Advanced Accounting Social Responsibility Case

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Capstone Accounting Winter 2021

Nicole Edge

Winter 2019

Mount Royal University

Table of Contents

Arthur Andersen (A): The Waste Management Crisis.......................................................................5

Hop Compost: Maintaining Environmental Accountability with Growth..........................................17

Tesco: From Troubles to Turnaround.............................................................................................31

Transfer Pricing at Cameco Corporation........................................................................................41

Capstone Accounting Winter 2021 Winter 2019

Nicole Edge Mount Royal University

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5-205-253(A)

©2011 by the Kellogg School of Management at Northwestern University. This case was prepared by Professor Daniel Diermeier and Research Associate Robert J. Crawford with the assistance of Charlotte Snyder from public sources. Research assistance was provided by Kristen Lueking, Denita Linnertz, Justin Heinze, and especially Julia Stamberger ’02. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 847.491.5400 or e-mail cases@kellogg.northwestern.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Kellogg School of Management.

DANIEL DIERMEIER

Arthur Andersen (A): The Waste Management Crisis

Think straight and talk straight. —Arthur E. Andersen1

The ’90s were a go-go period in which the mentality was, if you weren’t getting rich, you were stupid.

—Duane Kullberg, former Andersen chief executive2

In February 1998, Steve Miller, the interim CEO of Waste Management, released his in-depth review of the company’s audit practices. His findings stunned Wall Street: Waste Management, he announced, had “overstated” its pretax earnings by $1.43 billion from 1992 to 1996. Furthermore, the company would make a $1.7 billion restatement of its earnings—the largest in U.S. corporate history at that time. At this news, the stock price imploded, costing shareholders more than $6 billion virtually overnight. This ensured that the Securities and Exchange Commission (SEC) would investigate not only Waste Management but also its longtime accounting firm, Arthur Andersen, which had “signed off” on all of the revenue statements under revision.3

Miller, a well-known turnaround artist, had been under pressure from institutional shareholders to explain the company’s declining stock price and then set things right. While Waste Management had been one of the great success stories of Wall Street for more than twenty years, in the 1990s its momentum slowed. Apparently it had begun to employ “aggressive accounting” (i.e., manipulating income statements to satisfy investors and boost stock prices) as early as 1988 to maintain the appearance of growth. Since Waste Management’s beginnings, Arthur Andersen had served as the firm’s external audit company.4 From 1991 to 1997, Andersen had earned approximately $7.5 million in audit fees from Waste Management and nearly $12 million from consulting. That made Waste Management a “crown jewel client” for Andersen.5F

1 As cited in Susan E. Squires, Cynthia J. Smith, Lorna McDougall, and William R. Yeack, Inside Arthur Andersen: Shifting Values, Unexpected Consequences (Upper Saddle River, NJ: FT Prentice Hall, 2003), 31. 2 Flynn McRoberts, “A Final Accounting: Civil War Splits Andersen,” Chicago Tribune, September 2, 2002. 3 U.S. Securities and Exchange Commission v. Dean L. Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A. Getz, and Bruce D. Tobecksen, Civil Action no. 02C 2180, Release no. LR-17435, March 26, 2002. 4 U.S. Securities and Exchange Commission, “In the Matter of Arthur Andersen, LLP,” Release No. 34-44444, June 19, 2001. 5 See Barbara Ley Toffler and Jennifer Reingold, Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (New York: Broadway Books, 2003), 148.

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For years, the SEC had criticized the practices of the major accounting firms, in particular their double role as auditors and consultants.6F Now the SEC was contemplating a complaint against Andersen for conflict of interest, fraud, and perhaps more.

0BBackground

Arthur Andersen had long set the industry standard for professionalism in external accounting. In its own eyes, the firm stood for public service and independent integrity; it was committed to protecting shareholder interests and even saw itself as a guardian of public trust. Andersen employees often spent their entire careers at the firm, where the corporate culture was strong and uniform and was supported by a rigorous system of education and acculturation into the firm’s values. In the early years, the partners knew each other—governing “face to face”— and they largely agreed on the standards the firm needed to maintain. However, as the company experienced explosive growth and its mode of governance evolved, the culture and standards began to weaken.

4BThe Founding Father

Born in 1885 to a family of Norwegian immigrants, Arthur E. Andersen made his way in the world through “strong values and hard work.”F7F In 1913, while he was working as a professor at Northwestern University, he and a partner took over the company that came to bear his name. In an era when accounting standards were in flux, the firm distinguished itself for its willingness to tell the unvarnished truth. Rather than bend to a client’s demands, Arthur E. Andersen was prepared to lose an account in order to avoid compromising his firm’s standards. In one famous incident that became a staple in company lore, the president of a large client company barged into Andersen headquarters and demanded an audit certification on his own terms—flatly contradicting the findings of an accountant there. Without hesitation, Arthur E. Andersen answered, “There is not enough money in the city of Chicago to induce me to change the report.” While he lost the client, the reputation of his company for unyielding integrity was confirmed.8F In 1939 Andersen established the “Blueback” policy, a value-added service that had partners write a project wrap-up memo (in a blue cover) that detailed any financial, management, or strategy issues that might help their clients. These memos distinguished the company from other accounting firms, which concentrated almost exclusively on the certification of their clients’ numbers.9

As the firm grew, its partners formed a select elite; they all knew and respected each other as professionals. Under the strong leadership of Arthur E. Andersen, who owned the majority of shares in the partnership, an intimate and highly uniform culture developed in which Andersen’s personal voice spoke for everyone on matters of policy. He wanted the firm to remain small and directed the officers to seek outstanding talent just out of college—individuals who could be molded in an apprenticeship under a senior certified public accountant (CPA). He preferred young graduates from a modest background who possessed a “Midwestern work ethic” and

6 Arthur R. Wyatt, “Accounting Professionalism—They Just Don’t Get It!” Accounting Horizons 18, no. 1 (March 2004). 7 Squires et al., 26. 8 Ibid., 31–32. 9 Toffler and Reingold, 17.

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ideally came from a family farm. In 1940 the apprenticeship system was expanded into a formal training program that all new employees were required to attend.10 The “Andersen way” was based on (1) honesty and integrity; (2) a one-firm, one-voice partnership model; and (3) training in methodology that was uniformly applied and obeyed. Andersen employees were supposed to appear homogeneous and act predictably, and were “trusted to do as they were taught.” And while they should not expect to get rich, they knew that they represented a venerable profession with pride.11

5BSpacek’s Rule

In 1947 Arthur E. Andersen died without naming a successor. After a leadership crisis, the twenty-five remaining partners eventually elected Leonard Spacek to serve as managing partner (the de facto leader of the firm). Spacek resembled Arthur E. Andersen both in his Midwestern background and his staunch support of the Andersen way. While he could not control the partnership as the majority shareholder, Spacek quickly proved himself a domineering and forceful leader. He had a vision for the accounting profession, and eventually he became well known (and highly unpopular) as a severe critic of accounting standards and practices.12

To back up his beliefs, Spacek increased Andersen’s investment in its training programs, which consumed 15 to 20 percent of the net revenue of the firm. His goal was to create an educational system that would produce “Androids”—professionals of similar background, training, and demeanor—who would maintain the highest and most consistent professional accounting standards.13F Andersen employees also studied a series of methodologies that taught them technical audit procedures as well as the “proper” persona to display, from the company dress code to required daily appearances in the “correct” business-lunch restaurants. In the accounting profession, Andersen employees became famed as members of a culture that demanded the strictest conformity in appearance and behavior. This culture implied that employees were interchangeable and equally reliable as professionals of the highest caliber.14

Under Spacek’s leadership, Andersen grew rapidly, though cautiously, by entering international markets and offering new services. Rather than seek growth via acquisitions of similar accounting firms, Spacek chose to develop new offices and employees from within through the recruiting and training system. Maintaining a strict hierarchy based on expertise, Andersen sent experienced partners to open and run the new offices, many of which were overseas. As in the United States, the partner in charge of each new office built links with local universities to find high-quality candidates that would fit the Andersen style.15

Furthermore, the company’s consulting business really began to expand in earnest in the early 1950s when it designed and implemented the first business applications for a computer at General Electric. Having beaten the other big auditing companies to the punch in computer technologies, Andersen went on to establish itself as the preeminent provider of consulting services in the burgeoning field. The company began hiring computer consultants, but the new hires introduced a

10 Squires et al., 33–35. 11 Ibid., 38. 12 Ibid., 41–48. 13 Ibid., 48. 14 Ibid., 52–53. 15 Ibid., 49–50.

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different type of employee to the firm—the consultants were not part of the accounting culture, although in the beginning they received the same training as accountants. Later, the power of the consultants would grow commensurate with consulting revenues.16

To a degree, the Android culture remained cohesive, held together by the centralized training system and the authority and expertise of the partners. But by the 1970s tensions were brewing. During Spacek’s tenure, there was a great increase in the partnership ranks, which had expanded from 25 to 826 members. In addition, Spacek had also presided over a proliferation of international offices. The many partners, spread across several continents, were chafing under Spacek’s heavy-handed rule. When Spacek retired in 1973 they voted to ensure that no single partner would ever wield the kind of influence that Spacek and Arthur E. Andersen had; it became the era of “one partner, one vote.” Tensions also increased because the larger number of partners meant that they could no longer govern in person (“face to face”) as they had done in earlier times.17F Moreover, the rise of Andersen consultants introduced a new mentality into the company—salesmanship in search of discretionary funds from clients—that differed fundamentally from the legally required services that external auditors provided year by year.18F As a result, cooperation and cultural cohesion began to weaken, as did the ability of the firm’s managing partner to lead.

6BGrowth and Reorganization

After Spacek’s departure, the firm continued its rapid growth. To govern it more effectively, the new managing partner, Harvey Kapnick, broke the firm into service divisions of consulting, tax, and audit in the mid-1970s. While adopted to create manageable units, this move effectively split the firm into competing fiefdoms, with consulting experiencing the most rapid growth. According to some observers, at this moment the “common good” ceased to be the basis of company loyalty, and division and geographic location became the ties that bound people together. Consultants fought for, and won, the right to bypass the training regimen of the accountants, which further undermined the uniformity of Andersen’s culture.19

External factors also began to impact the firm. First, while audit revenues were dependable as a legal requirement for public companies, their profitability had hit a plateau. The U.S. government was pursuing efforts to inject more competition into the auditing industry. Prior to a 1973 legal challenge for violation of antitrust laws, industry associations had prohibited competitive bidding between accounting firms; four years later, similar industry bans on advertising were lifted. In addition, a wave of consolidation added to the competition between firms. Increasingly, clients were offered packages of audit services that resembled commodities, accompanied by advertising campaigns. As a result, consulting revenues became an increasingly important source of profit within the firm.20F

Second, in the wake of the merger-and-acquisition trend that began in the 1960s, disappointed investors began to seek legal compensation for failed deals—often from accounting firms. To

16 Toffler and Reingold, 71–72. 17 Squires et al., 60–62. 18 Toffler and Reingold, 49–50. 19 Squires et al., 60–64. 20 Mike Brewster, Unaccountable: How the Accounting Profession Forfeited a Public Trust (Hoboken, NJ: John Wiley & Sons, 2003), 136.

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respond to the explosion of audit-related litigation, Andersen adopted a damage-control policy on the advice of its lawyers.21F In addition, the firm joined the other big accounting companies to pool resources in an insurance fund to pay shareholder settlements.

Third, Andersen and the other major accounting firms began to consult each other regarding lobbying campaigns in order to oppose regulatory oversight from the SEC and other agencies, as well as to avoid political pressure from the U.S. Congress.22

In the face of these new conditions and pressures, some inside the firm began to fear that audit standards were slipping. For them, Andersen’s responses to the challenges it faced appeared largely defensive and reactive, paying little attention to the strategic direction of the company. The situation was, in their eyes, ripe for conflicts of interest to develop: in their search for big clients, many accountants had begun to act like salespeople for consulting contracts while doing their jobs as external auditors. Others argued that Andersen was still the best and that local partners could be trusted to do their jobs competently and with integrity.23

In the late 1970s, for example, Andersen won the DeLorean sports car account, which was secured in large part by partner Dick Measelle. John DeLorean, a flamboyant character, promised significant revenues for the firm. When presented with evidence that DeLorean was charging personal luxury expenses to his company—his Mercedes-Benz, some household items, and even a personal assistant—Measelle accepted his client’s explanations and offered Andersen’s approval of the company’s books. Rather than challenge DeLorean’s bookkeeping, Measelle appeared eager to accommodate DeLorean. Upon DeLorean’s company’s bankruptcy, the oversights sanctioned by Measelle and his colleagues led Andersen to pay $62 million to settle lawsuits with disgruntled investors; in addition, the British government barred Andersen from auditing in the country from 1985 to 1997. However, rather than suffering a damaged career, Measelle was promoted for his ability to bring in clients like DeLorean, and he eventually served as CEO. Apparently, most in the company viewed the DeLorean debacle as a one-off incident rather than a pattern that might indicate future problems at the firm.24

1BThe Rise of the Consultants

As the company entered the economic boom of the 1990s, its focus shifted to profitability, eclipsing Andersen’s spirit of public service. Because the new leadership viewed consultants and investment bankers as examples they wished to emulate, tremendous pressure was created within the company to find new sources of revenue. However, many other forces began to impact the firm as well, including internal tensions and pressures from government reformers.

7BThe Consultant/Auditor Balance Shifts

Back in 1979, the Andersen partners had chosen information systems consulting as the way to make up for the slow growth in audit revenues. While auditors continued to control the

21 Squires et al., 68–70. 22 Brewster, 148–152. 23 Flynn McRoberts, “A Final Accounting: The Fall of Andersen,” Chicago Tribune, September 1, 2002. 24 McRoberts, “Civil War Splits Andersen.”

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partnership, the consulting division operated autonomously and began to develop its own subculture. The group recruited veteran engineers, computer scientists, and consultants with little (if any) experience in accounting and sought business differently than Andersen had in the past. Consultants were salespeople; they were required to innovate, sell, and perform cutting-edge computer services, always with an eye to initiate a new consulting cycle for additional services. The major competitors, EDS and IBM, were cutting-edge technologists, which increased the pressure. Consulting hires also expected faster promotions, pay and bonuses that were directly tied to their immediate contributions, as well as a shorter wait to make partner. This “sales” mentality stood in stark contrast to the traditional mission of Andersen accountants: protection of the shareholders and the public interest in proper reporting standards.25

During the 1980s, consulting began to overtake auditing as a percentage of total revenues at Andersen (see Exhibit 1). However, of 2,134 partners in 1989, only 586 were consultants. In addition, on a per-partner basis, consultants were bringing in $2.3 million, while accountants achieved only $1.4 million. Not surprisingly, the consultants began to agitate for greater power within the organization. This led to a series of lawsuits between partners that further undermined the unity of the Andersen culture. The consultants eventually became an independent business unit called Andersen Consulting in 1989, as opposed to simply a division. The split allowed both the accounting and the consulting units to track all accounts separately, including income and profits. Each unit began to operate on its own floor of the same office building as an entirely separate entity.26 Although Arthur Andersen was largely restricted from engaging in consulting, the accounting side was still permitted to pursue consulting with clients that had less than $175 million in annual revenue.

While the arrangement appeared to work, it only papered over deeper fissures within the organization. Resentment and professional jealousies continued to fester, with accusations of disloyalty as well as a sense that the “stodgy” accounting side was holding the consultants back. As the split became ever more apparent—the two groups began to act as if they were independent companies—the tension between the two cultures became increasingly bitter and divisive.27

8BThe Rainmakers

While there was no decisive turning point in the evolution of the company, leadership of the accountants (within Arthur Andersen & Co.) slowly shifted to those who could bring in new business—the “rainmakers.” Unlike their predecessors, whose expertise was in technical accounting and auditing skills, these young leaders were distinguished by their ability to attract profitable consulting engagements.28F In 1992 this transition culminated in a huge purge of low- performance partners. Ten percent of all partners were forced out; often, some of those who departed represented the traditional values of the firm and had functioned as mentors to younger accountants. As a result, oversight of younger partners was sharply curtailed, while the local independence of Andersen offices grew.29

25 Squires et al., 75–79. 26 Ibid., 84–87. 27 Toffler and Reingold, 70. 28 Wyatt, 48. 29 Squires et al., 97–99.

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The Professional Standards Group (PSG), an oversight office within Andersen that was once a plum assignment for the future accounting elite, visibly diminished in importance. During the 1980s, for example, the PSG had ruled that stock options should be categorized as an expense— that is, as a charge against profits, identical to other forms of compensation. However, at the start of the 1990s boom, when stock options were rapidly increasing in popularity and prestige, both the high-tech industry and the U.S. Congress pressured accounting industry leaders to consider a different interpretation. After a brief debate, Andersen’s top leaders reversed the PSG ruling, allowing firms to avoid categorizing stock options as an expense. Many of Andersen’s old guard saw this as a shocking precedent. While the PSG would continue to make rulings and pronouncements, local offices had gained a new independence to overrule voices that dissented from their judgment calls on-site.30F During this period the company continued to sell lucrative services to their audit clients in the 1990s, and this strategy enabled top partners to triple their earnings. In 1994 Arthur Andersen created a formal practice entitled Arthur Andersen Business Consulting (AABC).

Some partners voiced concerns that in their effort to use audits as a gateway to far more lucrative consulting arrangements, Andersen auditors were trying to please their clients rather than carrying out their traditional audit functions. For example, in 1996 then-partner Barbara Toffler attended a lavish party to celebrate the twenty-five-year anniversary of Waste Management’s IPO as well as its longstanding professional relationship with Andersen. While there was no reason at that time to suspect anything about Waste Management’s accounting practices, Toffler later wrote, “[Andersen and Waste Management] were acting like they were on the same team—not as if one was supposed to be the other’s gatekeeper.”31 F It was during this period that Andersen’s accountants began to conduct both internal and external audits on the same clients, in effect operating on both sides of the coin—aiding corporations to prepare their books while at the same time providing accounting oversight functions.32 F

9BEnter the SEC

The issue of independence between the auditing and consulting functions began to concern SEC Commissioner Arthur Levitt.33F Early in his tenure, under pressure from the U.S. Congress, he had accepted (against the advice of the Financial Accounting Standards Board (FASB)) its contention that “expensing stock options” would be too costly to so-called “New Economy” startups. As he watched executive pay “spiral out of control in the mid-1990s,” he regretted his earlier decision and chose to open a new battle on auditor independence. In June 2000, despite the opposition of the largest accounting firms, Levitt proposed tough new rules that would bar accounting firms from consulting for their clients.34

A bitter political battle followed in which the big accounting firms lobbied Congress to pressure the SEC. Fortunately, a young peacemaker emerged from within the industry: Joseph Berardino, a partner from Andersen known for both his ability to attract clients and his integrity. Berardino negotiated compromises between all parties that structured a final deal, and he became

30 McRoberts, “The Fall of Andersen.” 31 See Toffler and Reingold, 146. 32 Ibid., 143. 33 See Arthur Levitt and Paula Dwyer, Take on the Street (New York: Pantheon Books, 2002). 34 Brewster, 205–206.

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known as “Levitt’s secret weapon.”F35F While Levitt had to abandon the strict separation that he proposed, the big accounting firms agreed to two principles. First, they had to disclose what they earned from auditing and consulting fees; and second, the audit committees of company boards had to certify that their non-audit services were compatible with their independence as auditors. While Levitt was impressed by Berardino’s shuttle diplomacy, he concluded the affair with misgivings about the accounting profession and the quality of its leadership. Accounting firms, in his view, were all facing the same challenges regarding their independence and potential conflicts of interest.36

10BThe Divorce

In dollar terms, the emphasis on sales and profit at Andersen appeared to be a success. The firm’s overall revenues grew from $3 billion in 1988 to $16 billion in 1999; during that time, employee rolls quadrupled.37F Nonetheless, the auditors were beginning to compete directly with the consultants for the same clients, and, fearing cannibalization from the accountants’ unit, the Andersen Consulting partners voted unanimously in 1997 to secede from Arthur Andersen. To come to terms with the corporate divorce as specified in Andersen Worldwide’s partnership agreement, George Shaheen, the head of Andersen Consulting, initiated an arbitration process at the International Chamber of Commerce in Paris; he argued that the competition between the two sides of the company violated the company’s existing division of labor agreement. At that point, relations between the two business units had degenerated into open hostility.38

This contentious corporate divorce initiated years of upheaval for Andersen leaders, who were uncertain what the final structure of the company would be. It diverted the attention of top management from other, perhaps more pressing, questions, such as the overall direction the firm should take and whether, as a highly decentralized partnership, the company could be governed effectively. In August 2000 the International Chamber of Commerce came down on the side of the consultants, agreeing with Shaheen’s contention that the accounting side had violated the agreed-upon division of labor between the groups. To become a separate corporate entity, Andersen Consulting was required to relinquish the Andersen name and pay $1 billion, far below the $14.6 billion that many Arthur Andersen partners had demanded and expected.39F In January 2001 Andersen Consulting changed its name to Accenture. This constituted not only a successful re-branding campaign, but the new company assumed no legal liability for the many charges that Arthur Andersen was facing.40

Leaders in the accounting unit were extremely bitter about the unexpectedly low settlement from the divorce, and they felt renewed pressure to find additional sources of revenue in a stagnant market for traditional accounting services.41 The push for profit, in the view of some partners, overtook all other concerns. Internal competition to claim the principal responsibility for

35 Kurt Eichenwald, Conspiracy of Fools (New York: Broadway Books, 2005), 378. 36 Brewster, 222–224. 37 Squires et al., 106–107. 38 Toffler and Reingold, 93–94. 39 Ibid., 97–98. 40 Squires et al., 106–107. 41 Ibid., 106–107.

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certain clients, and thereby earn points toward the year-end bonus, became particularly fierce. According to Toffler, the firm felt “rudderless.”42

2BWaste Management

Because of its long and intimate professional relationship with the firm, many of Waste Management’s internal accountants had been hired from Arthur Andersen, including virtually every chief financial officer and every chief accounting officer. Robert Allgyer served as the lead Andersen partner for the Waste Management account. According to Dick Measelle, the Andersen partner who had been promoted after the DeLorean incident, “Allgyer had a reputation as a businessman who was able to sell.”43 Another Andersen partner involved with Waste Management was Robert Kutsenda, who, as audit practice director from the Chicago office, was charged with final oversight on technical issues. Like Measelle, Kutsenda had been promoted for his sales ability in the wake of another major embarrassment for Andersen, the Supercuts account, in which he had signed off on some aggressive accounting.44

The SEC investigation of Andersen accounting proceeded, relying heavily on subpoenaed e- mails and memos written by Andersen employees. During the investigation, it appeared that Andersen auditors had uncovered a number of questionable practices at Waste Management as early as 1988. For example, Waste Management was attempting to increase its value by overestimating the salvage value of its older garbage trucks, in effect claiming that they were worth $30,000 when the actual figure was closer to $12,000.45 There were a number of similar instances of aggressive accounting, such as failing to properly depreciate the trucks, which many inside Andersen defended as judgment calls on local issues that accounting norms had not yet addressed clearly. While Andersen auditors had brought many of these issues to the attention of Waste Management executives (as well as to Andersen CEO Measelle), they did not press them to correct the company books, as documents subpoenaed by the SEC attested. Indeed, the Andersen auditors could have resigned in protest, but instead they chose to manage the risk of a valuable client. During the investigation, Andersen lawyers argued to the SEC that the auditors and the responsible partners had followed “accepted standards.” In Toffler’s view, however, “the auditors simply caved when the company refused to implement the changes they wanted. . . . So [the lead partners on the account] simply certified the audit and decided to hope that the company would see things their way the next year.”46

At the conclusion of the investigation in February 2001, the SEC determined that Arthur Andersen’s audit reports on Waste Management were “materially false and misleading.” Allgyer, who had already resigned, was suspended from practicing for five years, allegedly because he “recklessly caused the issuance” of the misleading reports. For his part, Kutsenda was suspended for one year, for conduct “in violation of applicable professional standards.” Andersen agreed to pay a $7 million fine—the largest ever levied against an accounting firm—with no admission or denial of guilt regarding the violation of professional standards. As part of the deal, however, Andersen also agreed to an injunction that it would adhere to generally accepted accounting

42 Toffler and Reingold, 130. 43 McRoberts, “Civil War Splits Andersen.” 44 Ibid. 45 Ibid. 46 As cited in Toffler and Reingold, 147.

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ARTHUR ANDERSEN (A) 5-205-253(A)

10 KELLOGG SCHOOL OF MANAGEMENT

practices/standards (GAAP/GAAS) in the future—in effect, a legal commitment to never again violate securities laws. It was akin to being placed on probation.47

3BPreparation Questions

Suppose you were retained as an outside advisor to Arthur Andersen during the Waste Management crisis. What would be your advice to Andersen’s leadership? What concrete next steps should the company take? In your view, what are the reasons for Andersen’s problems and what should management do about them?

47 See Levitt and Dwyer, 122–123.

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5-205-253(A) ARTHUR ANDERSEN (A)

KELLOGG SCHOOL OF MANAGEMENT 11

Exhibit 1: Andersen Revenues, 1984–1989 ($ in thousands) Year Total Firm Revenue Audit Revenue Consulting Revenue Tax Revenue

1984 1,387,947 702,900 (51%) 391,800 (28%) 293,200 (21%) 1985 1,573,883 767,100 (49%) 477,300 (30%) 329,500 (21%) 1986 1,924,006 903,700 (47%) 635,900 (33%) 384,400 (20%) 1987 2,315,769 997,900 (43%) 838,400 (36%) 479,500 (21%) 1988 2,820,412 1,708,000 (60%)

(includes tax revenue)

1,112,000 (40%) (combined with audit revenue)

1989 3,381,900 1,940,200 (57%) (includes tax

revenue)

1,441,700 (43%) (combined with audit revenue)

Source: Susan E. Squires, Cynthia J. Smith, Lorna McDougall, and William R. Yeack, Inside Arthur Andersen: Shifting Values, Unexpected Consequences (Upper Saddle River, NJ: FT Prentice Hall, 2003), 84.

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3.

9B18C044

HOP COMPOST: MAINTAINING ENVIRONMENTAL ACCOUNTABILITY WITH GROWTH Houston Peschl, Anne Kleffner, Olga Petricevic, Miranda Mantey, and Justin Zimmerman wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2018, Ivey Business School Foundation Version: 2018-11-01

It was a typical early morning in November 2015 for Kevin Davies, founder and chief executive officer of Hop Compost (Hop). Davies entered the company facility, which was located in a 678 square metre (7,300 square foot) revitalized warehouse in the inner city of Calgary, Alberta, Canada. The warehouse represented the beginning of a revolution in the food waste and compost industries. It was home to one of the major competitive advantages of Hop—the proprietary Hot Rot Organic Solutions (Hot Rot) system, a specialized technology that took food waste from local restaurants and processed it in just 10 days into the most nutrient dense compost in Canada. Hop had been operating since February 1, 2015, and while it had been consistently successful through 2015, Davies recalled the struggles he had in developing and licensing the technology, finding a centralized facility, and securing investment. He credited his passion for his business and environmental stewardship, as well as a strong team behind him, for overcoming the challenges and reaching facility capacity in less than one year. The team was already working toward launching Hop Vancouver in mid-2016; they were also looking forward to future expansion by building partnerships in Toronto and several cities across the United States. The impending growth, however, would bring more challenges to the Hop team. The company was going to need heavy investment for this expansion, but convincing investors of Hop’s social and environmental impact had proven difficult for Davies in the past. He also understood that with the expansion, he would no longer be able to have his hands in every aspect of the business, which could leave the company vulnerable to decisions that would threaten its core social and environmental mission. Meghan Perry, Hop’s chief financial officer, considered whether Hop should invest resources at this early stage of the company to pursue sustainability certifications, such as the “B Corp” certification, awarded by the non- profit B Lab. She also considered how to position Hop to investors to raise the CA$800,0001 necessary to fund a rapid expansion plan while ensuring that the company kept its core values. Now in early 2016, Davies and Perry had to report their strategy for both of these issues to Hop’s board of directors at the end of the next week.

1 All currency amounts are in Canadian dollars unless otherwise specified.

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Page 2 9B18C044 BACKGROUND: PLANTING THE IDEA The desire to innovate the composting market came from an unlikely source: Davies’ beloved dog, Willy, who had been poisoned by the fertilizer used in the family’s garden. Willy recovered, but the experience fuelled Davies’ determination to find an environmentally-friendly fertilizer that would not cause harm to humans or animals. With the idea planted, Davies investigated the competitive landscape of the composting industry. Davies discovered that municipal composting policies and programs had outdated, time-consuming, and unreliable approaches that led to low quality compost. With landfill space projected to run out in many major Canadian city by 2028,2 Davies did not see the existing rudimentary approach as the solution to waste management problems. He expanded his research, taking time to evaluate generational trends and the growth of clean technology, which had not yet been used at scale in the composting process. He then partnered with a technology firm in Britain to help develop his idea. During the research and development phase, Davies and the technology firm kept uncovering patents that would halt their work. All patents surrounding this technology led back to the Hot Rot device, created by a company in New Zealand. Instead of attempting to work around the patents to build a competing technology, Davies developed a licensing agreement with Hot Rot. This agreement gave Davies the exclusive rights to the equipment in Calgary, Edmonton, Vancouver, Toronto, Ottawa, Montreal, and four cities in the United States. Typically, well-sorted, warm, moist piles of food waste took approximately three months to compost, which starkly contrasted with Hot Rot’s ability to compost unsorted food scraps in 10 days. The Hot Rot process was fully enclosed; it barely released any odours or liquid by-product, and pest infestation was not a concern. The resulting compost was a certified organic, non-genetically modified alternative to fertilizer, which was so safe that it could be eaten, if one was so inclined. Hop’s compost had the highest nutrient quality of any compost in Canada, and with a live data stream that the Hot Rot system provided during the composting process, the ratio of components (nitrogen, potassium, and phosphate) could be customized. Davies hoped to use this advantage to create custom compost for farmers based on the nutrient needs of their soil. Davies recognized that his business idea was sound and that he had extremely valuable proprietary technology in North America. He used the technology to both offer a food waste collection service and sell organic compost for fertilization with little competition. He built his business model to capitalize on the technology while still making an environmental difference in his city. He offered local restaurants 90-day contracts for food collection services. With Hot Rot’s advanced technological abilities, the restaurants did not need to sort their food scraps and could include hard-to-compost materials like bones, meat, fish, and dairy. Hop provided restaurants with food scrap bins. When Hop collected the food waste, a scale weighed the volume of food waste collected and a bio-soap pump in the truck washed the emptied bins. Each month, using the data from the collection truck, Hop issued an impact report that enabled its clients to quantify their weekly efforts to reduce their environmental footprint—a first for many companies. In addition, Hop offered restaurants staff training and customized signs for their bins as part of the contract. PART A: SUSTAINING HOP’S ENVIRONMENTAL IMPERATIVE WHILE GROWING From the beginning, the team’s mission was to drive success by creating a positive environmental impact.

2 “With Fewer Landfills, Where Will Ontario Trash Go?,” Waterloo Region Record, accessed November 1, 2018, www.therecord.com/news-story/2592071-with-fewer-landfills-where-will-ontario-trash-go-/.

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Page 3 9B18C044 Since its launch in 2015, Hop had saved 1.8 million kilograms (3.9 million pounds) of food from landfills. The average restaurant wasted 40 per cent of its food, but Hop enabled restaurants to put all of that food to use. In 2015, Hop grew to fill its current capacity in Calgary and was looking to expand it, as well as develop a facility in Vancouver. When Davies and his team last met with Hop’s board, they discussed how to keep Hop’s environmental imperative at the core of its business as they expanded. Davies told the board that Hop was targeting growth within from January 2017 to January 2018 that would be four times its current production footprint. But, in early 2016, as Davies was preparing for the upcoming board meeting, he grasped the reality of Hop’s rapid growth. On a small scale, it was easy for businesses to keep their original focus and mission central to their operations, but growth created new threats and made it more challenging to keep the original mission at the forefront. Davies worried whether he had adequately prepared Hop for this challenge. He saw the issue boiling down to two potential solutions: meet the standards set by an external certification board such as B Lab or maintain internal accountability through procedures and company culture. B Corp Certification “Certified B Corporations” were for-profit corporations that used their businesses to help solve social and economic problems. To gain B Corp certification, businesses had to meet performance standards in social and environmental performance, accountability, and transparency for the good of the environment, community, and employees.3 B Lab, a not-for-profit organization founded in 2006, assessed applicant corporations and made the award. B Lab awarded its first certification in 2007.4 B Lab envisioned the B Corp certification as akin to the Fair Trade certification for coffee, chocolate, or milk: an instantly recognizable designation that signalled the business’s commitment to social and environmental goals.5 B Corp certification provided businesses with many benefits, among them, inclusion in a vast network of like-minded businesses, inherent marketing through B Lab’s many media outlets, and a verification to consumers of the business’s social and environmental claims.6 However, the cost of certifying was high for a start-up, the certification process was lengthy, and the meaning behind Certified B Corporations was still largely unrecognized by Canadian consumers. For a bootstrapping start-up tight on both financial and human capital, the question was whether the benefits of B Corp certification outweighed the costs for Hop. Stakeholder Accountability At the previous board meeting, Davies and the board of directors discussed the merits of B Corp certification. They wondered if achieving B Corp certification would help Hop remain accountable to its environmental promises and reach its goals. Meeting the environmental standards of an external certification board meant that accountability was essential. B Lab randomly audited 10 per cent of its Certified B Corporations each year; holding certified status meant that the company had to unfailingly meet the standards laid out for a corporation and have the documentation to back it up. 3 “What Are B Corps?,” B Lab, accessed July 10, 2018, www.bcorporation.net/what-are-b-corps; and “B the Change: People Using Business as a Force for Good,” B Lab, accessed July 10, 2018, www.bcorporation.net/b-the-change. 4 “Our History,” B Lab, accessed July 10, 2018, www.bcorporation.net/what-are-b-corps/the-non-profit-behind-b-corps/our-history. 5 “What Are B Corps?,” op. cit. 6 “Why Become a B Corp?,” B Lab, accessed July 10, 2018, www.bcorporation.net/become-a-b-corp/why-become-a-b-corp.

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Page 4 9B18C044 Davies and the board had similar goals for attaining B Corp certification. Operations would improve at Hop with the use of written procedures; it had been proven that having and using documented procedures led to greater efficiency and fewer errors in the workplace.7 Similarly, establishing policies that went beyond industry standards for the environment and the employees would improve Hop’s human resources, especially as its small team expanded over time. The team also believed that the businesses that provided Hop with food scraps would be more inclined to work with Hop if it had B Corp certification; it would reflect well on the co-operating businesses to be partnered with a company with noted exceptional standards throughout its operations. Perry offered her financial perspective, noting that “companies would rather deal with B Corps and may even give them discounts” for their products or services. Attaining B Corp certification could leverage supplier relations in a unique way and benefit Hop financially in the long term. Although Hop did not have direct competitors at the time, it was becoming standard in the industry for social enterprises to attain B Corp certification. The certification would help to establish Hop as a legitimate social enterprise in the group. Keeping Hop accountable to an overarching certification board would also help to leverage risk by establishing stronger relationships with suppliers and employees, and by creating operational efficiencies. One of the directors, however, wondered why Hop needed to pursue certification at that point, questioning why they needed other people to “tell us [what] we already know: [why] we are great.” The director believed that Hop would not struggle with accountability because Hop’s environmental mission was fundamental to the operations, meaning accountability and the mission could not be mutually exclusive. Hop did not need an external certification board to convey what was already clear through both its operations and marketing strategy. A final issue with certification was the time and cost involved. Attaining B Corp certification could be a time consuming and expensive process. As a start-up, Hop was constantly improving its standardized operating procedures. As a B Corp business, Hop would be required to continually update its documents with every latest change. That would be intensely time consuming. Another director had a different position. He suggested that with growth, a high standard in every aspect of their business would be easier to maintain if they were striving for an external expectation rather than a vague expectation established internally. The director suggested that meeting these standards early was key to Hop’s future success. It would be easier for Hop to adapt as a small start-up. Altering procedures later as a large, multi-city business would be much more difficult than building the procedures correctly from the beginning. The standards would also act as a risk management strategy as Hop expanded. If they did not establish appropriate procedures early, the company faced greater risks in the future. The director noted that Hop had already created a standard of impact reporting through its monthly reports to food suppliers, and that as a business, they would continue to demonstrate to their customers the value of reporting and transparency by attaining B Corp certification. Davies discovered that B Lab offered its “B Impact Assessment” online for free, without having to apply for certification. Hop could take advantage of the opportunity and self-assess the business without having to spend the money and time required for full certification. Hop could use the free impact assessment to build procedures that reflected its goal of making a difference through the business. Some directors, however, were concerned that if Hop generated its own standards and procedures, customers and the company itself might come to think the standards meant something more than they did. Without the 7 “How to Improve Quality with Standard Operating Procedures,” Project Management Hacks, blog, accessed August 16, 2018, http://projectmanagementhacks.com/improve-quality-standard-operating-procedures/.

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Page 5 9B18C044 accountability that B Lab provided and the documentation required to back the company’s claims, Hop’s internally generated standards could create false expectations, creating a risk for the business. The Power of a Network If Hop were certified, it would be connected to B Lab’s network of over 2,500 companies; that connection, especially to the 227 Canadian companies, would be a huge benefit to Hop. Without obtaining the full certification, Hop would have to spend its own resources to reach the vast number of companies available in B Lab’s network. Attaining B Corp certification could provide Hop with quick and easy connections that might be vital to Hop’s growth throughout North America. Another consideration was Davies’ plan to expand into Toronto after establishing Hop Vancouver. B Lab’s Canadian head office was in Toronto, which also had the largest concentration of B Corp certified businesses in Canada. Creating a Strong Story One of the directors believed that Hop should save money at this pivotal point and market itself using the statistics Hop had already developed. The director stressed that communicating how many millions of pounds of food waste Hop saved from landfills and profiling the resulting compost with the highest nutrient content available in Canada would be more tangible to Canadian consumers than B Corp certification. Another director agreed with this opinion, adding that the environmental benefits were fundamental to Hop’s operation, and that was immediately communicated to consumers by Hop’s business of taking restaurant food waste and making it into compost. B Corp certification, however, would also make consumers aware of the more difficult-to-market benefits of Hop, such as employee welfare. The certification would show that Hop went beyond the environmentally-friendly nature of the business to achieve excellence in a multitude of areas. Consumers had become skeptical about companies that did not substantiate their environmental claims. Unsubstantiated claims about “green” products put companies at risk of civil and criminal action for misleading consumers. At the very least, to protect themselves against legal action, Hop’s team needed to maintain documents to substantiate their environmental claims. Attaining B Corp certification would help with that by verifying Hop’s environmental claims and communicating to knowledgeable consumers that Hop was, indeed, an environmentally responsible company. Balancing Mission with Resources and Investors The cost of B Corp certification varied, depending on the size of the business and its industry; the cost could be as high as $25,000 per year, which was expensive for a start-up. Every financial decision made by a start- up during the early stage of negative cash flow (the “valley of death”) could make or break the company. Davies worked hard for every dollar he raised for Hop, and he was proud that his business gave investors a 140 per cent return on their shares. But Hop was resource-strapped, just like any other start-up (see Exhibits 1 and 2). There was very little room for extra spending in Hop’s budget for the next year. Spending money on B Corp certification at this particular time could be a financial blow for Hop, particularly because Hop needed to keep its returns as high as possible to prove Hop’s value to potential investors who would help fund Hop’s growth.

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Page 6 9B18C044 In addition, the process for B Corp certification, which needed to be completed every two years, was lengthy and time consuming. The process required that companies first meet the performance requirements, which was a six-stage process (see Exhibit 3) that started with completing the B Impact Assessment (see Exhibit 4). Davies felt that speed and growth were two of the main features of Hop’s approach. The team needed to make decisions and act quickly. Some directors worried that the certification process would slow Hop at a pivotal time; they questioned why certification could not wait for a better time. Five of Hop’s seven directors thought that certifying Hop immediately would be a waste of financial and human capital, and suggested waiting until a later date. In the heated meeting, the two directors who supported certification argued that the extra marketing and networking would bring additional revenue and accolades that would outweigh the financial burden. The five directors opposed to certification countered:

At this time, Hop has reached capacity in Calgary. Although there are expansion plans into Vancouver, Hop has already established a network and marketing plan [that has generated] enough committed interest to be, at minimum, at two-thirds capacity [in Vancouver] by the launch date. At this time, the money and time would be better spent on funding the Vancouver initiative rather than on certification.

Historically, Davies had struggled with investors disagreeing with his valuation of Hop, particularly with regard to the social impact of the business. Although the Hop team had never lowered their valuation in negotiations, the directors worried that putting capital into B Corp certification might alienate the investors Davies worked so hard to reach. The meaning behind B Corp certification was not well-known in Canada, so it was probable that Hop’s investors would not know what it was or see its value. The directors believed that investors would rather their money be spent on magnifying Hop’s environmental impact throughout North America as opposed to it being spent on officially labelling Hop’s current impact. PART B: THROUGH THE EYES OF AN INVESTOR Tied to the B Corp decision was a pressing financial need to fund Hop’s immediate plans for growth. Hop had proprietary technology, a long list of Calgary’s top restaurants already confirmed as clients, and an established facility location, but the barrier to entry for Hop was still enormous. The competitive landscape in the waste management industry included companies and methods that held a large part of the market share. To compete, Davies needed to raise $800,000 for Hop’s expansion into Vancouver, and then immediately begin raising funds for expansion into Toronto. Given the contrasting opinions from the board of directors, Davies wondered if he should focus his future pitches solely on the validity of Hop’s business model or spend time determining a better way to convince investors of the financial benefits of Hop’s social and environmental impact. He remembered how difficult the previous rounds of investment talks had been. His greatest struggle when seeking investment had been communicating the value of the social and environmental aspects of his business. Although Hop was now better established with a proven scalable business model, this struggle was inherent to Hop, no matter the size of the company. When Davies first approached potential investors, he realized that many of them did not understand the value of his company. Calgary was the economic centre for the oil and gas industry in Canada, and there was significant capital in the city. There was also a clear expectation about the high rate of return expected

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Page 7 9B18C044 by investors. During his first round of investment talks, Davies learned that investors’ main concerns were a lack of demand for Hop’s service and the dollar value that Davies had assigned to the environmental impact of his service. Yet, in spite of investor hesitation, Davies successfully managed to raise the initial $500,000 he needed to launch Hop in Calgary. With start-ups, angel investors were usually the primary type of investor, and that had been Hop’s source of investment so far. But all investors were heavily influenced by the trade-off of risk and reward in an opportunity. While each investor had a different level of tolerance and motivation for the allocation of their monetary gains, regardless of whether the strategic investment was short or long term, the primary concern of the majority of investors was their return on investment. To address this, an enterprise’s “book value” needed to be established to provide a baseline valuation of the company at its net present value. Perry had done an excellent job corroborating the financial statements and clearly modelling Hop’s past performance and future profitability. She was working with Davies to provide the information that would be the basis for predicting future performance. Her prediction would help mitigate the risk of not achieving the necessary future net cash inflows. Most of the modelling was done with traditional financial models that focused on estimated future earnings, achieved by scaling Hop to multiple cities. In order to prove stable financial performance, Davies and Perry needed to showcase Hop’s business model, future strategy, risk level, and longevity to investors. Davies knew that the size of the market and scalability would be questioned, as well as Hop’s competitive differentiation and exit strategy (in case the company should ever be sold), and he clearly saw the importance of keeping Hop’s financial stability as the basis of a valuation that included environmental and social performance. Financial performance had been the greatest determinant when valuing a company. But companies were facing an ever-increasing risk in attaining and maintaining their “social licence to operate,”8 and Hop’s mission-driven business model substantially lowered the impact of that risk for investors; however, Perry and Davies were uncertain where to place Hop’s positive environmental and social impact in the future prediction models. Davies needed to include qualitative characteristics, such as relevance and faithful representation. He had strong metrics for the environmental impact Hop was creating each month in landfill waste diversion, but he struggled with how to position this with investors. There were many valuation methodologies; however, in Hop’s case, there was an absence of comparable companies, a lack of historical data, and a lack of quantifiable valuation techniques with respect to intangible assets like waste diversion, carbon reduction, and hiring staff from organizations like the Calgary Drop-In Centre, which supported people at risk of homelessness. This was proving to be a troubling challenge for Davies and Perry, and time was running out to get a proposed solution for the board of directors meeting at the end of the week. The Value of Responsible Stewardship The traditional business paradigm of value focused on the financial bottom line, but there was a shift occurring—value increasingly included corporate social responsibility, impact investing, and social enterprises. Seed funds were being created with the goal of supporting mission-focused businesses. There were a few innovative, mission-focused funds in Canada; for example, there were clean technology funds, low carbon funds, and funds created by Vancouver City Savings Credit Union, MaRS Centre for Impact Investing, and Royal Bank of Canada. For Perry and Davies, this confirmed they were on the right track and

8 “Social licence to operate” referred to a project’s need for ongoing approval within the local community and among other stakeholders and ongoing broad social acceptance (“What Is the Social License?,” SociaLicense, accessed July 10, 2018, http://socialicense.com/definition.html).

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Page 8 9B18C044 that the triple bottom line accounting (social, environmental, and financial) that Hop needed could balance profit equally with the impact the organization had on the environment and society as a whole. The value of a company like Hop could not be solely defined by the bottom line. Hop was already attaining a better return on investment through its mission-driven business model, achieving a strong triple bottom line. And Hop was clearly challenging conventional thinking by suggesting that investment in socially responsible companies was part of a profitable investment portfolio. Some investors considered socially responsible investing to be the role of governments and non-governmental organizations. But Perry found considerable evidence to support Hop’s triple bottom line argument. For example, a recent Morgan Stanley study that found higher returns were derived from investing in sustainable companies:

Long-term annual returns of one index comprising firms scoring highly on environmental, social and governance criteria exceeded the S&P 500 by 45 basis points since its inception in 1990.9

The challenge for Davies and Perry was that their meetings with investors were still following the pure for- profit paradigm for making an investment decision. Davies was frustrated with investors’ adherence to the traditional train of thought in business, believing that if an organization was focusing on environment, people, and profit equally, profits would be diminished. Ironically, this belief resulted in less lucrative returns for investors. Regardless, the problem of misconception remained. Responsible Value in Practice Hop’s primary environmental goals focused on the interests of all stakeholders, bridging the gaps between farmers, restaurants, and food waste by diverting food waste away from landfills and using it to provide superior compost. Hop needed a process to integrate its core values around waste diversion and community in the company’s valuation. This process would be the catalyst to Hop’s success. Both Davies and Perry agreed that, ultimately, this integration would lead to an increased probability of lucrative returns for investors. Perry focused on understanding the crucial role Hop played in the reduction of greenhouse gas (GHG) emissions by diverting two million pounds of food scraps away from landfill in the first year of operations. The accomplishment was a source of pride for the Hop team; through their innovative Hot Rot technology, a single employee could manage this volume of food waste and turn it into the highest quality compost ever recorded in Canada. Impact tracking was a mechanism that allowed Hop’s clients to quantify their positive environmental impact. Essentially, clients were paying a premium of $75 per bin pick up for this service so they could demonstrate to their prospective customers that the company cared about its environmental impact. Thanks to the Hot Rot technology, Hop could weigh the food scrap bins from each client and determine the amount of food waste being diverted from landfill, the amount of water saved, and the reduction in the company’s GHG emissions. This valuable information allowed Hop to charge a 10 per cent premium. Perry continued to review the past year’s financial statements and focused on Hop’s three revenue streams. First, Hop provided a pick-up service of organic food waste from local food merchants for disposal. The service was provided on a contractual basis to help mitigate client turnover. Second, Hop distributed the

9 Morgan Stanley Institute for Sustainable Investing, Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies (Morgan Stanley, 2015), 1, accessed July 11, 2018, www.morganstanley.com/sustainableinvesting/pdf/ sustainable-reality.pdf.

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Page 9 9B18C044 highest quality fertilizer to local growers, organic farms, and home garden stores. Third, due to the large scale of GHG reduction created through Hop’s operations, Hop sold carbon credits under Alberta’s cap and trade system to energy companies such as Suncor Energy, an Alberta oil sands developer.10 This third revenue stream was extremely lucrative for Hop because its day-to-day operations dealt with the diversion of food waste that created methane. Methane contributed 20 to 25 times more GHG emissions than carbon dioxide (CO2).11 In Alberta’s carbon credit market, Hop could sell 30 tonnes of credit for $60,000. Hop was predicted to divert 70 tonnes by the end of 2017. Still, despite three stable revenue streams and a stable historical performance, Perry was at a loss with how to value Hop’s positive externalities. It was imperative to incorporate these into Hop’s valuation for investors. THE FUTURE OF HOP: B CORP AND INVESTOR DECISIONS Davies and Perry were focused on two major decisions that would impact Hop’s future. Davies thought about where he’d like to see Hop going over the years. Ideally, he saw Hop moving into every major North American city, providing a functional, closed-loop food cycle for thousands of restaurants. Davies was counting on an acquisition or going public by 2020. Davies had seen his business start as a simple idea, and despite many challenges along the way, he had grown it into a scalable company with care for the environment at the centre of its mission. Davies worried that as the company grew, the mission would be dissolved and replaced with only financial return on investment guiding the decision-making process. He struggled with how to best maintain the mission while hiring and training new staff, opening a second location, and raising the next round of investment. Davies did not know what was best. B Corp certification would establish accountability. It could create an advantageous network and help market Hop’s services and product to knowledgeable consumers. He conceded that most Canadians did not know about B Corps, and the time and expense put into certifying might be better used for expansion and magnifying Hop’s environmental impact. Davies was at a crossroads, and his trusted board of directors seemed just as conflicted as he was. While Davies wrestled with the B Corp decision, Perry knew they faced a dilemma with how to pitch Hop’s business model to investors. As Perry wrapped up her research on sustainable investing methodologies, she told Davies about the large and growing evidence for using a valuation technique that incorporated all stakeholders’ concerns through social and environmental positive externalities. With investor meetings scheduled, Perry and Davies had to decide how they would pitch Hop to the investors.

10 For more details on Alberta’s Cap and Trade system, please refer to “Here’s a Primer on Carbon Taxes and Cap and Trade in Canada,” Alberts Farmer Express, December 20, 2016, accessed August 16, 2018, www.albertafarmexpress.ca/2016/12/20/what-you-need-to-know-about-carbon-taxes-and-cap-and-trade/. 11 “Global Greenhouse Gas Emissions Data,” United States Environmental Protection Agency, accessed August 16, 2018, www.epa.gov/ghgemissions/global-greenhouse-gas-emissions-data.

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Page 10 9B18C044

EXHIBIT 1: HOP COMPOST—PROJECTED INCOME STATEMENT FOR 2016

in CA$ Revenue from services 450,000 Revenue from carbon credits 130,000 Compost sales — Total Revenue 580,000

Cost of goods sold (COGS) 10,000 Rent 84,000 Utilities 9,600 Warehouse insurance 34,000 Salaries 330,000 Truck and bobcat

Gas 5,000 Insurance 20,000 Depreciation expense—machine* 10,000 Depreciation expense—vehicle** 9,800 Total Costs 512,400

Earnings before interest and taxes (EBIT) 67,600 Tax Rate 27% Tax Expense 18,252 Net Income 49,348

Note: * Depreciation calculated at $500,000 over 50 years; ** depreciation calculated at $100,000 − $2,000 over 10 years. Source: Created by the case authors, based on an interview with Meghan Perry (chief financial officer, Hop Compost) on November 1, 2016.

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Page 11 9B18C044

EXHIBIT 2: HOP COMPOST—STATEMENT OF FINANCIAL POSITION, END OF FISCAL YEAR 1 (2016)

in CA$ Current Assets

Cash 250,000 Total Current Assets 250,000

Non-Current Assets

Trucks 250,000 Machines 1,000,000

Total Non-Current Assets 1,250,000

Total Assets 1,500,000

Current Liabilities

Bank Loan 100,000 Total Current Liabilities 100,000

Non-Current Liabilities

Bank Loan 600,000 Total Liabilities 700,000

Shareholders’ Equity

Common Shares 460,000 Retained Earnings 340,000

Total Equity 800,000

Total Liabilities and Shareholders’ Equity 1,500,000

Book Value 800,000 Source: Created by the case authors, based on an interview with Meghan Perry (chief financial officer, Hop Compost) on November 1, 2016.

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Page 12 9B18C044

EXHIBIT 3: PERFORMANCE REQUIREMENTS FOR B CORP CERTIFICATION 1. Take the B Impact Assessment.

1.1. Assessment varies depending on company’s size (number of employees), sector, and location of primary operation.

1.2. The assessment takes approximately two to four hours to complete. 1.3. Company receives a B Impact Report that contains an overall score. The company must achieve

a score over 80 out of 200 to proceed. 2. Schedule assessment review and submit supporting documentation.

2.1. Six to eight questions from the Impact Assessment that were answered in the affirmative are randomly selected by B Labs.

2.2. The company is asked to demonstrate those practices in more detail through documentation. 3. Complete the assessment review.

3.1. B Lab staff review questions that may have been difficult to answer or are unclear. 3.2. Review takes 60 to 90 minutes.

4. Submit additional documentation.

4.1. One to six additional questions are selected by B Labs from the Impact Business Model section of the assessment.

4.2. The company is asked to provide more documentation. 5. Complete disclosure questionnaire.

5.1. Company is asked to confidentially disclose any sensitive practices, fines, or previous sanctions. Disclosure does not affect rating.

5.2. If one or more items merit further transparency, the company will be required to provide incremental disclosure and possibly, implement specific remedies.

6. Background checks conducted. Source: “Performance Requirements,” B Lab, accessed July 11, 2018, www.bcorporation.net/become-a-b-corp/how-to- become-a-b-corp/performance-requirements.

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Page 13 9B18C044

EXHIBIT 4: SAMPLE B IMPACT ASSESSMENT 1. Select the description that best describes your business.

This is an unweighted question that will not impact your score and is asked only for research/benchmarking purposes.

◯ Positive social/environmental impact is desirable but not a particular focus for our business.

◯ Social and environmental impact is frequently considered but it isn't a high priority.

◯ We consider social and environmental impact in some aspects of our business but infrequently.

◯ We consistently incorporate social and environmental impact into decision-making because we consider it important to the success and profitability of our business.

◯ We treat our social/environmental impact as a primary measure of success for our business and prioritize it even in cases where it may not drive profitability.

2. Does your company have a corporate mission statement, and does it include any of the following? Please check all that apply.

☐ No written statement

☐ A written corporate mission statement that does not include a social or environmental commitment

☐ A general commitment to social and/or environmental responsibility and stewardship

☐ A commitment to a specific positive social impact (e.g., poverty alleviation, sustainable economic development)

☐ A commitment to a specific positive environmental impact (e.g., reducing waste to landfill with upcycled products)

☐ A commitment to serve a target beneficiary group in need (e.g., low-income customers, smallholder farmers)

3. Please type or paste your mission statement here.

4. Does the Board of Directors or equivalent governing body review your company’s social or environmental

performance on at least an annual basis? ☐ Yes

☐ No

☐ N/A- No Board of Directors or equivalent governing body 5. Are there key performance indicators (KPIs) or metrics that your company tracks at least annually to

determine if you are meeting your social or environmental objectives? ☐ We don't track key social or environmental performance indicators.

☐ We measure KPIs/metrics or outputs that we have identified and defined in order to determine if we are achieving our social and environmental objectives.

☐ We measure social and environmental outcomes over time (e.g., third-party impact assessments, progress out of poverty indexing, beneficiary outcome surveys).

Source: “B Impact Assessment,” B Lab, accessed July 11, 2018, http://bimpactassessment.net/bcorporation.

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4.

9B17B004

TESCO: FROM TROUBLES TO TURNAROUND1 Anupam Mehta, Utkarsh Goyal, and Sanchit Taneja wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2017, Richard Ivey School of Business Foundation Version: 2017-03-13

“We set out to start rebuilding profitability whilst reinvesting in the customer offer, and we have done this,”2 exclaimed Dave Lewis, chief executive officer (CEO) of Tesco PLC, while declaring the company’s annual results on April 13, 2016. Tesco, a U.K.-based retailer with a market capitalization of £14.73 billion,3 was Britain’s biggest grocer both by market share and revenue.4 The company had posted a £162 million pre-tax profit for fiscal year (FY) 2015/16, up from a loss of £6.38 billion in FY 2014/15. In Tesco’s 2016 annual report, Lewis stated, “This has been a significant year for Tesco. We have delivered unprecedented change over the past 12 months as we have begun to transform our business.”5 However, while the company had been able to churn out profitability, the net sales had consistently dropped since FY 2012/13. Similarly, the share price of the company had fallen by more than 20 per cent from January 2015 to January 2016, and by around 50 per cent from January 2014 to May 2016 (see Exhibit 1). What course of action would enable Lewis to improve Tesco’s value for shareholders? What area(s) should he focus on in order to bolster Tesco’s financial performance? What should Lewis do to improve Tesco’s market share in the United Kingdom? THE COMPANY Tesco was established as a grocery and general merchandise retailer in 1919.6 However, since 1990, the company had started to diversify by offering books, clothing, electronics, furniture, toys, petrol, software, financial services, and telecommunications/Internet services—all while expanding its reach geographically. Tesco offered both value range products (branded as “Tesco Value”) and premium range products (branded as “Tesco Finest”). As of 2016, the company had 3,460 stores in the United Kingdom (see Exhibit 2), 6,902 stores around the world, and 476,000+ employees (see Exhibit 3).7 Tesco ranked as the world’s fifth largest retailer in terms of revenue as of 2015.8 Tesco’s rank dropped from second in 2012 to fifth in 2013, attributed to the declining sales of the company.9 Tesco had been listed on the London Stock Exchange since 1947,10 and was a constituent of the Financial Times Stock Exchange 100 Index.11 The firm had a market capitalization of approximately £18.1 billion as of April 22, 2015—the 28th-largest of any company with a primary listing on the London Stock Exchange.12

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Page 2 9B17B004 Business Model According to Tesco’s 2015 annual report, the company’s business model focused on four key areas: customers, products, reinvestment, and channels. The company had a simple mission: “To be the champion for customers, helping them to enjoy a better quality of life and an easier way of living.”13 Growth Strategy Tesco had refocused its business under three operational headlines: (1) listening to, understanding, and reaching out to customers to create the best possible offer; (2) working with growers and suppliers to make great products, and helping to deliver the best value to customers; and (3) working across different channels to get those products to customers in the most convenient way possible. The company had a special blend of capability, skills, and reach, complemented by a rich heritage in retail, which management hoped would help to earn customer loyalty and subsequently create value for shareholders.14 Past Performance With close to 100 years of corporate history, Tesco had pioneered smaller convenience stores and provided products under its own brand.15 The number of Tesco stores in the United Kingdom increased from 2,715 stores in FY 2010/11 to 2,979 stores in FY 2011/12.16 This rapid expansion helped the company emerge as one of the biggest retail chains in the world. Tesco’s financial performance was on an upward trend until FY 2011/12. The company’s revenue increased from £60.46 billion in FY 2010/11 to £64.54 billion in FY 2011/12 (an increase of 6.76 per cent), while the gross profit increased from £5.13 billion in FY 2010/11 to £5.26 billion in FY 2011/12 (an increase of 2.65 per cent) (see Exhibit 4). However, Tesco’s revenue then fell from £64.83 billion in FY 2012/13 to £63.5 billion in FY 2013/14 (see Exhibit 4). Tesco’s then CEO, Philip Andrew Clarke, tried to revive the business with a plan to inject £1 billion to refurbish 430 stores and hire 8,000 new store workers to enhance the shopping experience for customers.17 The idea was to turn Tesco into a multi-channel retailer in an effort to revitalize its business and grow with customers’ needs. Despite these efforts, profits and share prices continued to decrease. As a result, Clarke was fired. The New CEO: Dave Lewis Lewis became group chief executive of Tesco on September 1, 2014. He brought with him 28 years of experience at Unilever in a variety of roles, which took him across Greater Europe, Asia, and the Americas. His last three roles included chairman of Unilever in the United Kingdom and Ireland, president of the company’s divisions in the Americas, and global president of the personal care division. During his career, Lewis had been responsible for a number of business turnarounds within these roles and areas.18 Upon Lewis’s move to Tesco, former Tesco board director Andy Higginson said, “I think Dave Lewis is a great hire for Tesco. . . . He’s very seasoned and a successful manager. He’s got great values and will be very strong on sorting the strategy out.”19 Market analysts agreed that Lewis’s appointment brought hope for Tesco, with one analyst noting that the appointment, coupled with the recent hiring of Alan Stewart from Marks & Spencer as Tesco’s finance director, meant that “shareholders now have the change they have been pushing for.”20

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Page 3 9B17B004 Lewis joined Tesco at a time when the company was undergoing a severe financial crisis. From the company’s cash position to its decreasing sales, Tesco’s new CEO had numerous issues to address. Soon after hiring Lewis in September 2014, Tesco experienced another massive setback in the form of an accounting scandal. Tesco’s previous chairman Sir Richard Broadbent explained:

The issues that have come to light over recent weeks are a matter of profound regret. We have acted quickly to clarify the financial performance of the company. A new management team is in place to address the root causes of the misstatement, and to develop and implement the actions that will build the company’s future.21

The fraud was publicly exposed when the company’s predicted profits for the first half of 2014 were cut back from £1.1 billion to £263 million. Accounting issues further affected Tesco’s performance. THE RETAIL INDUSTRY Although the U.K. retail industry had grown steadily until 2013, the trend started to dip after this point. This decrease was attributed to the United Kingdom’s slow economy at the time. The growth rate decreased from 2.3 per cent in 2014 to 2 per cent in 2015. With the country’s gross domestic product growth hovering around 2 per cent (which was less than the long-term economic growth rate), retail spending was projected to decrease by around 0.2 per cent every year until 2020.22 Several reports and trends exhibited a move toward technology and online retail in the U.K. retail industry. Moreover, the industry began to experience a dramatic shift toward discount retail stores, which were very simple in design. Due to the volatile economy, consumers started to prefer discount stores over all other offerings. The average 12-week market share of German discount stores such as Aldi and Lidl saw a rise of over 1 per cent from 2014 to 2016, while other competitors in the U.K. market saw negative market share growth during the same period (see Exhibit 5).23 TESCO’S FINANCIAL RESULTS FOR FY 2014/15 AND 2015/16 During FY 2014/15, there had been renewed focus on corporate governance. The company’s board spent a significant proportion of its time examining and strengthening Tesco’s processes throughout the group. Low-performing stores were shut down, and many staff members were laid off to reduce costs. Tesco closed 43 stores that were not yielding any profits and stalled the opening of 49 new stores. Moreover, the company regained ownership of 21 superstores to reduce rent exposure. In an attempt to focus on its core customers, Tesco also sold off all major non-core business. The company’s Korean business, Homeplus, was sold for £4.2 billion as a measure to strengthen Tesco’s balance sheet.24 In FY 2015/16, Lewis’s primary focus was to turn Tesco back into a customer-centric business. Therefore, Lewis implemented many strategic changes with three focal points to help Tesco recover from the accounting scandal of 2014: (1) regaining competitiveness in core U.K. business; (2) protecting and strengthening the balance sheet and profits; and (3) rebuilding trust and transparency.25 Competition in the market was driving companies to lower their margins and offer deep discounts. Tesco’s top competitors—Asda, Morrisons, and Sainsbury’s—had a solid hold in the market, and new players— Aldi and Lidl—were competing fiercely for market share. Under these circumstances, Tesco focused on delivering the best competitive price for its customers. Tesco’s 2015 strategic report stated, “In October 2015, we became the first—and still only—retailer in the [United Kingdom] to offer customers an

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Page 4 9B17B004 immediate price match at the till with Brand Guarantee.”26 To ensure lower prices, Tesco invested all excess profits in the prices of products. In 2015, the company launched a range of products with an emphasis on lower prices. Capital expenditure was also cut from £2.88 billion in FY 2013/14 to £2.32 billion in FY 2014/15, and was further reduced to £1.04 billion in FY 2015/16 (see Exhibit 6). When Tesco’s results for FY 2015/16 were announced, everyone was surprised with the turnaround that Lewis had achieved since his arrival: the company that had faced huge losses in FY 2014/15 had now registered a net profit of £138 million in FY 2015/16 (see Exhibit 4). According to the company’s 2016 strategic report, one of the most important changes was the establishment of a new purpose for Tesco: “Serving shoppers a little better every day.”27 This purpose began to guide all of Tesco’s decisions and shape every action the company took. Although Tesco’s revenue decreased (from £62.28 billion in FY 2014/15 to £54.43 billion in FY 2015/16), international sales contributed a great deal toward overall sales, constituting 19.1 per cent of total revenue. Tesco focused on cost management, leading to reductions in the cost of sold goods and operating costs, which enabled the company to achieve an operating profit of £1.05 billion in FY 2015/16 (see Exhibit 4).28 CHALLENGES AHEAD Mike Dennis, an analyst at Cantor Fitzgerald, predicted that Tesco would be fined roughly 1 per cent of U.K. grocery sales (approximately £350 million) attributed to the accounting scandal of 2014.29 In addition, the Serious Fraud Office (SFO) could levy other fines, which, together, could amount to around £500 million. Tesco also had to repay or refinance £1.1 billion in bonds due in September 2016, and £330 million due in January 2017 (see Exhibit 7).30 Additionally, the company had a pension deficit.31 According to the analyst:

[T]he possible fines and legal redress could be classified as exceptional costs but would also drain Tesco of needed cash resources [and] ability to repay debt, and potentially limit any margin recovery. . . . We believe, the implications of a stronger regulator, Groceries Code Adjudicator (GCA), a compliant grocery industry, and potential restrictions from the SFO could place significant limitations on Tesco’s ability to recover margin and repay/refinance [bonds]. . . . The whole industry is currently trying to manage cost pressures, ranging from the living wage to higher rent and rates, as well as falling sales in supermarkets and hypermarkets. So, for Tesco specifically, and the industry, this might severely limit any future price reinvestment against the discounters and margin recovery.32

The results for FY 2015/16 were encouraging, but in April 2016,33 Lewis acknowledged that Tesco’s recovery would not be smooth, and that the company was still facing major challenges. Share prices fell as investors became cautious of the company’s profit warning. Lewis also hinted at a likely fall in sales over the next year. Despite these statements, Lewis appeared optimistic in Tesco’s 2016 annual report and financial statements, saying, “Of course there is still more to do—but we are on the road to recovery and momentum is building across the business.”34 Given all of these efforts, would Tesco’s new CEO be able to bring the company out of its downward spiral? Could he convince shareholders that Tesco was a worthy investment?

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Page 5 9B17B004

EXHIBIT 1: TESCO’S SHARE PRICES, 2012 TO 2016

Source: “Tesco Share Price,” Thomson Reuters, accessed April 22, 2016.

0.00

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6,000.00

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0.00

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FT SE  1 00

 In de

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lu e  (£ )

TS CO

 S ha re  P ric e  (£ )

TSCO ‐ Close FTSE 100 ‐ Close

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Page 6 9B17B004

EXHIBIT 2: TESCO STORE TYPES IN THE UNITED KINGDOM, WITH COUNT AND FEATURES

Format Year Number of stores Total area of

stores (in square feet)

Mean area of each store (in

square feet)

(%) of total space

owned by Tesco

Tesco Extra

2016 252 17,846,000 70,817 42.99 2015 250 17,763,000 71,052 42.01 2014 247 17,610,000 71,296 42.12 2013 238 17,051,000 71,643 42.11

Homeplus

2016 0 0 - 0.00 2015 11 488,000 44,364 1.15 2014 12 523,000 43,583 1.25 2013 12 523,000 43,583 1.29

Tesco Superstores

2016 478 14,002,000 29,293 33.73 2015 487 14,254,000 29,269 33.71 2014 482 14,110,000 29,274 33.75 2013 481 14,053,000 29,216 34.70

Tesco Metro

2016 177 2,005,000 11,328 4.83 2015 191 2,150,000 11,257 5.08 2014 195 2,191,000 11,236 5.24 2013 192 2,145,000 11,172 5.30

Tesco Express

2016 1,732 4,031,000 2,327 9.71 2015 1,735 4,030,000 2,323 9.53 2014 1,672 3,883,000 2,322 9.29 2013 1,547 3,588,000 2,319 8.86

One Stop

2016 779 1,256,000 1,612 3.03 2015 770 1,235,000 1,604 2.92 2014 722 1,142,000 1,582 2.73 2013 639 991,000 1,551 2.45

Dobbies

2016 36 1,652,000 45,889 3.98 2015 35 1,648,000 47,086 3.90 2014 34 1,638,000 48,176 3.92 2013 32 1,540,000 48,125 3.80

Tesco Dotcom

2016 6 716,000 119,333 1.72 2015 6 716,000 119,333 1.69 2014 6 716,000 119,333 1.71 2013 5 604,000 120,800 1.49

Source: Compiled by the case authors, based on Tesco PLC, Annual Report and Financial Statements 2016, 163–164, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf; and Tesco PLC, Annual Report and Financial Statements 2015, 151–152, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf.

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Page 7 9B17B004

EXHIBIT 3: TESCO: FIVE-YEAR RECORD

2015/16 2014/15 2013/14 2012/13 2011/12 Revenue (in £ millions) 54,433 56,925 63,557 63,406 63,916 Revenue growth (%) −4.28 −10.43 0.24 −0.80 - Profit/(Loss) (in £ millions) 129 (5,766) 970 24 2,814 Profit/(Loss) growth (%) Number of stores 6,902 6,849 7,305 6,653 6,049 Average number of employees 482,152 480,607 510,444 506,856 514,615

Source: Compiled by the case authors, based on Tesco PLC, Annual Report and Financial Statements 2016, 85, 163, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf; Tesco PLC, Annual Report and Financial Statements 2015, 83, 151, 168, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2014, 69, 138, 144, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2013, 72, 136, accessed April 22, 2016, www.tescoplc.com/media/1456/tesco_annual_report_2013.pdf; and Tesco PLC, Annual Report and Financial Statements 2012, 90, accessed April 22, 2016, www.tescoplc.com/media/1455/tesco_annual_report_2012.pdf.

EXHIBIT 4: TESCO AND SUBSIDIARIES, CONSOLIDATED STATEMENT OF OPERATIONS AND

COMPREHENSIVE LOSS

Source: Compiled by the case authors, based on Tesco PLC, Annual Report and Financial Statements 2016, 85, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf; Tesco PLC, Annual Report and Financial Statements 2015, 83, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2014, 69, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2013, 72, accessed April 22, 2016, www.tescoplc.com/media/1456/tesco_annual_report_2013.pdf; Tesco PLC, Annual Report and Financial Statements 2012, 90, accessed April 22, 2016, www.tescoplc.com/media/1455/tesco_annual_report_2012.pdf; and Tesco PLC, Annual Report and Financial Statements 2011, 94, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf.

INCOME STATEMENT Fiscal year ends in February (in £ millions, except per share data) 2015/16 2014/15 2013/14 2012/13 2011/12 2010/11

Revenue 54,433 62,284 63,557 64,826 64,539 60,455 Cost of revenue 51,579 64,396 59,547 60,737 59,278 55,330 Gross profit 2,854 (2,112) 4,010 4,089 5,261 5,125 Operating expenses Sales, general, and administrative 1,852 2,695 1,657 Other operating expenses (44) 985 (278) 1,901 2,486 2,290 Total operating expenses 1,808 3,680 1,379 1,901 2,486 2,290 Operating income 1,046 (5,792) 2,631 2,188 2,775 2,835 Interest expense 498 499 447 445 417 465 Other income (expense) (386) (85) 75 217 1,477 1,271 Income before income taxes 162 (6,376) 2,259 1,960 3,835 3,641 Provision for income taxes (54) (657) 347 574 879 864 Minority interest (9) (25) (4) (4) 8 16 Other income (9) (25) (4) (4) 8 16 Net income from continuing operations 216 (5,719) 1,912 1,386 2,956 2,777 Net income from discontinuing operations (87) (47) (942) (1,266) (142) (106)

Other 9 25 4 4 (8) (16) Net income 138 (5,741) 974 124 2,806 2,655 Net income available to common shareholders 138 (5,741) 974 124 2,806 2,655

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Page 8 9B17B004

EXHIBIT 5: AVERAGE MARKET SHARE GROWTH (12 WEEKS ENDING) 2014–2016

Source: Compiled by the case authors, based on Kantar WorldPanel, “Great Britain—Grocery Market Share (12 weeks ending),” Kantar WorldPanel, 2016, accessed May 5, 2016, www.kantarworldpanel.com/en/grocery-market-share/great- britain.

EXHIBIT 6: TESCO AND SUBSIDIARIES: CASH FLOW STATEMENT

Fiscal year ends in February (in £ millions, except per share data) 2015/16 2014/15 2013/14 2012/13 2011/12 2010/11

Net cash provided by operating activities 2,126 484 3,185 2,837 4,408 4,267 Net cash used for investing activities (615) (2,015) (2,854) (278) (3,183) (1,859) Net cash provided by (used for) financing activities (604) 814 56 (2,365) (1,366) (3,036)

Effect of exchange rate changes 1 78 (105) 26 24 (46) Net change in cash 908 (639) 282 220 (117) (674) Cash at beginning of period 2,174 2,813 2,531 2,311 (6,790) (7,929) Cash at end of period 3,082 2,174 2,813 2,531 (6,907) (8,603) Operating cash flow 2,126 484 3,185 2,837 4,408 4,267 Capital expenditure (1,038) (2,318) (2,881) (2,987) (3,708) (3,551) Free cash flow 1,088 (1,834) 304 (150) 700 716

Source: Compiled by the case authors, based on Tesco PLC, Annual Report and Financial Statements 2016, 89, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf; Tesco PLC, Annual Report and Financial Statements 2015, 87, accessed April 22, 2016www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2014, 73, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2013, 76, accessed April 22, 2016, www.tescoplc.com/media/1456/tesco_annual_report_2013.pdf; Tesco PLC, Annual Report and Financial Statements 2012, 94, accessed April 22, 2016, www.tescoplc.com/media/1455/tesco_annual_report_2012.pdf; and Tesco PLC, Annual Report and Financial Statements 2011, 98, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf.

(0.15%) (0.20%) (0.24%) (0.28%)

1.28% 1.17%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

Tesco Sainsbury's Asda Morrisons Aldi Lidl

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EXHIBIT 7: TESCO AND SUBSIDIARIES: CONSOLIDATED BALANCE SHEET

FY ends in February (in £ millions, except per share data) 2015/16 2014/15 2013/14 2012/13 2011/12 2010/11 Assets

Current assets Cash

Cash and cash equivalents 3,082 2,165 2,506 2,512 2,305 2,428 Short-term investments 3,639 746 1,096 580 1,284 1,170 Total cash 6,721 2,911 3,602 3,092 3,589 3,598

Inventories 2,430 2,957 3,576 3,744 3,598 3,162 Receivables 2,121 2,190 2,525 2,657 2,330 Prepaid expenses 440 516 388 417 420 387 Other current assets 5,237 3,453 5,816 3,318 2,599 2,562

Total current assets 14,828 11,958 15,572 13,096 12,863 12,039 Non-current assets

Property, plant, and equipment Land 22,557 25,298 25,734 24,817 Fixtures and equipment 9,967 8,895 Other properties 10,468 11,493 10,851 10,826 27,058 25,767 Property and equipment, at cost 33,025 36,791 36,585 35,643 37,025 34,662 Accumulated depreciation (15,125) (16,351) (12,095) (10,773) (9,324) (8,401) Property, plant, and equipment, net 17,900 20,440 24,490 24,870 27,701 26,261

Goodwill 2,517 2,288 2,286 2,954 Intangible assets 357 1,483 1,509 1,408 4,618 4,338 Deferred income taxes 49 514 73 58 23 48 Other long-term assets 8,253 7,531 6,234 7,743 5,576 4,520

Total non-current assets 29,076 32,256 34,592 37,033 37,918 35,167 Total assets 43,904 44,214 50,164 50,129 50,781 47,206 Liabilities and stockholders' equity Liabilities

Current liabilities Short-term debt 2,815 1,998 1,904 760 1,838 1,386 Capital leases 11 10 6 6 Accounts payable 4,545 5,076 5,831 6,036 5,971 5,782 Taxes payable 807 461 893 959 416 432 Other current liabilities 11,536 12,265 12,765 11,224 11,024 10,131

Total current liabilities 19,714 19,810 21,399 18,985 19,249 17,731 Non-current liabilities

Long-term debt 10,623 10,520 9,188 529 9,911 9,689 Capital leases 88 131 115 9,539 Deferred taxes liabilities 135 199 594 1,006 1,160 1,094 Pensions and other benefits 3,175 4,842 3,193 2,378 Minority interest (10) 7 18 26 88 Other long-term liabilities 1,553 1,641 953 1,031 2,660 2,069

Total non-current liabilities 15,564 17,333 14,050 14,501 13,757 12,940 Total liabilities 35,278 37,143 35,449 33,486 33,006 30,671 Stockholders' equity

Additional paid-in capital 5,095 5,094 5,080 5,020 4,964 4,896 Retained earnings 3,265 1,985 9,728 10,535 12,369 11,197 Accumulated other comprehensive income 266 (8) (93) 1,088 442 442

Total stockholders' equity 8,626 7,071 14,715 16,643 17,775 16,535 Total liabilities and stockholders' equity 43,904 44,214 50,164 50,129 50,781 47,206

Source: Compiled by the case authors, based on Tesco PLC, Annual Report and Financial Statements 2016, 87, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf; Tesco PLC, Annual Report and Financial Statements 2015, 85, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2014, 71, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf; Tesco PLC, Annual Report and Financial Statements 2013, 74, accessed April 22, 2016, www.tescoplc.com/media/1456/tesco_annual_report_2013.pdf; Tesco PLC, Annual Report and Financial Statements 2012, 92, accessed April 22, 2016, www.tescoplc.com/media/1455/tesco_annual_report_2012.pdf; and Tesco PLC, Annual Report and Financial Statements 2011, 96, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf.

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Page 10 9B17B004 ENDNOTES

1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Tesco PLC or any of its employees. 2 Tesco PLC, “Preliminary Results 2015/16,” 1, accessed April 22, 2016, www.tescoplc.com/media/1866/prelim_2015- 2016_results_statement.pdf. 3 £ = GBP = Great Britain pounds; all currency amounts are in £ unless otherwise specified; TSCO share price = £1.81 on February 27, 2016; Outstanding shares = 8,140,701,516 on February 27, 2016; and Tesco PLC, “Share Price,” accessed May 17, 2016, www.tescoplc.com/investors/share-price-information/share-price. 4 Jane Denton, “Sales Boom Sees Aldi Overtake Upmarket Rival Waitrose to Become UK’s Sixth-Biggest Supermarket,” This is Money, April 8, 2015, accessed April 26, 2016, www.thisismoney.co.uk/money/markets/article-3030079/British-shoppers- quids-prices-fall-fastest-rate-records-began-Aldi-UK-s-sixth-biggest-supermarket.html; and “Top 10 UK Retailers by Sales in 2015,” Retail Economics, accessed April 26, 2016, www.retaileconomics.co.uk/top10-retailers.asp. 5 Tesco PLC, Annual Report and Financial Statements 2016, 4, accessed May 22, 2016, www.tescoplc.com/media/264194/annual-report-2016.pdf. 6 “History,” Tesco PLC, accessed April 22, 2016, www.tescoplc.com/about-us/history. 7 “Key Facts,” Tesco PLC, accessed April 22, 2016, www.tescoplc.com/about-us/key-facts. 8 J. William Carpenter, “The World's Top 10 Retailers (WMT, COST),” Investopedia, December 24, 2015, accessed May 5, 2016, www.investopedia.com/articles/markets/122415/worlds-top-10-retailers-wmt-cost.asp. 9 Deloitte, “Top 10 Global Retailers Show Modest Growth in 2014,” press release, September 25, 2014, accessed May 5, 2016, www2.deloitte.com/an/en/pages/about-deloitte/articles/consumerbusiness.html. 10 Steve Hawkes, “Tesco Vows Shake-Up as Shares Crash by £5 Billion,” Sun, January 13, 2012, accessed April 22, 2016, www.thesun.co.uk/sol/homepage/news/money/4057898/Tesco-vows-shake-up-as-shares-crash-by-5billion.html. 11 “TESCO Share Price (TSCO),” London Stock Exchange, accessed April 22, 2016, www.londonstockexchange.com/exchange/prices- and-markets/stocks/summary/company-summary/GB0008847096GBGBXSET0.html. 12 AJ Bell Media, “Markets: Indices,” Telegraph, accessed April 30, 2016, http://shares.telegraph.co.uk/indices/?index=UKX. 13 “Core Purpose and Values,” Tesco PLC, accessed April 22, 2016, www.tescoplc.com/about-us/core-purpose-and-values. 14 Tesco PLC, “Our Business Model,” in Annual Report and Financial Statements 2015, 8, accessed April 22, 2016, www.tescoplc.com/media/1908/tescoar15_br_businessmodel.pdf. 15 Richard Anderson, “Tesco Turns Stale as Competitors Freshen up Ideas,” BBC News, April 22, 2015, accessed October 2, 2016, www.bbc.com/news/business-29310445. 16 Tesco PLC, Annual Report and Financial Statements 2011, 2, 2011, accessed April 22, 2016, www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf. 17 Zoe Wood, “Tesco Profits Fall for First Time in Almost 20 years,” Guardian, October 3, 2012, accessed April 31, 2016, www.theguardian.com/business/2012/oct/03/tesco-profits-fall-uk-supermarkets. 18 “Tesco’s Board and Executive Committee,” Tesco PLC, accessed April 31, 2016, www.tescoplc.com/about-us/board-and- executive-committee/board/. 19 Rupert Neate, “We Know Dave Lewis Can Sell Soap. Can He Really Run Tesco?” Guardian, July 27, 2014, accessed October 2, 2016, www.theguardian.com/business/2014/jul/27/dave-lewis-tesco-manage-dove. 20 Paras Anand, Head of European Equities, Fidelity International, as quoted by Ben Marlow and Katherine Rushton, “Shareholders Split on Phil Clarke's Resignation from Tesco,” Telegraph, July 21, 2014, accessed October 2, 2016, www.telegraph.co.uk/finance/newsbysector/epic/tsco/10980835/Shareholders-split-on-Phil-Clarkes-resignation-from-Tesco.html. 21 “Tesco Shares Slump after Raised Profit Error,” BBC News, October 23, 2014, accessed April 31, 2016, www.bbc.com/news/business-29735685. 22 “The Retail Forecast for 2013–2016,” Centre for Retail Research, January 5, 2016, accessed April 31, 2016, www.retailresearch.org/retailforecast.php. 23 “Great Britain – Grocery Market Share (12 weeks ending),” Kantar WorldPanel, 2016, accessed May 5, 2016, www.kantarworldpanel.com/en/grocery-market-share/great-britain. 24 Ashley Armstrong, “Tesco Sells South Korean Homeplus Business for £4Bn,” Telegraph, September 7, 2015, accessed April 24, 2016, www.telegraph.co.uk/finance/11848185/Tesco-sells-South-Korean-business-for-4bn.html. 25 Tesco PLC, Strategic Report 2015, 3, accessed April 28, 2016, www.tescoplc.com/media/1189/tesco_cr15_strategicreport.pdf. 26 Ibid, 4. 27 Ibid. 28 Tesco PLC, Annual Report and Financial Statements 2016, op. cit., 87. 29 Graham Ruddick, “Tesco to be Censured by Supermarket Watchdog Over Conduct with Suppliers,” Guardian, January 25, 2016, accessed April 21, 2016, www.theguardian.com/business/2016/jan/25/tesco-censured-supermarket-watchdog- suppliers-groceries-code-adjudicator. 30 Lynsey Barber, “Tesco Share Price Falls as Serious Fraud Office’s Investigation is Set to Conclude,” City A.M., January 25, 2016, accessed April 27, 2016, www.cityam.com/233040/the-serious-fraud-offices-tesco-investigation-is-set-to-conclude. 31 Ruddick, op. cit. 32 Barber, op. cit. 33 Saabira Chaudhuri, “Tesco Shares Fall as Company Warns on Profit,” Wall Street Journal, April 13, 2016, accessed April 22, 2016, www.wsj.com/articles/tesco-swings-to-full-year-profit-1460528432. 34 Tesco PLC, Annual Report and Financial Statements 2016, op. cit., 6.

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5.

9B14B011

TRANSFER PRICING AT CAMECO CORPORATION1 Professors Walid Busaba, Nourhene BenYoussef and Saqib Khan wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2014, Richard Ivey School of Business Foundation Version: 2020-11-05

Laura Anderson, a fund manager for Saskhedge fund2, was studying her portfolio’s closing numbers for the third quarter of 2013 for the quarterly review meeting of the investment board. She was particularly concerned about her investment in Cameco stock. Anderson had bought 150,000 shares of Cameco at Cdn$23.233 per share in February 2013. The stock was now trading at $18.58, which was a 20 per cent loss. In addition to this, Canada Revenue Agency (CRA) had filed a law suit against the firm for tax avoidance, which could result in Cameco having to pay around $800 million in Canadian corporate taxes. Anderson needed to explain to the investment board the implications of the CRA lawsuit on the stock price and advise the board on whether the projected $800 million tax liability was a fair estimate. THE URANIUM INDUSTRY The demand for uranium comes mainly from power utilities that account for about 85 per cent of uranium consumption. Uranium is used as a fuel in nuclear power plants. Currently around 435 nuclear reactors are operating around the world, and the number is likely to increase. The shift towards greener energy solutions has also increased the demand for nuclear energy and is expected to further increase the demand for uranium. One important feature that differentiates the uranium market from those of other commodities is the predictability of demand. The nuclear power plants are characterized by high capital costs but relatively very low fuel costs. Once a plant is commissioned, it is optimal to run it at maximum operating capacity, irrespective of economic conditions. Therefore, the demand for uranium is a deterministic function of the number of nuclear power plants and the installed capacity. If the installed capacity increases by one GWe (gigawatt electrical), demand for uranium goes up by 150 tonnes/year plus an initial fuel load of 300 to 450

1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Cameco Corporation or any of its employees. 2 Laura Anderson is a fictitious person and Saskhedge fund is a fictitious company. 3 All currency in Canadian dollars unless specified otherwise.

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Page 2 9B14B011 tonnes. According to the World Nuclear Association 2011 Market Report, the demand for uranium is expected to increase 48 per cent over the period 2013 to 2023.4 As is the case for other commodities, cyclical patterns are observed in uranium spot prices. However, less than 20 per cent of global supply is traded in the spot market as the bulk of the produced commodity is presold directly to industrial users under long-term fixed-price contracts. These contractual prices, nevertheless, are based on the spot price prevailing at the time. The spot price is highly dependent on supply conditions and is, therefore, more volatile than the long-term prices. Exhibit 1 shows the relationship between the spot and the long-term prices over the period 1987 to 2013. Exhibit 2 shows the production of uranium by country. Canada used to be the largest producer in the world until 2008. Since then, Kazakhstan has taken over the title. The total known recoverable reserves of uranium are about 5.3 million tons (4.8 billion kilograms). Australia has the largest reserves, followed by Kazakhstan, Russia and Canada. The uranium industry consolidated in the 1990s, resulting in a few large firms controlling global supply. In 2012, eight companies were responsible for 84 per cent of global uranium supply, and Cameco was the third largest company by the volume of uranium marketed. CAMECO Cameco is one of the leading uranium producers, commanding 14 per cent of the world’s uranium production (see Exhibit 2). The company, with its head office in Saskatoon, Saskatchewan, controls approximately 65 million pounds (29 million kilograms) of proven and probable reserves. The company is a major player in providing the processing services for uranium fuel for power plants and it owns stakes in nuclear power plant operation. Cameco operates five mines in Canada, the United States and Kazakhstan. The majority of the Canadian operations are in Northern Saskatchewan, where the uranium reserves are abundant. The average grade of Uranium in Cameco’s McArthur river mine is 100 times the world average.5 Cameco was created in 1988 via a merger of Saskatchewan Mining Development Corporation and Eldorado Nuclear Limited, both of which were crown corporations. The company went public in 1991, listing on the Toronto and the Montreal stock exchanges under the ticker symbol CCO. In 1996 Cameco cross-listed on the NYSE and traded under the ticker symbol CCJ. In the same year Cameco Gold was formed as a subsidiary that operated the firm’s gold production. Over the next few years, Cameco grew by acquiring other companies in the United States and Canada. In 1999, the company entered into an agreement to purchase the natural uranium that was obtained from the dismantling of the Russian nuclear arms. Cameco has pursued a strategy of vertical integration in the nuclear industry by buying stakes in the uranium enrichment business, nuclear fuel processing industry and nuclear power generation. The company has a partnership with GE Hitachi Nuclear Energy in the area of uranium enrichment, and it owns a 24 per cent stake in Global Laser Enrichment. It has also acquired 100 per cent interest in Zircatec Precision Industries Inc., whose primary business is manufacturing fuel bundles for Candu reactors. Cameco holds a 31.6 per cent stake in Bruce Power, which operates the largest nuclear power reactor in Ontario.6

4 “Uranium Markets,” World Nuclear Association, http://world-nuclear.org/info/Nuclear-Fuel-Cycle/Uranium- Resources/Uranium-Markets/, accessed July 6, 2014 5 Cameco website, www.cameco.com/mining/mcarthur_river/, accessed July 6, 2014 6 Cameco website, www.cameco.com/about/history/, accessed July 6, 2014.

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Page 3 9B14B011 CAMECO EUROPE LTD. Cameco Europe Ltd. (CEL) is a wholly owned subsidiary of Cameco created in 1999. It is registered in Zug, Switzerland, which boasts very low corporate tax rates. The Swiss tax rate is around 10 per cent as compared to Canada’s 27 per cent average rate. Due to its proximity to European customers, CEL primarily functioned as the marketing unit of Cameco in Europe. Cameco charges CEL for the cost of the European sales, and CEL then bills its customers, although the product is shipped to the customers directly from Canada. Cameco had entered into a seventeen-year fixed price contract with CEL in 1999. As per convention, the price of the contract was fixed based on the spot price existing in 1999, which was at US$10 per pound (453.59 grams). The spot price had increased since, at one point reaching US$140 per pound (see Exhibit 1). This rise resulted in increased profits for CEL, which operates in the low tax environment of Zug, and a lower tax burden for Cameco. TRANSFER PRICING AND TAX DIFFERENTIAL IN CANADA AND SWITZERLAND Transfer pricing involves setting prices for transfer of goods and services among different divisions or subsidiaries of a firm. Multinational corporations have subsidiaries in different countries, which are subject to different tax regimes. This presents an opportunity for the multinational corporation to set transfer prices in such a way that lowers the overall tax burden of the firm. Exhibit 3 provides an example of how transfer pricing can impact the overall tax burden and hence the net income of a multinational corporation. Column ‘A’ shows the hypothetical impact of transfer pricing on the income statement of Cameco Canada. Column ‘B’ shows the impact of transfer pricing on the income statement of Cameco Europe, and column ‘C’ shows the impact on Cameco’s consolidated income statement. Two scenarios are illustrated. Scenario I represents a case in which Cameco Canada charges a high transfer price, while Scenario II is a case of a low transfer price. As the tax rate in Canada (27 per cent) is significantly higher than that of Switzerland (10 per cent), the second scenario, with the lower transfer price, results in a lower overall tax burden and hence higher consolidated net income. In scenario one, Cameco pays the tax amount of $94,500 to the Government of Canada whereas in the second scenario, the company owes no taxes in Canada. ALLEGATIONS OF TAX EVASION BY THE CANADIAN REVENUE AGENCY During the annual audit in 2008, CRA identified issues with the transfer pricing approach employed by Cameco to set the price of uranium sold to its Swiss subsidiary. Based on this finding, CRA reassessed Cameco’s earnings and the amount of tax payable for the years 2003 through 2007. The income for the years 2003 through 2007 was revised upwards respectively by $43 million, $108 million, $197 million, $243 million, and $708 million. The company had to make cash payment of $27 million to cover for its increased tax liability for 2007 (2012 Cameco consolidated financial statements, accessed from SEDAR on July 6, 2014).7

7 Cameco used its existing tax pool (accumulated tax credits from previous years) to cover the additional tax assessed for the years 2003 through 2006. Veritas Investment Research Corporation, Accounting Alert, April 2, 2013.

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Page 4 9B14B011 Cameco is contesting CRA’s decision; however, Cameco’s management has made a provision of $63 million for the period of 2003 through 2012.8 Market analysts estimate that if CRA wins the case, the additional tax liability for the years 2008 through 2012 could be around $800 million.9 Exhibit 4 presents Cameco’s consolidated income statements for the years 2003 through 2013. CONCLUSION As Anderson studied the Cameco transfer pricing issue in more detail, it was not clear to her whether CRA’s allegations were correct. If they were, it would be difficult to understand how the questionable practice could have gone on for so long, in spite of all the regulations and reporting requirements. Who would be responsible in that case? Is it Cameco’s management, just the board, or should the responsibility be extended to the regulatory authorities as well? Where did the problem lie, and how could it be prevented in the future? Like all other stakeholders, Anderson needed answers to these important questions.

8 Cameco consolidated financial statements, accessed July 6, 2014. 9 Canadian Broadcasting Corporation, September 19, 2013, www.cbc.ca/news/canada/saskatchewan/ottawa-accuses- cameco-of-multi-million-dollar-tax-dodge-1.1860079, accessed July 6, 2014.

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Page 5 9B14B011

EXHIBIT 1: URANIUM SPOT AND LONG TERM PRICES

Note: Euratom long-term price is the average price of uranium delivered into the EU that year under long term contracts. It is not the price at which long-term contracts are being written in that year. Printed with permission from World Nuclear Association, http://world-nuclear.org/info/Nuclear-Fuel-Cycle/Uranium- Resources/Uranium-Markets/, accessed July 6, 2014.

Ux spot price

Euratom long-term price

Ux long term price

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Page 6 9B14B011

EXHIBIT 2: URANIUM GLOBAL PRODUCTION

Panel A: Mine Production (tonnes Uranium) Country 2005 2006 2007 2008 2009 2010 2011 2012

Kazakhstan 4,357 5,279 6,637 8,521 14,020 17,803 19,451 21,317 Canada 11,628 9,862 9,476 9,000 10,173 9,783 9,145 8,999 Australia 9,516 7,593 8,611 8,430 7,982 5,900 5,983 6,991 Niger (est) 3,093 3,434 3,153 3,032 3,243 4,198 4,351 4,667 Namibia 3,147 3,067 2,879 4,366 4,626 4,496 3,258 4,495 Russia 3,431 3,262 3,413 3,521 3,564 3,562 2,993 2,872 Uzbekistan 2,300 2,260 2,320 2,338 2,429 2,400 2,500 2,400 USA 1,039 1,672 1,654 1,430 1,453 1,660 1,537 1,596 China (est) 750 750 712 769 750 827 885 1,500 Malawi 104 670 846 1,101 Ukraine (est) 800 800 846 800 840 850 890 960 South Africa 674 534 539 655 563 583 582 465 India (est) 230 177 270 271 290 400 400 385 Brazil 110 190 299 330 345 148 265 231 Czech Republic 408 359 306 263 258 254 229 228 Romania (est) 90 90 77 77 75 77 77 90 Germany 94 65 41 0 0 8 51 50 Pakistan (est) 45 45 45 45 50 45 45 45 France 7 5 4 5 8 7 6 3 total world 41,719 39,444 41,282 43,853 50,773 53,671 53,494 58,394 tonnes U3O8 49,199 46,516 48,683 51,611 59,875 63,295 63,084 68,864 percentage of world demand* 65% 63% 64% 68% 78% 78% 85% 86%

Panel B: Known Reserves Panel C: Production by Company

tonnes Uranium percentage of world Australia 1,661,000 31% Kazakhstan 629,000 12% Russia 487,200 9% Canada 468,700 9% Niger 421,000 8% South Africa 279,100 5% Brazil 276,700 5% Namibia 261,000 5% USA 207,400 4% China 166,100 3% Ukraine 119,600 2% Uzbekistan 96,200 2% Mongolia 55,700 1% Jordan 33,800 1% other 164,000 3% World total 5,327,200

Company tonnes Uranium % KazAtomProm 8,863 15 Areva 8,641 15 Cameco 8,437 14 ARMZ - Uranium One 7,629 13 Rio Tinto 5,435 9 BHP Billiton 3,386 6 Paladin 3,056 5 Navoi 2,400 4 Other 10,548 18 Total 58,394 100%

Printed with Permission from World Nuclear Association website, July 2013, http://world-nuclear.org/, accessed July 6, 2014.

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Page 7 9B14B011

EXHIBIT 3: TRANSFER PRICING EXAMPLE

Source: Case writers

A

Cameco Canada B

Cameco Europe C

Consolidated

1000 of Cdn$ 1000 of Cdn$ 1000 of Cdn$ Scenario I: High transfer prices Sales 1,000.0 1,500.0 1,500.0 COGS 500.0 1000.0 500.0 Gross Profit 500.0 500.0 1,000.0 Operating and General Expenses 150.0 100.0 250.0 Income before Taxes 350.0 400.0 750.0 Tax 27% 94.5 10% 40.0 134.5 Net Income 255.5 360.0 615.5

Scenario II: Low Transfer prices Sales 650.0 1,500.0 1,500.0 COGS 500.0 650.0 500.0 Gross Profit 150.0 850.0 1,000.0 Operating and General Expenses 150.0 100.0 250.0 Income before Taxes 0.0 750.0 750.0 Tax 27% 0.0 10% 75.0 75.0 Net Income 0.0 675.0 675.0

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Page 8 9B14B011

EXHIBIT 4: CAMECO CONSOLIDATED STATEMENTS OF EARNINGS (for the years ended December 31)

($Cdn thousands, except per share amounts) 2013 2012 2011 2010 2009 2008 Revenue from products and services $ 2,438,723 $ 1,890,660 $ 2,384,404 $ 2,123,655 $ 2,314,985 $ 2,182,553 Cost of products and services sold 1,549,238 1,133,263 1,333,449 1,113,963 1,324,278 1,146,462 Depreciation and amortization 282,756 217,381 274,663 238,308 240,643 207,453 Cost of sales 1,831,994 1,350,644 1,608,112 1,352,271 1,564,921 1,353,915 Gross profit 606,729 540,016 776,292 771,384 750,064 828,638 Administration 184,976 180,900 157,487 154,698 135,558 86,392 Impairment charges 70,159 168,000 0 Exploration 72,833 97,260 84,875 95,796 49,061 53,224 Research and development 7,302 9,301 4,514 4,794 630 4,998 Cigar Lake remediation 16,633 17,884 11,369 Loss (gain) on sale of assets 6,766 (1,660) 7,602 107 (566) 202,651 Earnings from operations 264,693 86,215 521,814 499,356 547,497 470,004 Finance costs (62,121) (67,654) (73,668) (86,179) Interest and other 12,470 (93,281) Gains (losses) on derivatives (61,970) 41,416 (4,417) 75,183 243,804 4,097 Finance income 6,967 13,934 24,547 20,894 Share of earnings from BPLP 109,553 157,846 Share of loss from equity-accounted investees (10,867) (5,896) (7,233) (4,176) Earnings from discontinued operations 382,425 83,968 Other income (expenses) (18,326) (24,746) 556 4,388 (36,912) (39,273) Earnings before income taxes 227,929 201,115 461,599 509,466 1,149,284 425,515 Income tax expense (recovery) (89,758) (50,641) 11,755 3,427 52,897 (24,357) Minority interest (3,035) (245) Net earnings $ 317,687 $ 251,756 $ 449,844 $ 506,039 $ 1,099,422 $ 450,117 Earnings per common share $ 0.81 $ 0.64 $ 1.14 $ 1.31 $ 2.83 $ 1.29

Source: SEDAR - Company files

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