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/)

Oiling (or soiling) the wheels of justice

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Many of you will remember the tragic events in April 2010 of the BP Deepwater Horizon drilling disaster.  The fire on the drilling rig resulted in multiple deaths and untold environmental damage.  The drilling rig was operated by BP who rightly took a lot of the heat for the disaster.  You may not have been aware that the actual drilling platform was not owned by BP but was owned by a separate company, Transocean Ltd.  BP, Transocean and many other companies associated with the disaster are involved in multiple lawsuits resulting from the disaster.  This article is an excellent summary of the events, particularly the lawsuits.  BP was the main player and has paid or will pay at least $40 Billion due to the disaster.

Recently, Transocean settled the bulk of their lawsuits with the US Justice Department for $1.4 Billion.  Interestingly, the very same day Transocean’s stock price (NYSE:RIG) rose dramatically (~ 6.3%):

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A very interesting situation … a huge payout which is seemingly bad news for Transocean but the investors react positively.  What’s going on?  Well it turns out that paying just $1.4 Billion was seen as good news by the shareholders.  As large as that figure is, it was less than they were expecting to pay out.  It’s worth looking at Transocean’s financial statements in a bit more detail to see how the Deepwater Horizon disaster impacted the accounting.  Transocean’s financial statements can be found here, we’re going to look at their 2011 annual report (December 31, 2011) and their 3rd quarter report (nine months ended September 30, 2012).

The first significant impact on Transocean’s financial statements is the goodwill (and other intangibles) impairment charge they took in 2011.  This impairment charge was $5.2 Billion dollars and resulted in a net loss for the year of $4.8 Billion (on revenue of $8.3 Billion).  The goodwill impairment charge was directly related to the Deepwater Horizon disaster and note 5 of the financial statements discusses it in more detail:

Goodwill and other indefinite-lived intangible assets—As a result of our annual impairment test, performed as of October 1, 2011, we determined that the goodwill associated with our contract drilling services reporting unit was impaired due to a decline in projected cash flows and the market valuations for this reporting unit, and we recognized our best estimate of the loss on impairment in the amount of $5.2 billion ($16.15 per diluted share from continuing operations), which had no tax effect.

Essentially, the Deepwater Horizon disaster permanently damaged Transocean’s drilling service reputation and they are doubtful that they will get as much business as they previously expected.  That seems reasonable to me and its a very good example of the cost of repetitional damage.  $5.2 Billion.  Wow.

The second significant impact on Transocean’s financial statements was accruing a liability for the lawsuits they are expecting.  In their September 30, 2012 financial statements the note disclosure related to the disaster is in Note 15 (pages 26-31).  Its an interesting discussion that includes a lot of legalese around multi-party lawsuits and counter lawsuits and potential insurance proceeds.  As at September 30, 2012 they had accrued a total of $1.9 Billion related to lawsuits and potential payouts.  While the $1.4 Billion payment to the Justice Department is not the only lawsuit that Transocean will have to pay, it will be the largest.  The $1.4 Billion settlement removed some of the uncertainty about how fault would be spread between Transocean and BP and will likely be reflected in any further settlements.  So the positive share price bump of +6.3% is really a case where the bad news is just not as bad as it could have been.

Now hopefully those fines and settlements can be put to good use providing partial compensation to the victims and cleaning the environment.

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

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.

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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(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

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.

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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(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

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(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)