Advisors and their cli-ents should soon be able to make better comparisons among Canadian income trusts if the trusts adopt new guidelines for financial reporting.
While the guidelines issued by the Canadian Institute of Chartered Accountants are not mandatory, they may help bolster investor confidence in the asset class, following Ottawa’s decision a year ago to remove the tax advantages that had driven huge gains in the sector over the past decade.
Margaret Lefebvre, executive director of the Canadian Association of Income Funds, expects “the vast majority” of Canadian income trusts will follow the CICA’s new financial reporting guidelines — issued in July — when they report their fourth-quarter and yearend results.
One of the most important new recommendations deals with “distributable” cash — that is, potential vs actual distributions to unitholders. The CICA’s new guidelines recommend standardized disclosure in two areas of vital importance to unitholders: one deals with the source of the “distributable cash” (for instance, whether it is derived from earnings or capital); the other deals with how and why capital spending is being used to maintain the trust’s operations (known as “production capacity”).
“The result, for the investor, is that there will be a consistency to the reporting,” says Lefebvre. “Trusts will explain exactly how they achieved their calculations. I would expect the vast majority would go in that direction.”
The biggest hurdle to implementing the guidelines, Lefebvre says, is the time crunch. Many trusts are already bogged down by the massive task of dealing with the changes to federal tax regulations governing distributions for existing trusts, which were announced in November 2006 and will take effect in 2011. Energy trusts in Alberta have also been busy digesting Premier Ed Stelmach’s new royalty system, announced in October of this year.
“Distributable cash” — a key measure for income trust unitholders who buy into trusts for yield — is not defined under generally accepted accounting principles.
Although distributable cash is commonly reported in the management discussion and analysis that accompanies financial statements, critics say, there has been little consistency in how it has been calculated and reported, thus allowing a wide latitude for management interpretation.
The result is that the way in which some trusts disburse cash to unitholders is not always transparent or easily compared with other trusts. And, in some cases, distributions are not sustainable.
The change in the tax rules last fall also makes disclosure of trusts’ capital-spending strategies more important than ever, the CICA says. Kevin Dancey, president and CEO of the CICA, which represents 71,000 chartered accountants, says the main issue is investor protection. The gap in financial reporting, he says, “has put investors in income trusts at undue risk.”
The key questions, according to Dancey: “Where did the cash come from that funded the cash distributions and, in arriving at the amount available for distribution, has the income trust made the investments necessary to maintain its operations?”
Chris Hicks, head of knowledge development at the CICA, says that while some critics believe distributable cash should be calculated from net income, the CICA recommends using cash flows from operating activities. After deducting capital expenditures that are required to maintain existing operations and provide for future strategies such as acquisitions, the remainder makes up the bulk of distributable cash.
That number should also be expressed on a per-unit basis, which is very relevant if a trust has issued additional units, Hicks says: “I would hope that all income trusts follow this guidance.”
TOO LITTLE, TOO LATE
The Canadian Securities Ad-ministrators has also developed a policy statement on how distributable cash should be reported. But, according to critics such as forensic accountant Al Rosen of Toronto-based Accountability Research Corp. , they are not stringent enough. Rosen, who has crusaded against slack legislation and enforcement in the Canadian financial world, says the recent guidance issued by the CICA is an improvement on the CSA policy, but both are “too little, too late.” And the CICA’s new guidelines lack impact because they are not mandatory.
“It has no teeth and there’s nothing you can do about it,” he says. “When you turn it into recommendations, it kind of goes nowhere.”
Rosen, who has published a report on income trusts, says most funds are overvalued because investors may not understand how the distributions are funded. He says the way some income trusts report yield can result in confusion. For example, an investor with an 11% return may not realize that only 3% was derived from net income; the other 8% might simply be a return of the unitholder’s capital, or even money borrowed from the bank.
@page_break@“The real problem is not telling people they’re getting their own money back,” Rosen says. He fears for naive investors and vulnerable senior citizens.
Because guidelines from the CSA do not require the trusts to calculate yield based on income, Rosen says, “You can carefully select data so that the senior is left uninformed.”
Trusts call it “return of capital” — capital returned to the client that is not income — but Rosen compares funds that have such murky accounting methods with Ponzi schemes.
While most wouldn’t go that far, the track record of income trusts on distributable cash has drawn fire from many business and financial experts, including Standard & Poor’s Corp.
“The current state of distributable cash calculations and related disclosures leaves much to be desired,” S&P analysts Kevin Hibbert and Ronald Charbon in Toronto wrote in a January 2006 report. “Coupled with insufficient and inconsistent disclosure by management, the information risks inherent in this area of the Canadian capital markets continue to be quite significant.”
For the report, S&P studied distributable cash calculations in a random sample of 40 income funds in 2005, and reported that 10% of the income funds had cash available for distribution that was “lower than what was reported by management and insufficient to cover distributions over a two- to three-year period.”
The S&P analysts also discovered the use of 19 terms to describe the cash distributed to investors.There have been no new reports since.
Brent Fullard, president and CEO of the Canadian Association of Income Trust Investors, says that while he applauds more transparency on one level, the whole debate is somewhat moot because so many trusts are now being snapped up in mergers and acquisitions or taken out by private equity as a result of the changes to the tax laws. According to CAITI, there are fewer than 200 trusts left in Canada, down from about 250 in mid-2007.
One Calgary-based trust, Enerplus Resources Fund, has sidestepped the whole issue by dropping references to all non-GAAP measures such as distributable cash, says CFO Robert Waters. The trust focuses on reporting cash flow from operations in order to give investors insight into the fund’s finances, he says, noting that other trusts are following suit. This, Waters says, is a positive result of the CICA initiative.
Enerplus and other energy trusts still take issue with the idea of forecasting how they will sustain their business models, as much growth occurs through buying other companies or trusts. Says Waters: “It’s pretty hard to predict your next acquisition.”
ALREADY ADOPTED
Lefebvre says that two other Calgary-based trusts, Penn West Energy Trust, the largest conventional oil and natural gas-producing income trust in North America, and Bonterra Energy Income Trust have already adopted the new recommendations.
But several other trusts say that they don’t plan to do so. Marie Fenez, spokeswoman for Canadian Oil Sands Trust in Calgary, says disclosure for the third quarter ended Sept. 30 reflects that trust’s “enhanced discussions regarding distributions as required by the CSA. We believe changes are required to the CICA guidance to make it more practical for issuers to implement.”
On Oct. 31, the Oil Sands trust announced it would hike quarterly distributions by 38% after profit jumped by 30% in the quarter.
David Carey, senior vice president of capital markets with ARC Energy Trust, also based in Calgary, argues there is a lot of supplemental disclosure required in the oil and gas business that provides investors with detailed information about independently evaluated reserves on an annual basis. “We do not plan to adopt the full CICA recommendations on distributable cash,” he says, “because we believe our disclosure is more appropriate for an oil and gas royalty trust.
“It is important to remember that we are in the oil and gas business and, as such, it is important that investors are able to compare our results directly to those of other oil and gas entities,” he adds. “We believe that to be more important than having statements that may be comparable with a restaurant or a mattress company.”
A major business income trust, Toronto-based waste-management titan BFI Canada Income Fund, says it is “aware” of the CICA’s “interpretive release.” However, it is focusing on complying with the policy from securities regulators, says Chaya Cooperberg, BFI’s director of investor relations.
But the CICA says its recommendations are not an either/or situation, because they are designed to be a framework to complement and support the securities regulators’ policy guidelines. IE
Mixed reviews for income trust accounting guides
Some say they have no force, while others question whether they will fit their operations
- By: Laura Bobak
- December 5, 2007 December 5, 2007
- 11:44