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Creative Bookkeeping?

The Ontario Securities Commission's allegations describe situations in which Philip recorded certain financial transactions and inventory in an inappropriate manner. Its treatment of the CIBC copper-s...

The Ontario Securities Commission’s allegations describe situations in which Philip recorded certain financial transactions and inventory in an inappropriate manner. Its treatment of the CIBC copper-swap arrangement illustrates how the company turned what was really a financing arrangement into a “sale.”

In or around May of 1997, Philip and Canadian Imperial Bank of Commerce (CIBC) began negotiation of a complex financing arrangement, the purpose of which was to provide Philip with funds as a result of the “sale” of copper inventory to CIBC. At the same time, Philip agreed to:

(a) process the inventory and store it on its premises; and

(b) market and sell the inventory on behalf of CIBC, remitting the proceeds to the bank.

Philip wanted to record this series of agreements as a sale of inventory despite the fact that this was a financing transaction. The fact that CIBC also insisted that Philip enter into swap agreements effectively meant that all of the risks of ownership of the inventory remained with Philip. According to the OSC, the transaction should properly have been recorded as a financing transaction.

On or about June 27, 1997, Philip agreed to sell to CIBC “commodities” (unprocessed copper) representing the equivalent of 31.5-million pounds of finished product. Philip agreed to retain physical possession of the inventory. The CIBC “directed” Philip to process the commodities pursuant to a prescribed schedule: two million pounds per month between July 1997 and April 1998, and 11.5-million pounds in May 1998.

CIBC “directed” Philip to remit the sales proceeds, at the COMEX price at the date of the sale, to CIBC, on each settlement date. Philip received $26.8-million in cash, net of prepaid interest and net of a hold-back of the processing and sales agency fees due to Philip.

Also on June 27, 1997, Philip entered into a swap agreement with CIBC. The swap agreement ensured that Philip would remit to CIBC proceeds of at least the amount initially paid by CIBC, plus interest, thus eliminating the risk to CIBC of future fluctuations in the copper prices.

CIBC provided Philip with an accounting opinion indicating that the transaction, as initially contemplated, could be recorded as a sale. Philip sought the advice of its auditors, Deloitte, on the accounting of this transaction. On the basis of the information that was provided to Deloitte (and after considerable debate), the accountants found that recording the transaction as a sale was acceptable. However, the existence of the swap agreement was not disclosed to Deloitte.

Rolling the transaction

Philip did not process any of the inventory as required pursuant to the agreements. Rather, as swap agreements came due every month, Philip simply “rolled” the transaction. The “rolls” necessitated a net payment from Philip to CIBC or vice-versa.

Philip’s VP Finance recorded the transaction as a sale with a corresponding reduction in inventory that would result in an increase in the cost of sales. The VP Finance also recorded the accounting for the swaps and the rolls. Philip recorded the sale of its inventory and did not record the transaction as a finance arrangement. As a result, a gross profit of $3.2-million in the second quarter of 1997 was realized due to the manner in which the transaction was recorded.

Disclosure to Deloitte

During that time, Philip continued to fail to disclose the existence of the swap agreements to Deloitte. In early February 1998, at the time that he resigned from Philip, the VP Finance informed Allen Fracassi and Graham Hoey that Deloitte was unaware of two further adjustments that Philip should take. One of these related to the CIBC transaction.

On March 5, 1998, Philip issued a press release indicating that, “[t]he amount of the discrepancy was confirmed at $92.2-million pre-tax caused by trading losses and $32.9-million pre-tax caused by the incorrect recording of copper transactions within the copper division.”

These figures did not include an adjustment for CIBC.

On March 19, 1998, while finalizing the audit, Deloitte discovered that there were no accounting entries for certain transactions. In particular, Deloitte identified the swap agreements, their impact on the CIBC transaction and the lack of recognition of a liability. As a result, Philip made further adjustments to the financial statements.

As a result, the OSC says the financial statements in the November 1997 share prospectus were misleading and not accurate due to the inappropriate accounting treatment of the CIBC transaction.

In the “Form 10-K” the financing arrangement with CIBC formed a component of the adjustments (i.e., the “special charges”) announced by Philip and made to its financial statements for the year-end December 31, 1997. The adjustment was in the amount of $10-million. Yet the matters were known to Philip’s executives prior their filing the prospectus.

Readers should note that the OSC allegations have yet to be proven at the hearings. — ed.

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