Accounting rules muddy the waters
Opinion & Analysis
OPINION: Henceforth charter schools, if any are created, will be called partnership schools. The name change was announced by ministers Hekia Parata and John Banks on Thursday in an effort, Chalkie reckons, to alter at least one side of the equation: charter schools = lousy idea.
Who knows, it may even work. A bit of rebranding worked for Norma Baker, David Jones and the town of Pile o Bones, Saskatchewan.
That sort of thing is fine for aspiring actors and one-horse towns on the prairie, but there are times when names really shouldn't be messed with - when compiling company accounts, for example.
Imagine what a pickle we could get into if we started calling a liability an asset. Why, the whole balance sheet could look quite different. A company's financial strength could appear better than it really was. People could buy or sell shares with a mistaken impression of value. It would be an investor's nightmare.
Regrettably, this is not as far- fetched as it sounds. Indeed, it is not far-fetched at all.
Chalkie will illustrate the point with an example involving listed company PGG Wrightson and its Cayman Islands-registered, New York Stock Exchange-listed Chinese investor Agria Corporation.
In 2009, PGW was going through a bad patch, requiring a waiver of debt covenants and a raising of capital. As well as a share placement to Agria and a rights issue to shareholders, giving Agria a 19 per cent stake, the capital raising also involved Agria subscribing for $33.8 million of $1 convertible redeemable notes, or CRNs. The notes were issued in January 2010.
Although PGW's dire position meant dividends were out of the question, the CRNs paid 8 per cent interest.
The notes had no maturity date and were redeemable into cash or convertible into PGW shares - at the ratio of 2.1 shares per note - only at the discretion of PGW.
In addition, the interest paid would change in future years: in 2012 it would become the two-year swap rate plus 5.5 percentage points; in 2014 it would become the two-year swap rate plus 6.5 per cent.
With two-year swaps at the time of more than 4 per cent, this meant the rate was almost certain to rise the longer Agria held the notes.
PGW did have discretion to stop paying the interest, but doing so would mean the interest simply piled up. Until it started paying again, PGW was not permitted to pay any dividends.
So here's the question. Do you think PGW owed $33.8m, plus interest, to the owner of the CRNs, Agria?
Before you mull too hard over that one, Chalkie will give you the official answer, according to PGW and its auditor, which was no, it did not.
The CRNs were classified by PGW as equity. This meant the $33.8m, less some costs, was added to the company's net equity value.
So in effect, classifying the CRNs as equity meant PGW was worth, on paper, about $31m more than if they had been classified as debt.
The classification has other effects we'll come back to shortly, but let's consider what difference it could have made for investors.
Investors keep an eye on many things when trading shares. One is a company's underlying value.
An advanced exponent of value investing, such as Warren Buffett, will try to buy shares for less than the underlying value, the difference between the two numbers being called the "margin of safety".
Of course, figuring out the underlying value is not easy, nor is finding shares that trade at a discount - that's what makes Buffett special. A good place to start, however, is a measure known as net tangible assets, or NTA.
NTA can be thought of as a company's total assets, minus its liabilities and intangible assets such as goodwill or brands.
As of June 2010, after the capital raising and issue of CRNs, PGW calculated its NTA at 38c a share. A year later it was 35c a share.
An investor with an eye to underlying value might therefore see PGW's share price shrinking towards its NTA in the second half of 2011 and think it could be worth a go. In August last year, when the results were announced, PGW shares were trading around 45c, but they kept falling and by November were about 35c.
What if the CRNs were debt?
Chalkie calculates that adding $31m to PGW's liabilities would reduce its NTA by about 4c a share.
That's a difference of about 11 per cent and could easily affect an investor's view of underlying value.
But what does it matter - the CRNs were equity, weren't they?
Yes, or should that be no. Last December PGW decided to redeem the CRNs and told the stock exchange "refinancing of this more costly subordinated debt with bank debt results in an interest saving to PGW".
So after classifying them for two years as equity, PGW changed its tune and said the CRNs were "costly subordinated debt".
The $33.8m of equity suddenly turned into $33.8m of bank debt through the refinancing, with an effect on NTA as discussed above.
When Chalkie asked PGW to clarify whether the CRNs were equity or costly debt, he was told the debt reference in December was "accidental" and "not intentionally misleading".
No doubt that is the case, but Chalkie reckons many a true word is spoken by accident.
Technically, the CRNs were classed as equity because PGW said it "may elect at its sole discretion to suspend payment of any interest at any time". Maybe so, but Chalkie reckons the discretion was barely there given shareholders could whistle for future dividends if the interest was unpaid.
The trouble is that modern accounting standards give companies a great deal of leeway over how to classify hybrid securities like these CRNs.
Classifying the CRNs as equity meant the interest was treated as a dividend instead of being an expense, so the reported profit for the year to June last year, for example, was $2.8m more than it would otherwise be.
The episode sadly reinforces the pitfalls for investors in our sharemarket. These days, accounting standards are so complex that a keen private investor needs the instincts of a predator, the suspicion of a police officer and the analytical skills of Sherlock Holmes.
Companies have a strong interest in ensuring private investors know they are not mere cannon fodder in someone else's campaign. Slipperiness with names may be fine for politicians selling a policy, but it's no good for the capital markets.
Chalkie is written by Fairfax Business Bureau's Tim Hunter.
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