Southstar Mining

Limited
Case 1

June 12, 2007

Arjun Sawhney -
Errol O. Ilchi - 100849394
Faisal Bhatti -
Owais Afzal - 102315350
Sameer Aizad -
Pension disclosure
From the Case

The company has a net pension liability of $24.6 million ($58.9 million - $34.3 million)
as of 1994, which will have to be paid over the next 15 years as per the labor
agreement of Southstar Mining Limited. The company has two diversified group for
pension purposes: Salaried and hourly employees. $7.5 million has already been
expensed for the year for the current fiscal year.

Observation

Southstar Mining Limited has a projected benefit obligation of pension which has
been pro rated on services. It is also known as accrued benefit obligation. Pension
plans are organized by either a mutual funds or insurance companies. The
responsibility of these enterprises is to report the accrued gains or losses annually. In
CICA under section 4100.14 it says that any changes in pension plan’s net asset
should differentiate between:
♦ Investment income by type and
♦ Changes during the period.

Section 4100.14 only requires the disclosure of the net change in the fair value. The
gains/losses on the disposal are not required by the GAAP.

Section 3280 which states that any contractual obligation in relation to the current
and future financial position should be disclosed. So in this case, as per the labor
agreement, the company must disclose all the necessary information regarding the
pension plan for the employees.

Section 3461.150 states that a company must disclose the information to the users of
financial statements about: (i) effect of employee future benefits on the financial
statements and (ii) the effect of plan obligations. 3461.076 states that a company
must disclose whether the benefits are prorated based on service or number of years.
It should also describe whether the return on assets is based on fair value or market
value. 3461.092 tell us to disclose whether all the gains or losses are amortized or
only the excess of benefit, the method used to amortize and the amortization period.

All the above mentioned must be disclosed in the foot notes but the company does
not have to include a pension liability on the balance sheet. The main objective here
is to provide the best and most accurate and as much information as possible to the
users in order for them to track and control the business risk, especially when the
statements are materially misstated. Not only it affects their business decisions but
also allows them to look into the future and make predictions more precisely. After
the fateful events of Enron and WorldCom, the business world was changed. The
implementation of CPAB right after Sarbanes Oxley Act, is being the most important
legislation affecting the Canadian Accounting Board. The main purpose of the
footnote is to display the meaning of the account stated in the financial statements
accordance with the GAAP. Companies must disclose anything which is most likely to
affect the decision of the users in the footnotes or in the Management, Decisions and
Analysis (MD&A). The users must know how to read between the lines to fully
understand the meaning of a particular account. In order to see the warning signs, a
reader must be able to read thoroughly. For example increases in debt or an
increases in write offs are major signs to keep in mind.
Dividend payment
The president and CEO, Ben South, in his address to the audit committee and board
of directors stressed on a “no dividend” policy to rectify the erosion Southstar’s
equity position over the last year. Record losses during the year ate into $73.8 million
($189.4 million - $115.6 million) of Southstar’s equity over the year resulting in a
suspension of dividend.

Though Southstar projects a small marginal profit for the year 1995, Ben is of the
opinion that future profits and zero dividends would rectify the situation. The decision
as to whether dividend be paid or not is at the discretion of the management.
Dividend payment requires that a company has sufficient retained earnings and cash
to pay the dividend. Canadian Companies are allowed to defer dividend payment
without any queries being raised by regulators for the maximum of eight to ten
years.

During recession and cyclical swings, such as the one that Southstar is currently
experiencing, financing operations from debt is considerably cheaper than equity as
the streams of cash outflows and inflows are known. Currently the interest payment
on Southstar’s debt is determinable and any unforeseen changes in interest
payments are relatively unlikely. Dividends are paid out from after-tax income as
compared to interest on debt that is paid out from pre-tax income. Southstar would
benefit from the tax shields available on interest payments and would not have any
such benefits from paying out dividends.

Amongst management’s financial reporting objectives vital objective is to smooth

income and dividends. The marginal profit expected during the current year may be
an indication of better financial performance in future years. The president’s stand for
a ‘no dividend’ policy may be aimed at making the financial position stronger;
however, Southstar may alternately implement a minimal dividend policy to make
the market position strong in addition to making the financial position stronger.

The current debt covenants allow Southstar for a debt/equity ratio of 2.5 to 1.
Southstar may pay out dividend to the maximum of $1.92 million without violating
the requirements of the debt covenant. Ignoring deferred taxes the current
debt/equity ratio allows for retained earnings to drop by $1.92 million.

Total liabilities 358.8

million
Deferred taxes 74.6 million
Total Debt 284.2
million

Maximum debt/equity ratio 2.5 to 1

Minimum equity (284.2 ÷ 2.5) 113.68
million
Current equity 115.6
million
Deferred Taxes
Southstar Mining Limited had a long term debt with terms and conditions that specify
the company’s maximum debt-to-equity ratio cannot exceed 2.5. As at December 31,
1994, company has a debt-to-equity ratio of 3.1 including deferred tax liability and a
ratio of 2.46 without including deferred tax liability. Argument took place between the
president of the company and a member of audit committee. The president explained
that the company has agreed with the lenders that deferred tax liabilities are
excluded and added:”…deferred taxes, which will never really have to be paid
anyway …”

In this case, the company is in compliance with GAAP by showing the 74.6 Million
deferred income tax liabilities on the face of its balance sheet using historical cost
accounting and their agreement with lenders to exclude the deferred income tax
liabilities in calculating the debt-to-equity ratio is just fine, nothing wrong with it. All
they need in excess of showing it on the balance sheet is to fully disclose in its notes
to financial statements any information related to deferred income tax and long term
debt such as the debt covenant terms and conditions as well as the agreement with
the lenders to exclude the deferred income tax in debt-to-equity ratio calculation.
However, the president’s statement of”…deferred taxes, which will never really have
to be paid anyway …” is questionable. Deferred or future income tax liability, as it is
defined, is the future tax consequence associated with a taxable temporary
difference. It represents the increased I taxes payable in future years as a result of
taxable temporary differences existing at the end of the current year. Even though it
is dismissed in assessing a company’s financial strength by some analyst in practice,
it cannot be ignored as “never payable” because it meets the definition of a liability
established in CICA handbook Section 1000 for the following reasons: It is result of
past transaction; it is a present obligation; and it represents a future sacrifice.