible mistakes
18:47
and writing down their value. I love this approach
18:51
so much. Instead of trying to become a CPA, you're
18:55
just acting as a search engine for the exact
18:57
phrases that lawyers use to cover their tracks.
19:01
It takes mere minutes. And if you really want
19:03
to leverage this, you compare the exact text
19:05
of the paragraphs you find to the same note from
19:08
the previous year. As we discussed earlier, lawyers
19:11
and auditors do not change their vocabulary casually.
19:14
Right. Every word is negotiated. Exactly. If
19:16
a phrase changes from remote to possible, or
19:20
if a brand new paragraph suddenly appears in
19:22
the related party section, that changed language
19:24
is the ultimate signal. You are letting the lawyer's
19:27
own precision work against them. But, you know,
19:31
I think there's a broader philosophical point
19:33
here about the notes themselves because sometimes
19:35
even if you use the five word search, even if
19:38
you try to read the segment reporting, the document
19:41
remains a complete mess. Oh, for sure. And if
19:44
you put in an honest effort and the notes are
19:47
still genuinely incomprehensible, like if you
19:50
literally cannot follow how the company actually
19:52
makes its money or who owes what to whom, that
19:55
is itself incredibly valuable information. Because
19:58
complexity is often doing a job. Exactly. Sometimes
20:01
a business is simply complex by nature. I mean,
20:04
a massive multinational bank is going to have
20:06
complicated notes. Sure. But for most businesses,
20:09
complexity is deliberately constructed to keep
20:11
you in the dark. If the plumbing of a seemingly
20:14
simple manufacturing business requires 60 cages
20:17
of indecipherable related party entity diagrams,
20:20
you have to ask yourself what that complexity
20:22
is hiding. It's the ultimate Enron lesson. Before
20:26
Enron collapsed, the smartest financial analysts
20:28
in the room couldn't explain how the company
20:30
actually generated cash. And it wasn't because
20:33
the analysts were dumb. It was because the company
20:36
didn't want them to know. When the explanation
20:38
feels like a maze, the maze is the point. So
20:53
here is your homework. Pick a company that you
20:55
own or one you've been thinking about buying.
20:57
Go to CDAR Plus F, pull up their latest annual
21:00
report, hit CDAR Plus F, and run the five -word
21:04
search for yourself. Related party, contingent,
21:07
going concern, subsequent, and impairment. See
21:10
what secrets are hiding in the back pages. See
21:12
if the company you thought you knew has a cracked
21:14
foundation you never noticed. You will be astonished
21:16
at what you find sitting out in the open, fully
21:18
disclosed, just waiting for someone to actually
21:20
take the time to look. Because at the end of
21:22
the day, you can't just stand in the living room
21:24
and admire the staging. You have to open the
21:26
kitchen drawer. You have to read the inspector's
21:28
report. The cookies smell great, but it's the
21:31
termites in the wall. that are gonna cost you.