Stability still a concern among trust watchers

Telus’s recent decision to convert its $10 billion-plus operation to an income trust has reopened debate about the stability of the trust sector. Experts hope the company’s award-winning corporate accounting practices will make it the poster child for other trusts. At the same time, there are fears that it will take a major disaster before the sector cleans up its act.

As it is, Kevin Hibbert, chief accountant for Standard & Poor’s Canada, says the sector’s accounting practices leave something to be desired. Although the financial reporting of trusts is seen to be as good as corporations, he says the accepted accounting practices can still distort the cash-flow statement. And that’s a big deal when investors rely on that figure to determine the payout ratio.

Investors got a taste of this when trusts Hot House Growers Income Fund and Spinrite Income Fund cut their distributions. Unit prices in those trusts dropped like a stone and have yet to recover. But they’re small potatoes. Now imagine would happen if Telus or Yellow Pages Income Fund, another giant income trust, did the same thing.

Masking problems on the cash-flow statement is easier than most people think, says Hibbert. He relates a colourful anecdote: “I have a little goddaughter, and [when] she came over the other day, I asked her if she cleaned up the room before she went outside, and she said ‘yeah.’ When I went upstairs, the room was still dirty. So I called her back and I said you didn’t clean the room, and she said ‘Yes I did, the last time I was here.'” His point is that he wasn’t specific about the rules given to his goddaughter. “I think that is sort of the same thing you are seeing in the trust sector; because the [accounting] rules are not rules-based, it leaves that door open.”

As another example of how people often fail to recognize that cash-flow figures can be masked, Hibbert offers that of furniture companies that offer a moratorium on payments for the first year after a sale. Some of those companies are recording the sale on their earnings, even though they haven’t collected a dime. That can distort the payout ratio and could cause a lot of grief for the unitholder, particularly if the trust isn’t able to make its monthly distribution payout.

The Accounting Standards Board distanced itself from the issue earlier this year saying distributable cash is a non-GAAP issue; the Canadian Securities Administrators have released more strict and explicit wording of this issue, but the various provincial regulators still aren’t on the same page.

One jurisdiction can change its wording, but if the rules aren’t consistent across the country, the poor accounting practices will likely continue. “Even if you have specific rules, that might not solve the problem because we have a fragmented set of authoritative bodies,” says Hibbert. Even if the distributable cash number is made a GAAP measure so that auditors can start looking at it, the CSA allows non-GAAP measures in the MD&A, which leaves management open to use whichever number suits its needs best.

“Accounting it a lot like car insurance in the minds of a lot of capital market participants: No one really sees the value in it until they get into an accident,” says Hibbert. “I have a sneaking suspicion that it is going to take something major to happen before you really see a more concerted effort on the part of all the participants in this area to try to curb this thing from happening.”

To cut through some of these reporting issues, Hibbert suggests looking for a reconciliation between the GAAP cash from operations figure on the income statement and the cash-flow figure that they present in their payout ratios. Although the CSA requires trusts to report that, some still don’t. “To the extent that that reconciliation is there, it would provide great insight for investors into the different items that have been added back or pulled out from the numbers that the auditors looked at and signed off on.”

But accounting standards are not the only issue. Dermot Foley, vice-president of strategic analysis with Vancouver-based SRI-specialist Inhance Investment Management, is worried companies ill-suited for the trust structure are converting regardless, if only for the tax benefits.

Again, consider the example of Telus. About one-third of the telecom company’s business comes from the highly competitive sectors of cell phone and internet service, says Foley. He worries that after the company converts to a trust, it may not have the resources available to deal with the challenges of those sectors.

It’s not just whether a company will have cash on hand to battle for market share that has Foley concerned; it’s important also to know whether companies are able to deal with environmental problems and have good labour relations. Those are important factors in whether the trust can maintain its distribution, he says. “It means that you are not going to be hit with a strike and you are not going to have a significant environmental liability.”

Essentially, it’s a legal issue. While shareholder rights are spelled out by Canadian Business Corporations Act, including the rights to file resolutions, there is no similar document that spells out unitholders rights. Foley says the consequence of this is that unitholders are removed as stakeholders in ensuring the company is run properly.

Still, Foley doesn’t want to paint the whole trust sector with the same brush. There are some companies that have extremely high levels of reporting. You just have to look.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(09/20/06)