L.S. Rosen Award – sincere thanks to many of you

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Today at the annual CAAA conference, I was awarded the L.S. Rosen award which is an annual award for contributions to accounting education.  The official write up is here.  Below I provide the text of my short acceptance speech which I used to thank some very important people in my career.

 

First, a huge thank you to the selection committee – Theresa, Michel, and Gary.  I can’t imagine the time it took to read all the nomination packages and how difficult it must be to choose just one.

I want to take this opportunity to thank some key people who have significantly influenced my career.  There are of course, 20 or 30 key people, many of whom are in this room right now but let me instead focus on just four particularly important people.  Many of you will know personally the four names I am about to mention.  My hope is that as I briefly share stories of how important their influence has been to me that you will also recall similar events with these people in your own life.

In time series order, then I want to say a huge thank you to Pat O’Brien, Mike Gibbins, Fred Phillips, and the fourth person is … well … I’ll keep you in suspense.

Pat O’Brien was my doctoral supervisor when I was at the University of Waterloo.  If you’ve worked with Pat you know that she is incredibly bright and that she also has a very kind heart.  Pat has the uncanny ability to listen to a cockamany idea and then gently guide you into a brilliant idea, all the while having you think the brilliant idea was yours from the get go.  Pat, the lesson I learned from you was that smart comments and criticism are no less effective when delivered with a teaspoon of sugar and a smile.  Thank you.

Mike Gibbins was my first boss at the University of Alberta.  Mike may be a foot shorter and 25 years older than I, but my goodness his energy is boundless and contagious.  It was from Mike that I learned how hard it was to be an effective educator and how important it was to understand and connect with each student.  I watched Mike first hand deal with a variety of student issues – from devastating deaths in the family to homework being eaten by pets.  Mike’s patience and fairness were incredible.  My experience with Mike can be best summed up with a quote by Rohinton Mistry

There’s a fine line between compassion and foolishness, kindness and weakness.  Wondering always about how firm to stand, how much to bend.

Mike, thank you for showing me the line between compassion and foolishness.

The third person I want to thank is Fred Phillips from the University of Saskatchewan.  I owe Fred a number of thank-you’s – he was the one who pulled together the nomination package for this award, contacted so many alumni and colleagues for letters of support and wrote a very flattering nomination letter.  But my thanks to Fred go so far beyond that.  Fred is likely one of the best accounting educators in the country and without doubt the top accounting education researcher.  He won this award three years ago and a 3M national teaching award before that.  Fred’s research on accounting education, particularly on cognitive development, will continue to influence our work at CPA Canada and I assume many other institutions.  While Fred and I have never worked at the same institution, he’s been a true colleague and dear friend for over ten years. Fred was unfortunately unable to be here today, but Fred from the bottom of my heart, thank you.

Now, to end the suspense …

The fourth person is not a person at all – it’s the accounting profession.  The opportunities I have had to work with the legacy accounting associations and now with CPA Canada have, without a doubt, been an incredible influence on my career.  In my role at CPA Canada, there are of course days that I wake up and wonder if the volume of work and stress are worth it.  But then I remember that I have the privilege of working for an institution who has publicly stated that one of its key objectives is to be a leader in accounting and business education.  That’s a pretty cool objective – be a leader in accounting and business education.  The support for achieving that objective is tremendous.  While there are those depressing moments when you wonder how we can possibly achieve it, there really is no doubt that we will achieve that.  The support of the executive team at CPA Canada, my boss Tashia, my many colleagues, and especially my PEP team and PREP team has been endless and invaluable.  Thank you for making that grandiose objective achievable.

These four people have obviously had a tremendous positive influence – life changing even for me.  If we remember nothing else from this conference, can we each take away the importance of community and support?  My career to date is the result of a community pushing me, challenging me, and supporting me.  While we can go through our careers as a set of individuals, undoubtedly we can do more to improve accounting education if we instead choose to work together.

Thank you again for this tremendous honour.

A cheque in the mail is better than a tweet?

After my post a month ago bemoaning the potential death spiral facing Canada Post, I thought I would provide some balance by discussing the merits of Royal Mail, England’s original version of Canada Post.

In the world of old mail and new mail, there are two key stories right now: the initial public offering (IPO) of Royal Mail and the IPO of Twitter. Perhaps on the outset these two companies don’t seem to have much in common, but at their core they are both in the business of sharing information. Royal Mail delivers traditional letters and packages (a lot of packages these days due to online shopping). Twitter delivers breaking news stories from around the world and LOL cats.

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Image Source: http://www.lolcats.com/

With most traditional IPOs, security regulators require substantial disclosure, including audited financial information months prior to the actual IPO date. Twitter is using a special IPO procedure, the Jumpstart Our Business Startups (JOBS) Act, which allows for substantially less disclosure than a normal IPO. In order to qualify for the JOBS Act IPO, Twitter must have less than $1 billion in revenue. This is about all the financial information we currently know about Twitter. The Globe and Mail had an interesting piece in which the writer stated that they preferred the Royal Mail IPO to the Twitter IPO. Shocking, perhaps, particularly after my post about Canada Post. Royal Mail might seem like a dusty old horse compared to Twitter’s 500 horsepower shiny red convertible. But the G&M article has some excellent points that are worth raising for all accounting students.

Basically, don’t let flash and sparkle distract you from a company’s underlying business model. One thing that financial statements generally do not tell a reader is what the future profitability of the company will be. Financial statements, by design, are historical—they reflect the past. The past is a decent predictor of the future… until it’s not.

What do I mean by that? Well, consider Royal Mail’s history. It has been in the delivery business for over 100 years. It has infrastructure (trucks and buildings) in place and some consistent market demand. Clearly the mail delivery business has changed over the past 100 years and Royal Mail will need to continue to adapt as the market continues to change. But until people stop sending letters and birthday packages, and until people stop buying goods on the Internet and having them delivered, Royal Mail has a stable or slightly declining market. Now lets consider Twitter. Tweeting is free (you get what you pay for in my opinion), so it doesn’t cost Suzi or Tom anything to tweet about their meal or their clothes or some celebrity gossip. Twitter earns revenue through advertising. Companies pay to have their tweets pushed to your twitter account. This can be annoying and I, for one, rarely (if ever) click on those ads. So how effective are those ads? We don’t know—we need to wait to see Twitter’s financial statements.

Now consider the barriers to entry for Royal Mail and Twitter. If you want to compete with Royal Mail, the barriers to entry are high. You need to build a network of collection and delivery locations and you need trucks, buildings, and delivery people. If you want to compete with Twitter, you need a few computer science gurus, some servers, and some late night pizza. The next Twitter could be right around the corner. Instagram, Tumblr, and their like could very well trump Twitter. Then what happens to its advertising revenue? Cue descending slide-whistle sound effect.

Perhaps you remember one of Aesop’s most famous fables, “The Tortoise and the Hare.” Slow and steady may win the race, so choose your investment wisely.

The Tortoise and the Hare, by Arthur Rackham

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

 

Interest Can Fly Under the Radar

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Image source: http://www.bombardier.com/en/home.html

Bombardier is one of Canada’s larger manufacturers and has frequently made the news recently as the production of its new C-Series commercial jet gets tantalizingly close. The C-Series jet is apparently key to Porter Air’s expansion plans out of the Toronto Island Airport (YTZ), and it is obviously very important to the future success of Bombardier.

Bombardier (BBD.B) already has 177 firm orders in place with hopes of another 150 orders a year or two from now. The development costs of this new jet are close to $4 billion. When Bombardier sells a C-Series jet to Porter (or any other airline), the price of the aircraft must include a portion of these development costs in addition to the direct labour and materials involved in building the plane itself. As the development costs creep higher, Bombardier really only has two options: (1) charge more for each jet once they start selling, or (2) give up any hope of recovering the development costs. Under IFRS (IAS 38), it is important to distinguish research costs from development costs. The distinction is important: development costs can be capitalized as an asset while research costs much be expensed. IAS 38.57 defines the development phase of a project to be when six criteria are met:

  • technical feasibility can be demonstrated
  • there is intention to complete the project for use or for sale
  • there is ability to use or sell the asset
  • there is existence of a market for the output (sale)
  • there are adequate resources ($$) to complete the project
  • the expenditures for the project can be accurately tracked

Obviously the C-Series jet is in the development phase. Bombardier also has other aircraft in the development phase but does not provide a breakdown of development costs by jet-type. The chart below shows how much the development cost asset has grown over the past three years. We will assume the bulk of this growth is due to the C-Series.

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These development costs include the costs of the prototypes, scientists’ salaries as they figure out aerodynamics, retooling costs, building and tweaking engines, testing prototypes, etc. All of these costs are capitalized up to the time that Bombardier starts actually selling C-Series jets. Then, Bombardier must start amortizing its development cost asset, in this case on a per-unit basis calculated on a best-guess for the number of jets to be sold.

If you’re in introductory financial accounting, or you are like 90% of the population and just dabble (or less) in accounting, I suspect this idea of capitalizing development costs may seem strange. Recall that an asset is a cost that has been incurred that has future benefit. A very common asset is a company’s property, plant, and equipment (PPE). We allow companies to capitalize PPE (i.e., set it up as an asset) because the PPE will hopefully generate a future stream of cash flow through product sales or service sales. Development costs aren’t all that much different, except they are intangible. The development costs related to a new jet allow the company to sell a new product and keep current with technology. Without spending money on development, Bombardier would find itself using outdated technology while trying to compete with other plane manufacturers that have new technology. This is unlikely to be a successful strategy.

Now that we have a decent understanding of development costs, we can explore Bombardier’s costs a bit more. According to the September 17, 2013 Globe and Mail article, Bombardier doesn’t seem to clearly understand how much it has actually spent on developing the C-Series. This is not really true; some accountant inside Bombardier knows exactly how much the company has spent. The issue here is whether Bombardier should be including the interest cost in its development costs. This is covered in IAS 23 (Borrowing Costs) and is an intermediate to advanced topic. The basic idea is that if Bombardier borrowed money to fund development costs, then the interest related to the borrowed money should be included in the capitalized development costs, hence increasing the development costs. There are only a few instances where interest costs are not immediately expensed, so if capitalizing interest seems odd to you, you’re not alone.

Another example of when interest can be capitalized is building a new factory. Assume for a second that you are building a new factory and borrow $1 million to fund the construction costs. Interest related to your loan should be capitalized during construction and is hence considered part of the overall cost of the factory. That cost will be amortized over the useful life of the factory. Interest incurred on the construction loan after the factory is put into use would be immediately expensed. The same is true for Bombardier’s development costs. So in the Globe and Mail article, the confusion stems from one Bombardier executive speaking about direct costs related to development while another, likely with more accounting experience, included interest costs related to the development. The second person is technically correct.

So what is the quick synopsis for us?  First, development costs, when they meet the definition, can be capitalized. Second, interest costs can also be capitalized in certain circumstances. And third, planes are bloody expensive!!

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Yeah right, the cheque is in the mail

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When was the last time you mailed something?  I mean, really mailed it?  Stamp, envelope, dropping it off in a red box?  Alternative forms of communication have clearly replaced traditional letter mail and Canada Post is suffering as a result.  Badly.  If you take a moment to think about the business model of Canada Post, you realize that a large portion of their costs must be the delivery process which is primarily done by individuals walking through neighbourhoods, hand delivering … flyers, packages from Amazon, and the odd letter from Grandma.  We used to complain about our mail boxes being full of bills but even those are being delivered electronically now.  The graph below summarizes the basic problem with Canada Post’s business model – shrinkage:

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But even that doesn’t tell the whole story.  The other side of the problem is the increasing number of houses/addresses that require some delivery:

 

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So we’ve got a business with a delivery system that needs to expand, but shrinking revenues.  No surprise then that Canada Post is losing money,

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But wait.  Maybe its not losing money.  Fo the year ended December 31, 2012 they had net income of $94 million, that looks pretty good.  Yes, except that net income is inflated by $152 million due to a one-time, non-cash pension correction.  If you look at the second line under “Cost of operations” you will notice that the employee benefits are about $130 million less than the prior year.  Essentially Canada Post squeezed the union in their latest round of of negotiations and was able to reduce some of the pension and benefits.  That reduction shows up as a one-time gain in 2012.  I’ll admit that Canada Post is very upfront about that adjustment in their annual report.  I would argue that they are more transparent about their true loss than most for-profit businesses that I have seen.

The most latest quarterly report (June 2013) isn’t any more favourable, showing losses for the first two quarters of 2013:

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There is one more view of this that I want to point out – the Statement of Cash Flows.  Remember that the statement of cash flows summarizes how the business got cash and where it spent cash.  That summary is broken down into three main categories: Operations (the main business activities), Investing activities, and Financing activities.  I’ve written about the importance of analyzing the statement of cash flows before, you may want to read that post as well. 

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What do we see here?  On a first glance it looks OK.  Canada Post is obviously a mature business so we should expect the operating activities to be generating sufficient cash to support the investing activities and the financing activities.  In 2012, it looks like it does.  Let’s ignore the financing activities for a moment since (a) the total financing activity cash flows are very small and (b) its a non-traditional business that is owned by the Government.  Now focus on the investing activities and pick out just the capital asset expenditures.  This is for items like new delivery trucks and sorting machines.  In each of the last two years, the capital expenditures have been pretty constant, about $1/2 a billion per year.  Now compare the operating cash flows to the capital expenditures required and you will see the rest of the problem.  Canada Post is struggling to earn enough money to replace its necessary capital assets.  Without those capital assets for delivery, Canada Post has no business model.  No cash, no assets.  No assets, no business.  No business, no cash.  And the death cycle begins.

Canada Post has one massive financial problem that I haven’t mentioned yet – pensions.  I won’t go into that here since I talked about that in the last post.

The Globe and Mail had a terrific story about the issues that Canada Post is facing and included some potential solutions such as less-frequent delivery or not doing door-to-door delivery.  Neither of those likely affect you or I since we get very few traditional letters.  I am sure that the older generations are more frequent users/receivers of traditional mail and I suspect they’re not going to be very happy with any reduction in service.  Perhaps its our job to explain the dilemma that Canada Post finds itself in?  One weekend when you visit your parents, friends’ parents or grandparents I encourage you to ask them what they think about Canada Post, explain the financial issues, and see what solutions you can come up with.  Then submit your ideas to Canada Post, they’re actively soliciting them on the the homepage.  You might as well put your financial acumen to work and help solve this problem.

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Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Barbie needs some cash

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Looking at Mega Brands most recent audited financial statements (December 31, 2012), in many ways they look financially stable.  Their current ratio (current assets/current liabilities) is in decent shape, their debt:equity ratio (total liabilities/total equity) is improving year over year, they had positive earnings for the past two years, and they have a positive cash balance.  So the transaction I’m about to describe wasn’t done in a panic, it was done to take a reasonably healthy company and make it stronger.  Imagine for a second that you are the CEO or CFO of Mega Brands.  You don’t like paying 10% interest since that requires more cash than you feel is really deserved for debt repayment.  You need your other cash resources for day-to-day operations, and you don’t have excess assets that you can sell to generate cash.  What do you do?

Well, you look closely at your balance sheet and you remember that in 2010 Mega Brands issues a whole bunch of warrants.  Warrants are just like a stock option.  It is a financial instrument that gives the investor the right to purchase a common share of the company at a set price.  For general background on options and warrants, see this.  The investors originally paid to get the warrants ($0.50/warrant) and then have to pay again if they exercise their option to purchase the common share (called the strike price, $9.94/share in this case).  Obviously no investor would exercise their warrant if the common share was trading at a price below the strike price.  These particular warrants expire about two years from now and in most cases, finance theory suggests that a holding strategy is optimal.

Mega Brands wanted to raise some cash and had ~240,000,000 warrants still outstanding.  If they could convince all those warrant holders to exercise their warrants, pay the exercise price Mega Brands would receive ~$115 Million.  That essentially enough to cover all the long term debt which would then wipe out the debt with the 10% interest payment.  Early news releases don’t suggest any modified terms, rather Mega Brands executives just had some friendly chats with the major holders of the warrants (i.e. institutional investors) and explained the situation.  The warrants were already in the money since the common shares were trading above $13.  Remember that a warrant holder receives a common share (market value ~$13/share) by paying $9.94/share.  That’s a good deal.  Further, the executives explained that the cash they raised would be used to repay that expensive 10% debt thereby reducing the interest cost and increasing cash available for expansion and dividends.  Win-win for the company and the warrant holders.  No surprise then that approximately 1/2 of the warrant holders have agreed to early exercise.

What will be the impact on the financial statements?  Let’s do this on a single share basis, but in reality closer to 600,000 shares will be issued.  First Mega Brands receives the exercise price from the warrant holders (Dr Cash $9.94) removes the warrant value from equity since the warrants no longer exist (remove at the initial value Dr Warrants (equity) $10) and recognize the new common share being issued in exchange (Cr Share capital $19.94).  Then Mega Brands will turn around and use that cash to reduce their debt, Cr Cash XX, Dr Long term debt XX.  So when the next financial statements get released we should see an increase in equity and an equal decrease in liabilities.

Warrants and options are very common financial instruments.  Mega Brands move to tap into them as a way to raise cash is interesting and a little unusual but quite admirable.

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The full financial statements are here.  I encourage you to look at the balance sheet (page 5), and Notes 15 and 16 in particular (pages 33-35).

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

The CERCLA of life

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Like all mining and natural resource extraction companies, Teck can take a bad rap for their actual or perceived damage to the environment.  I will be a realist and admit that some damage is going to be incurred whether we are talking about the oil sands in Fort McMurray or Teck’s lead/zinc smelter in Trail, BC.  Of course I am still very concerned about the extent of the damage and companies must be doing all they can to minimize the impact on the earth and the people affected.  The smelter in Trail BC is currently owned by Teck, but some of what I’ll mention here preceded their ownership.  Historically the Trail, BC smelter has not been the cleanest enterprise in the world.  In fact the city of Trail was ranked as the second most polluted city in North America.  As early as 1925, nearby settlers sued the smelter for damages to crops and forests. The real push to clean up their act started in 1975 when a study of the lead levels in young children were well above any reasonable safe level.

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Teck has recently been in the news for some pollution that they have admitted they dumped into the Columbia river that flows past the smelter.  Trail, BC is a stones throw away from the US border and the Columbia river flows south so the pollution has ended up in the US.  I’d been reading the recent news stories and then bumped into the Teck controller the other day.  I asked him how the lawsuit was affecting their financial reporting, expecting him to say that they were accruing millions of dollars for the potential costs.  Nope.  It turns out that while everyone knows what was dumped in the river, no one is all that clear on how much damage has occurred.  Some people (mostly Teck employees) claim very little damage has occurred.  So they’re paying for a bunch of environmental studies but no accrual beyond the costs of those studies has happened.

Then the controller mentioned to me that their bigger concern is selenium.  What?  I’ve studied Teck for years and never heard of selenium, how bad could it be?  It turns out its not good news.

Ok, so Teck has some trouble with pollution of the Columbia river and then this selenium problem.  How do these impact their financial statements?  I was expecting the Columbia river lawsuit to show as an accrual which is a liability.  Check out the balance sheet (the December 2012 financial statements have not yet been released).  First, note that Teck is financially very healthy: total debt ($16 Billion) is less than 50% of the total assets ($34 Billion) and the current assets ($7.4 Billion) far exceed the current liabilities ($2.1 Billion).  Next, realize that to find out very much about the accruals we’ll need to dive into the financial statement notes, particularly note 20 for “Other liabilities and provisions”. Also, notice at the bottom of the balance sheet, that contingencies are discussed in note 22, that will be interesting to read as well.  Access the full financial statements and notes from the left hand side, “Consolidated Financial Statements (PDF)”.

Here is a portion of note 20:

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This is a complex financial reporting topic but notice that selenium is mentioned in the second paragraph.  Accounting for these types of costs requires a lot of estimation: how much the remediation may cost, when it will occur, an appropriate inflation rate, and an appropriate discount rate.  Be very clear that the number shown in the financial statements is an estimate.  I look forward to seeing how they adjust the December 2012 financial statements, I suspect the remediation costs will be dramatically higher.

Now let’s turn to note 22, the contingencies:

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The important paragraph to read is that last one, “until the studies … are completed, it is not possible to estimate the extent and cost …”  What that means is that Teck has not recorded any liability yet for the Columbia river pollution.  They simply have no idea how much they may be on the hook for, if any amount, so have not recorded anything.  This isn’t devious or wrong, its in accordance with generally accepted accounting principles (IFRS) and highlights again how estimation and judgement are a huge part of the financial reporting.

Now back to the title, “CERCLA of life” – yes its a bad pun, my apologies to Simba et al.  CERCLA is the US Comprehensive Environmental Response, Compensation and Liability Act, otherwise known as Superfund.  It does affect Teck, it has no impact on the Lion King.

 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Groupon’s coupons, Botox and revenue

I posted about Groupon’s difficulty figuring out how to record revenue 18 months ago.  It got its knuckles rapped then and, as I mentioned in my latest post on Livent, revenue recognition is a common problem in accounting errors and frauds.  Groupon has some tricky revenue to sort out, its not exactly clear to many people what Groupon sells.  Do it simply broker transactions between the customers paying for the coupons and the restaurants, spas, and Botox providers or does it do more than that?  

In the financial reporting world we refer to this as the “principal versus agent” (or “gross versus net”) revenue recognition problem.  For instance, assume Groupon sells you a coupon that you pay $10 for.  Further, assume that Groupon pays $8 of the $10 to the Botox provider.  Should Groupon record revenue of $10 and cost of sales of $8 for net income of $2?  Or should they record revenue of $2 and net income of $2?  A simple view of this says, “Who cares!?  Net income is the same under both approaches!”  But it does matter.  It affects things like revenue growth rates and gross profit margins.  Investors care about those sorts of things.

This is a tricky area and has caught many large businesses including Ebay and Amazon.  IFRS, particularly IAS 18: Illustrative example #21, deals with exactly this type of revenue and reporting dilemma and is very similar to US GAAP (EITF N0. 99-19) which Groupon reports under.  Answering “yes” to most of the key factors from that standard determine whether Groupon should record the gross or net revenue.  The key criteria are:

  1. Does Groupon have any inventory and inventory risk? (In my opinion, no),
  2. Does Groupon establish the selling price? (In my opinion, perhaps),
  3. Does Groupon have the primary responsibility for providing the spa or Botox treatment? (In my opinion, no).
Groupon used to report their revenue using the gross method, that is the $10 of revenue and $8 of costs.  After getting its hands slapped 18 months ago, it seems that it adjusted its revenue recognition policies.  The income statement (or statement of operations) below indicates that Groupon earned $1.8 Billion in revenue from coupon sales (third party transactions) and only recorded $297 Million in related costs.  That very high gross profit suggests that they are recording net revenue, that is the $2.

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To really figure this out though we need to dive deep into Groupon’s financial statement notes, particularly Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73 which is copied below for easy reference.  Look carefully at the third paragraph, particularly the portion I’ve highlighted for you.  Groupon now records the net revenue, that is just the $2 (based on the $10 it initially receives from the customer less the $8 it submits to the merchant/Botox provider).  The final sentence of that paragraph clearly explains that the revenue recognition policy is based on the interpretation that Groupon is simply an agent, matching buyers and sellers.  That is completely consistent with my brief analysis of Groupon’s business model using the criteria from IAS 18.

The final thing I will point out is in the fourth paragraph and highlighted for you as well – Groupon loves it when you buy a coupon and don’t ever redeem it.  You lose the coupon, they win.  You forget about the coupon, they win.  It reminds me of the gift card scam, millions of dollars of gift cards expire and the retailers love it.

Finally, I will point out that I have nothing against Groupon although I’ve personally never bought a Groupon coupon.  Perhaps when I need a Botox injection in a few years …

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The following excerpt is copied directly from Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73:

Revenue Recognition

The Company recognizes revenue when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the selling price is fixed or determinable; and collection is reasonably assured.

Third party revenue recognition

The Company generates third party revenue, where it acts as a third party marketing agent, by offering goods and services provided by third party merchant partners at a discount through its local commerce marketplace that connects merchants to consumers. The Company’s marketplace includes deals offered through a variety of categories including: Local, National, Goods, Getaways and Live. Customers purchase the discount vouchers (“Groupons”) from the Company and redeem them with the Company’s merchant partners.

The revenue recognition criteria are met when the number of customers who purchase a given deal exceeds the predetermined threshold (where applicable), the Groupon has been electronically delivered to the purchaser and a listing of Groupons sold has been made available to the merchant. At that time, the Company’s obligations to the merchant, for which it is serving as a marketing agent, are substantially complete. The Company’s remaining obligations, which are limited to remitting payment to the merchant and continuing to make available on the Company’s website information about Groupons sold that was previously provided to the merchant, are inconsequential or perfunctory. The Company records as revenue the net amount it retains from the sale of Groupons after deducting the portion of the purchase price that is payable to the featured merchant, excluding any applicable taxes and net of estimated refunds for which the merchant’s share is recoverable. Revenue is recorded on a net basis because the Company is acting as a marketing agent of the merchant in the transaction.

For merchant payment arrangements that are structured under a redemption model, merchant partners are not paid until the customer redeems the Groupon that has been purchased. If a customer does not redeem the Groupon under this payment model, the Company retains all the gross billings. The Company recognizes revenue from unredeemed Groupons and derecognizes the related accrued merchant payable when its legal obligation to the merchant expires, which the Company believes is shortly after deal expiration in most jurisdictions that have payment arrangements structured under a redemption model.

Direct revenue recognition

The Company evaluates whether it is appropriate to record the gross amount of its sales and related costs by considering a number of factors, including, among other things, whether the Company is the primary obligor under the arrangement, has inventory risk and has latitude in establishing prices.

Direct revenue is derived primarily from selling consumer products through the Company’s Goods category where the Company is the merchant of record. The Company is the primary obligor in these transactions, is subject to general inventory risk and has latitude in establishing prices. Accordingly, direct revenue is recorded on a gross basis, excluding any applicable taxes and net of estimated refunds. Direct revenue, including associated shipping revenue, is recorded when the products are shipped and title passes to customers. For Goods transactions where the Company is performing a service by acting as a marketing agent of the merchant, revenue is recorded on a net basis and is presented within third party revenue.

 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

The Phantom of the Audit

 

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You have probably never heard of Livent Inc. or if you have your memory of what transpired within the company may have faded over the past 15 years.  Yes, one of Canada’s most disgraceful accounting scandals is “celebrating” its 15th anniversary this year.  Livent has also recently been in the news since the Ontario Securities Commission, the stock exchange regulator for Livent, has finally decided to actually regulate.  I don’t want to be too harsh on the OSC, but really – it takes 15 years for you to decide that the perpetrators should be banned from being involved with publicly traded companies?  

Let’s rewind to 1998 when the *&^% hit the fan. Livent had been on a roll; it was producing great theatre performances in Toronto including the Phantom of the Opera and had been reporting fantastic financial results.  Ex-Disney executive Michael Ovitz purchased Livent in 1998 and then realized that it was a financial house of cards.  Note: all the following documents are publicly available through SEDAR.com

First, let’s take a look at the original December 31, 1997 balance sheet:

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Things to note:

  • A small negative deficit ($27M)
  • Accounts payable and accruals ($29 M) that are less than the cash available ($10M) and the accounts receivable ($32M)
  • A preproduction cost asset, representing money already paid to develop future performances, $67M

Now, here is the restated balance sheet after examining some dodgy accounting practices:

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Look at the December 31, 1997 column and compare that to the original figures:

  • The deficit is longer small, it is $124M, approximately $100M larger than originally reported.  Total equity now represents just 1% of the total assets.  That means that 99% of the assets really belong to debt holders
  • Accounts receivable have gone down by $13M and accounts payable has gone up by almost $20M
  • Preproduction cost assets have decreased by $8M

With virtually all frauds, one key culprit is revenue recognition.  Revenue would seem to be an easy thing to account for, but it can get complex pretty easily; primarily timing and amounts.  A simple example of this was Livent’s treatment of certain sponsorship revenue.  Like many arts organizations, Livent earned a portion of its revenue through sponsorship dollars – companies paying for the right to have their logo and signage in the lobby, on the stage, or on the playbill.  This is very similar to the corporate logos you see at the hockey rinks.  Assume that a business paid Livent $500,000 for the right to have their logo on the playbill of the Phantom.  The company probably paid months in advance to secure its sponsorship right.  When should Livent record that payment as revenue?  (a) When they received the cash?  (b) When the show started its 3 year run? (c) Or spread evenly over the three year run?  If you answered (a) you want to review revenue recognition criteria ASAP, before you meet Livent executives in jail (IAS 18).  If you answered (c), congratulations you’re well on your way to becoming an excellent accountant.  Or it was just common sense.  Its interesting how accounting, when done right, involves a lot of common sense.

Another frequent area of accounting fraud is to record expenses as an asset.  How does this work?  Well there is a fine line between assets and expenses.  To keep it relatively simple, assets are expenses that have a benefit in the future.  That’s why we capitalize property and buildings – they will provide a benefit for years to come.  Conversely expenses do not have any future benefit, their benefit has all been used up in the current period.  Well a fairly simple (and fraudulent) technique is to increase your net income by recording expenses as an asset.  Did you notice that decrease in Livent’s preproduction costs?  Yep, that’s what was going on.  They were capitalizing (recording as an asset) production costs that were never going to generate any future value.

A third area where Livent got caught with their hand in the cookie jar was less common (I’ll explain why in a minute) – not even recording the expense.  What was happening was as Livent got a bill in near year end, they were not paying the bill yet (that’s fine, that’s good cash flow management).  A proper accounting system would set that bill up as an expense and as an account payable before year end.  By ignoring that, Livent was artificially increasing their net income (since they didn’t record the expense) and artificially decreasing their liabilities (since they didn’t record the accounts payable).  Wrong on both accounts.  Now why is this not a common area of fraud?  Because its pretty damn easy to find.  All an auditor has to do is look through a stack of unpaid bills and subsequent bill payments and note the date on the bill.  Prior to yearend?  It should be recorded.  Just after yearend?  Let’s do a little more investigation.  So Livent was a case of really sloppy auditing.  No surprise that the three key auditors have all got their knuckles rapped pretty hard.

In conclusion, I know this case is REALLY old but its worth revisiting since it highlights very basic accounting principles that all accounting students should be able to understand.  One final thought – if you’re involved as an accountant with a business avoid this kind of crap at all costs, its not worth it to your reputation.

Here is the official description of the accounting restatements that I discussed above (November 18, 1998 letter):

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 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

The apple never falls far from the tree

The last six months have not been kind to Apple.  Their share price has fallen about 30%.  They briefly held the record for the all-time highest market capitalization of any firm.  They released their first products since Steve Jobs passed away, to mixed acclaim.  I should admit up front that I’m writing this post on an Apple computer with at least four other Apple products within 3 meters.  I’ll try to remain neutral.

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Despite the stumbles over the past six months, Apple has been an astounding success for the past decade.  If you had sunk $1,000 into Apple stock (AAPL) 10 years ago, you’d have roughly $60,000 now.  No matter how pessimistic you are or how much you dislike Apple products, that is an incredible return.  Beyond that amazing return, what makes Apple interesting?  Or at least from an accounting perspective?

Apple is sitting on a ton, a TON, of cash.  In their latest annual financial statements (September 29, 2012) they report $10.7 Billion in cash.  Scroll through the attached annual report to find the balance sheet on page 44.  That $10.7 Billion in cash is in addition to $18.4 Billion in short term investments and another $92.1 Billion in other liquid investments.  Why does Apple need approximately $120 Billion in cash and investments?  They don’t.  Most companies operate with very little cash on hand, barely scrapping enough cash together to pay the electricity bill or pay employees.  Apple is on the complete other end of the spectrum.

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A humourous article points out that Apple’s cash reserves are enough to purchase 100% ownership in Starbucks, Facebook and Yahoo.  Yes all three together.  Corporate finance theories suggest that cash management is very important for a business to succeed.  A business needs to have enough cash on hand, but not be wasteful.  Once a business gets to a stable point, they generally start repaying shareholders via dividends.  Remember that dividends are NOT an expense, they are a return of earnings and therefore reduce retained earnings.  Apple refused to pay dividends for years, arguing that it needed its massive cash resources for company purchases and to fund its large research and development costs.  Finally a year ago, Apple decided that it had more cash than it could ever use so it began paying dividends.  The third such dividend was just paid out last week, $2.65/share or about $2.5 Billion in total.  As dividends go that’s fairly large, but you need to think of the dividend as a proportion of the cost of purchasing the share.  That’s referred to as the dividend yield and for Apple is a paltry 2.4%.

Apple is currently involved in a complex lawsuit regarding the dividend payout.  It is important to note that with the current dividend rate, Apple is “only” paying dividends of $10 Billion per year and there are plenty of projections out there that suggest Apple will generate substantially more net cash from operations every year so their cash reserves could in fact be growing.  Apple is an interesting case study – they were almost bankrupt 25 years ago and some experts suggest that their cash hoarding is the result of a “depression era” mentality – they are so petrified of being near bankruptcy again that they play a very conservative game.  The other issue is that Apple is notorious for leaving significant (almost $100 Billion) cash overseas in other countries.  That overseas cash and profit was generated from legitimate sales of their products and services worldwide.  In most cases Apple has paid the domestic (i.e. local country) income taxes as required by the local jurisdiction.  Apple has taken advantage of a few low-tax countries, that’s not nefarious, its solid business planning.  The problem is that the US makes it very difficult to repatriate overseas earnings, that is, bring the money back into the US.

There are three good lessons to learn here:

  1. Cash is important which means that a company’s dividend policy is also important.  If it’s too high then the company will run out of cash.  If it’s too low, investors will be less happy.
  2. International taxation and cash management is complex.
  3. Psychology and history impacts business decisions.  We need to understand the past before we can understand current decisions.

 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Turkeys, forks and dual class shares

Dual class equity structures are a hot topic of discussion in Canada.  In simple terms dual class equity structures have more than one class of common shares.  These two (or more) classes may have similar cash flow rights (i.e. dividends) but always come with different voting rights.  Remember that voting rights refer to voting for particular members of the board of directors.  Some companies have shares with one-vote shares and no-vote shares or one-vote shares and multiple-vote shares.  In Canada, these dual class share companies are generally controlled by family dynasties – Magna International was controlled by the Stronach family for many years.  Other examples include Shaw Communications (controlled by the Shaw family), Power Corp (controlled by Paul Desmarais), and Rogers Communications (controlled by the Rogers family trust). In Magna’s case, those multi-vote shares provided 300 votes votes per share resulting in the Stronach’s only holding a 1% equity interest in the company but controlling 66% of the votes.  The purpose of such equity structures is that it allows the founding families to retain control while still raising equity on the open stock market from Joe Plumber or Jane Mainstreet.  The problem is that the holders of the less powerful shares take on a ton of the equity risk without getting the benefits of control.  That disparity usually results in the less powerful shares trading at a discount.

In recent years, some of these companies have tried to simplify or clean up their equity structure by consolidating all the shares into one single class with equal voting rights and equal cash flow rights.  Magna did that in 2010 and in my opinion paid dearly to convince the Stronachs to give up their super-voting shares.  Ultimately they were paid a 1800% premium and close to $1B to give up their family shares.

Telus is not a family-owned corporation but as a result of the merger of BC Tel and Telus in 1998, they ended up with no-vote and single-vote shares.  They are now trying to clean that up.  The problem they have run into is that an institutional shareholder that did control the company by holding a substantial number of the single-vote shares would lose control once the no-vote shares are converted into single-vote shares.  A very interesting corporate governance situation.

As a shareholder of Telus (I own both the no-vote and the single-vote shares) the proposed transaction doesn’t affect me very much.  I usually don’t exercise my voting rights at the annual general meetings, I’m just happy to collect the dividends they pay me.  However, if I owned significant numbers of those shares then I would definitely be interested in the settlement.

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Voting rights can be an abstract and complicated issue – let me use an analogy.  Imagine sitting down for a Thanksgiving dinner with five other people.  There you are, one of six people at the table, a tasty roasted turkey (or tofurkey if you prefer) in the centre of the table.  The only problem is that there is only one fork at the table.  The person with the fork clearly has an advantage – that’s the multi-vote shares.  The rest of you still have a seat at the table but no real tools to eat the dinner.  If you want to equalize everyone around the table there are two obvious options: (1) take the existing fork away or (2) find five more forks so all six of you have a seat and a fork.  In either case, the person with the only fork at the beginning of dinner probably feels ripped off.  Fixing the dual class equity structures is even more complicated than settling forks and turkey dinners.

There are not any difficult accounting implications to dual class equity structures except appropriate disclosure that outlines the dividend and voting rights.  Dividends are still dividends, share issuances and share retirements are dealt with just like a single class structure.  As discussed above, you should see the corporate governance implications and the difficulty trying to unwind such structures.  Dual class equity structures are becoming rarer in Canada and were never popular in the US.  Keep your eye out as Telus completes the proposed transaction and as the other remaining dual class companies start to clean their equity structures up.  In every case you will find that either the fork-holder or the non-fork-holders will be unhappy – that’s the consequence of cleaning up a mess.

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)