28 May 2013

A hiring action that was really dumb...

The National Post had an interesting article this morning about an Ontario barrister who, having been downsized and was unable to make a go of private practice, decided at the age of 60 to apply for a relatively low-paying legal writer position at CCH. He was awarded CAD 5000 by the Ontario Human Rights Tribunal because an outside consultant at CCH advised him that his application was rejected, as the company was looking at "candidates that are more junior in their experience and salary expectation." The consultant was not the decision maker, but it was held that his communication made the applicant conclude that it was not worth following up. Accordingly, it was considered to be age discrimination that had an adverse affect, and an award was made for injury done to his "dignity, feelings and self-respect."

Reiss v. CCH Canadian Limited (2013 HRTO 764) is a rather interesting case to read. Reiss asked for a lower salary range than the other two, and declined to state the year he was admitted to the Bar, and these were considered to be "red flags". CCH hired one of the other two, who quit within a week, and the second had accepted a position elsewhere. The hiring manager then hired a former employee for the job, who she had bumped into on the subway. Reiss' application was meanwhile placed on hold. He called to follow up, but his behaviour in doing so was considered to be aggressive.

The whole affair was badly handled, but, in this case, only the outside consultant stepped over the line. The decision does make some useful points. It points out (at par. 61) that a prima facie case of discrimination is established by proving the following:

  • that the applicant was qualified for the particular employment;
  • that the applicant was not hired; and
  • that someone no better qualified but lacking the distinguishing feature which is the gravamen of the human rights complaint subsequently obtained the position

It also points out that discrimination is held to exist when it is a factor (not necessarily the sole or major factor). In that regard (at par. 47), a recital of the analysis that is made in cases of circumstantial evidence is as follows:

The relevant principles that apply in cases where an allegation of racial discrimination has been raised have been usefully summarized as follows: 

  • The prohibited ground or grounds of discrimination need not be the sole or the major factor leading to the discriminatory conduct; it is sufficient if they are a factor; 
  • There is no need to establish an intention or motivation to discriminate; the focus of the enquiry is on the effect of the respondent's actions on the complainant; 
  • The prohibited ground or grounds need not be the cause of the respondent's discriminatory conduct; it is sufficient if they are a factor or operative element; 
  • There need be no direct evidence of discrimination; discrimination will more often be proven by circumstantial evidence and inference; and 
  • Racial stereotyping will usually be the result of subtle unconscious beliefs, biases and prejudices.

This applies to all types of discrimination, and it is something to certainly keep in mind in assessing whether hiring practices are truly focused on getting the best candidate.

22 May 2013

What is your cost of capital?

It is a classic rule in economics that, if a proposed investment is expected to have a rate of return that is greater than your cost of capital, you should invest in it. That is a case of marginal benefit over marginal cost. However, there are still too many businesses that do not know what their cost of capital really is — many are probably severely overestimating it.

I am not against adjusting the rate to account for expected risks with respect to particular investment. There are some rules of thumb that have been given in that regard:

  • venture capital investors generally expect an annual after-tax rate of return around 40%
  • angel investors will generally expect at least 50%

There have been other arbitrary rates that have been employed in the past. One company I worked at in the past (which was a part of the Ford Motor Company) expected a minimum return of 15% for any capital investment proposal. As this was back when corporate tax rates were approaching 50%, that meant that before-tax returns were around 30%, which was extremely conservative even in those days when the prime rate was around 11%.

Most good financial management texts have good discussions on the subject of determining a firm's cost of capital, and they all generally agree on the following key points:

  • the emphasis must be on calculating the ideal mix of debt, equity and other financing for the firm
  • the rate will be a weighted average of the returns arising from the different financing components
  • where the firm is privately owned, proxy rates may be employed using data from the industry and the geographic area concerned
  • adjustments for risk may be made for different types of investments, but that is a step subsequent to the initial calculation, and they should reflect the risks faced by the firm in question, as opposed to a blanket adjustment
In these days when many companies have been cutting back on their dividend payouts and capital investments, and interest rates are still around historical lows, "dead money" on corporate balance sheets has been of great concern to many people. The emphasis around such excess liquidity still runs counter to classical economic theory, which holds that excess funds should be paid out as dividends, if there are no alternatives available to earn rates of return in excess of the cost of capital. I would like to see more discussion from corporate executives and analysts as to why that is not the case at this time, or whether this is an extreme case of risk aversion even for Canadian businesses.

21 May 2013

A good idea that's been abused

One particular story that has struck a chord this past while has been the use and abuse of the Temporary Foreign Workers visa programme by Canadian employers. It really exploded this past weekend with the revelation that an IT professional with 20 years' experience that is currently receiving employment insurance benefits is unable to obtain interviews. That in spite of high demand for his skills!

It doesn't help that a former manager with one of the companies this person applied to stated that the company policy is not to hire qualified Canadians. The situation is even uglier when a former manager with the government agency concerned declares that it is being run as a "factory" where the objective is to churn out the Labour Market Opinions as quickly as possible in order to have the visas issued, with no due diligence undertaken to verify that employers have undergone a genuine effort to search out and hire qualified applicants who are Canadian citizens or permanent residents.

I must say that this is wrong on multiple levels. Never mind that now fees will be charged for the issue of such opinions that were previously issued at no charge, or that pay for such workers must be at parity with local wages and not at a 15% discount, or that searches should not call for knowledge of languages other than English or French as a job requirement (although the previous rules were both sick and wrong!). I can verify from personal observation that the so-called searches are being undertaken with criteria so stringent that it would be impossible to find anyone in Canada that could qualify. As the CBC story noted above observes, many people coming in under the TFW programme do not have such qualifications anyway, and in many cases the employer did not really need them. That is the real abuse that must be stopped, and the changes that have been announced will not really bring that about.

This is a story that will be definitely continued...

20 May 2013

The need to be vigilant

The position that most of us CMAs find ourselves in is the necessity of managing risks and ensuring that operations are properly kept under control (I guess that's why so many are controllers at some point in their career!). There are many instances that have flourished over the last few years about compliance with respect to:

The controls relating to all areas will only become more stringent over time. Financial institutions — who were already under a general duty to know their client — are now legally required to confirm identities of the principal players of the enterprise, be familiar with the nature of the business they are in, and know how funds will normally flow to and from the enterprise. That only makes sense, and any principals that wish to restrict access to such information will only find it more difficult to remain in business. Any unusual movements in funds that may occur without advising financial institutions will also attract unwarranted attention. I always advise executives and others in a controlling position to maintain an excellent working relationship with their bankers and other financial and legal advisers, in order to assure that any required financial transactions will occur without a hitch.

Bribery and anti-corruptions laws are being aggressively enforced in Canada, the US, the UK and other jurisdictions. They all tend to have a "long-arm" component attached, and must be taken into account in any corporate policy.

Economic sanctions are a critical area that all organizations need to be familiar with. I am not talking about controlled goods that are subject to special regulation in Canada and the United States: that is a special topic that affects a small set of business. There are many more that affect destinations and specific clients from which many organizations may receive orders and other contracts. As Canada's requirements are distinct from those imposed by the US, it is necessary for businesses to know what is required by each. It can be a minefield if you don't watch out.

Some companies have published compliance manuals in order to navigate this field, and they are worth checking out. However, any moves that organizations undertake should be vetted by properly qualified legal advisers (as well as other key players familiar with the subject).

15 May 2013

Capital investment appraisal: the importance of assessing it right

I did some work over on Wikipedia on this topic with respect to the Canadian context, and thought it might be a good idea to expand upon it here.

Capital investment projects are always assessed on their cash flows. As we know, cash flows are segregated into streams arising from activities in:
  • operations
  • investment, and
  • financing
The initial assessment of a project will match up the expected streams from operations and investments, in order to assess viability. Streams relating to financing will become relevant when assessing the best option for the acquisition of the assets (ie, lease vs buy, debt vs equity, and so on), but that is by definition the second step of the process, after the initial appraisal has been completed.

Let us assume the following factors for use in our calculations or capital cost allowance fhere:
  • I = Investment 
  • d = CCA rate per year for tax purposes 
  • t = rate of taxation 
  • n = number of years
  • i = cost of capital, after-tax rate of interest, or minimum rate of return (whichever is most relevant)

Full-year rule

When CCA is calculated at the maximum rate, the values claimed by year for a specific class under the full-year rule will be broken out as follows:

$ Id + Id(1-d) + Id(1-d)^2 + \cdots + Id(1-d)^{n-1} $

Therefore, the tax shield in year n = $ Itd(1-d)^{n-1} $, and the present value of the taxation credits will be equal to $ Itd \sum\limits_{n=1}^\infty \frac{(1-d)^{n-1}}{(1+i)^n} $.

As this is an example of a converging series for a geometric progression, this can be simplified further to become:

$ PV = \frac{Itd}{i+d} $

The net present after-tax value of a capital investment then becomes:

$ I  \left (1-\frac{td}{i+d}\right ) $

Half-year rule

For capital investments where CCA is calculated under the half-year rule, the CCA tax shield calculation is modified as follows:

$ \begin{align}
PV & = \frac{1}{2}\left (\frac{Itd}{i+d}\right ) + \frac{1}{2}\left (\frac{Itd}{i+d}\right )\left (\frac{1}{1+i}\right ) \\
& =\frac{Itd}{i+d}\left [\frac{1}{2} + \frac{\frac{1}{2}}{1+i}\right ] \\
& =\frac{Itd}{i+d}\left [\frac{\frac{1}{2}\left (1+i\right ) + \frac{1}{2}}{1+i}\right ] \\
& =\left (\frac{Itd}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \\
\end{align} $

Therefore, the net present after-tax value of a capital investment is determined to be:

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \right ] $

Specialized calculations

The methods shown above are the default calculations used for standard pools of undepreciated capital cost using the declining-balance method for accounting for CCA. There are certain classes where different calculations will be employed:

  • Class 13 (leasehold improvements) - Over the original lease period plus one renewal period (Minimum 5 years and maximum 40 years, but half-year rule applies)
  • Class 14 (franchises, concessions, patents and licenses) - Length of life of property (no half-year rule applies)
  • Class 29 (effectively recognized over three years, at 25%/50%/25%)
These are instances where standard spreadsheet calculations will still need to be employed. These are quite well presented in most financial management texts.

There are also special rules for companies that are involved with industrial mineral mines or timber limits and cutting rights. In addition, resource companies will need to assess the impact of the resource and processing allowances that are available to them. These rules are beyond the scope of this article.

14 May 2013

Assessing a suitable price for real estate income properties

Having once worked for several companies that were involved in real estate acquisition and management, it has always amazed me how many deals are arrived at without a proper financial assessment of cash flows and risks. Fortunately, there are some tools available to help make the analysis more rigorous and dispassionate.

The capitalization rate ("cap rate" for short) is very useful in that regard. In order to calculate it, you must first assess what the net operating income is for the property you are investigating, which is simply the operating profit before amortization and interest expense. You then determine what the NOI will be over the timeline you are assessing.

Assuming that a = NOI and i = cap rate, therefore the price of a property should be equal to

$ \large \sum\limits_{n=1}^\infty  \frac{a}{(1+i)^n}  $

which is the infinite series:

$ \large \frac{a}{(1+i)} \,+\, \frac{a}{(1+i)^2} \,+\, \frac{a}{(1+i)^3} \,+\, \frac{a}{(1+i)^4} \,+\, \cdots $

This is a geometric series with common ratio $ \frac{a}{(1+i)} $. The sum is the first term divided by (one minus the common ratio):

$ \large \frac{a/(1+i)}{1 - 1/(1+i)} \;=\; \frac{a}{i} $

You will then be in a position to compare the cap rate with the financing rates that is being proposed for the debt and equity components of the acquisition, in order to assess the viability of the deal.

What does this mean in practice? According to a recent article in The Globe and Mail, cap rates for Canadian commercial properties are currently in the range of 5.75% - 7.50%. Therefore, the purchase price for such a property should be its NOI divided by its cap rate. Conversely, the NOI of a property divided by its purchase price should equal the cap rate. Of course, if NOI varies by year, you will need to set this out in a spreadsheet to compute the present value of NOI over multiple periods, but that is relatively simple to produce these days.

If, on the other hand, the above calculations show that the cap rate for a property falls outside the acceptable range, it should lead to negotiations for a more appropriate price, or choosing to walk away from the deal.

The B and C teams

Every so often an observation just leaps out at you when you are reading an article off the beaten path. That happened today when I read Margaret Wente's latest column in The Globe and Mail. She was writing about the Hemda Centre for Science Education in Tel Aviv, and there was a very striking comment as to how they identify who should attend:

Canada has nothing like Hemda. That’s too bad, because we could use a lot more of the creativity and innovative mindset that Hemda fosters.

“We recruit for the ability to solve problems,” Tehilla Ben Gai, the school’s director, told me as she showed me around the bright and airy school. Its 1,100 students, who are in Grades 10 to 12, have all been assessed in person to see if they have the right stuff. “B and C students are sometimes smarter than A students,” she says. “We’re looking for students who are creative – and we teach them that science is fun.”
Contrast that philosophy with what is happening these days over here, where absolute perfection seems to be demanded of anyone who is applying for a position anywhere. This organization is really doing its diligence to see who can really succeed, and many times being on the A team will not truly help.

13 May 2013

Corporate structure: to simplify or not?

When considering how to structure an operation, I normally prefer the single-entity route - after all, Occam's Razor is a practical method that works. However, there are circumstances that may dictate establishing multiple entities in a group:

  • Is it necessary to ring-fence certain assets? This can be as simple as placing an operation in an operating company, and the acquisition of the building it is operating from in a separate company. Of course, there would have to be a valid lease executed between the two companies, with rent and other connected charges being properly paid from one to the other, but it is an excellent strategy for creditor-proofing.
  • Does a company have a particularly valuable brand or other intellectual property (ie, patents, trademarks, etc)? These can be vested in separate management companies, with appropriate licensing agreements being executed between companies. All the fast food franchise operations (such as Tim Hortons or McDonald's) practice this.
  • Does the head office of a group perform significant services on behalf of its subsidiary operations? There should be a valid intercompany services agreement in place, with services being charged at appropriate rates.
Much of this strategy has arisen from transfer-pricing litigation by the various taxation authorities in cross-border cases, but the logic is the same even when done within the same country, given the provisions in income tax legislation mandating fair market valuation.

10 May 2013

The book that inspired my career

One of the (few) positive aspects of moving is that you get to spot things you haven't touched in years. One of them is a Pelican book I picked up back when I first started pursuing my studies in accountancy.1

There are some great quotes in it that provided both warning and inspiration about the path I would take, and they still hold true today.

First of all, there is a warning as to what an accountant must not be, which was first noted by Elbert Hubbard:

A man past middle age, spare, wrinkled, intelligent, cold, passive, non-committal, with eyes like a codfish; polite in contact but at the same time unresponsive, calm and damnably composed as a concrete post or a plaster of Paris cast; a petrification with a heart of feldspar and without charm of the friendly germ, minus bowels, passion or a sense of humour. Happily they never reproduce and all of them finally go to Hell.

 On the other hand, a more modern description of a management accountant by Joseph R. Dugan has served to be the inspiration for my career:

A highly skilled technician - well educated, complex, confident, intelligent, optimistic - who abhors detailed direction. He expects to be influenced, persuaded and enlightened. He wants to be confronted with choices and alternatives, demanding freedom to structure his work, select his alternatives, present his solutions and speak for himself. He refuses to be considered an automaton who is supposed to respond eagerly to orders, edicts and ultimatums.
Looking back, I would say I have been fulfilling the latter quite well, but I can also confirm that there are still too many people - accountants included - that still stick to the first description (although I would say that middle age has nothing to do with the underlying attitude).

Finally, an observation about the nature of profit is provided from Peter Drucker, who pointed out that it serves three purposes:2

  1. It measures the net effectiveness and soundness of a business's effort.
  2. It is the premium that covers the costs of staying in business.
  3. It ensures the supply of future capital for innovation and expansion - either directly or indirectly.
I have never seen this explained so succinctly anywhere else, and it has certainly given greater focus to the approach I have taken to the work I have performed.

All in all, this was a refreshing reminder of inspirations and aspirations both past and present.

1 John Sizer, An Insight into Management Accounting, Penguin Books, London, 1969, ISBN 0-14-021087-3.
2 Peter Drucker, The Practice of Management, Mercury Books, London, 1961, pp. 65-9

07 May 2013

Practical applications of the cloud

Although many people still prefer to store files solely on their own hardware (whether workstation, laptop, tablet, and so on), there are useful instances where it is more efficient to use cloud storage:

  • collaboration within a group
  • resource for web presentations
  • practical access for clients
  • free storage for small accounts (ie, up to 2Gb)
Box.com is one example, and you can now embed your files from their storage into your own work on the web, such as this:

Another great one can be found at Scribd, and embedded content from their storage will look like this:

Let's not forget Google Docs:

There are others, but I find these three to be quite useful.

06 May 2013

Thoughts on the 2013 Ontario Budget

The budget that Charles Sousa presented last week is geared more towards ensuring the survival of the present minority government. This is obvious from the goodies that were announced, such as the mandated 15% reduction in auto insurance premiums. The law of unintended consequences dictates that this decrease will be made up elsewhere by the various insurance companies - another example of an initiative by the Province that is not clearly thought out for any reason other than to preserve potential Liberal votes for the next election.

Probably the most crucial issue is that of productivity in the business sector. The budget does acknowledge this, together with the issues of underinvestment in R&D and M&E compared to US-based businesses. Unfortunately, neither the provincial nor federal levels of government can influence this more than they have already done — their incentives are already very generous — other than to introduce sanctions for not doing so, which will be difficult to either conceive or be accepted.

There is little to report about tax changes — other than for tax rates and credits, Ontario automatically parallels federal taxation rules. The only significant item to note is what will happen to the calculation of Employer Health Tax. Beginning in 2014:

  • the portion of total Ontario payroll that is EHT-exempt will rise from CAD 400,000 to CAD 450,000
  • the exemption will be adjusted for inflation once every five years,  using the Ontario Consumer Price Index
  • private-sector employers (other than registered charities) with a total Ontario payroll greater than $5 million will no longer be able to claim the exemption
How does this translate in terms of total headcounts that will be impacted? According to Statistics Canada, average hourly weekly earnings for 2012 in Ontario amounts to CAD 908.00, which translates to an annual amount of CAD 47,216. Therefore:

  • the annual exemption in 2014 is equivalent to a headcount of just over 9 (450000/47216 = 9.53)
  • the maximum threshhold beyond which the exemption will cease to have effect is equivalent to a headcount of just over 105 (5000000/47216 = 105.90)
  • the EHT rate continues to be 1.95%

Considering how risk-averse most Canadian small businesses tend to be, there may be a lot of thought being given as to whether to hire employee #106, as that will mean an immediate increase of CAD 8775 (450000*0.0195 = 8775) in their total EHT liability. That is probably the wrong message to give to employers, and definitely a negative message to those people who are trying to find work after coming through the recent Great Stagnation.

Again, this strikes me as a measure that was not fully thought out. Let's see if this survives the coming budget debate.