As people begin talking about taking care of  LaRue, they will undoubtedly want to start talking about its financial situation.  One place to look is at the Financial Statements.   I know there are cousins out there with more expertise in reading such statements, and am looking forward to someone doing a basic “Financials 101” post for us! (ie. how to read Financial Statements) Til then, let me get a start on it.

With LaRue, since a big part of the controversy over the past 10 years has involved questions about “audited financial statements” (and who should pay for them), I thought it might be worth having a short discussion about “Audits”.  In brief,

“WHAT IS AN AUDIT AND WHY SHOULD I CARE?”

SHAREHOLDER RIGHTS

The answer to this begins with the rights of shareholders.  In any company structure, shareholders have three basic rights:

1. to vote for directors at the Annual General Meeting
2. to share in any dividends declared by the company
3. to share in the proceeds of the company at its dissolution.

In a small ongoing company like LaRue, it is the first of these rights that is most meaningful: LaRue has not been a big money-making venture, and thus has never paid out dividends (and is unlikely to ever do so); the right to share in proceeds at dissolution is only meaningful when the company ‘dies’.  So, it is the first right (the right to vote at the AGM) that really matters.

Extract from LaRue Financial Statements, 1982

In order for the voting in a company to be meaningful, the shareholders need to have access to information, and particularly, information about the financial health of the company.  Thus, on a yearly basis, the shareholders have the right to be provided with financial statements. (See sections 155 to 159 of the Alberta Business Corporations Act).  Above, as an example, is one page from the LaRue Financial Statements – 1982 (this is the first year that Arta took responsibility after Doral’s death).

The legislation specifies that financial statements must also be AUDITED (note that the financial statements above are unaudited…we will come back to this below).  While an audit does not guarantee that there is no fraud going on (see the Enron accounting scandal in 2001), it does enable the auditor to state that the statements are a fair representation of the company’s financial situation. In short, when the financial statements are audited, there is a sort of structured scrutiny of the records.  An audit puts additional eyes on the corporate records.

This of course involves both time and cost.  The cost of an audit is simply part of the cost of doing business in a larger corporation.  In a small corporation, however, the cost of an audit may well be greater than its value to the shareholders.  In a small company, the shareholders have additional ways of having access to information (methods not available to shareholders in big publicly traded companies).

The LaRue Ledger – a page from 1997

For example, for LaRue, Arta brought all the books out to the lake each summer, so people who wanted to could look at the bank statements, the ledger, the cancelled cheques, etc. This is significantly more information than would be available to shareholders in the ordinary course of events.  In such situations, the audit does not provide more information than the shareholders already have.  In this context, shareholders might not WANT to pay for the audit.  An audit is indeed expensive.  Even in a small company like LaRue where there is very little business transacted (maybe only 30 cheques written over the course of a year), an audit can cost between $6000 and $10000.

DISPENSING WITH AN AUDIT

Unanimity required to dispense with audit

LaRue is not the only small company in which audits may cost more than they are worth.  The legislative framework acknowledges that audits may not make sense for small companies.  And so, in a small company (less than 50 shareholders), the shareholders have an additional right: the right to vote to DISPENSE with audited statements.   That is, if all the shareholders mutually agree, the company does not have to incur the costs of audited financial statements.  See s. 163 of the Alberta Business Corporations Act.

The company still must provide shareholders with financial information each year, but the statements needn’t be audited.  For many years, this is how LaRue functioned.  From LaRue’s beginnings, up until 2005, the financial statements were unaudited.  The sibling shareholders really took over the work with LaRue after Doral’s death in 1982.  If you go to the Corporate Documents page, you can find the links to the financial statements which were filed from 1982 forward.

The LaRue Ledger – a page from 2004

Things changed around 2003-2004 when Earl was the President of LaRue.  At that point, LaRue’s books were no longer available to the shareholders as they once had been.  Click here for a set of commuications in between Glen, Earl and the lawyer about access to the corporate books.  There was conflict between the three directors (Earl, Bonnie, and Arta) about how the corporation should run, and what information should be available to shareholders (and on what conditions).  Shareholders no longer had open access to books, and the synoptic ledger was not seen again (by the excluded shareholders) until 2009.  It is this conflict over access to information that led the excluded shareholders, in 2004, to vote for an audit at the AGM.

To be clear, the shareholders have the right to have the statements audited, though they can vote against it.  Unless the shareholders unanimously vote to dispense with an audit, there must be an audit and the COMPANY has to pay for it (not the shareholders themselves).  In brief, the shareholders can force the company to incur this cost.

WHAT IS THE OUTCOME OF AN AUDIT?

A failed audit, 2011

An audit can pass or fail. A failed audit does not mean there is fraud. It simply means that there are issues in reporting that need attention.  A ‘failure’ is expressed in words like “unable to express an opinion” or “disclaimer of opinion”.  You can see an example of this in the image to the right.  You can read it as part of the  LaRue 2011 Financial Statements

For example, LaRue’s statements were first audited in 2004.  They have been audited most years since then.  Shareholders on both sides of the conflict have been unwilling to dispense with the audit.  And each year, the audit has consistently failed.  There have been two recurrent problems: Timber, and Shareholder Loans.   Here is a bit of the story on each of these two problems.

• TIMBER: One year, 5 loads of timber were sold (5 loads of timber removed from Bonnie’s lot). The question was how to account for the money from the timber. Did it belong to Bonnie (the lot licencee) or to LaRue (the landowner).  In some ways, the answer to the question does not matter; either is possible. But until the question can be answered one way or there other (timber taken off the land will belong to EITHER the licensee OR to larue), you cannot have clarity in the books.
• SHAREHOLDER LOAN ACCOUNTS: The shareholder loan account is linked to the way in which the Shuswap land originally passed from Doral to LaRue. There will be a page with a fuller account, but for now, in brief, LaRue purchased the land from Doral for $500,000 (in 20 promissory notes of $25,000 each). LaRue has not yet paid out those loans.
  • In 1978, Doral transferred his interest in those promissory notes to his children in equal measure.  See LaRue Directors Minutes, July 13, 1978 Thus, each child not only had 10 shares in LaRue, but was entitled to $62,500 each. The way to understand this, is that each sibling was loaning that money to LaRue. On the LaRue books, these promissory notes would have showed up under the heading of Shareholder Loans.
    

    Excerpt from the LaRue Financial Statements, 2008

  • What happened next was that the accountant began to add various amounts to the shareholder loan accounts — amounts related to expenditures that were made by individuals on either buildings or infrastructure. These amounts did not involve any transfer of money, but were transactions that the accountant thought would work for the purposes of some tax deductions.  As a result, the ‘amount’ in the individual shareholder loan accounts went up for Darla, Arta, Glen and Earl [who paid for a gate]).  So, here notice that “Due to Shareholders” is higher than the $500,000 which reflected the promissory notes.
  • Later, in the early 2000s, LaRue’s accountant (Max Wiebe) re-thought the approach he had taken, and determined that the extra amounts he had added to the shareholder loan accounts should be backed out.  No problem, since no extra money had changed hands, and no LaRue had not taken tax deductions on the basis of these numbers, but he was still of the view that a better practice would be to correct the books to remove these amounts.  This, however, was a point of contention for some shareholder who were of the view that their particular shareholder loan accounts should stay with the higher number.  Max Wiebe resigned his position around this time, and so a new accountant (and auditor) had to be hired.
  • In order to address the question of the shareholder loan accounts, In order to do this, he needed an unanimous shareholder agreement affirming that the additional amounts were not in fact loans, but were accounting moves that should be corrected on the books. In otherwords, that there had not in fact been additional loans to LaRue beyond the initial promissory notes. All this was made visible in the 2004 audit.  Here is the memo written for LaRue by Deborah Isley, summarizing the issues and how to resolve them. Click here for Email from Deborah Isley to Earl, with attached Memo (Dec 31, 2004) on issues arising in the audit
  • Unfortunately, not all shareholders were willing to sign that agreement, and thus, the auditor could not say that the books represented reality, and thus the audit that year failed.  And has failed each year since.

“Management Discussion & Analysis”

A failed audit is nothing more than a message to the shareholders. When an audit fails, it is also possible for the directors to attach a message to the shareholders explaining their perspective on the failed audit. Such messages are often titled “Management Discussion and Analysis”.  The goal of such a document is to simply provide more information to the shareholders, to help them better understand the implications of the audit results. Here is an example of the MDA that was attached to the 2012 Financial Statements.

So… to return to the beginning? Why do audits matter?  They increase transparency, but also increase the costs to LaRue.

LaRue has no way to recoup those costs other than by increasing the assessments on Licence holders.  There is something that is imbalanced in a system where a shareholder (who is not also a licence holder) can require the company to hold an audit, passing the costs of that decision along to the licence holders.  This is one reason why, as people discuss how to re-organize the LaRue structure, it is important to think about re-attaching shares to licences (so that those voting for audits are the same people who will either bear the costs, or reap the benefits of that decision.