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Cash distributions unsustainably high for many income trusts, says forensic accountant

by Wayne Cheveldayoff, 2005-12-01

If you are buying income trusts only on the basis of the cash yield they offer, you could be in for a nasty surprise.

Some investors already know this from hard experience, as a few income trusts have run into industry downturns that have led to a reduction or suspension of distributions.

But a recent report by Accountability Research Corp. warns individual investors to be careful about income trusts for a different reason.

It says investors rarely understand that many trusts do not have the income to support the cash distributions being made to unitholders.

These trusts, especially because they are not holding back enough cash for capital investment, are likely to get into trouble in the future, resulting in a curtailment of cash distributions or even bankruptcy.

The group, led by forensic accountant Al Rosen, says part of the problem is that individuals choosing trusts don’t realize that some of the cash distributions are simply a return of capital, rather than a full investment return like, for example, interest on a bond.

When investors misinterpret the nature of the cash distributions, they pay more for a trust unit than they should.

This has led to the situation where some trust units are overvalued and therefore vulnerable for a fall.

The group’s review of the financial statements of the 50 largest business income trusts (they did not analyze energy, royalty or real estate income trusts) found that less than two-thirds of the cash distributions come from income (or profit). The rest is a refund of capital.

The group concludes that if these business income trusts only paid out their reported income, unit values would likely drop by 20 per cent on average.

The key to understanding income trusts is the notion of ‘distributable cash’. It is rightfully a notion, rather than an accounting principle, because each trust determines its own definition of distributable cash.

Generally, a business receives cash revenue and pays out cash expenses incurred in earning the revenue. Of what is left over, a certain amount, known as depreciation, is money that is supposed to be set aside to replace machinery and buildings when they wear out. This is why depreciation is deducted before determining pre-tax reported income. The business then additionally deducts income taxes to get net income (or net profit).

Because they don’t pay income taxes, most trusts consider distributable cash to be net income, plus money that would otherwise be paid in income taxes, plus some or all of the depreciation. If a trust feels it will not need to replace machinery and buildings, or that it will borrow when it needs to do so, it will simply pay out the depreciation to unitholders rather than holding it back in reserve.

Accountability Research found that the group of 50 trusts was only holding back 32 per cent of depreciation. With so little being reserved for replacing capital assets, the risk is that they will run the capital assets into the ground. In the end, the trust would have to borrow or issue more units in order to raise the money needed to keep the business operating.

While the report raises important issues, it shouldn’t stop investors from owning income trusts.

Contrary to the report, some trusts define distributable cash in a way that leaves enough cash within the trust to sustain the business in the long run.

Also, some trusts are growing rapidly and generating large increases in distributable cash and deserve to be highly valued as growth vehicles.

In fact, the route to success for investors in this sector has been to identify business income trusts that are paying out substantially less than 100 per cent of distributable cash, which gives them a cushion to absorb shocks, and that have a strong potential to grow and expand distributions in the future.

In order to find these trusts among the 165 business income trusts trading on the TSX, you have to do a fair amount of research.

As one portfolio manager recently said, when it comes to income trusts, “you shouldn’t just buy them simply on yield. You have to go through them one by one to see what you’re buying.”

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2005 Wayne Cheveldayoff