Penron
Limited (PL) is in the energy business of buying and selling gas and oil and
related derivatives. It is a public company whose shares are widely held. It
recently underwent a tremendous expansionary period over the past decade, and
revenues quadrupled and continue to climb. Executives are remunerated using
stock options, and the employee pension plan invests heavily in the company's
stock. It is currently October 2011. The year end is December 31, 2011. Many of
the benefit plans of the top executives vest at the end of the year (i.e., the
executives will have legal entitlement to the benefits even if they leave the
company). As a matter of fact, there is a concern that several of these top
executives will announce that they plan to leave the company right after the
year-end financial statements are released.
PL
was seen as a "hot stock" by the marketplace. Numerous analysts
followed the stock carefully and had been advising their clients to buy the
stock as long as revenues and profits kept increasing. The third-quarter
results had shown steadily increasing revenues and profits. The company had
been signalling that this trend would continue through the fourth quarter.
During
the fourth quarter, PL sold some of its pipelines to LPL Corporation. The
pipelines had not been in use for some time and were seen as non-essential
assets. Over the past two years, PL has steadily been divesting itself of non
essential assets. PL had not written the pipelines down in the financial
statements since they were able to sell them and recover twice their cost. This
one deal was responsible for substantially all of the fourth-quarter profits.
Under the terms of the deal, the pipelines were sold for $15 million cash.
LPL
Corporation was owned by the president of PL. The company had been established
just before the pipeline deal was signed. Since LPL was a new company and
otherwise had very few assets, it borrowed the money for the deal from the
bank. The bank had requested that PL guarantee the loan, which it did.
During
the year, PL issued Class A shares to certain executives of the company. The
shares participate in the earnings of the entity much like the common shares of
the company (i.e., dividends accrue to the shareholders out of the residual
earnings after the preferred dividends have been paid). They are mandatorily
redeemable if a triggering event occurs, such as the resignation or termination
of the shareholder. The shares are otherwise similar to common shares in that
they have no preferential rights.
During
the year, the company also began the planning stages for development of a new
website that will allow customers to transact with the company. A significant
amount of time was spent in this planning phase to determine the feasibility
and desirability of this type of customer interface. Toward the end of the
year, after lengthy discussion about whether or not to go down this path, the
company began to acquire software and hardware to facilitate the new website.
A
large amount was spent on the site's graphic design and on its content.
Instructions
Assume
the role of Penron's auditors and discuss the financial reporting issues for
the year ended December 31, 2011.
Overview
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PL is in
the business of selling oil and gas and derivatives. Even though they are
expanding, they appear to be spinning off “non-essential assets”. Due to the
growth, there may be pressure to manipulate the financial statements to
continue this trend.
-
In
addition, the company has signaled to the marketplace that they will meet their
growth targets, adding further pressure.
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The bank
would be a key user since the company has guaranteed the LPL debt and LPL
otherwise does not seem to have any cash flows.
-
The
analysts will also be key users and will be looking for information to support
whether they should tell their clients to buy or sell. They will be looking for
signals such as declines in revenues or profits.
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The
pension plan would also be a key stakeholder since it is investing significant
amounts of money onto the company stock. The plan would be looking at the
stability and solvency of the company.
-
There is
additional potential bias for management to overstate earnings since they have
stock options. It appears as though many of the executive may leave next year
and so they may be interested in producing short- term profits (versus longer
term). Finally, the Class A shares are mandatorily redeemable if management
resigns and so they stand to gain if the share price is higher or the company
looks good in the financial statements.
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The auditor must be very conservative since
there appears to be multiple opportunities for biased information.
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IFRS is
a constraint since this is a public company.
Analysis and
Recommendations
Issue – how to
account for the pipeline sales.
This is related
party since LPL is owned by the President of the company. Additional
disclosures are required. IFRS does not require re-measurement of related party
transactions however, this information is relevant to the users especially
given the magnitude of the transactions and significance to the bottom line.
Issue – how to account for the Class A share
issue
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Liability
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Equity or part debt/part equity
|
|
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The shares
are liabilities in substance since they have a mandatory redemption feature.
In this case, the shares must be redeemed if the executives/shareholders
resign. At this point, the company will have to pay the shares out and this
creates a liability or obligation to pay cash.
-
The
probability of the triggering event must be assessed. At year end, it appears
likely that many of the executives will leave since their benefits vest and
there is a concern that they will resign.
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Thus the
obligation to pay cash is likely.
|
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The shares
are equity-like since they represent residual ownership interests in terms of
asset and dividend distribution.
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They have no
preferential rights and do not obligate the company to pay cash.
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The legal
form is equity and more importantly, the shares are equity in substance since
absent the triggering event, they are residual in nature.
|
Recommendation: More
conservative to treat at least part of the instrument as liability since the
entity stands ready to pay of the triggering event occurs.
Issue – how to account for the website costs?
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Capitalize costs
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Expense costs
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- Once in development
stage, costs should be capitalized if related to hardware and software as
they have future benefit.
- Development of
graphics would be seen as an integral part of the software and thus
capitalized.
- Costs incurred
to develop content should be capitalized since they will have future benefit—
lasting beyond the next year.
|
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All costs in
the planning stages should be expensed due to the uncertainty attached to
possible future revenues. In this case, the company had not even decided
whether to go ahead with this new business model.
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The benefit
of any content is uncertain and should therefore be expensed.
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Content will
likely change every year and thus is an ongoing cost of doing business.
|
Recommendation: More
conservative to expense due to the uncertainty of future revenues
Other: Disclosure of guarantee and/or going concern.
