Problems in Canadian Business Law

Problems in Canadian Business Law Pol/Soc Sci 3165 6.0A Tuesdays, 2:30-5:30 pm Simon Archer sarcher@torys.com

Movie Review • “The Corporation”, Achbar, M. based on book by Balkan, J. • Anyone seen it? Thoughts? • What role does corporation play... • in the movie? • in the capitalist system? • How are corporations similar to “natural persons”? • How are corporations dissimilar to people? • What is the primary “engine” or “driving force” or reason behind “corporate behaviour”? • What was the primary remedy identified? • Question: is a corporation a “democratic” form of association, or a “totalitarian” form of association (or neither)?

Last class • Partnerships

Mini problems • Simon and Tina purchase a sail boat in crap condition with the aim of fixing it up and selling again. Are we partners? Why? • Simon and Tina decide to make a partnership. They call their partnership Tina LLP and register their partnership, and hire Grajame to clean up the boat. Grajame carelessly injures Annie, who wants to sue him. Annie wants to know who she can sue.

Answers • Simon and Tina are probably partners. We have collaborated on the project for the purposes of profiting. We do not have enough information about the rest of the relationship. • Annie can sue Grajame, and Grajame’s employers are vicariously liable *if* he injures Annie in the course of his duties. Annie can sue the partnership, and usually, all partners are liable for the torts of other partners or employees of the firm. This is a firm liability, not a personal liability, so Simon is liable for the negligence as well. Alternately, we say that if Annie sues Tina, Tina can claim against Simon for his portion of the liability.

This class • Financial Statements, valuation, stuff.

Why financial statements? • Every business requires money to meet expenses - pay for premises; pay employees; pay for telephone. • Every business will need a source or sources for money to meet such requirements - customers, a bank, an investor. • To keep track of the money inflow and outflow, the business will set up accounts. • Financial statements used as tool for valuation: valuation is key exercise in business and business law.

Basic Accounting • Basic accounting systems work from double-entry book keeping • Sell a widget for $10. Add $10 to cash account. Subtract $10 from inventory account. (Double-entry) • The various double-entries are then put together to form a picture of the financial health of the business - known as a financial statement

Financial statements... • Used by business to show how business is progressing. • Important for dealings with investors, banks and government. • Important in valuation of business whether by owners or third parties. • Lawyers are not required to be accountants but need to know the basic concepts. Think, Enron.

Double Entry... • Entries are called debits and credits. • Entered daily to be used at the end of a period, usually monthly, to build income statement for the business. • Used annually to build the balance sheet. • Monthly income statements aggregated annually to form annual income statement. • Also used to build cash flow statement.

Balance Sheet • Designed to show the assets and liabilities of the enterprise at a specific point in time. • Divided into assets and liabilities. • Normally based on historic cost not on current value.

Short-Term Assets Cash $3,050 Inventory 20,000 Prepaid Rent 1,000 Long-Term Assets Fixtures 10,000 Charter 950 $35,000 Simple balance sheet Short-Term Liabilities Bank debt $15,000 Long-Term Liabilities Supplier 5,000 Equity Shares 15,000 $35,000

Classical theory • Borrow short term to finance short term assets; for example banks will loan money on a demand basis (line of credit) and take security on items i.e. assignment of accounts receivable/security over inventory. • Long term assets should be covered by long term capital, whether debt or equity. Long term debt is usually provided by the issuance of bonds, debentures or notes, usually secured by long term assets and perhaps also by a pledge of the founder’s shares.

Long term debt – key issues A) Maturity date; B) Rate of interest; C) Security (e.g. mortgage on real property); D) Covenants (e.g. no dividends and no capital expenditure over $5,000 without approval from lender). E) Obligation to retire part of principal of debt before maturity.

Depreciation... • Very important accounting concept • Buy a truck for $20,000. • Useful life of 5 years. • Should asset be written down $4,000 per year? • Impact on Balance Sheet after two years: • Truck • Cost 20,000 • Depreciating 8,000, leaves • 12,000

Continued • Note that the balance sheet does not tell the value of the business in any meaningful sense. • Everything is based on historical cost - not present value or replacement value. • Concepts like depreciation involve estimation, moving balance sheet away from historical concepts. • Reg. 72(1)(a) under the CBCA says financial statements shall include a balance sheet.

Income statement • Has become a more important part of the financial report than the balance sheet. • Tries to track revenues and expenses of a business over a specified period often quarterly. • Income statements do not normally cover a period longer than a year. • Most important financial statement in the last half of the 20th Century.

Sample IS Sales $73,550 Cost of goods sold 50,350 Gross Profit 23,200 Selling, General And Admin Expenses 5,750 Earnings b/f interest, tax & depreciation 17,450 Depreciation 4,300 Interest on debt 2,050 Earnings before income taxes 11,100 Income taxes 4,200 Net Earnings 6,900

Timing is everything • Timing questions arise when looking at the income statement. • For example, do you show an expense when you receive a bill (accrual basis) or when you pay the bill (cash basis)? • Most accounting now is done on the accrual basis - another fundamental accounting concept.

Leasing • Think of getting a car. • Can buy or lease. • If buy then shows on balance sheet and impacts income statement • If lease, is “off balance sheet” - only impacts income statement • CICA Handbook - GAAP

Stock options • Issued to management, directors and some employees • Exercise price is normally set at market price when issued (no cost charged as expense on income statement before 2002) • Vest over several years • Can only exercise after vesting • Issuer gets exercise price at date of exercise • Secondary market purchaser provides the profit • How should one account?

Gaps in GAAP • Broker sells shares in a mutual fund and mutual fund management company pays him/her a commission... • A) Expense 50% immediately, remaining 50% expensed over 18 months; [Investors Group] • B) Capitalize whole amount and expense over 3 years; [Trimark] • C) Capitalize and expense over 7 years, which is average life of mutual fund investment [MacKenzie]

What would you believe? • Which is most effective? • Which shows better performance on financial statements? • Does better performance mean higher price for widely held corporations?

GAAP consistency • May be several correct entries in accounting - only different ways of painting the picture. • This affects comparability - to have comparability we need consistency. • Does this mandate the need for toughness and activism of some regulatory body? • Who? • The securities commission; • Auditing Standards Board - CICA.

Cash flow statements • This has become the most important financial statement. • Is based on fewer assumptions

Example Cash Flows from Operating Activities Cash Received from Clients 186,064 Cash paid to suppliers and employees (166,694) Distribution from equity investments 96 Interest Received 2,930 Interest Paid (3,221) Income Taxes Paid (7,217) Cash Flow from operating activities 11,958 Cash Flows From Investing Activities Business Acquisitions, net of cash required (6,718) Net proceeds on disposition of investments 85 Purchase of capital assets (4,579) Proceeds on disposition of capital assets 762 Cash Flow from investing activities (10,450) • cont

cont’d Cash Flow from Financing Activities Repayment of long-term debt (2,998) Proceeds from long-term borrowing nil Repurchase of shares for cancellation (459) Current tax benefit of financing costs 396 Proceeds from issue of share capital 11 Cash Flow from financing activities (3,050) Net increase (decrease) in cash and cash equivalents (1,542) Cash and cash equivalents, beginning of the year 7,613 Cash and cash equivalents, end of the year 6,071 Cash and cash equivalents consist of: Cash 6,071 Bank indebtedness nil 6,071

Two methods of cash flow a) Indirect Method Starts with net income from the income statement and then adds back non cash items. b) Direct Method Starts with gross cash receipts from business activities and then deducts cash paid to suppliers or employees as well as interest paid and tax paid. c) How do you treat stock options?

EBITDA • Modification of both the cash flow calculations and the income statement. • Adds back into income all interest paid, taxes, depreciation and amortization. • This is because these categories are relative to the financial position of the owner.

continued • Now seen commonly in financial reporting and probably the principal basis for assessing the value of a business today. • Value by using industry average ratio of EBITDA to Enterprise Value (EV) • EV = debt plus market value of securities • Debate for Airco valuation of Air Canada – price/earnings, EBITDA

6 approaches to value of shares a) The quoted market price on the stock exchange - the market value approach b) The valuation of the net assets of the company at fair market value: the assets approach c) Price/earnings ratio: the earnings (investment value) approach d) Some combination of preceding three approaches: the combined approach e) Capitalization of maintainable earnings: discounted Cash Flow f) EV/EBITDA

Auditors • Basic Role - do not prepare Financial Statements - audit them - report to shareholders

Hercules v. E&Y • Auditor was negligent in review of financial statements of two listed corporations • Shareholders lost money when the stock price fell once truth was known • Shareholders sue auditors • S.C.C. uses Anns test

Anns test • Two part test: 1. Duty of Care 2. Limits on a) duty itself b) class to whom owed c) damages for breach • Court says auditors owe duty • Court says to look to specific purpose of audit – not to advise investor, is to allow shareholders to oversee management

Auditors are supposed to be • First line of defence for investors against fraud • But no liability – Hercules Management case • What about lawyers? Why did they escape? Any guesses? • Convergence -- MDPs – whither the MDP?

Problems in Canadian Business Law