Stelco Inc. is a Canadian steel manufacturing company. In 2004, the company filed for bankruptcy protection

Stelco Inc. is a Canadian steel manufacturing company. In 2004, the company filed for bankruptcy protection, citing the following reasons for declining profits and viability problems:

1. Costs have risen dramatically for inputs such as natural gas and electricity and raw materials, such as coal, coke, and scrap.

2. The cost of employee future benefits—pensions and health care—are also increasing due to improved pension benefits negotiated in contracts with unionized employees, increasing health care costs, lower returns on pension plan assets, and the effect of lower interest rates on the discount factors that are used to determine the Corporation’s liabilities under the pension and other benefit plans.

3. Global steelmaking overcapacity has created downward pressure on selling prices due to significant and continued import penetration of the Canadian market by steel products offered, in management’s opinion, at unfairly low prices over the last several years.

4. The appreciation in the value of the Canadian dollar during 2003 further negatively affected selling prices. Selling prices strengthened in the early part of 2004, due in part to increased demand, particularly in China. However, the Corporation believes that these price increases are not sustainable and therefore are not expected to be sufficient to offset growing cost issues.

5. Several North American steel producers have emerged from court-supervised bankruptcy protection with a cost structure that is more competitive than that of the Corporation. The Corporation cannot compete effectively in this new environment unless it takes steps to reduce its liabilities and lower its overall costs.

6. In addition, the Corporation requires additional funding to complete strategically critical capital projects at its Hamilton and Lake Erie business units. The Corporation is unable to raise additional funds to complete these projects.

The protection afforded by the Companies’ Creditors Arrangement Act (CCAA) was challenged by the United Steelworkers of America (USWA). The president of USWA Local 1005 was quoted in the newspapers as saying, “We are not going to allow them to blackmail us by using CCAA as a way to convince us to give up our wages and benefits. It amounts to legalized corruption. In my opinion, the CCAA process is an abuse of power.” The USWA challenged the courts as to whether Stelco should be protected by CCAA.

Stelco’s assets had a book value of $2.74 billion and liabilities of $2.09 billion in the bankruptcy documents. The following is an excerpt from the 2003 financial statements:

Instructions

Adopt the role of the company and analyze the financial reporting issues. (Although the company would have been following pre-2011 PE GAAP, use IFRS to analyze the financial reporting issues for purposes of this case).

-       Company has filed for bankruptcy protection.

-       As management they will want to show that they are in cash flow difficulties and therefore deserve the protection and yet need to show that the company will be able to pull out of the protection successfully and continue to operate as a going concern. They would also like to raise funds for expansion and so need to show that investment in the company is worthwhile.

-       USWA have taken them to court to try and prove that they really should not have bankruptcy protection, i.e., their financial health is much better than they are letting on.

-       Problems with increasing costs and downward pressure on selling prices are squeezing profit margins. Unable to compete since competitors have already reorganized.

-       The most pressing issue appears to be to make the case that they need bankruptcy protection. The bias would be to minimize net worth on the balance sheet as well as profits.

-       GAAP is a constraint since the company is public.

-       NB as directed in the question, use IFRS for the analysis even though the company would have followed pre 2011 GAAP.

Analysis and recommendations

Issue: Convertible unsecured debentures

Debt and equity

- Legal form is debt. - Obligation to pay set amount of interest creates an obligation that the company cannot avoid. - The conversion feature would be equity. - The fact that the company may settle the obligation with shares does not negate the fact that the obligation to pay interest and principal is a fixed amount. The number of shares used to settle the obligation will vary but the set obligation must be settled.

Recommendation: The obligation to pay interest and principal reflect a liability since the amount to be repaid is fixed. The conversion feature will be shown as equity. This accounting treatment maximizes debt and minimizes net worth.

Issue: Pension plan obligation

The company had $2 billion ($0.752 billion + $1.254 billion) of unfunded obligation relating to pensions and other future benefits. Of this, only $650 million ($924 million - $274 million) was recognized in the balance sheet. Historically, GAAP allowed the differences to be deferred and recognized over time. IFRS also allows this although vested past service costs must be recognized.

Leaving the unfunded deficit off the balance sheet does not represent reality however. The difference is a real obligation and represents a drain on future cash flows. In reality, it should be recognized as a liability and the USWA should see how this affects net worth. It would definitely worsen the position as the unrecognized deficit is a material amount.