The uncertainty over the tax treatment of income trusts has mercifully put to rest. Now investors can focus attention on other problems inherent in the products, such as murky accounting issues.

Ottawa put a short-lived scare into many income trust investors late last year when it threatened to pull away the income trust punch bowl by undermining the fundamental tax advantage that trusts enjoy compared with the traditional corporate structure. That storm seems to have passed. But investors would be foolish to assume that other risks to the trust structure have also evaporated.

The income trust phenomenon has attracted its share of critics. Some claim there are trusts on the market that are fundamentally unsustainable, while others simply demand much better disclosure. Regulators have voiced their concerns, too, not least because the products have been very popular with retail investors despite their complexity.

Last August, the Canadian Securities Administrators issued a staff notice highlighting its worries about income trusts’ disclosure of distributable cash. John Hughes, manager of corporate finance at the Ontario Securities Commission in Toronto, says the CSA was moved to put out the notice because, over time, it had begun seeing numerous adjustments added to trusts’ reporting of distributable cash that “were not particularly transparent.” There was also a lack of information about the sustainability of distributable cash — something that’s obviously critical for trust investors, who are presumably buying trusts for their perceived ability to generate yield.

The CSA notice set out its expectations as to the depth and breadth of disclosure that’s necessary to ensure transparency when reporting distributable cash, which is a non-GAAP measure. Since then, Hughes says, the regulator has seen some improvement.

The issue is far from resolved, however. In mid-January, credit-rating agency Standard & Poor’s Corp. published a report highlighting the problems it found through a survey of income funds’ calculation and reporting of distributable cash. S&P hosted a conference call to discuss the issue.

During the call, Kevin Hibbert, director of financial reporting and co-author of the report, noted that there is a perception in the market that income funds “are somehow insulated” from the accounting risks that have afflicted traditional corporations. The view has been fostered, he says, by the fact that high-profile accounting problems exposed in the corporate world have generally been focused on the quality of reported earnings. As income funds’ reporting tends to focus more on cash flow than earnings, investors may be lulled into thinking that they don’t have the same issues.

Not so, says Hibbert: “Income funds are in reality much more similar to their corporate cousins, from a financial reporting risk standpoint, than one might think. In particular, there’s little consistency in how distributable cash is calculated [or] how it’s reported. And there’s often significant judgment and subjectivity within the cash figures presented. Consequently, the figures may look like cash, sound like cash and may even be located in a cash-flow statement, but may not be indicative of the cash that was generated and available at the time of distribution.”

S&P’s research looked at 40 income trust funds’ financial statements and found wide disparities in what trusts count as distributable cash and how it’s reported. S&P notes that even the basic nomenclature is vastly different. Among the 40 funds, there were 19 names used for distributable cash. It found that 20% of the funds overstated distributable cash and, on average, it was overstated by 22%.

This suggests those funds are financing some portion of their distributions rather than simply generating the cash to pay them.

The fear that income funds are funding their distributions with sources other than the cash generated by operations echoes concerns expressed late last year by forensic accountant Al Rosen in a report he published criticizing the trust sector.

Rosen, head of Toronto-based Accountability Research Corp., says 75% of the 50 largest business trusts are paying distributions that are well in excess of their net income. He says trusts are overvalued by about 28%, largely because many investors don’t understand that some portion of their distributions includes a return of their own capital.

The question of how distributions are being funded is at the core of concern about funds’ financial reporting. Hibbert notes that there is little consistency in the adjustments that funds have made to their cash calculations, even among funds that are operating in the same sector. Although the vast majority of funds rely on an operating subsidiary to generate their cash, only 14% provide public disclosure of that subsidiary’s financials. “This makes it extremely difficult for investors to reconcile the reported distributable cash figures to the cash actually received by the income fund from its operating subsidiary,” he adds.

@page_break@The lesson, then, is that investors and their advisors would be well advised to scrutinize funds’ reporting closely.

“What does it all mean? It means ‘investors beware’ and dig deeper because the devil in these things is in the details,” warns Ron Charbon, the S&P report’s co-author and director of S&P’s stability ratings group.

In addition to heightened investor vigilance, Rosen has called for the government to tax business trusts, and he suggests that authorities crack down on the “accounting, valuation and marketing abuses surrounding business trusts.”

Given the investor alerts that have been issued and last year’s CSA staff notice, it’s clear that regulators have their own concerns. The OSC’s Hughes says regulators are conscious of the ongoing debate about whether they should bring greater rigour to the reporting of distributable cash, which could involve prescribing the format in which the cash is reported, standardizing the names that trusts can use for distributable cash or even determining exactly what sort of adjustments can and cannot be made in the calculations.

“Obviously, we are aware of that debate, but there are a lot of issues,” Hughes says. “It’s easy to say that we should put something out that would be standardized. But when one really thinks about it, it may not be quite that simple.”

As a result, regulators have yet to decide whether they should be forcing some standards or reporting protocols on the trust industry. “We are aware of it, we’re thinking about it and, obviously, it’s a very sensitive sector of the market — so we’re watching it very closely,” he says. “But in terms of a specific answer as to what we might take as a next step, we don’t really have one.”

One hope is that increased attention from analysts, regulators and, ultimately, investors will push trusts toward greater consistency. Since the notice was published, Hughes says, there has been better prospectus disclosure from income trusts with regard to the derivation of adjustments to cash flow and the sustainability of the flow.

“We’re starting to see better disclosure on the variability of cash flow,” he says. “In addition to providing the distributable cash number, there’ll be some ‘sensitivity analysis’ as to how that would change if some of the assumptions went up or down by X%.”

Hughes says the increased disclosure allows some basis for comparison among trusts, while also allowing them to report their distributable cash in a way that makes sense in their particular situation. He adds, however, that the question of whether there should a standardized way of reporting the items raises a host of issues.

Foggy financial reporting is just one of many criticisms the trust sector has faced as it has grown into a significant segment of the Canadian market. Many other problems have eventually been overcome. The provinces moved to close the liability loopholes that initially kept many institutional investors away from the market segment. Trusts have been legitimized as an alternative structure by their acceptance into indices, and the segment has weathered several high-profile blow-ups by some of the shakier trusts. For now, it appears that the tax advantage will be preserved, albeit reduced slightly by the decision to drop dividend tax rates.

It remains to be seen if the trust industry can be left to clean up financial reporting on its own, or whether regulators will ultimately have to get involved. Until one or the other happens, however, investors should be prepared to spend lots of time trying to decipher some financial statements. IE