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/)

The aluminum can gets crushed

Rio Tinto recently announced a massive write down of $11 Billion of its aluminum producing assets.  I’ve written about asset write downs before related to RIM’s (oops, Blackberry’s) inventory, BHP Billiton’s oil and gas assets, and Talisman’s gas assets.  They all have one thing in common – someone paid too much for some assets and has to eat crow and admit that those assets are now worth substantially less.  I will point out that at the time they bought those assets they had reason to suspect that they were getting a real deal, in fact the purchasers thought it was a bargain.  Only after the fact, as new information came to light or commodity prices fell or consumer interests changed, did the overvaluation come to light.  We all do something similar – just look in your closet and find your (literal or metaphorical) red cowboy boots.  They seemed like a good idea at the time but then reality (and fashion) stepped in and there they sit, unused, collecting dust.

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Those three asset write downs I have previously blogged about and the Rio Tinto situation are similar to those red cowboy boots.  At the time you had great reasons to justify their purchase so you paid whatever price they were asking, in Rio Tinto’s case they paid $38 Billion for Alcan, a company focused on producing aluminum.  In late 2007 when aluminum was trading for$2,640/ton and certain Rio Tinto executives were certain that the price of aluminum could only increase, they felt paying $38 Billion to increase their stake in the aluminum market made sense.  It’s worth looking at the 2007 financial statements since this purchase shows up very clearly in Rio Tinto’s statement of cash flows as an investing activity (purchase of long term assets including subsidiary companies) [in particular look at page 48, note 41 for the full valuation details].

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Unfortunately for Rio Tinto, the price of aluminum has not increased as they expected and in fact has decreased by 12%.

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IAS 36, the impairment standard for IFRS, requires that an asset write down occur when the assets cost ($38 Billion) exceeds both of the value-in-use (the revenue less costs from using the asset) and a reasonable amount if the asset was sold to another party.  Value-in-use is fairly easy to calculate (see another of my projects) for mining companies and no surprise, as the commodity price falls with no reasonable increase in the future, the value-in-use declines rapidly.  Note that a 12% decline in the aluminum price does not mean that the aluminum production assets decline by 12% as well.  In fact mining assets are incredibly sensitive to the commodity price.  Assume that the cash production cost for aluminum is somewhere around $2,000/ton.  If the commodity price falls from $2,600/ton to $2,000/ton, a 23% decrease, the value-in-use for the production assets falls to zero, a 100% decrease.

In 2011, Rio Tinto recorded an almost $10 Billion write down related to the Alcan purchase.  They just announced a further $10 Billion write down.  Essentially they paid $38 Billion for an asset group that they now believe to be worth about $18 Billion.  A portion of the 2011 financial statements is below showing the initial write down (“Impairment charges less reversals”).  The 2012 write down will be obvious once they release their 2012 financial statements in a month or so.

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I don’t mean to imply that Rio Tinto’s management di anything fraudulent or made bad decisions.  In hindsight they clearly made a poor decision but playing sideline quarterback doesn’t count.  At the time, using the information they had, they made a reasonable decision.  They can’t be expected to forecast the future with certainty, life and business are not that easy.  The purpose of blogging about this story is to reinforce how financial accounting and reporting is dominated by uncertainty and the future.  Virtually every asset on the balance sheet requires accountants to forecast into the future and hence every balance sheet value involves uncertainty.  Anyone who believes that financial statements are perfect and accurate has completely missed the boat.  Financial statements are simply a set of estimates, hopefully good estimates that are not biased.  Kudos to Rio Tinto accounting staff and auditors for at least being honest about the necessary write down.  There are plenty of stories where such overvaluation goes unreported for years.  As an investor and financial statement reader we may not be happy about an asset write down but its better than management hiding it from us.

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