Moretel or … More on Nortel (part 1)

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Although I wrote about Nortel a few posts ago, it really is the never-ending financial reporting story in Canada. A recent Globe and Mail article outlines the argument (no, that’s too strong… ‘discussion’) that occurred between Nortel executives and their auditors, Deloitte & Touche. The issue at the core of the article and current legal discussions involves when Nortel should have undone some of their “reserves.” This is a complex topic for anyone that hasn’t completed a few accounting courses. I doubt that 5% of the people on the street have a grasp of what went on at Nortel. At the risk of over-simplifying, let me try to explain it here.

The reserves they refer to in the article are actually liabilities, which would be sitting there on the balance sheet as credit balances. The term “reserve” has a slightly different meaning under different GAAP, so lets clear that up now. Under IFRS (Conceptual Framework, para 4.20), reserves are actually an equity item and mean something different than what we’re discussing here. Nortel reported under US GAAP (despite being a Canadian company). In US GAAP, “reserves” refer to liabilities with uncertain timing or uncertain amounts. Under IFRS, these are called “provisions” (IAS 37).

Getting back to the stuff in the recent news—what Nortel referred to as “reserves” were liabilities. Nortel execs and the auditors were arguing about when to remove those credit balances from the balance sheet. These reserves are no different than regular liabilities. Nortel believed that they owed someone some amount of money or future service. There are essentially two options when dealing with these types of liabilities: 1) Nortel could have settled the liability by paying the other party or providing the expected service (this is the normal course of action), or 2) Nortel could have decided it was no longer responsible for settling the liability and removed the credit balance from its balance sheet. Let’s quickly walk through examples of each of these options.

Assume that Nortel offers a customer a special warranty to fix a specific piece of equipment if it breaks in the next three years. This warranty meets the definition of a liability. Therefore, on the date of the sale Nortel books a special warranty liability related to the piece of equipment. The journal entry on the sale date should be:

Dr Warranty Expense $X

Cr Special Warranty Liability $X

This would reduce net income immediately and create a liability.

Case 1: Over the next three years, the equipment breaks and requires service. Nortel provides the service and parts necessary. Assuming that Nortel pays cash for the workers and parts, the journal entry on the date of the repair would be:

Dr Special Warranty Liability $Y

Cr Cash $Y

This would have no impact on net income.

Case 2: Over the next three years, the equipment performs flawlessly and requires no warranty service. At the end of the three years, Nortel would still have that original Special Warranty Liability on its balance sheet for $X, but since the warranty will have expired it would no longer owe anything and wouldn’t have a true liability. Therefore, it should reverse the liability:

Dr Special Warranty Liability $X

Cr Warranty Expense** $X

Note that this journal entry actually increases net income at the end of the third year. What Nortel is in trouble for is Case 2, reversing the liability (“reserve”) at a potentially inappropriate time. Notice the substantial difference between Case 1 and Case 2: the first does NOT impact net income, the second does. If Nortel wanted to inflate its income, reversing a liability would definitely accomplish that. In some cases, reversing the liability is completely justified. The question is, did Nortel have the proper justification? In the next part, we’ll look at the reserve leading up to the time Nortel reversed it and examine some potential incentives that Nortel had to artificially increase net income.

** While it may seem unusual or wrong to credit (Cr) an expense account it is acceptable.  It is unlikely that the Cr to Warranty Expense would create a negative expense.  Since there would have been other Dr entries to that same account during the year, the Cr only reduces the expense rather than making it negative.

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

Running A Student Pub (into the ground)

Earlier this spring, the University of Windsor Students’ Alliance (www.uwsa.ca) announced that they were closing the student-owned-and-operated pub (The Thirsty Scholar) due to financial reasons. This announcement surprised me; why can’t a business successfully sell beer to an audience traditionally associated with beer and pubs? I suppose there are a myriad of potential reasons—students don’t like beer, the pub is paying outrageous rent to its landlord, or general mismanagement for starters. I decided to dig through the pub’s financial statements (they should be publicly available, as records for most student organizations are). You should check their financials web page… you may have better luck than I did (www.uwsa.ca/financials.php). I couldn’t find a working link to any financial statements for the pub that were more recent than April 30, 2009. Note to the UWSA executive: I suggest you hire a computer science student to fix up your website.

What’s the point of looking at these financials? What can they really tell us? Financial statements should be one source for examining an entity’s history. With a little interpretation, we can usually learn quite a lot. Financial statement sleuthing may not be as popular as CSI-style forensics, but really is not that much different. Let’s take a look at the statements that were available.  Note to reader: you will want to open a set of the financial statements and follow along with me.

The second page of the 2009 financial statements is the “Review Engagement Report.” A review engagement is one type of assurance on the financial statements. It’s not nearly as good as an audit engagement, but provides some level of comfort that the financial statements are not grossly misstated. The third page is the index—not useful.

The fourth page is the “Statement of Income” for the year with comparatives for the prior year. We find out that the pub had just over $450,000 of revenue, compared to $511,000 the year before, with beer sales declining from $172,000 to $123,000 (a 28% decline!). Gross profit increased though, which is usually good news. Gross profit is the amount left over after paying for the direct costs of beer, food, and liquor. For 2009, gross profit was $201,702. In order for the pub to be profitable, all the rest of the expenses needed to be less than that. Unfortunately this wasn’t the case. Actual expenses were $261,854, resulting in an operating loss for 2009 of $60,152. That’s a slight improvement from the prior year when the pub had an operating loss of over $95,000. What was by far the biggest expense? Wages. In fact, the wage expense exceeded the gross profit in both 2009 and 2008. That means the pub had no chance of being profitable even before it paid for any advertising, insurance, policing and security, or repairs on the facility. I hunted around for some industry statistics on drinking establishments and food services and I found the following data (www.restaurantcentral.ca/ResearchTrends/IndustryStatistics.aspx): average cost of goods sold was 36% of revenue, and average labour cost was 33.9% of revenue. The Thirsty Scholar’s numbers for 2009 were: Cost of goods sold, 56% of revenue; and labour, 48% of revenue. That both of those figures were so grossly out-of-line with industry norms suggests management incompetence. I’ve seen similar issues with student-run businesses before. Don’t get me wrong, I love student-run and student-owned businesses, but they must be run by people with appropriate training and it is important that the student associations ensure the managers are properly trained. Ok, enough on the income statement, let’s move on.

The fifth page is the “Statement of Retained Earnings,” which accumulates all the profit or loss retained by the business. Again, it isn’t good news for the Thirsty Scholar. By April 2009, they had accumulated total losses of almost $1 million. The losses that we saw on the income statement for 2009 and 2008 were not a short-term issue—the pub must have been accumulating losses for quite a while.

The sixth page, the balance sheet, is the last that I will examine for this post. Remember the key accounting equation: Assets = Liabilities + Equity. The Thirsty Scholar had total assets of $29,764 (mostly cash and accounts receivable). Their liabilities? $885,359! That’s incredible! They owed almost 30 times what they had in assets. I’ve rarely seen such a poor Asset:Liability ratio, and without digging too much further it seems pretty obvious that this business is broke both financially and structurally. Shut it down, pull the pin.

I hope you’ve enjoyed this somewhat macabre walk through the financial statements of a student pub. Next time you’re sitting in your local school pub enjoying a beverage, don’t forget the lessons we can learn from examining the financial statements of a business.

Drink responsibly!!

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

Financial reporting: between a rock and a hard place?

Nortel. The word is never used in a positive way in Canada. Nortel Networks Corp. was one of the most dramatic corporate failures in the country. While Nortel’s collapse and failure occurred over a decade ago (in 2000), remnants of the scandal still remain, including recent stories in national newspapers (see Jan 30/12 and Feb 14/12). While there were some obvious business factors that precipitated the company’s failure (including a collapse of the entire high-tech sector), poor and fraudulent accounting practices were clearly in play. The specifics of the fraud are still being investigated but a few things are clear and impact students taking an accounting course.

  1. Management probably had financial reporting incentives that differed from those of other stakeholders—particularly shareholders. In the recent news about Nortel it seems clear that management was keen to receive bonuses that were triggered or affected by the profitability of the firm. It appears that those incentive contracts were based on some non-GAAP (i.e., unofficial) profit number. Instead of reporting the GAAP-compliant profit (which was negative), management decided it would be “better” to artificially inflate the financial statements to show a profit so they wouldn’t look as greedy for taking their bonuses. That makes some sense—how happy would you be if your boss took a bonus but everyone else got nothing? Of course, that doesn’t make it right, it just makes it logical. Another option available to management would have been to properly disclose the negative GAAP net income and not take their bonuses. Financial incentives are strange beasts and can create odd logical-but-unethical behaviour.
  2. Financial reporting involves a lot—a LOT—of flexibility and judgment. This doesn’t make accounting good or bad, it just is. If users of financial statements are unaware of this flexibility, they may use financial statements improperly. If we think about the most common financial statement metric discussed, net income, many readers might feel that it must be an accurate number. More experienced financial statement users are aware that net income is simply the sum of a bunch of estimates and, therefore, an estimate itself.In addition, the two main building blocks of financial statements, assets and liabilities, are future oriented. That is, the value of an asset or a liability requires some estimation of what will occur in the future. Nortel obviously used this flexibility to its advantage for many years. As a future user of financial statements, you need to read them with a fair degree of skepticism. It’s not that they’re wrong, but they’re definitely not perfectly correct. Nortel is a reminder of this aspect of financial statements.

The collapse of Nortel is a high-profile reminder of some underlying characteristics of financial statements—they are prepared by people with extensive insider information and potentially odd incentives, and they contain a ton of estimation. Nortel’s fall contains many other interesting lessons, and we may revisit it over the next while as the Nortel investigation continues. If you have any questions or comments on Nortel or on the concepts discussed above, please leave a comment below.

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

Pensions – Paying for them for life

The recent federal budget included some interesting ideas about the correct retirement age and the impact that pensions have on taxpayers. Most post-secondary students are young and really don’t give much thought to pensions—what they are, how they work, or how they affect the finances of a business. Other than tobacco lawsuits, pensions are one of the largest liabilities that a business will ever face, and they impact retirees, soon-to-be-retirees, and young employees alike. In the case of post-secondary institutions, pensions also have a substantial impact on tuition and current students. They are worth paying attention to.

First, let me quickly explain what pensions are and how they impact financial statements. A pension is a future payment to a current employee that is paid out once the employee retires. There are two basic types of pensions: defined benefit (DB) plans and defined contribution (DC) plans. The type of plan (DB or DC) has a massive impact on how we account for the pension plan and its potential effect on financial statements. If you’re comfortable reading IFRS, see IAS 19.43 and 19.48 for more information. For the sake of this discussion we’ll consider DC plans as relatively simple, with few accounting concerns. DB plans, on the other hand, should not be dismissed as quickly.

A DB plan essentially guarantees a current employee a set amount once he or she retires. Hence, it clearly meets the definition of a liability: it’s a current obligation from a past transaction that arises due to the employee working for the employer, and will be settled in the future when the pension is actually paid out. Estimating the amount or the liability is difficult but not impossible. For instance, we need to estimate how long the employee is likely to live. Once the experts estimate the pension liability, the employer and employee must begin saving enough money to eventually be able to pay that liability. This pot of money is referred to as the pension asset. Determining the correct amount to save is difficult as well, since it requires estimating a future rate of return. In a volatile market like we’ve had for the past 5–10 years, this can be very challenging. When the pension liability exceeds the pension asset, it is an underfunded pension since there won’t be enough cash to settle the liability when the employee retires and the employer is on the hook to make up the difference. If the employer only had one employee, an underfunded pension might not be a significant dollar amount. But when thousands of employees are involved, as in most universities in Canada, the underfunded pension amount can be substantial. How much? A recent Globe and Mail article reports that the University of Toronto is facing an underfunded pension liability of almost $1 billion. This works out to about $20,000 per student currently enrolled at U of T. Other schools are not immune, and when scaled by student enrolment are actually in worse shape. The University of British Columbia and some other schools in Canada operate DC plans, and therefore have no underfunded pension liability.

Make no mistake about it, there are a limited number of options when facing an underfunded pension plan. The employer can try to renegotiate the terms of the pension plan with employees (which is VERY difficult) or the employer must generate additional money to save in the pension asset, which reduces or eliminates the underfunding. Post-secondary institutions have limited ways to earn additional revenue, and primarily have to rely on tuition increases. Should students be concerned? Definitely. I don’t think you need to worry about your institution going bankrupt, but I do think you should be informed about where your tuition dollars are spent. Do a quick search and see if your institution has a DB or DC plan. If it has a DB plan, is it underfunded? If so, by how much? What strategies does the institution have to fund that liability and how much are you paying for? To get started, try using the search term <institution name> pension plan news.

As a faculty member, I’m keen to get a pension when I do retire and I don’t mean to bash pensions or pension administrators. In all fairness, the bulk of the underfunded pension liabilities are the result of the financial market crash in 2008 rather than deliberate mismanagement. We don’t necessarily need to blame anyone for the situation we’re in, but we do need to work together—students, faculty, and administrators—to develop a strategy to solve the problem. I hope that you feel more knowledgeable about pensions and how they affect your school, and that you are willing to ask your accounting instructor more about this topic—it does affect you.

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