Pensions? Let’s just wing it.

During this holiday time many of you may be flying around the country visiting family and friends.  There’s a good chance you are flying on Air Canada so I thought this post may interest you.  We’ve talked about pensions before, mainly related to universities.  A quick reminder: defined benefit pension plans (like most of Air Canada’s) involve a massive liability since the company agrees to pay each retiree a set amount per month and a large pot of money handled by a third party trustee.  The pot of money is intended to fund that massive liability.  The company is supposed to put substantial amounts of money into that pot of money held by the trustee each year so that the pot of money is equally massive as the liability.  When I say “massive” how big are we talking?  Well in Air Canada’s case the liability was $14.4 Billion at the end of 2011 (see Note 10 of the 2011 financial statements).  To put that in perspective, the province of BC’s debt is about $34 Billion.


Air Canada’s liability isn’t really that big because they have been putting money away for years to help pay those pensions, and its the net liability (liability-assets) that’s key. In a perfect world, the pot of money would be equal to the liability.  Then retirees could relax, knowing that no matter what happens to the company, they will be receiving their pension payments.  Like virtually every other defined benefit plan out there right now, Air Canada’s is “under funded” meaning that the pot of money (or “plan assets”) is less than the pension liability (or “pension obligation”).  There are two main reasons that so many (~93%) defined benefit plans are underfunded right now: (1) the financial market melt down of 2008 that decimated plan assets and (2) the incredibly low interest rates for the past 5 years.  Wait … what do interest rates have to do with this?

The pension obligation is an interesting liability that demonstrates quickly so many measurement problems in accounting.  Imagine the defined benefit plan for just one current employee.  Let’s assume that the employee and employer agree on a pension of $1,000 per month once the employee retires (after 67) until the employee dies.  First we need to estimate how long the future retiree will live for, then we need to calculate a present value of the annuity that we will be paying them from the time they retire until they die.  Then we need to take the present value of that annuity back to today to calculate today’s value of that liability.  Obviously those two present value calculations involve some discount rate.  The higher the discount rate, the smaller the present value.  As interest rates have fallen, appropriate discount rates for pension calculations have also fallen.  So the pension obligations have risen.  So its the perfect storm for pensions – the plan assets have taken a loss due to the market fall and the pension obligations have risen due to falling interest rates.  The end result?  93% of defined pension plans are currently underfunded.

Now, back to Air Canada.  How bad is Air Canada’s situation?  Well at the end of 2011, they had an unfunded pension balance of $4.5 Billion!  I know that we lose sight of the scale of numbers these days, but remember that Air Canada has about $11 Billion of revenue each year combined with about $11 Billion of operating expenses.  Their net income is rarely positive.  If I was a current or future retiree of Air Canada I’d be wondering where my pension payments were going to be coming from.  Is Air Canada worried about this situation?  Absolutely.  So is the Canadian government.  Under federal rules, Air Canada is supposed to be making extra payments to be closing that gap.  They recently asked the federal government for an extension that reduces their catch-up payments.  Air Canada was lucky to get a bit of a pension contribution holiday a few years ago, it is an interesting political situation to see what the government does this time.  On one hand the government wants to protect current and future retirees which means that Air Canada has to pony up the cash.  On the other hand the government can also read financial statements so they know far too well that Air Canada really doesn’t have the capacity to pay the necessary money.  Forcing Air Canada to make the necessary payments doesn’t make a ton of sense since that would basically mean bankruptcy.  Then you’ve got the competition issues – is a break for Air Canada fair to the other national airline, Westjet?

As you take flight this holiday season give this some thought.  There is no easy answer but jot your thoughts down as a comment and I’ll be happy to pass them along to Jim Flaherty, the finance minister who will have to deal with this.  Best of the holidays to you and have a fantastic 2013!

Note: this blog was originally posted on my site hosted by Pearson Education(

Cash: where does it go? Where does it come from?

A recent Globe and Mail article on Thompson Creek Metals Co (TCM) caught my eye.  TCM just finished raising some debt in the market to help fund their operations.  That by itself is not really that interesting – businesses raise debt financing every day of the week.  What I found interesting was the rate of interest that TCM had to offer investors to make this debt marketable – about 14%!  Let’s put this in context: bank mortgage rates are hovering between 3% and 4%.  Credit card debt is somewhere around 20%.

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Interest rates are a pretty good measure of risk.  Mortgages are generally low rate because they are secured by a substantial asset (your house) and the approval process is usually pretty thorough (ignoring the housing disaster in the US in the past five years).  Credit card debt is unsecured and pretty much anyone breathing can get a credit card these days.  So TCM’s projected interest rate of 14% is somewhere in the middle – why do I think its interesting?  Just 18 months ago (May 2011), TCM also went to the debt market and raised $350M.  That debt was initially issued to yield ~7.3%.  So why has TCM’s cost of capital (think “interest rate”) jumped so much in 18 months?  Two key factors: (1) their main product is not selling well and (2) they are bleeding cash.  It turns out that financial statements demonstrate this very well, primarily the Statement of Cash Flows.


The Statement of Cash Flows is the “ugly duckling” of financial statements and generally plays second or third fiddle to the Balance Sheet and the Income Statement.  The purpose of the Statement of Cash Flows (SCF) is to tell the reader where cash has come from and where it is being used.  There are three main categories of items on the SCF: operations, investing, and financing.  Operations is the day-to-day business portion; proceeds from selling product and services less the cash required to pay all the business costs like purchasing inventory and paying for wages.  Investing activities are generally related to expanding the business’ assets (new mines, new dump trucks) or replacing those items.  Financing activities relate to raising new money from debt or from issuing shares or repaying debt or shareholders.  The table below summarizes TCM’s SCF (in millions US$) for the past three years:

  2011 2010 2009
Operations 202.7 157.4 105.9
Investing (716.4) (242.6) (412.6)
Financing 495.9 236.0 200.7

The SCF tells a pretty clear story – TCM is in a rapid expansion period.  They have spent over $1.3 Billion on new projects and new expansion in the past three years.  Since their current operations have only generated cash flow of $466 Million, they are scrambling to raise the remainder of the required cash.  In 2009 they issued new shares for $200 million.  In 2010 they raised $236 million mainly from an arrangement to sell future gold production (the “Gold Stream Arrangement”).  In 2011 they raised the majority of the total financing of $495 million from the issuance of the debt mentioned above, $350 M at ~ 7%.  

The picture painted by the SCF is a common story for start-up businesses.  They generally don’t produce much (or any) cash from operations, they require substantial amounts of new assets (negative cash flow from investing activities), so they end up raising new financing from debt or equity investors.  At some point though the business needs to reach a sustainable point where the cash flow from operations is sufficient to fund the required investing activities and start to repay financing activities.  As the story around TCM indicates, investors and management hope to reach that sustainable point before all sources of financing dry up.

I am a firm believer that the Statement of Cash Flows should not be the “ugly duck” and in fact should be the first financial statement that readers turn to.  Rare is the case that the SCF doesn’t tell a very accurate story of the firm simply by looking at the subtotals for the three main sections.  I encourage you to find a set of financial statements for a company you are interested in and create a table like the one above.  There are some common patterns for successful businesses, for new businesses, and for businesses that are a breathe away from bankruptcy.  What does the data from the SCF say about the company you were interested in?

Note: this blog was originally posted on my site hosted by Pearson Education(

Can’t See the Trees in the (Sino-)Forest?

Sino-Forest has been the centre of a major accounting scandal in Canada since June 2011, when the first word of missing trees came out. The gist of the scandal is that Sino-Forest, a Chinese tree farm/lumber company listed as a publicly-traded company on the Toronto Stock Exchange, claimed to own hundreds of thousands of acres of forest in China. It turned out that those forests were as fictional as Treebeard and the rest of his clan in The Lord of the Rings.

How does one lose a forest? You might have thought that the auditors (Ernst & Young) would have checked for their existence, and they probably did. But auditing forests is not an easy job. Auditors might ask management to take them to the forests to see them first hand, but would have no way to know if the trees they were looking at actually belonged to Sino-Forest. I also suspect you could almost blindfold any auditor, spin them around three times, clap your hands, and the forest would look different enough that you could claim they were looking at a different package of land.

Things were also complicated by the fact that many of the documents were in Chinese, and most of the audit staff didn’t read Chinese.Its difficult to consider a purchase/sale document for a hunk of land as solid audit evidence when very few people could actually read the document. So, we have a “potential” case of audit failure. Again. (Sigh.)  Ernst & Young (Canada) has settled all civil litigation related to this failure for $117 million—the largest such settlement in Canadian history. I should point out that the settlement clearly states that there is NO admission of guilt.

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The Sino-Forest scandal and Ernst & Young’s settlement comes right on the heels of all the Big 4 accounting firms getting their knuckles rapped for violating some US SEC audit rules about disclosure of audits of foreign (primarily Chinese) companies. But if an audit firm does disclose the necessary information to keep the SEC happy, it breaks a Chinese rule about privacy and non-disclosure—a can’t-win situation. Nonetheless, the SEC has kicked over 40 Chinese companies off American stock exchanges in the past few years for various violations.

What’s going on here? I suspect that Chinese companies that are growing and need access to capital look to North America (NYSE, TSE, etc.) with eyes wide with anticipation. These companies are greeted by North Americans who have been told time and time again that they should invest in the red-hot Chinese economy (Sino-Forest shares were recommended as recently as May 2011, less than a month before things unraveled). In order to be listed in North America, a Chinese company must enlist the help of one of the Big 4 North American accounting firms. The Big 4 are all too happy to help since they want to hold on to market share and grow their billings. Combine uninformed investors with compliant auditors and a massive language barrier and you get the obvious result: Sino-Forest.

From an accounting perspective, what went on at Sino-Forest? To keep it simple, money was flowing out of the company supposedly for the purchase of massive tracts of forest. In reality, the money disappeared into the hands of a select few executives. So Sino-Forest had no cash, massive debt, no forests, and hence no future revenue. Its stock plummeted and the firm went bankrupt.

Stories like this make investing in Walmart or Apple substantially more appealing, don’t they? I can drive down the street and see a Walmart store with my own eyes; I can see and hear the massive crowds in the store buying merchandise. I can sit at my local coffee shop and observe that more than half the people there are using iPhones. But I can’t easily see, hear, or smell the forests “owned” by Sino-Forest. They were supposedly halfway around the world in some remote area of China, and since one forest looks pretty much like any other forest out there, I couldn’t have told them apart even if I had seen them. What’s the lesson here? KISS (keep it simple stupid), I think. Invest where you can see, hear, feel, or smell the business. At least then you’ll have some assurance that Treebeard won’t sweep in and steal the business out from under your eyes/ears/nose.

Note: this blog was originally posted on my site hosted by Pearson Education(

Wholesale Dividends: Good or Just Special?

NewImageA number of US companies (including Costco, for example) are rushing to pay out massive dividends before December 31, 2012 to beat the dividend tax hike that is pending. A quick refresher on dividend taxes in the US: Under George W., long-term capital gains and dividends were subject to a temporary tax break resulting in a maximum tax rate of 15% (compared to normal business and employment income subject to a maximum tax rate of 35%). This tax holiday was supposed to have expired December 31, 2010 but was extended for two years by President Obama. Politically, dividend and capital gains tax rates are important. Those with less-than-average wealth generally don’t care about these rates since that set of the population doesn’t usually own investment portfolios that generate capital gains and dividends. However, the wealthy really do care, and they’re the ones who contribute to political coffers. But let’s leave the political aspects aside since they can be all-consuming on their own.



If you are a US company and you know the dividend tax holiday is about to expire, you would prefer to give your shareholders cash before December 31, 2012 so they would only pay the 15% tax rate. If you paid the dividend the next day, January 1, 2013, your shareholders would be subject to a maximum 40% tax rate (39.6% to be exact). That’s a big difference. Especially when your dividend payment is $675 million. What? Who gets dividends like that?? Well, the Walton family does. Yes—the founding family and controlling shareholders of Walmart. They own and control 51% of the shares of Walmart and have decided to trigger a one-time, special dividend of roughly $1.3 billion, of which their portion is roughly $675 million. Issuing the dividend by December 31, 2012 results in tax savings of about $166 million for the Walton family alone. That’s a big deal and smart tax planning.

In Costco’s case, the special dividend works out to about $7 per share. This is well above the normal dividend rate of about $0.14 per share and works out to a total of $3 billion. Interestingly enough, the very same day that Costco announced its special dividend, it also announced new debt offerings (meaning it will be borrowing from investors) of $3.5 billion. Do you see any connection between the two? Paying the dividend requires $3 billion in cash, but Costco needs that cash for day-to-day operations, so it borrows more cash.

Should we care? I think so. This is a clear case of tax policy driving economic decisions—maybe even bad economic decisions. In Costco’s case, the US Treasury will collect substantially less tax than if the dividend was paid a month later, and the interest cost on the new debt is tax deductible for Costco, which will decrease its taxable income for years to come. In my opinion, this is a clear case of a wealth transfer to the rich at the expense of the general US tax payer, or at least the expense of the US government. There are some potential arguments to justify such behaviour but I don’t find them compelling. I will chalk this up to a capitalism #fail.

Note: this blog was originally posted on my site hosted by Pearson Education(

Fracking government

The Quebec government’s decision to extend the moratorium on natural gas hydraulic fracturing (commonly referred to as “fracking”) has certainly raised some eyebrows within Canada and internationally.  Fracking has been used to access natural gas reserves that were previously thought to be inaccessible or at least not economically feasible to access.  The science is pretty simple: pump water at great pressure into rock with cracks and natural gas and viola, the water pressure opens the cracks up letting the natural gas be captured.  I’m not convinced that this does not carry substantial health risks but I will admit that the research is not conclusive.


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As a result of some mixed results, the Quebec government introduced a temporary moratorium on all natural gas fracking in the province.  In the middle of September, there was some indication that the government was considering a permanent ban.  While this has clear political repercussions, and potentially some health benefits, it also has some substantial accounting implications.  There are a number of companies that had started natural gas fracking operations or exploration within Quebec prior to the moratorium, most notably Talisman Energy and Lone Pine Resources.

Talisman just reported their third quarter results and included a substantial impairment charge related to their Quebec fracking operations.  An impairment charge is a non-cash write down of an asset.  Over the past two or three years, Talisman had purchased exploration rights (an asset), done some successful drilling and exploration (an asset), and started to building capital infrastructure to support fracking (an asset).  Now that Quebec is considering a permanent ban, those assets are virtually worthless.  Under generally accepted accounting principles (IAS 36, IAS 16), that decline in value is referred to as an “impairment”.  The asset must be written down to its value-in-use (pretty much zero if you can’t pull natural gas out of the ground) or its recoverable amount if you can sell it (pretty much zero since no one will buy those assets with a government strongly considering a permanent ban).  The asset write down creates an expense for the same amount – a non-cash expense but an expense nonetheless.  This expense is typically large and commonly results in a loss for the period.  Check out Talisman’s third-quarter financial statements, particularly the income statement (page 2) and note 9 (page 9) for more information on this impairment.  For another example of an impairment charge see the post about Microsoft.

This is another great example of how accounting is a pretty good reflection of real life or at least economic reality.

Note: this blog was originally posted on my site hosted by Pearson Education(

Welcome back Alberta!

While I doubt that my recent post shaming the Alberta CAs had any influence, it is great to see them come to their senses and rejoin the national CPA unification initiatives.  This is better for students and for the public, no question about it.  For those remaining curmudgeons, I toss you this encouraging message from Gloria Gaynor:

For the complete formal announcement, click on the image below.

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Is Teavana the Next Nirvana? Starbucks Thinks So.

In recent news, coffee giant Starbucks decided to expand beyond its well-known Tazo tea line by purchasing Teavana Holdings Inc. This purchase raises a number of interesting strategic questions (e.g., has Starbucks saturated the coffee market and can only achieve growth through new markets?) and also has some interesting accounting aspects. Most notably, Starbucks is offering $15.50 per share, while Teavana shares were trading at approximately $10 per share prior to the announcement. What do these share prices represent? Or more importantly, how do these share prices tie into accounting information? Below are copies of Teavana’s Income Statement (Consolidated Statements of Operations) and the equity portion of its balance sheet.


Balance Sheet (Equity Portion)


At the bottom of the income statement, earnings per share (EPS) is calculated and disclosed as $0.47 per share for the year ended January 29, 2012. EPS is a “flow”—how much each share earned for the past year. Let’s look at another metric. At the bottom of the balance sheet, we find out that total equity (assets – liabilities) is $67 million. Divide that equity by the number of common shares outstanding, and we find that the accounting value is $1.75 per share ($67,002,000 / 38,281,836 shares). Why is there such a dramatic difference between the EPS and the accounting value per share?

This difference between the market value (or fair value) of the shares ($15.50 per share) and the book value (or accounting value) of the shares ($1.75 per share) is really the result of accounting using (primarily) historical cost (i.e., IAS 16) to measure assets and the refusal by standard setters to value internally generated intangible assets (IAS 38). What this means is that Teavana’s assets on the balance sheet are undoubtedly undervalued. If the assets are undervalued and the liabilities are correctly valued, then equity will also be undervalued—dramatically so in Teavana’s case.

I have two comments on this: 1) This is not a horrible thing. The other option is to try to fair value all assets, which would create measurement problems and introduce some big bias issues for management when valuing assets. 2) This is not a horrible thing. Wise financial statement users (like you) who are aware of this measurement issue can still use financial statements to make decisions. We’ve pointed this out before; financial statements are not designed to reflect market values, and we shouldn’t expect them to.

I look forward to seeing Starbucks integrate Teavana into its stores and I will also try to write a later post that shows how Starbucks accounts for Teavana post-acquisition. Now, go brew yourself a cup of tea!

Note: this blog was originally posted on my site hosted by Pearson Education (