Compare the bad debt allowance practice of Poseidon and Open Range.

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On February 25, 2013 Paulina Ortega, the chief investment officer (CIO) of University of Regina Investing (URI), was reviewing a draft copy of the annual report for fiscal year 2012 that was to be submitted to its client, the University of Regina. One investment that stood out was Poseidon Concepts Corporation (Poseidon), which had lost all its stock value. The investment was made in April 2012 at CA$14.02¹ per share and had gained 14 per cent by September, when the stock price hit a high of $16.02. Ortega decided to review the Poseidon transaction to understand the reasons for the loss on this investment, which included the potential that Poseidons management team had manipulated its financial statements. More importantly, Ortega wondered whether there had been early signs or red flags, for such manipulation. If there were, and they had been read and acted on in time, those signs would have saved URI the loss incurred on the transaction. The ability to identify such red flags could help avoid similar situations in the future.

URI

The URI program was a student-run investment fund, where students managed approximately $1.5 million in funds provided by the University of Regina. The majority of these funds were contributed by the Universitys endowment. The program was an important aspect of the finance curriculum because it complemented the vision of the faculty to become a school of choice for experiential learning. The URI program received strong support from the Regina business community. Students in the program regularly received guest lectures and presentations from investment professionals, as well as free trading and research services from CIBC Wood Gundy.

The URI fund was structured like a professional investment fund. It was headed by an executive team that included a CIO and a chief compliance officer. The student analysts were divided into sector teams, each headed by a manager.

POSEIDON CONCEPTS CORPORATION

History

Poseidon was formed in November 2011, when the parent company, Open Range Energy Corporation (Open Range) reorganized and split into two independent entities. Open Range continued to operate as a natural gas exploration and production company, while Poseidon was structured as an energy service and supply company. Open Range shareholders of record, at the time of the reorganization, received one share of the new Open Range company and 0.8839 shares of Poseidon for each share of the old company.

Poseidon inherited a management team with strong experience in the industry. Independent board members also had rich experience, both in the oil and gas sector and in capital markets. Lyle Michaluk, the vice- president (VP) of finance and chief financial officer of Open Range, became the chief executive officer (CEO) of Poseidon. Cliff Wiebe, who was responsible for designing the Poseidon tank system while acting as completion manager at Open Range, became the chief operating officer. Brad Wanchulak, the VP of business development at Poseidon, was previously the VP of business development at Talisman Energy. The CEO of Open Range, Scott Dawson, was appointed chair of the Poseidon board of directors. Michaluk and Wiebe joined the board as management representatives.

Tank Rental Business

The core business of Poseidon was its proprietary tank rental to oil and gas companies. These tanks were designed by an employee of Open Range (prior to the companies splitting) to enhance operational efficiency. Once the tanks were successfully tested on Open Ranges sites, the company began renting them to other companies sites.

The proprietary design of the tanks afforded them several competitive advantages in terms of costs, efficiencies, and environmental concerns. The tanks were relatively large. The larger model could handle up to 41,000 oil barrels, compared to the average conventional tank size of around 500 barrels. Despite their large size, however, Poseidons tanks could be installed, uninstalled, and reinstalled quickly, generally within one day. They could be transported easily and more economically than the smaller conventional prefabricated tanks. The above-ground installation of Poseidons tanks also provided huge environmental benefits, relative to the alternative of storing the fluid in lined pits. The pits experienced frequent leaks, which could not be detected until the pits were reclaimed. Due to this significant disadvantage of lined pits, Poseidons tank rentals increased from 25 units at the end of 2010 to 170 tanks in September 2011.²

Poseidon supplied its tanks to both U.S. and Canadian customers. Of the companys total revenue for the nine months ending September 30, 2012, 85 per cent was generated from U.S. rentals.³ In the United States, Poseidon operated through a wholly owned subsidiary under the same name.

Boom and Bust

Poseidon started trading on the TSX on November 4, 2011 under the ticker symbol PSN. The closing price on that day was $11.52. The stock price saw a steady increase over the next several months, peaking at

$16.69 (closing price) on February 23, 2012. The stock price remained in the range of $14 to $15 until November 2012. During this period, investors remained optimistic about the firms prospects. Some analysts considered managements earnings guidance to be too conservative, setting a higher target price for the company.⁴

On November 14, 2012, Poseidon issued financial statements for the third quarter of 2012, as well as for the nine months ending September 2012. In these statements, Poseidon reported an increase in accounts receivable to $125.5 million, out of which $36 million was outstanding for more than 120 days. It also took a charge of $9.5 million for bad debt.⁵

Market backlash was strong following Poseidons disclosures. The next day, on November 15, 2012, the companys stock price plunged to $5.00a drop of 62 per cent from the previous days closing price of

$13.22.

On December 27, 2012, Poseidon established a special committee of the board to investigate the controversy surrounding the companys accounts receivable. The committee retained legal counsel, who in turn consulted with Ernst and Young Inc. The findings of the investigation were disclosed on February 14, 2013. Poseidon admitted that it had materially inflated revenues. In particular, $106 million out of $148 million total revenue for the period January to September 2012 was based on non-existing or uncollectible take-or-pay contracts,⁶ and should not have been recorded as revenues.⁷

Long-term sales and service contracts were common in the mining industry and in the oil and gas industry. One type of long-term contractthe take-or-pay arrangementobliged Poseidons customers to rent a minimum number of tanks at an agreed rate. Poseidon offered many take-or-pay contracts to its U.S. customers.

After the investigation, Poseidon announced that it would restate its financial statements according to the findings. However, stock trading ceased altogether upon this disclosure on February 14, 2013.

THE ANALYSIS

Ortega looked up the historical quarterly financial statements of Poseidon (see Exhibit 1). Her goal was to identify any red flags that her team could have missed, so that they could be better prepared to avoid such scenarios in the future. The November 15 announcement that triggered the downward spiral in the stock price was related to accounts receivable and a considerable bad debt expense recognition. Therefore, Ortega collected data relating to accounts receivable and bad debt allowance for Poseidons parent company, and compared the two companies accounting practices (see Exhibit 2).

While looking for the companys historical financial statements, Ortega stumbled upon a record detailing a number of Poseidon shares sold by the CEO, the chair of the board, and a third director (see Exhibit 3). She wondered if the particular timing of these sales was indicative of the events that followed thereafter. In order to put things in perspective and organize her thoughts, Ortega listed chronologically all the significant events to date about Poseidon (see Exhibit 4). Was there a revelation in the information she had collected? Could this information be valuable to avoid a similar issue in the future?

EXHIBIT 1: POSEIDON HISTORICAL FINANCIAL STATEMENTS (IN CA$ THOUSANDS)

Panel A: Statements of Financial Position

Statements of Financial Position	March 31, 2012	June 30, 2012	September 30, 2012	December 31, 2011
Assets
Current assets:
Cash and cash equivalents	1,828	12,124	3,461	-
Accounts receivable	83,018	118,641	125,516	53,595
Prepaid expenses and deposits	720	2,507	4,362	1,105
Inventory	4,108	6,430	6,507	2,856
	89,674	139,702	139,846	57,556
Deferred taxes	6,945	2,586	2,484	11,492
Property, plant, and equipment	45,589	50,471	59,451	33,836
	142,208	192,759	201,781	102,884
Liabilities
Current liabilities:
Accounts payable and accrued liabilities	17,803	24,052	23,102	12,437
Dividends payable	7,296	7,299	7,405	6,725
Current taxes payable	-	6,600	6,600	204
Bank indebtedness	-	-	-	18,305
Due to Open Range	-	-	-	36,419
Note payable	10,000	-	-	10,066
	35,099	37,951	37,107	84,156
Deferred taxes	-	-	1,635	-
Long-term debt	-	34,544	55,544	-
	35,099	72,495	94,286	84,156
Shareholders' Liabilities:
Share capital	378,603	92,616	92,616	299,531
Contributed surplus	7,074	9,256	11,566	5,315
Accumulated other comprehensive income (loss)	(584)	783	(232)	188
Retained earnings (deficit)	(277,984)	17,609	3,545	(286,306)
	107,109	120,264	107,495	18,728
	142,208	192,759	201,781	102,88

EXHIBIT 1 (CONTINUED)

Three Months Ended March 31, 2012		Three Months Ended March 31, 2011	Three Months Ended June 30, 2012	Three Months Ended June 30, 2011	Three Months Ended September 30, 2012	Three Months Ended September 30, 2011	Year Ended December 31, 2011	Nine Months Ended September 30, 2012
Revenue	52,129	11,327	54,875	9,647	41,116	23,969	78,767	148,120
Expenses:
Operating	4,709	1,928	3,329	1,760	9,069	2,658	9,623	17,107
General and administrative	3,717	561	5,538	643	5,458	1,191	4,523	14,713
Stock-based compensation	1,759	21	2,182	36	2,310	43	1,134	6,251
Depreciation	1,108	359	1,329	585	679	1,159	2,149	3,116
Bad debt expense	-	-	-	-	9,476	-	-	9,476
Total expenses	11,293	2,869	12,378	3,024	26,992	5,051	17,429	50,663
Operating income	40,836	8,458	42,497	6,623	14,124	18,918	61,338	97,457
Other expense (income) items:
Interest and finance expenses	729	1	648	69	531	133	757	1,908
Foreign exchange	-	-	-383	-	3,305	-	-	2,922
Income before income taxes	40,107	8,457	42,232	6,554	10,288	18,785	60,581	92,627
Tax expense	10,468	2,176	11,049	1,773	2,456	4,487	15,581	23,973
Net income from continuing operations	29,639	6,281	31,183	4,781	7,832	14,298	45,000	68,654

EXHIBIT 2: OPEN RANGE ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS

Period	AR (Net of Allowance)	Allowance Recorded	Uncollectible Amount Written off
Q3 2008	$9.38 million	$523,000	Nil
Q4 2008	$18.46 million	$785,000	Nil
Q1 2009	$4.45 million	$785,000	Nil
Q2 2009	$1.76 million	$1.05 million	Nil
Q3 20009	$2.99 million	$1.05 million	Nil
Q4 2009	$10.50 million	$949,000	$94,000
Q1 2010	$9.20 million	$949,000	Nil

Note: All currency amounts are in CA$; AR = accounts receivable; Q = quarter (financial)

EXHIBIT 3: SALE OF POSEIDON SHARES BY MANAGEMENT

Date	Name	Total Shares Sold	Gross Proceeds (in CA$ Million)
November 14, 2011	Winger	238,464	2.640
November 14, 2011	Winger	75,523	0.860
November 14, 2011	Dawson	1,000,000	11.000
November 14, 2011	Michaluk	675,000	7.460
February 9, 2012	Winger	30,000	0.480
February 9, 2012	Winger	30,000	0.486
February 9, 2012	Dawson	400,032	6.360

EXHIBIT 4: CHRONOLOGY OF SOME IMPORTANT EVENTS

Date	Major Events
July 6, 2012	The Poseidon stock is well off its mid-February 2012 closing high of $16.80 on the TSX, currently yielding 8.3 per cent.
August 8,2012	Poseidon announces dividends.
November 15, 2012	Poseidon shares are down 55 per cent on quarterly results and 2012 guidance.
November 15, 2012	Disappointing third quarter results lead to a decline in the share price.
December 27, 2012	Poseidon forms a special committee (of board of directors), suspends future dividends, and announces board and managerial changes.
December 28, 2012	The Poseidon stock drops after dividends are suspended and the CEO is replaced.
January 11, 2013	Poseidon reviews the December 31, 2012 dividend and announces additional management changes.
February 14, 2013	Poseidon states that it will restate results for the first three quarters of 2012. Poseidon states that up to $106 million of its $148.1 million revenue for the nine months to September 30 should not have been recorded.
February 14, 2013	Poseidons stock dives to $0.27 from $16.03 earlier in the year, as a result of a slowing down of activities.
February 14, 2013	A cease trade order is issued by the Alberta Securities Commission.
February 18, 2013	A cease trade order is issued by the British Columbia Securities Commission.
February 20, 2013	Poseidon provides an update with respect to its business and operations.