Flaws in accounting rules

The international accounting brains trust scored another victory over common sense yesterday when Djerriwarrh Investments booked a post-tax loss of almost $50 million on so-called impaired investments in some of Australia's top companies, pushing its formal result into the red.

Djerriwarrh is a listed, long-term investor in top-50 ASX-listed companies that supplements dividend income and share sale profits by writing options against a portion of its shares, call options primarily.

It was founded by JB Were two decades ago and, in keeping with its parentage, is conservatively run: its management fees are low, its investment palette is restricted to the biggest companies that offer exchange-traded options, and its policy is to stream the bulk of its earnings straight out to investors, in the form of fully franked dividends.

And it actually posted solid numbers in a tough year to June 30. Here's the result, scrubbed of the accounting interference.

Net operating profit rose by 21.1 per cent, from $45.6 million to $55.2 million. That's excluding capital gains and losses on the sale of shares and it partly reflects the tendency for dividend cuts to trail a market downturn, as companies try to keep investors happy by maintaining dividends even as earnings fall, and as dividend payments, as usual, lag dividend declarations.

The slide in dividend income that is accompanying the downturn will be most noticeable to investors in this current December half, when dividends recently declared and ones declared in next month's June 30 profit season are actually paid.

The banks are a big slice of most portfolios, and accounted for 28.9 per cent of Djerriwarrh's portfolio by value at June 30, up from 22.9 per cent a year earlier. But Commonwealth Bank runs to a June 30 balance date and its first dividend cut is expected to be announced with its result in the second week of August. NAB, Westpac and ANZ balance on September 30. They announced dividend cuts in their March 31 interim profit statements, but mailed the cheques at the beginning of this month, after the June 30 year had closed.

The market slump was evident in a 23.9 per cent slide in the value of Djerriwarrh's share portfolio during the year, from $959.4 million to $730.2 million. Cash holdings jumped from negligible levels to almost $58 million, and net assets declined by 15.9 per cent, slightly better than the general market, which sank by 20.1 per cent.

There were net losses of $35 million on shares sold out of the portfolio during the year compared with a gain of almost $30 million in 2007-08, but that partly reflected a cull of laggards. The options trading strategy delivered an offsetting net gain of $10.5 million, and a pre-tax gain of $23.3 million, up from $19.8 million in 2007-08. Djerriwarrh had ratcheted up the number of call options it wrote during the year as it saw dividend income begin to weaken, and it also benefited from high share-price volatility as uncertainty ruled and the market gyrated.

Those are the basic elements of the profits Djerriwarrh reports year in and year out: dividend income, income from its options writing overlay, and net gains or losses from the sale of shares, often into takeovers - Westpac's offer for St George for example in the latest year.

But this year Djerriwarrh has also reported a pre-tax "impairment" charge of $70.9 million, and a net charge of $49.7 million, pushing its total loss to $14.1 million.

The charge against earnings is the work of International Accounting Standard 39 and its local equivalent, AASB 139. They force companies to assess whether share investments have triggered "loss events", then to declare such investments to be impaired, and to take the "impairment loss" straight into their profit and loss statements.

Shares in Djerriwarrh's portfolio qualified for the charge at June 30 if they were either 30 per cent or more below their purchase cost, or below their purchase price for 15 months. They were, in other words, the sort of investments that in this downturn stud investment portfolios like stars in the Milky Way - shares in companies that aren't even remotely close to going broke, but have been hammered lower as part of the biggest sharemarket rout in living memory.

In Djerriwarrh's case, the impairment list includes AMP, Brambles and Insurance Australia Group. And to make matters worse, as share prices recover, impairment charges already taken against earnings cannot be reversed. Any gains in future will need to be taken into the balance sheet as an adjustment to reserves, bypassing the profit and loss statement.

Does the current rule make sense? Of course not, and the international accounting gurus, recognising this, are rushing through an amendment to IAS 39 and its Australian equivalent.

Expected to be in in time for the December 31 rule-off this year, it will allow long-term share investment companies like Djerriwarrh and its stablemate, Australian Foundation Investment Co, to book changes in the value of their shares against balance sheet reserves.

But if they elect to do so, the decision will be irrevocable, and all dividends and any other gains or losses that their shares generate will also have to be booked into the balance sheet, as a change in reserves.

It would seem, in other words, that after the amendment, investment companies will be able to avoid gutting their profit and loss statements with misleading impairment charges. But if they do so, they will no longer be able to report dividend income as what it is - income. Whether that's a solution or just another international accounting version of unreality is open to question

- © Fairfax NZ News