What is Fair? Golden Agri-Resource Ltd

It is the “Annual Report” season again. Yes, I have been getting Annual Reports in recent times (either in hard-copy or CD).

I haven’t found the time to really dig into all of them.

I have a habit of reading the annual reports of those companies which are not doing well for the past year. I am always intrigued by the creative writing by some management in trying to justify for the poor performance. However, as much as I like to read the front portion (Statement by the Chairman or CEO), I often skip that and go straight into the figures at the back.

Recently, I looked through the 2015 Annual Report of Golden Agri-Resource Ltd. After all, Golden Agri, to me, isn’t one of my better performing stocks, even though the recent quarters’ earnings have been improving.

The odd one out (Golden Agri) – read here

I looked through the Chairman’s Statement, Financial Highlights, Operations Review, Financial Review etc…. In one particular section in the Financial Review, I saw the following (see image below):

Ok, I have read about the phrase “fair value” way back in 2011 (and maybe earlier) after I invested in Golden Agri stocks.

First time I read about it was in the Value Buddies forum – read here. In the forum post, it appears that Golden Agri is using the Fair Value gain to inflate its profit. Well for those not sure what Fair Value is, there are quite a number of articles online explaining it:

On fair value and biological assets (read here)
Accounting for Agricultural Assets: to Fair Value or Not to Fair Value (read here)
Fair Value and Biological Assets (read here)
Putting a value on biological assets an area of judgement (read here)

I have not studied Accountancy, but to put it in very simple terms (using the 1st article above):

“A simple example to illustrate this issue is assuming a company bought a piece of land at $100 million a few years ago, and the fair value of the land today is $150 million. The issue is whether the land should be reported in the company’s balance sheet today at $100 million (historical cost) or at $150 million (fair value). There are pros and cons. The historical cost of $100 million is a reliable measure but may not be relevant to investors’ decision-making, whereas the fair value of $150 million is relevant to investors’decision-making but may not be reliable.”

Ok, back to the article in the Golden Agri annual report, it mentioned: “historical cost less accumulated depreciation“. So what is that? Read here and here.

“For example, if Sunny purchased an asset for $5,000 and estimated depreciation expense of $500 per year for 10 years, the cost of the asset after the first year less depreciation is $4,500. If the market value of the asset were $4,800 after year one in the open market, Sunny would not write up the asset after the first year. Rather, the asset would remain at original cost less any depreciation until the asset is sold.”

Nevertheless, this post is not a post about the definition of Fair Value or Historical value. Nor is this post an argument on which method is better.

The historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However, the historical price is not necessarily relevant information. For instance, land that was purchased 20 years ago could be worth much more than the balance sheet shows.

For this reason, many accountants and users of financial statements argue that the market price, or fair value should be used when reporting financial information. The fair value is more relevant, but is not necessarily reliable. Selling the same item at different auctions will lead to a wide range of winning bids for the same item, and even professional appraisers will value an asset at a range of prices instead of a set value.

Assets

I can see the merit in using Fair Value when the market / economic sentiments are generally good and the price of the asset / commodities are inflated (for extended period). For example when the economy is good, generally speaking, commodities would be in demand and property prices should be in an uptrend. So if we draw a chart showing the Historical cost less accumulated depreciation vs Fair Value, we should see something like this (see below).

For extended period (of the good times), the Fair Value is higher than the historical cost less accumulated depreciation. People / consumers are generally willing to pay more than the actual ‘cost’. In the earning reports, the fair value gain will add significantly to the overall profit (much earlier than the profit is actually realised) – of course the flip side is that investors would expect more dividend with the ‘better profit’ reported.

Golden Agri-Resources achieves record earnings in 2010 (read here)

Extract from the article above:

Net profit attributable to owners of the Company (increase 134%), and this include “Net gain from changes in fair value of biological assets (increase 149%)”.
Net profit for FY 2010 is USD 1.42 billion, of which Net gain from changes in fair value of biological assets contributed USD 1.01 billion.

Of course there are exceptions, especially if we are talking about non-commodity type of items. For instance, if we are talking about typical run of the mill Japanese model cars (commodity), the historical cost less accumulated depreciation is generally straight forward. But if we are talking about a limited edition, rare Maserati previously owned by a famous actor (strong companies with a very strong moat eg. brand / patent etc), the historical cost less accumulated depreciation is less straight forward. Even in bad times, the ‘fair’ value might take the form of the red dash line above (eg. people will still be willing to fork out excess cash above its ‘cost’ to buy it).

Likewise a diamond in a Tiffany Blue Box would cost a premium over a similar diamond from most other retailers. However, since we are talking about Palm Oil stocks (whereby in general, most companies are price takers / No one company controls palm oil prices) – this exception would not be applicable. A bottle of Palm Oil from Golden Agri would not differ much from a bottle of Palm Oil from First Resource or Wilmar to most people / clients.

3 Things Investors Should Know About The Palm Oil Industry From Golden Agri-Resources Ltd’s Annual Report (read here)

On the flip side, I can see the merit in using historical cost less accumulated depreciation when the market / economic sentiments are generally depressed and the price of the asset / commodities are below their historical prices (for extended period).

In bad times, the actual selling price of the product may drop below the value of historical cost less accumulated depreciation (such is the nature of cyclical commodities). And the drop can be significant.

In FY 2015, the Core Net profit is USD 221.4 million. While the Net loss from changes in fair value of biological assets is USD 197.6 million! Proportionally that is a lot. That is a huge chunk out of the eventual net profit attributed to the owners of the company. (See below)

Like I mentioned earlier, this post is not about the pros and cons of using Fair Value or the historical cost less accumulated depreciation (in calculating the eventual profits). A lot has been written about this online. Each got its merits and flaws.

However, if you ask me, I would much rather that the company stick to historical cost less accumulated depreciation. Especially for a company with such a huge asset base like Golden Agri, I doubt that fair value could be reliably determined… with the typical accounting manpower.

Nevertheless, what I am particularly concerned about is the flipping of the different methodology at different times (esp. when prices of the commodities are inflated for extended period and when prices of the commodities are depressed for extended period).

Guess in this case, it is removing the obvious loss of fair value change when palm oil prices are depressed (and just tell you the eventual loss at a later date – assuming the fair value is accurately quantified in the first place).

It is just a manipulation of the earnings at the particular time of reporting. Just give me the worse case scenario as soon as possible…instead of sugar coating it till the last minute. Just Keep It Super Simple (KISS) and keep the methodology consistent.