How income trusts report capital expenditures (capex) may be more complicated than many investors think and is key to understanding income trusts, suggests Standard & Poor’s Ratings Services in a new report.
S&P used the unveiling of the report today to call for improved disclosure in the sector.
According to a new study, the way sustaining capex is reported and disclosed by income funds adds another substantive layer of distortion to reported distributable cash figures. The report looks at the accounting-based distortions within reported distributable cash figures that are caused by the omission of current period sustaining capital expenditures, and discusses the analytical challenges in assessing the adequacy of current and future sustaining capex spending.
“Despite the critical importance of sustaining capex to the generation and availability of distributable cash, we found that 57% of income funds sampled excluded it from the distributable cash calculation, materially overstating the amount of operating cash on hand at the time of distribution,” says Kevin Hibbert, director of financial reporting and co-author of the report. Hibbert adds that the exclusion of sustaining capex from distributable cash calculations caused a total average two-year reporting distortion of 14%.
The way that capex is reported can significantly influence the perceptions of distributable cash, and thus, it warrants early investor attention before an assessment of the sufficiency of capex spending can take place, S&P says.
“Capex is a double-edged sword: on one hand it may not be included in the distributable cash calculation; but, even if it is, it’s difficult for investors to assess if it’s enough,” says Ron Charbon, director of S&P’s stability ratings group. “We hope that by publishing this series of articles, income fund investors have another tool to use in their decision-making process, specifically for understanding reporting nuances and the different ways these can influence their perceptions of distributable cash,” he adds.
In the first part of S&P’s series of commentaries on income funds, S&P concluded that the initial starting point to the distributable cash calculation was plagued with quantitative distortions and information risks that, when coupled with insufficient and inconsistent disclosure by management, left much to be desired in the financial reporting and disclosure practices of Canadian income funds.
“Our conclusion with respect to assessing the adequacy of current and future sustaining capex requirements is that investors should use a number of reference points to gauge required future spending needs of an income fund, including but not limited to, depreciation/depletion, industry rules of thumb, capex commitments, and asset retirement obligations,” S&P suggests. “The overall conclusion from this series of commentaries is that the calculation of distributable cash should be more thoughtful and the related disclosures, significantly improved.”