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Equity accounting: fair value or fairy tales?

By Shoeshine

Friday 12th September 2003

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No big firm accountant who lived through the corporate scandals typified by Enron is likely to remember the period fondly. The memory of Arthur Andersen's vapourisation strikes fear into even the stoutest beancounting heart and overseas the episode had saddled the industry with swathes of new legislation and regulation.

Nonetheless, in the acrimonious behind-the-scenes conflict between the profession and its critics, Enron might actually have been a help.

Enronitis, Andersen notwithstanding, has tilted the balance of power towards the accountancy "hawks" and away from the businessmen and investment bankers who argue accounting standards increasingly fail to reflect economic reality.

One hotly debated item is financial reporting standard (FRS) 38, which requires a company with "significant influence" over another company to equity-account the investee companies' profits and losses ­ that is, take its share of the profits and losses through its own earnings account as though actual money had changed hands.

High-profile critics such as Warren Buffett and Sir Ron Brierley insist this is foolishness that distorts true earnings and artificially pumps up asset values on companies' balance sheets.

Sir Ron's Guinness Peat Group, he argues in the last annual report, receives dividends from the companies in which it holds shares on exactly the same basis as the smallest private shareholder.

"The inclusion of additional amounts to which there is no legal or commercial entitlement is simply reporting bogus income," he thunders.

"This course is not adopted by choice but is forced upon us by so-called 'international accounting standards' of which 'equity accounting' is but one of many serious deficiencies."

Shoeshine's beancounting buddies think Sir Ron's outrage is a tad disingenuous.

"Ron doesn't invest hundreds of millions just to earn dividends," one remarked. "He's going to make sure he's in a much better position to influence operating earnings and dividend payments than any small shareholder."

Sir Ron's views add spice to the saga of GPG, Fletcher Challenge Forests and Rubicon. GPG has 19.9% of Rubicon and two seats on the nine-strong board. It has made it plain it is not at all enamoured with the way the company is run.

One sore point for GPG's New Zealand director Tony Gibbs was the change of accounting policy which saw Rubicon start equity-accounting its 19.9% Fletcher Forests stake. Last year this saw Rubicon book $17.5 million of equity-accounted profits from its Fletcher holding, without which it would have reported a loss.

Gibbs reckoned this was nothing more than a "profit grab," even though the policy change had the blessing of, and might even have been required by, auditor KPMG.

The change followed a move by Rubicon from 17.6% to 19.9% but that should not have been the deciding factor. GPG doesn't have to equity account its Rubicon holding because it manifestly doesn't have "significant influence."

The decision to equity account was more likely made because, with two seats on a seven-man board, Rubicon was deemed to have significant influence.

FRS38 is a "substance not form" standard and there are no hard-and-fast rules for auditors to follow. Quite why a minority two out of seven seats deserves different treatment from a minority two out of nine is something only KPMG in its infinite wisdom knows.

If Gibbs feels Rubicon's accounting policy change was a cynical profit grab, this year's turn of events must be affording him some grim satisfaction.

The company will have to equity account its shares of the whopping loss Fletcher Forests will report today as a result of the writedown of the value of its forests.

The size of the writedown wasn't known as Shoeshine went to print. If as analysts suspect it's in the order of $245 million, and Fletcher meets its earnings guidance of $58 million, the loss will be $187 million. Rubicon's share of this will be $37.2 million, a fortunate figure, as it happens.

Rubicon and Fletcher have been a marvellous illustration of the asset inflation FRS38's critics complain of.

At the end of the 2002 year the value of the Fletcher stake was shown on Rubicon's books at $154.5 million. In 2003 the directors downgraded the shares' "fair value" by $21.6 million to $132.9 million. But the extra shares bought during the year, and the addition of $17.5 million of equity-accounted earnings, took the value of the stake to $164.8 million, or $1.48 a share, at the March 31 balance date.

As the shares were trading on-market at $1.12 earlier this week, the value of the holding on Rubicon's books exceeded its market value by $39.9 million.

So a $37.2 million equity-accounted writedown will put the holding's book value back pretty much square with the market, for now at least.

But you don't have to be a financial Einstein to see that adding to your balance sheet, year after year, amounts notionally "earned" but for which no cash changed hands could put your published accounts way out of line with economic reality.

Sophisticated investors pay not the slightest attention, of course. An asset is worth no more than the income stream it produces, no matter what the balance sheet says.

But accounting rules are supposed to ensure mum and dad investors get the fair and true picture. Will they know the difference?

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