Retirement planning by the Vulcans

“Live long and prosper” is best known as a Spock greeting in Star Trek but may be the new call to arms for retirees, pension plans, and employers.  It seems that on average, we’re living longer.  Surely that’s good news – more rounds of golf, more time with the (future) grandkids, more time to enjoy retirement.  Who can argue against that?!  Of course, those activities, retirement in general, requires substantial retirement savings.  Traditionally those savings have come from employer-organized defined benefit (DB) pension plans.  I’ve written about pension plans before here and here.  Given my prior posts, does pension accounting really deserve another look?  In my opinion, absolutely.  Especially with the latest revelation that we’re living longer.

You may ask yourself, “What impact does average life span have on pension plans?”  That’s a good question, and a bit complex but to keep it simple, if you promise to pay your best friend $100 a year until they pass away you quickly understand how their expected lifespan matters.  Longer life = more money that you owe them.  The same is true for pension plans except that it is on a much bigger scale.

Take the University of Toronto as an example.  They owe their employees over $4 billion for future retirement payments.  If those employees live longer, U of T is on the hook for even more than that.  Now the good news – if you can call it that – U of T has put away $2.9 billion as savings towards that pension liability.  That pension asset doesn’t change as employee lifespan changes.  Perhaps you’ve seen the problem already: $2.9 billion in assets – $4 billion in liabilities = trouble.  Yes, that’s right.  U of T as an unfunded pension plan to the tune of $1.1 billion.  Take a look at the liability portion of U of T’s latest (April 30, 2013) balance sheet below (the columns are from left to right: April 30, 2013, April 30, 2012, April 30, 2011).  What’s the biggest liability U of T has?  Pensions.  The “Deferred capital contributions” are just a fancy way of accounting for revenue and all of that amount has already been received as cash but U of T can’t call it revenue yet, so let’s remove the $1,076.4 from the bottom of the column.  That leaves $3,254.7 million of actual liabilities.  Now take the “Accrued pension liability” plus the “Employee future benefit obligation …” for a total of ($1,122.9 + $734.7) $1,857.6 million.  That is  57% of U of T’s real liabilities.  Nearly $2 billion is owed with no savings for that portion.

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Perhaps you say to yourself, “big deal.  U of T is a massive enterprise with billions of dollars of revenue.”  And you’d be partly correct. U of T does have billions of dollars of revenue but in fact they have very little flexibility on raising additional dollars of revenue.  As large as U of T is (~50,000 students), the unfunded pension liabilities are almost double the total amount of tuition dollars raised every year.

This situation is not sustainable.  As more employees retire and live longer, the pension assets will quickly be used to support them.  Current employees who contribute to the plan are not really saving anything for themselves; they’re funding the older, retired faculty as they golf and play with their grandkids.  Another way of looking at this is that for every dollar of tuition that a U of T student pays, a portion of that is going to fund a retired U of T employee – an individual that is not contributing to the student’s current experience.

What is U of T’s plan to get out of this mess?  Beyond a terrible reversal in the expected lifespan of its retirees and employees, U of T must be hoping for a dramatic positive performance in the stock market.  If they could double their pension asset within a reasonable window, say 10 years, they would mostly be out of this mess.  Of course that would require an average rate or return of about 10%, far in excess of traditional pension plan returns.  Other than that miracle cure, all they can do is continue to save excess cash where they can and add it to the pension assets.  That’s tough to do when you have to provide services to 50,000 current students, support Nobel prize-winning researchers, and maintain 100 year old buildings.

Three last points: (1) U of T is not the only enterprise in this mess.  I could quickly identify about 25-50 other large, well known Canadian businesses that have similar pension problems.  (2) Accounting standards around pension plans (for instance, IAS 19) are finally providing relevant information to financial statement users – I encourage you to ask your financial accounting instructor for their opinion on the standards and on pension plans in general.  (3) Why does this matter to you?  You are likely YEARS away from retirement, pension plans are the farthest thing from your mind.  Similar to many other problems in the world however, the problems of one generation get passed to the next.  As a future employee, a future contributor to CPP, a future caregiver to your parents, as a student paying tuition, this pension problem is yours.  Sorry.  I encourage you read some more, here’s a recent Globe and Mail commentary that you may find interesting.

I’d be interested in your thoughts on pension plans.  How do you think U of T should get out of this mess?  Is it fair to pass the buck to the next (your) generation?  What are your plans for funding your retirement? 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/)

The CERCLA of life

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

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

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

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

Here is a portion of note 20:

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

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

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

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

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

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/)

Moretel or … More on Nortel (part 2)

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Continued from part 1

In part 1 we reviewed the basics for accounting for liabilities. Nortel uses the term “reserve” instead of liabilities, but the same principles hold true. Nortel is currently under legal discussions about their accounting for reserves. If you haven’t read Part 1 and want a quick review of what liabilties are and how to account for them, read that first.

So Nortel has gone ahead and set up these reserves and now wants to reverse them. The reversing entry will definitely increase income (again, see Part 1 for the reasons). Nortel executives argue that the liability no longer exists and therefore the reserve must be reversed. The auditors aren’t so sure that the liability has been fully settled and would prefer to leave the liability on the balance sheet.  Leaving the liability there would have no effect on net income.

It possible that the Nortel execs are telling the truth or maybe they are trying to manipulate net income.  These types of financial reporting decisions are never transparent and the small shareholder is always at an information disadvantage.  Perhaps you are starting to see the potential conflict of interest – Nortel execs had plenty of motivation for wanting to improperly reverse the reserves. I’m not saying that what they did was wrong, the courts will decide that. I am saying that they had lots of incentive for doing the wrong thing.

What incentives? Well after Nortel profitability fell dramatically in the early 2000’s, the board of directors introduced a new bonus plan referred to as “The Return to Profitability”. Seems like a good idea. Nortel needed management to bear down and focus on making sure that the company turned the corner to being a profitable business again. Providing incentives to management for successfully accomplishing that seems like common sense. The problem with so many of these bonus plans is that they focus on accounting profitability as a pseudo-measurement of true, economic profitability. That too makes sense – economic profitability is rarely known, accounting profitability when done properly is a reasonable (but not perfect) proxy.

But, and this is a big BUT … accounting profitability is subject to manipulation or massaging. And when you have the ability to earn a substantial bonus, you definitely have incentive to mess around with the accounting. I’m sure there are very ethical people out there that would never fall into that trap but history has shown that many people choose the dark side when faced with this issue.

Rewind to 2002-2003: Nortel exec’s are sitting around wishing they could get their bonuses when they look at the financial statements and see these reserves (liabilities) sitting on the balance sheet. They think to themselves, “hey, if we reverse those we can quickly increase net income, triggering the bonuses”. The auditors disagree or at least try to disagree but the reserves get reversed, net income gets an upward pop, bonuses get triggered, executives spend lavishly.

Bad accounting? Sure, but it is just one more example of well-intentioned incentive plans back firing. When you create bonus plans and incentives for managers, be careful that you eliminate or reduce their motivation to improperly trigger those bonuses. That’s not easy to do but the downside of not carefully developing the bonus plan and monitoring the accounting process is, well – Nortel. You don’t want that.

What’s the lesson here: financial reporting is not perfect; use financial statements carefully!

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