Canadian Pacific (CP) is one of Canada ’ s best known companies and one of Canada ’ s two large railway companies (the other being Canadian National Railways Company or CN).
We present and discuss CP ’ s financial statements in this chapter, and in the next chapter we provide some tools that can be used to analyze these statements.
Learning Objective 3.4 Analyze a firm ’ s financial statements.
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76 CHAPTER 3 Financial Statements
Accompanying Statements
We begin by looking at the information the company files with its financial statements. Figure 3-2 provides “Management ’ s Responsibility for Financial Reporting,” from CP ’ s 2014 annual report. This report, from both the CEO and the CFO, discusses the responsibility of management, and the board of directors (through its audit committee), to ensure the integrity of the process by which the company ’ s financial statements were prepared. Although CP is based in Calgary, it files its state- ments according to Securities and Exchange Commission (SEC) regulations (and according to the rules of SOX) in the form of a 10-K statement, since its common shares are listed on the New York Stock Exchange (NYSE), as well as on the Toronto Stock Exchange (TSX). 15
Notice in Figure 3-2 that the CEO and CFO conclude that
“the Company maintained effective internal control over financial reporting as of December 31, 2014.” In essence, the CEO and CFO assume responsibility for the integrity of the financial statements, as well as for the process under which they were prepared. This is impor- tant to note, as it means the CEO and CFO are personally “liable” for the integrity of the finan- cial statements.
Figure 3-3 provides a sample of an independent auditor ’ s report. Notice that the report is addressed to the board of directors and shareholders of the company. The section titled
“Auditor ’ s Responsibility” describes the scope of the auditor ’ s examination, which includes various audits and tests to verify things were as management said they were. Previously, auditors checked everything, but that isn ’ t feasible now, so they do spot checks. The audi- tor also checked on the judgement (e.g., the estimates and principles applied) that man- agement used. Remember, a considerable amount of judgement is involved in the preparation of financial statements. The auditor also assessed the overall financial state- ment presentation.
The audit “Opinion” states that “in our opinion” the statements “present fairly, in all material respects, the financial position of ” the company. The auditor does not say that the statements fairly present in an absolute sense, but simply that the company has cho- sen a set of allowable accounting principles and has prepared the statements fairly in accordance with those principles. This difference may seem picky, but sometimes finan- cial statements that fairly present according to GAAP do not fairly present in an absolute sense.
Canadian Pacific ’ s Balance Sheet
CP ’ s financial statements are relatively straightforward for 2013 and 2014, which is one reason we chose them. Figure 3-4 shows CP ’ s balance sheets for 2013 and for 2014 as presented in its 2014 annual report.
Figure 3-4 shows that in fiscal 2014, CP had total assets of $16.640 billion. This figure included $1.277 billion in current assets, including, among other items, $226 million in cash and cash equivalents, $702 million in accounts receivable, and $177 million in materials
Larry MacDougal/The Canadian Press
E. Hunter Harrison, chief executive officer for Canadian Pacific, addresses the audience at the company ’ s annual general meeting in Calgary, Alberta, on May 14, 2015 .
15 Not all Canadian companies that list on U.S. exchanges prepare their annual reports using U.S. GAAP as CP has chosen to do.
Many Canadian companies, such as BCE Inc., prepare their annual reports using IFRS.
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77 CHAPTER 3 3.4 Canadian Pacific Accounting Statements
FIGURE 3-2 Canadian Pacific’s Management ’ s Responsibility for Financial Reporting Source: Canadian Pacific Annual Report 2014, p. 68.
and supplies. The items listed above are all called current assets , because they are expected to be converted into cash within a year as receivables are collected, materials and supplies used, and so on. For longer-term assets, by far the largest item is properties (net) at $14.438 billion.
Deferred income tax items arise due to timing differences between the tax and reporting values of certain assets and liabilities. CP reports two deferred income tax figures on its bal- ance sheet: $56 million under current assets (collectible within a year) and $2.773 billion under long-term liabilities (due from the company in the long term). The investments figure of
$112 million includes $82 million in equity investments—which represents CP ’ s share in com- panies in which it has a substantial ownership position (typically between 20 and 50 percent
current assets assets (cash and cash equivalents, short-term investments, accounts receivable, inventories, prepaid expenses, and other items) that are expected to be converted into cash within a year or operating cycle
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FIGURE 3-3 Canadian Pacific’s Independent Auditor ’ s Report Source: Canadian Pacific Annual Report 2014, p. 69.
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79 CHAPTER 3 3.4 Canadian Pacific Accounting Statements
FIGURE 3-4 Canadian Pacific ’ s Consolidated Balance Sheet Source: Canadian Pacific Annual Report 2014, p. 73.
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ownership), but that do not qualify as subsidiaries, and thus would not be included in the consolidated statements. 16
For current liabilities , CP reported accounts payable and accrued liabilities of $1.277 billion, $407 million of which was trade payables, and the rest of which represented a variety of accrued expenses. 17 The company also had $134 million representing the current portion of long-term obligations (i.e., the portion due to be repaid in the coming year). In total, CP had current liabilities of $1.411 billion. The main components of its long-term liabilities consisted of long-term debt of $5.659 billion, pension and other benefit liabilities of $755 million, and other long-term liabilities of $432 million, in addition to the $2.773 billion in deferred income taxes mentioned previously. CP ’ s equity holders have contributed $5.610 billion in sharehold- ers ’ equity, either through original contributions or by having net income retained and rein- vested within the business.
In looking at CP ’ s assets and liabilities, you should recognize the similarity to the simple statements prepared for Jim ’ s Widgets. Of course, the preparation of the statements for a firm with $16.640 billion in assets is more complex than it is for Jim ’ s Widgets, but, in principle, the same GAAP have been followed. Just as Jim ’ s Widgets does, CP has cash, accruals, receivables, and properties.
Canadian Pacific ’ s Income Statement
How much money did CP make in fiscal 2014? To see this, we look at the consolidated state- ments of income (also known as statement of earnings) as reported in Figure 3-5 .
We can see from Figure 3-5 that in 2014, CP had revenues of $6.620 billion. Subtracting operating expenses of $4.281 billion from revenues gave it operating income or earnings before interest and taxes (EBIT) of $2.339 billion, from which it paid $282 million in net inter- est expense (i.e., interest expense less interest income) and $562 million in income tax.
Overall, in 2014, CP produced $1.476 billion in net income. So when CP ’ s net income is divided by the average (adjusted) number of shares outstanding, it produces a basic EPS figure of
$8.54. Companies are also required to report “diluted” EPS, which is simply the adjusted net income divided by the total possible number of shares that could be outstanding if all poten- tially “dilutive” securities outstanding were converted into common shares. For example, a company might have some “convertible” bonds outstanding, which, under certain circum- stances, could be converted into common shares. The diluted EPS takes into account all the potential shares that could “dilute” the EPS by spreading the net income over a greater num- ber of shares. CP had minimal potential for equity dilution, so its diluted EPS figure is only
$0.08 below its basic EPS figure at $8.46.
Canadian Pacific ’ s Cash Flow Statement
We examine CP ’ s statement of cash flows in Figure 3-6 . In terms of non-cash items, the biggest item is depreciation and amortization of $552 million, which represents an “expense,” as fixed assets are written down; however, no cash is actually paid out. The net working capital current liabilities liabilities (e.g.,
accounts payable, notes payable, bank loans, and so on) that are due within a year or operating cycle
16 Technically, this is because such inter-company investments are accounted for using the “equity method.” The equity method requires the company that owns the shares in other companies to report its “net equity” position in those other companies on its balance sheet, and also requires it to record a percentage of those companies ’ incomes (i.e., the percentage it owns) as “equity income.” Generally, a company is denoted as a subsidiary when the “parent” company owns more than 50 percent of its common shares and is accounted for using the “consolidation method.” The consolidation method requires the parent to include all of the subsidiary ’ s assets, liabilities, and profits on its financial statements (less inter-company items). The percentage of the subsidiary that the parent does not own shows up as “minority interest” on the liability side of its balance sheet, and as a minority interest charge against income on the income statement. If a company owns less than 20 percent of another company, it accounts for this using the “cost method,” which basically means it only accounts for any dividends received from the other company as dividend income.
17 Note 18 of the consolidated financial statements provides a complete list of accounts payable and accrued liabilities.
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81 CHAPTER 3 3.4 Canadian Pacific Accounting Statements
FIGURE 3-5 Canadian Pacific ’ s Income Statement Source: Canadian Pacific Annual Report 2014, p. 71.
adjustments are relatively minor, so cash flow from operations (CFO) of $2.123 billion is very close to the net income plus depreciation and amortization total of $2.028 billion, which is commonly referred to as “traditional cash flow.” This similarity in numbers essentially indi- cates that CP is not prematurely recording sales, building up inventory, or avoiding paying its bills. Its net income figure is reliable.
In 2014, CP ’ s cash flow from investing activities (CFI) was −$750 million, mainly due to
$1.449 billion in additions to properties, which is offset by sales of properties and other assets totalling $288 million, and a change in restricted cash of $411 million. The 2014 net CFI figure is very different from the 2013 figure of −$1.597 billion, a big portion of which is due to the reversal of the restricted cash figure in 2014. Firms that are growing and constantly investing in (that is, acquiring) new assets typically have negative CFI figures, such as is the case for CP.
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FIGURE 3-6 Canadian Pacific ’ s Consolidated Statement of Cash Flows Source: Canadian Pacific Annual Report 2014, p. 74.
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83 CHAPTER 3 3.5 The Canadian Tax System
The cash flow for financing (CFF) figure for 2014 of −$1.630 billion is due primarily to the purchase of $2.050 billion of CP stock, the payment of dividends ($244 million), and the repay- ment of $183 million in debt, all of which were offset to some extent by the issue of $771 mil- lion in commercial paper. This figure was much more negative than the 2013 and 2012 figures, due to the large share repurchases in 2014. Finally, adding the CFO, the CFI, and the CFF shows that CP had a net decrease in cash of $250 million in 2014, relative to increases in cash of $143 million and $286 million in 2013 and 2012 respectively.
The strength of CP can be seen when we use the information from the cash flow statement to estimate the company ’ s free cash flow, as shown in Table 3-2 . 18
TABLE 3-2 Canadian Pacific ’ s Free Cash Flow Estimated
Free Cash Flow (for the years ended December 31) 2014 ($Million) 2013 ($Million)
Net income 1,476 875
Total cash flow from operations (CFO) 2,123 1,950
Additions to properties, or capital expenditures (capex) (1,449) (1,236)
Free cash flow 674 714
Source: Data from Canadian Pacific Annual Report 2014 .
The company had 2014 total income of $1,476 million and cash flow from operations of
$2,123 million. After deducting additions to properties (or capital expenditures) of $1,449 mil- lion, the 2014 free cash flow was $674 million, slightly below the 2013 figure of $714 million.
The free cash flow can be viewed as the funds available to the company and its subsidiaries to pay dividends after taking care of investment requirements. CP ’ s dividend payments were actually well below their free cash flow numbers in both 2013 and 2014, at $244 million in both years. This explains why the company was able to repurchase such a large number of CP shares in 2014. Overall, CP ’ s financial statements are “clean,” in the sense that there are very few adjustments that make the statements difficult to understand.
1. Who is responsible for the preparation of a company ’ s fi nancial statements?
2. What are the scope and purpose of the auditor ’ s opinion?
3. Identify the main components of a fi rm ’ s balance sheet and income statement.
CONCEPT REVIEW QUESTIONS