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Focus On Cash Flows

When companies make investment decisions with their capital, such decisions should be based on the cash flows the investment is expected to return. Because cash flows are volatile, earnings calculations are a useful way of measuring how successful such investments have been. Unfortunately, this creates a management incentive to invest in a manner that maximizes earnings rather than cash flow, which does a disservice to shareholders.

Consider Equitable Group (ETC), a mortgage lender to single families and commercial interests.

Equitable operated under Canadian GAAP for many years, but has now been forced to transition to IFRS due to regulations.

Because IFRS treats certain types of Equitable Group's transactions more conservatively than did Canadian GAAP, Equitable has actually decided to curtail such activities:

"Given the changes to the manner in which these mortgages are accounted for under IFRS, however, the Company intends to reduce the volume of mortgages securitized relative to previous years."

The company also decided to change how it hedges some of its positions as a result of how IFRS treats those hedges.

This is a giant red flag! Instead of making decisions that maximize cash flow, the company appears to be maximizing earnings (at the necessary expense of cash flow).

When the choice of accounting method affects investment decisions, it's unlikely that returns to shareholders are being given priority. Real, cash returns are being sacrificed in order to make the numbers look better than they otherwise would. Shareholders may wish to avoid such companies, opting instead for companies that make decisions in the best long-term interests of shareholders.

Disclosure: No position

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the feed.