A Cheque in the Mail Is Better than a Tweet?

After my post a month ago bemoaning the potential death spiral facing Canada Post, I thought I would provide some balance by discussing the merits of Royal Mail, England’s original version of Canada Post.

In the world of old mail and new mail, there are two key stories right now: the initial public offering (IPO) of Royal Mail and the IPO of Twitter. Perhaps on the outset these two companies don’t seem to have much in common, but at their core they are both in the business of sharing information. Royal Mail delivers traditional letters and packages (a lot of packages these days due to online shopping). Twitter delivers breaking news stories from around the world and LOL cats.


Image Source: http://www.lolcats.com/

With most traditional IPOs, security regulators require substantial disclosure, including audited financial information months prior to the actual IPO date. Twitter is using a special IPO procedure, the Jumpstart Our Business Startups (JOBS) Act, which allows for substantially less disclosure than a normal IPO. In order to qualify for the JOBS Act IPO, Twitter must have less than $1 billion in revenue. This is about all the financial information we currently know about Twitter. The Globe and Mail had an interesting piece in which the writer stated that they preferred the Royal Mail IPO to the Twitter IPO. Shocking, perhaps, particularly after my post about Canada Post. Royal Mail might seem like a dusty old horse compared to Twitter’s 500 horsepower shiny red convertible. But the G&M article has some excellent points that are worth raising for all accounting students.

Basically, don’t let flash and sparkle distract you from a company’s underlying business model. One thing that financial statements generally do not tell a reader is what the future profitability of the company will be. Financial statements, by design, are historical—they reflect the past. The past is a decent predictor of the future… until it’s not.

What do I mean by that? Well, consider Royal Mail’s history. It has been in the delivery business for over 100 years. It has infrastructure (trucks and buildings) in place and some consistent market demand. Clearly the mail delivery business has changed over the past 100 years and Royal Mail will need to continue to adapt as the market continues to change. But until people stop sending letters and birthday packages, and until people stop buying goods on the Internet and having them delivered, Royal Mail has a stable or slightly declining market. Now lets consider Twitter. Tweeting is free (you get what you pay for in my opinion), so it doesn’t cost Suzi or Tom anything to tweet about their meal or their clothes or some celebrity gossip. Twitter earns revenue through advertising. Companies pay to have their tweets pushed to your twitter account. This can be annoying and I, for one, rarely (if ever) click on those ads. So how effective are those ads be? We don’t know—we need to wait to see Twitter’s financial statements.

Now consider the barriers to entry for Royal Mail and Twitter. If you want to compete with Royal Mail, the barriers to entry are high. You need to build a network of collection and delivery locations and you need trucks, buildings, and delivery people. If you want to compete with Twitter, you need a few computer science gurus, some servers, and some late night pizza. The next Twitter could be right around the corner. Instagram, Tumblr, and their like could very well trump Twitter. Then what happens to its advertising revenue? Cue descending slide-whistle sound effect.

Perhaps you remember one of Aesop’s most famous fables, “The Tortoise and the Hare.” Slow and steady may win the race, so choose your investment wisely.

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Interest Can Fly Under the Radar

Screen Shot 2013 09 23 at 8 50 36 AM

Image source: http://www.bombardier.com/en/home.html

Bombardier is one of Canada’s larger manufacturers and has frequently made the news recently as the production of its new C-Series commercial jet gets tantalizingly close. The C-Series jet is apparently key to Porter Air’s expansion plans out of the Toronto Island Airport (YTZ), and it is obviously very important to the future success of Bombardier.

Bombardier (BBD.B) already has 177 firm orders in place with hopes of another 150 orders a year or two from now. The development costs of this new jet are close to $4 billion. When Bombardier sells a C-Series jet to Porter (or any other airline), the price of the aircraft must include a portion of these development costs in addition to the direct labour and materials involved in building the plane itself. As the development costs creep higher, Bombardier really only has two options: (1) charge more for each jet once they start selling, or (2) give up any hope of recovering the development costs. Under IFRS (IAS 38), it is important to distinguish research costs from development costs. The distinction is important: development costs can be capitalized as an asset while research costs much be expensed. IAS 38.57 defines the development phase of a project to be when six criteria are met:

  • technical feasibility can be demonstrated
  • there is intention to complete the project for use or for sale
  • there is ability to use or sell the asset
  • there is existence of a market for the output (sale)
  • there are adequate resources ($$) to complete the project
  • the expenditures for the project can be accurately tracked

Obviously the C-Series jet is in the development phase. Bombardier also has other aircraft in the development phase but does not provide a breakdown of development costs by jet-type. The chart below shows how much the development cost asset has grown over the past three years. We will assume the bulk of this growth is due to the C-Series.


These development costs include the costs of the prototypes, scientists’ salaries as they figure out aerodynamics, retooling costs, building and tweaking engines, testing prototypes, etc. All of these costs are capitalized up to the time that Bombardier starts actually selling C-Series jets. Then, Bombardier must start amortizing its development cost asset, in this case on a per-unit basis calculated on a best-guess for the number of jets to be sold.

If you’re in introductory financial accounting, or you are like 90% of the population and just dabble (or less) in accounting, I suspect this idea of capitalizing development costs may seem strange. Recall that an asset is a cost that has been incurred that has future benefit. A very common asset is a company’s property, plant, and equipment (PPE). We allow companies to capitalize PPE (i.e., set it up as an asset) because the PPE will hopefully generate a future stream of cash flow through product sales or service sales. Development costs aren’t all that much different, except they are intangible. The development costs related to a new jet allow the company to sell a new product and keep current with technology. Without spending money on development, Bombardier would find itself using outdated technology while trying to compete with other plane manufacturers that have new technology. This is unlikely to be a successful strategy.

Now that we have a decent understanding of development costs, we can explore Bombardier’s costs a bit more. According to the September 17, 2013 Globe and Mail article, Bombardier doesn’t seem to clearly understand how much it has actually spent on developing the C-Series. This is not really true; some accountant inside Bombardier knows exactly how much the company has spent. The issue here is whether Bombardier should be including the interest cost in its development costs. This is covered in IAS 23 (Borrowing Costs) and is an intermediate to advanced topic. The basic idea is that if Bombardier borrowed money to fund development costs, then the interest related to the borrowed money should be included in the capitalized development costs, hence increasing the development costs. There are only a few instances where interest costs are not immediately expensed, so if capitalizing interest seems odd to you, you’re not alone.

Another example of when interest can be capitalized is building a new factory. Assume for a second that you are building a new factory and borrow $1 million to fund the construction costs. Interest related to your loan should be capitalized during construction and is hence considered part of the overall cost of the factory. That cost will be amortized over the useful life of the factory. Interest incurred on the construction loan after the factory is put into use would be immediately expensed. The same is true for Bombardier’s development costs. So in the Globe and Mail article, the confusion stems from one Bombardier executive speaking about direct costs related to development while another, likely with more accounting experience, included interest costs related to the development. The second person is technically correct.

So what is the quick synopsis for us?  First, development costs, when they meet the definition, can be capitalized. Second, interest costs can also be capitalized in certain circumstances. And third, planes are bloody expensive!!

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Yeah Right, the Cheque Is in the Mail


Source: Canada Post, "250 Years of Postal History,"

When was the last time you mailed something? I mean, really mailed it—with a stamp, an envelope, and a trip to a big red mailbox. Alternative forms of communication have clearly replaced traditional letter mail and Canada Post is suffering as a result. Badly. If you take a moment to think about Canada Post’s business model, you might realize that a large portion of its costs would probably be the mail delivery process, which primarily involves individuals walking through neighbourhoods to hand-deliver flyers, packages from Amazon, and the odd letter from Grandma. We used to complain about our mail boxes being full of bills, but even many of those are now delivered electronically. The graph below summarizes the basic problem with Canada Post’s business model: shrinkage.

Screen Shot 2013 08 28 at 5 33 14 AM

Source: Canada Post, Annual Report 2012, http://www.canadapost.ca/cpo/mc/assets/pdf/aboutus/annualreport/2012_AR_Overview_en.pdf

But even this doesn’t tell the whole story. The other side of the problem is the increasing number of houses/addresses that Canada Post must deliver to, as illustrated in the image below.

Screen Shot 2013 08 28 at 5 51 39 AM

Source: Canada Post, Annual Report 2012, http://www.canadapost.ca/cpo/mc/assets/pdf/aboutus/annualreport/2012_AR_Overview_en.pdf

So, we’ve got a business with a delivery system that needs to expand, yet it has shrinking revenues. No surprise then that Canada Post is losing money. The excerpt from its 2012 statements, below, illustrates its recent revenues/losses.

Screen Shot 2013 08 28 at 5 53 55 AM

Source: Canada Post, Annual Report 2012, http://www.canadapost.ca/cpo/mc/assets/pdf/aboutus/annualreport/2012_AR_Overview_en.pdf

But wait… maybe it’s not losing money. For the year ended December 31, 2012, Canada Post had net income of $94 million, which looks pretty good. Except net income is inflated by $152 million due to a one-time, non-cash pension correction. If you look at the second line under “Cost of operations” you will notice that the employee benefits are about $130 million less than the prior year. Essentially, Canada Post squeezed the union in its latest round of negotiations and was able to reduce some of the employee pensions and benefits. This reduction shows up as a one-time gain in 2012. I’ll admit that Canada Post is very upfront about this adjustment in its annual report. I would argue that it is more transparent about its true loss than most for-profit businesses that I have seen.

The most recent quarterly report (June 2013) isn’t any more favourable, showing losses for the first two quarters of 2013:

Screen Shot 2013 08 28 at 6 01 10 AM

Source: Canada Post, Annual Report 2012, http://www.canadapost.ca/cpo/mc/assets/pdf/aboutus/annualreport/2012_AR_Overview_en.pdf

There is one more view of this that I want to point out—the statement of cash flows. Recall that the statement of cash flows summarizes how a business obtained cash and where it spent cash. The statement is broken down into three main categories: operations (the main business activities), investing activities, and financing activities. I’ve written about the importance of analyzing the statement of cash flows before, you may want to read that post as well for a refresher on cash flows. Canada Posts’ Statement of Cash Flows for 2012 is provided below.

Screen Shot 2013 08 28 at 6 03 02 AM

Source: Canada Post, Annual Report 2012, http://www.canadapost.ca/cpo/mc/assets/pdf/aboutus/annualreport/2012_AR_financial_en.pdf

What do we see here? At first glance, everything looks OK. Canada Post is obviously a mature business, so we should expect its operating activities to be generating sufficient cash to support its investing and financing activities. In 2012, it looks like they do. Let’s ignore the financing activities for a moment since (a) the total financing activity cash flows are very small and (b) Canada Post is a non-traditional business that is owned by the government. Now focus on the investing activities and pick out just the capital asset expenditures. These are expenditures for items like new delivery trucks and sorting machines. The capital expenditures were pretty constant for two years shown; about $0.5 billion per year. Now compare the operating cash flows to the capital expenditures required and you will see the rest of the problem. Canada Post is struggling to earn enough money to replace its necessary capital assets. Without those capital assets for delivery, Canada Post has no business model. No cash, no assets. No assets, no business. No business, no cash. And the death cycle begins.

Canada Post also has a massive financial problem that I haven’t mentioned yet—pensions. I won’t go into pensions here since I talked about them just last week.

The Globe and Mail had a terrific story about the issues that Canada Post is facing and included some potential solutions, such as less-frequent delivery or eliminating door-to-door delivery. Neither of those options is likely to affect you or I since we get very few traditional letters. I am sure that older generations are more frequent users/receivers of traditional mail and I suspect they’re not going to be very happy with any reduction in service. Perhaps it’s our job to explain the dilemma that Canada Post finds itself in? One weekend when you visit your parents, friend’s parents, or grandparents, I encourage you to ask them what they think about Canada Post, explain its financial issues, and see what solutions you can come up with. Then submit your ideas to Canada Post; it is actively soliciting them on its homepage. You might as well put your financial acumen to work and help solve this problem.

Screen Shot 2013 08 28 at 6 19 30 AM

Source: Canada Post, http://www.canadapost.ca

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Retirement Planning by the Vulcans

“Live long and prosper” is best known as a Vulcan 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 (and retirement in general) require substantial retirement savings. Traditionally, these savings have come from employer-organized defined benefit (DB) pension plans. I’ve written about pension plans before here and here. Given my previous 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?” This is a good question. It’s a complex issue but, to keep it simple, if you promise to pay your best friend $100 a year until they pass away you can quickly understand how their expected lifespan matters. Longer life = more money that you owe them. The same is true for pension plans except that they are on a much bigger scale.

Take the University of Toronto as an example. It owes its employees over $4 billion for future retirement payments. If those employees live longer, U of T will be 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 its pension liability. But this pension asset doesn’t change as employee lifespan changes. Perhaps you can see the problem already: $2.9 billion in assets − $4 billion in liabilities = trouble. Yes, that’s right, U of T has 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, and April 30, 2011). Pensions are U of T’s biggest liability. The “Deferred capital contributions” are just a fancy way of accounting for revenue. All of that amount has already been received as cash but U of T can’t call it revenue yet. If we 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” ($1,122.9) plus the “Employee future benefit obligation…” ($734.7) for a total of $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.


Source: http://www.finance.utoronto.ca/Assets/Finance+Digital+Assets/reports/financial/2013.pdf

You might say to yourself, “Big deal, U of T is a massive enterprise with billions of dollars of revenue.” If so, you’d be partly correct… U of T does have billions of dollars of revenue but it has 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 who have already retired. 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 it could double its pension asset within a reasonable window, say 10 years, it would mostly be out of this mess. Of course, that would require an average rate of return of about 10%, far in excess of traditional pension plan returns. Other than a miracle cure, all it can do is continue to save excess cash where it 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 and pension plans are the farthest thing from your mind. However, like many other problems in the world, this problem will be passed on from one generation to the next. As a future employee, a future contributor to CPP, a future caregiver to your parents, and as a student paying tuition, this pension problem is yours. Sorry. I encourage you read more about this issue, in particular, 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?

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Barbie Needs Some Cash

Mega Brands Inc. is a toy manufacturer best known for its building block toys that are similar to a more well-known brand that starts with “L” and rhymes with your favourite frozen waffles. Mega Brands’ Mega Bloks come in many varieties, including numerous versions that incorporate other big brand names, such as Barbie, Dora the Explorer, Power Rangers, and World of Warcraft. Financially, the company has struggled in the past and as of December 31, 2012 had a cumulative deficit of ~$358 million (remember that a deficit is the same as negative retained earnings). That’s not good news. Lenders aren’t fond of large deficits, so Mega Brands’ latest borrowing came with a steep cost: 10% interest. This interest rate includes a fair risk premium and obviously costs a lot of cash every year.

In many ways, Mega Brands looks financially stable on its audited financial statements (December 31, 2012). Its current ratio (current assets/current liabilities) is in decent shape, its debt:equity ratio (total liabilities/total equity) is improving year over year, it had positive earnings for the past two years, and it has a positive cash balance. So the transaction I’m about to describe wasn’t done in a panic, it was done to take a reasonably healthy company and make it stronger.

Imagine for a second that you are the CEO or CFO of Mega Brands. You don’t like paying 10% interest since it requires more cash than you feel is really deserved for debt repayment. You need your other cash resources for day-to-day operations and you don’t have excess assets that you can sell to generate cash. What do you do?

Well, you look closely at your balance sheet and you remember that in 2010 Mega Brands issued a whole bunch of warrants. A warrant is just like a stock option. It is a financial instrument that gives the investor the right to purchase a common share of the company at a set price. (Investopedia provides helpful background information on options and warrants.) Investors pay to get the warrants ($0.50/warrant) and then have to pay again if they exercise their option to purchase the common share (called the strike price, $9.94/share in this case). Obviously, no investor would exercise their warrant if common shares were trading at a price below the strike price. Mega Brands’ warrants expire about two years from now and, in most cases, finance theory suggests that a holding strategy is optimal.

Mega Brands wanted to raise some cash and had ~240,000,000 warrants still outstanding. If it could convince all the warrant holders to exercise their warrants and pay the exercise price, Mega Brands would receive ~$115 million. That would essentially be enough to cover all its long-term debt and wipe out the debt with the 10% interest payment. Early news releases don’t suggest any modified terms—rather, Mega Brands executives just had some friendly chats with the major holders of the warrants (i.e., institutional investors) and explained the situation. The warrants were already in the money since the common shares were trading above $13. Remember that a warrant holder receives a common share (market value ~$13/share) by paying $9.94/share. That’s a good deal. Further, the executives explained that the cash they raised would be used to repay that expensive 10% debt, thereby reducing the company’s interest cost and increasing cash available for expansion and dividends… a win-win situation for the company and the warrant holders. No surprise, then, that approximately 1/2 of the warrant holders have agreed to exercise their warrants early.

What will be the impact on Mega Brands’ financial statements? Let’s do this on a single-share basis (in reality, closer to 600,000 shares will be involved). First, Mega Brands will receive the exercise price from the warrant holders (Dr Cash $9.94), remove the warrant value from equity since the warrants no longer exist (remove at the initial value, Dr Warrants (equity) $10), and recognize the new common share being issued in exchange (Cr Share capital $19.94). Then, Mega Brands will turn around and use the cash to reduce its debt (Cr Cash XX, Dr Long term debt XX). So, when the next financial statements get released we should see an increase in equity and an equal decrease in liabilities.

Warrants and options are very common financial instruments. Mega Brands’ move to tap into them as a way to raise cash is interesting, and a little unusual, but quite admirable.


Mega Brands’ full financial statements are here. I encourage you to look at the balance sheet (page 5), and Notes 15 and 16 in particular (pages 33–35).

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The CERCLA of Life

Like all mining and natural resource extraction companies, Teck can take a bad rap for its actual and 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 should do all they can to minimize their impact on the earth and all its inhabitants (including us). The smelter in Trail is currently owned by Teck, but some of what I’ll mention here preceded Teck’s ownership. Historically, the Trail 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 damage to crops and forests. The real push to clean things up started in 1975 when a study showed that lead levels in young children were well above any reasonable or safe level.

Teck has recently been in the news for pollution that it admitted dumping into the Columbia River, which flows past the smelter. Trail, BC is a stone’s throw away from the U.S. border and the Columbia River flows south, so pollution has ended up in the U.S. 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 Teck’s financial reporting, expecting him to say that it was 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. Teck is paying for a bunch of environmental studies but no accrual has happened beyond the cost of those studies.

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

Ok, so Teck has some trouble with pollution of the Columbia River and then this selenium problem. How do these issues impact its financial statements? I was expecting the Columbia River lawsuit to be shown as an accrual (which is a liability). Check out Teck’s 2011 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 total assets ($34 billion), and current assets ($7.4 billion) far exceed 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, which should prove interesting to read as well. Access the full financial statements and notes from the menu on the left of the page linked to above: “Consolidated Financial Statements (PDF).”

Here is a portion of note 20:

Source: Teck 2011 Consolidated Financial Statements, www.teckannualreport.com/DocumentViewer.aspx?elementId=201918&portalName=tc

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 Teck adjusts the December 2012 financial statements… I suspect the remediation costs will be dramatically higher.

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



Source: Teck 2011 Consolidated Financial Statements, www.teckannualreport.com/DocumentViewer.aspx?elementId=201918&portalName=tc

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 this means is that Teck has not recorded any liability yet for the Columbia River pollution. It simply has no idea how much it may be on the hook for, if any amount, so has not recorded anything. This isn’t devious or wrong, it’s in accordance with generally accepted accounting principles (IFRS) and highlights again how estimation and judgement are a huge part of financial reporting.

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

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Groupon’s Coupons, Botox, and Revenue

I posted about Groupon’s difficulty figuring out how to record revenue 18 months ago. It got its knuckles rapped then and, as I mentioned in my previous post on Livent, revenue recognition continues to be a common culprit in accounting errors and frauds. Groupon has some tricky revenue to sort out, its not exactly clear to many people what Groupon sells. Does it simply broker transactions between the customers paying for the coupons and various restaurants, spas, and Botox providers, or does it do more than that?

In the financial reporting world, we refer to this as the “principal-versus-agent” (or “gross-versus-net”) revenue recognition problem. For instance, assume that you pay Groupon $10 for a coupon for Botox. Further, assume that Groupon pays $8 of that $10 to the Botox provider. Should Groupon record revenue of $10 and cost of sales of $8, for a net income of $2? Or should it record revenue of $2 and net income of $2? A simple view of this says “Who cares!? Net income is the same under both approaches!” But it does matter. It affects things like revenue growth rates and gross profit margins. Investors care about those sorts of things.

This is a tricky area that has tripped up many large businesses, including eBay and Amazon. IFRS, particularly IAS 18: Illustrative example #21, deals with exactly this type of revenue and reporting dilemma and is very similar to US GAAP (EITF N0. 99-19), which Groupon reports under. Answering “yes” to most of the key factors from that standard determine whether Groupon should record the gross or net revenue. The key criteria are:

  1. Does Groupon have any inventory and inventory risk? (In my opinion, no.)
  2. Does Groupon establish the selling price? (In my opinion, perhaps.)
  3. Does Groupon have the primary responsibility for providing the spa or Botox treatment? (In my opinion, no.)

Groupon used to report its revenue using the gross method; that is, the $10 of revenue and $8 of costs. After getting its hands slapped 18 months ago, it adjusted its revenue recognition policies. The income statement (or statement of operations) below indicates that Groupon earned $1.8 billion in revenue from coupon sales (third party transactions) and only recorded $297 million in related costs. This very high gross profit suggests that it is recording net revenue (the $2).


Source: http://files.shareholder.com/downloads/AMDA-E2NTR/2344091799x0xS1490281-13-8/1490281/filing.pdf

To really figure this out, we need to dive deep into Groupon’s financial statement notes, particularly Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73, which is copied below. Look carefully at the third paragraph, particularly the portion I’ve highlighted for you. Groupon now records the net revenue (just the $2, based on the $10 it initially receives from the customer less the $8 it submits to the merchant/Botox provider). The final sentence of the paragraph clearly explains that the revenue recognition policy is based on the interpretation that Groupon is simply an agent, matching buyers and sellers. This is completely consistent with my brief analysis of Groupon’s business model using the criteria from IAS 18.

The final thing I will point out is in the fourth paragraph (highlighted below as well)—Groupon loves it when you buy a coupon and don’t ever redeem it. You lose the coupon, they win. You forget about the coupon, they win. It reminds me of the gift card scam… millions of dollars of gift cards expire and the retailers love it.

Finally, I will point out that I have nothing against Groupon, although I’ve personally never bought a Groupon coupon. Perhaps when I need a Botox injection in a few years …


The following excerpt is copied directly from Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73:

Revenue Recognition

The Company recognizes revenue when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the selling price is fixed or determinable; and collection is reasonably assured.

Third party revenue recognition

The Company generates third party revenue, where it acts as a third party marketing agent, by offering goods and services provided by third party merchant partners at a discount through its local commerce marketplace that connects merchants to consumers. The Company’s marketplace includes deals offered through a variety of categories including: Local, National, Goods, Getaways and Live. Customers purchase the discount vouchers (“Groupons”) from the Company and redeem them with the Company’s merchant partners.

The revenue recognition criteria are met when the number of customers who purchase a given deal exceeds the predetermined threshold (where applicable), the Groupon has been electronically delivered to the purchaser and a listing of Groupons sold has been made available to the merchant. At that time, the Company’s obligations to the merchant, for which it is serving as a marketing agent, are substantially complete. The Company’s remaining obligations, which are limited to remitting payment to the merchant and continuing to make available on the Company’s website information about Groupons sold that was previously provided to the merchant, are inconsequential or perfunctory. The Company records as revenue the net amount it retains from the sale of Groupons after deducting the portion of the purchase price that is payable to the featured merchant, excluding any applicable taxes and net of estimated refunds for which the merchant’s share is recoverable. Revenue is recorded on a net basis because the Company is acting as a marketing agent of the merchant in the transaction.

For merchant payment arrangements that are structured under a redemption model, merchant partners are not paid until the customer redeems the Groupon that has been purchased. If a customer does not redeem the Groupon under this payment model, the Company retains all the gross billings. The Company recognizes revenue from unredeemed Groupons and derecognizes the related accrued merchant payable when its legal obligation to the merchant expires, which the Company believes is shortly after deal expiration in most jurisdictions that have payment arrangements structured under a redemption model.

Direct revenue recognition

The Company evaluates whether it is appropriate to record the gross amount of its sales and related costs by considering a number of factors, including, among other things, whether the Company is the primary obligor under the arrangement, has inventory risk and has latitude in establishing prices.

Direct revenue is derived primarily from selling consumer products through the Company’s Goods category where the Company is the merchant of record. The Company is the primary obligor in these transactions, is subject to general inventory risk and has latitude in establishing prices. Accordingly, direct revenue is recorded on a gross basis, excluding any applicable taxes and net of estimated refunds. Direct revenue, including associated shipping revenue, is recorded when the products are shipped and title passes to customers. For Goods transactions where the Company is performing a service by acting as a marketing agent of the merchant, revenue is recorded on a net basis and is presented within third party revenue.

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The Phantom of the Audit

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 took 15 years 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 documents referenced below are publicly available through SEDAR.com

First, let’s take a look at the original December 31, 1997 balance sheet:


Source: Livent Consolidated Balance Sheet, as at December 31, 1997, www.sedar.com

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:


Source: www.sedar.com

Look at the December 31, 1997 column and compare that to the original figures:

  • The deficit is no longer small. It is $124M, approximately $100M larger than originally reported. Total equity now represents just 1% of total assets. This means that 99% of Livent’s assets really belong to debt holders
  • Accounts receivable has 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 become complex pretty easily, depending on revenue timing and amounts. A simple example of this is Livent’s treatment of certain sponsorship revenue. Like many arts organizations, Livent earned a portion of its revenue through sponsorship dollars—companies paid for the right to have their logos and signage in theatre lobbies, on the stages, or in playbills. This is very similar to the corporate logos you see at hockey rinks. Assume that a business paid Livent $500 000 to have its logo on the playbill for the Phantom of the Opera. The company probably paid months in advance to secure its sponsorship right. When should Livent record that payment as revenue? (a) When it received the cash; (b) when the show started its 3 year run; or (c) it should be spread evenly over the show’s three year run. If you answered (a), you may 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, you just used common sense. It’s interesting how accounting, when done right, involves a lot of common sense.

Another frequent form of accounting fraud is to record expenses as assets. How does this work? Well, there is a fine line between an asset and an expense. 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 benefit for years to come. Conversely, expenses do not have any future benefit—their benefit has been entirely used up in the current period. A business can (fraudulently) increase its net income by recording expenses as assets. Did you notice that decrease in Livent’s preproduction costs? Yep, this is exactly what was going on. Livent was capitalizing (recording as an asset) production costs that were never going to generate any future value.

A third area where Livent got caught with its hand in the cookie jar was less common: it didn’t even record some of its expenses. When Livent received a bill near its year end, it didn’t pay the bill immediately (that’s fine, it’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 not doing this, Livent artificially increased its net income (since it didn’t record the expense) and artificially decreased its liabilities (since it didn’t record the accounts payable). This is wrong on both accounts. Now, why is this not a common area of fraud? Because its pretty darn 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 year end? It should be recorded. Just after year end? 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 had their knuckles rapped pretty hard.

In conclusion, I know this case is REALLY old but it is 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. It’s not worth the damage to your reputation.

Here is the official description of the accounting restatements that I discussed above (November 18, 1998 letter):


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The Apple Never Falls Far From the Tree

The last six months have not been kind to Apple. Its share price has fallen about 30%. It briefly held the record for the all-time highest market capitalization of any firm, at any time. It released its 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.

Screen Shot 2013 02 21 at 8 35 16 PM

Source: Google Finance, https://www.google.com/finance?q=aapl&ed=us&ei=EfQmUfjdJ4aViQLkDQ

Despite stumbles over the past six months, Apple has seen astounding success for the past decade. If you had put $1000 into Apple stock (AAPL) 10 years ago, today you’d have roughly $60 000. No matter how pessimistic you are or how much you dislike Apple’s products, that is an incredible return. But beyond amazing returns, what makes Apple interesting from an accounting perspective?

Apple is sitting on a ton, a TON, of cash. In its latest annual financial statements (September 29, 2012), it reported $10.7 billion in cash. Scroll through the 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? It doesn’t. Most companies operate with very little cash on hand, barely scraping enough cash together to pay its electricity bill or employees. Apple is on the complete other end of the spectrum.


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 shouldn’t be wasteful. Once a business gets to a stable point, it generally starts 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 to pay dividends. The third such dividend was just paid out last week and was $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. This is 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. Yet many projections that suggest Apple will generate substantially more net cash from operations every year, so its cash reserves could in fact continue to grow.

Apple makes an interesting case study—it was almost bankrupt 25 years ago and some experts suggest that its cash hoarding is the result of a “depression era” mentality: it is so petrified of being near bankruptcy again that it plays a very conservative game. Another issue is that Apple is notorious for leaving significant cash (almost $100 billion) overseas in other countries. This overseas cash and profit was generated from legitimate sales of its 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, and that’s not nefarious, it’s solid business planning. The problem is that the US makes it very difficult to repatriate overseas earnings—that is, bring the overseas 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 dividends are too high, the company will run out of cash.  If dividends are too low, investors will be unimpressed.
  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.


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Turkeys, Forks, and Dual-Class Shares

Lately, dual-class equity structures have been 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, its multi-vote shares provided 300 votes per share, resulting in the Stronach’s holding only a 1% equity interest in the company but controlling 66% of the votes. The purpose of such equity structures is that it allows founders to retain control of their companies 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 equity risk without getting the benefits of control. This disparity usually results in the less powerful shares trading at a discount.

In recent years, some companies with dual-class shares have tried to simplify or clean up their equity structures by consolidating all their shares into a single class with equal voting and cash flow rights. Magna accomplished this in 2010 and, in my opinion, paid dearly to convince the Stronachs to give up their super-voting shares. Ultimately, the Stronachs were paid a 1800% premium and close to $1 billion to give up the family shares.

Telus is not a family-owned corporation but, as a result of the merger of BC Tel and Telus in 1998, it ended up with no-vote and single-vote shares. It is now trying to clean up its equity structure but has run into opposition from an institutional shareholder that holds a substantial number of the single-vote shares and would lose its voting power if Telus’ no-vote shares were converted into single-vote shares. This is a very interesting corporate governance situation.

As a shareholder of Telus (I own both the no-vote and 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 a significant number of those shares, I would definitely be interested in the settlement.

Voting rights can be an abstract and complicated issue, so 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—the fork is like the multi-vote shares. The rest of you still have a seat at the table but no real tools to eat your dinner. If you want to make everyone around the table equal, 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 who originally had the fork will probably feel ripped off. Fixing 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, and share issuances and share retirements are dealt with just as they are in a single-class structure. As discussed above, you should see the corporate governance implications and the difficulty of 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 up their equity structures. In every case you will find that either the fork-holders or the non-fork-holders will be unhappy—this is the consequence of cleaning up a mess.

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