Stelco
Inc. is a Canadian steel manufacturing company. In 2004, the company filed for
bankruptcy protection, citing the following reasons for declining profits and
viability problems:
1.
Costs have risen dramatically for inputs such as natural gas and electricity
and raw materials, such as coal, coke, and scrap.
2.
The cost of employee future benefits—pensions and health care—are also increasing
due to improved pension benefits negotiated in contracts with unionized
employees, increasing health care costs, lower returns on pension plan assets,
and the effect of lower interest rates on the discount factors that are used to
determine the Corporation’s liabilities under the pension and other benefit
plans.
3.
Global steelmaking overcapacity has created downward pressure on selling prices
due to significant and continued import penetration of the Canadian market by
steel products offered, in management’s opinion, at unfairly low prices over
the last several years.
4.
The appreciation in the value of the Canadian dollar during 2003 further
negatively affected selling prices. Selling prices strengthened in the early
part of 2004, due in part to increased demand, particularly in China. However,
the Corporation believes that these price increases are not sustainable and
therefore are not expected to be sufficient to offset growing cost issues.
5.
Several North American steel producers have emerged from court-supervised
bankruptcy protection with a cost structure that is more competitive than that
of the Corporation. The Corporation cannot compete effectively in this new
environment unless it takes steps to reduce its liabilities and lower its
overall costs.
6.
In addition, the Corporation requires additional funding to complete
strategically critical capital projects at its Hamilton and Lake Erie business
units. The Corporation is unable to raise additional funds to complete these
projects.
The
protection afforded by the Companies’ Creditors Arrangement Act (CCAA) was
challenged by the United Steelworkers of America (USWA). The president of USWA
Local 1005 was quoted in the newspapers as saying, “We are not going to allow
them to blackmail us by using CCAA as a way to convince us to give up our wages
and benefits. It amounts to legalized corruption. In my opinion, the CCAA
process is an abuse of power.” The USWA challenged the courts as to whether
Stelco should be protected by CCAA.
Stelco’s
assets had a book value of $2.74 billion and liabilities of $2.09 billion in the
bankruptcy documents. The following is an excerpt from the 2003 financial
statements:
Instructions
Adopt
the role of the company and analyze the financial reporting issues. (Although the
company would have been following pre-2011 PE GAAP, use IFRS to analyze the
financial reporting issues for purposes of this case).
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Company has filed for bankruptcy protection.
-
As management they will want to show that they are in
cash flow difficulties and therefore deserve the protection and yet need to
show that the company will be able to pull out of the protection successfully
and continue to operate as a going concern. They would also like to raise funds
for expansion and so need to show that investment in the company is worthwhile.
-
USWA have taken them to court to try and prove that
they really should not have bankruptcy protection, i.e., their financial health
is much better than they are letting on.
-
Problems with increasing costs and downward pressure
on selling prices are squeezing profit margins. Unable to compete since
competitors have already reorganized.
-
The most pressing issue appears to be to make the case
that they need bankruptcy protection. The bias would be to minimize net worth
on the balance sheet as well as profits.
-
GAAP is a constraint since the company is public.
-
NB as directed in the question, use IFRS for the
analysis even though the company would have followed pre 2011 GAAP.
Analysis and
recommendations
Issue: Convertible
unsecured debentures
|
Debt and equity
|
|
- Legal form is debt.
- Obligation to pay set amount of interest creates
an obligation that the company cannot avoid.
- The conversion feature would be equity.
- The fact that the company may settle the
obligation with shares does not negate the fact that the obligation to pay
interest and principal is a fixed amount. The number of shares used to settle
the obligation will vary but the set obligation must be settled.
|
Recommendation: The obligation to pay interest and
principal reflect a liability since the amount to be repaid is fixed. The
conversion feature will be shown as equity. This accounting treatment maximizes
debt and minimizes net worth.
Issue: Pension plan obligation
The company had $2 billion ($0.752 billion + $1.254
billion) of unfunded obligation relating to pensions and other future benefits.
Of this, only $650 million ($924 million - $274 million) was recognized in the
balance sheet. Historically, GAAP allowed the differences to be deferred and
recognized over time. IFRS also allows this although vested past service costs
must be recognized.
Leaving the unfunded deficit off the balance sheet
does not represent reality however. The difference is a real obligation and
represents a drain on future cash flows. In reality, it should be recognized as
a liability and the USWA should see how this affects net worth. It would
definitely worsen the position as the unrecognized deficit is a material
amount.
