AASB 1037 Accounting for Self-Generating and Regenerating Assets (SGARAs)

25 May 1999

Sir Bryan Carsberg
Secretary General
International Accounting Standards Committee
166 Fleet Street
London EC4A 2DY
United Kingdom

Dear Sir Bryan

Agriculture

As you will be aware The Australian Accounting Standards Boards issued an Accounting Standard AASB 1037/AAS 35 "Self-Generating and Regenerating Assets" in August 1998 operative for reporting periods ending on or before 30 June 2000. This Standard was issued in advance of the development of an IASC standard. I am informed that the IASC proposes to finalise an exposure draft that will propose similar requirements at its meeting in June 1999. The Group of 100 believes that the experience of its members in preparing for the implementation of AASB 1037/AAS 35 may provide valuable input to the IASC’s consideration of an exposure draft. The Australian Boards have recently deferred the operative date of AASB 1037/AAS 35 in response to the implementation and systems difficulties in complying with the requirements of the Standard.

In our submissions to the Australian Boards, the Group of 100 expressed concerns that because of the uncertainties, difficulties and diversity in implementation on key issues it was unlikely that the key objectives of AASB 1037/AAS 35 to provide relevant, reliable and comparable information would be achieved. The Group of 100 considered that additional work dealing with practical implementation issues was necessary and that this work could be undertaken in conjunction with industry participants and industry bodies. We are of the view that agreement and guidance achieved in this way would help ensure that the application of the Standard would result in the provision of comparable and reliable information on a consistent basis and achieve its objectives. We believe that these concerns are also relevant to the IASC’s discussions and unless addressed by the IASC similar issues will arise on the implementation of any standard.

Our members have raised issues relating to the lack of implementation guidance on dealing with process of measuring agricultural assets at their net market values and appropriate transitional provisions.

Determining Net Market Values

A number of issues arise in determining the net market values of agricultural assets, particularly where net present value techniques need to be applied because an active market rarely exists. In the absence of appropriate guidance diverse practice is likely to result because of different interpretations with respect to the choice of a discount rate and the process for allocating values to different assets. Examples of these problems arising in respect of forestry operations and vineyards are set out in detail in our submission to the Australian Accounting Standards Board dated 4 May 1999 (refer attachment). These implementation problems include:

(a) Selection of the discount rate.

Substantial practical difficulties arise in respect of the choice of an appropriate discount rate. For example, these include:

determining what is the most appropriate rate of return and whether this is adjusted on an annual basis to take account of changes in the expectations of investors or movements in bond rates (ie if the bond rate moves from year to year is this taken into account in determining the net market value of plantations);
applying present value methodology inevitably results in a negative net present value of newly planted areas (ie for early years plantations may not meet the return criteria). This gives rise to a further implementation problem of whether different hurdle rates should be used for young plantations (1-3 years) than that used for mature plantations;
whether the discount rate should be different where the entity has forests or plantations on leasehold land as distinct from freehold land and whether, in these cases, comparability is enhanced if estimated cash flows include an allowance for holding costs of freehold forest land; and
whether the NMV should be determined for each coop or whether it should be determined on an aggregate basis. The level of aggregation adopted will have a significant impact on the value of the assets recognised in the financial reports. For example, the discount rate used if coops are valued separately will be significantly higher than the discount rate that would be used if plantations are valued on a portfolio basis.

(b) Determining the net market value (NMV) of vines.

The relationship between vines and the land that they occupy is unique and integrated. The vine itself has little value. However, in conjunction with the land and other vineyard infrastructure the vines do have value. One methodology of determining the value of vines is to determine the aggregate value of a vineyard and to determine the value of vines as a residual in the valuation process. Under this methodology the value of the vines is calculated by deducting current unimproved value of the land, trellis, irrigation, water licences and other vine related infrastructure at each reporting date from the NMV.

In these cases because the valuation of the vines is a residual, and because of estimates and subjectivity the valuation of the vines is open to substantial variability and manipulation the comparability and reliability of the information in financial reports is not assured. Different assumptions used in this computation could result in significant variations between the valuations by companies for similar assets planted in the same area. This concern is exacerbated by the requirement to recognise movements in the NMV of the asset in the periodic profit and loss.

The Group of 100 and its members who have experience in attempting to implement the Australian Standard believe that the IASC in developing an exposure draft on agriculture should be mindful that detailed implementation guidance is essential if the information included in financial reports is to be reliable and comparable.

Transitional Provisions

Our members are particularly concerned about the transitional provisions of an accounting standard on agriculture. The Australian Standards require the transitional adjustment to recognise agricultural assets at net market values to be recognised in the opening balance of retained earnings. This adjustment has the effect of "locking-up" revenues in retained earnings that will never be recognised in the operating profit of the entity and, as such, not reported in measures of earnings per share. This is a major concern of our members engaged in these activities, particularly those having forestry operations, and we believe that it is incumbent on the IASC to consider transitional provisions that do not penalise companies to which the standard applies.

We believe that the objective of transitional provisions in new accounting standards is to:

assist with mitigating, rather than exacerbating, any economic and other impacts associated with implementing a new standard; and

ensure that the reporting of financial performance in the current period’s profit and loss statement is not distorted by initial adjustment to balance sheet amounts.

Presently, most entities within the forestry industry recognise profit on a historical cost/realisation basis, whereby revenues and related historical cost based expenses are recognised mainly at the point of sale of the forest product. That is, most forestry operations currently recognise a profit on the sale of timber or timber-related products at the point of sale, the profit being the difference between the sale price and the historical cost of the forest product.

However, AASB 1037/AAS 35 changes, and the IASC proposals will change, the basis upon which profits are recognised in the forestry industry, from a historical cost/realisation basis to a "mark-to-market" approach. Under this approach, an entity involved in forestry operations will measure and recognise the total net market value (NMV) of its forest asset in the balance sheet and will recognise profit on the basis of changes in the value of that asset (which will arise from changes in the volume of the forestry asset controlled and price changes).

This approach changes the accounting paradigm applying to agricultural assets. The switch from the conventional accounting profit recognition paradigm to the new (market value) paradigm will result in an anomalous treatment of the latent revenues and expenses embodied in the opening (revised) balance of the forestry asset in the first period in which the Standard is required to be applied. The anomaly results from ‘locking-up’ the difference between the acquisition (historical) cost and the current NMV (net of tax), in retained earnings. As such, these future revenues will never be recognised in the profit and loss statement. Put another way:

if the mark-to-market approach had always been applied, the revenues and costs would have been progressively recognised as the forest asset grew and its NMV increased. Under this approach by the time the forest product is sold, the difference between its historical cost and its NMV at the point of sale would have been recognised as profit in the profit and loss statement;

where the historical cost approach is applied, the difference between the historical cost of the forest product and its NMV at the point of sale would be recognised as profit in the profit and loss statement; but

in moving from the historical cost approach to the mark-to-market approach, while the revenues and costs relating to forestry assets grown and/or acquired after the operative date of the Standard will be progressively recognised as those assets grow and their NMV increases, the latent profit embedded in forestry assets controlled when the standard is first applied will be transferred to retained earnings. As such, it will never be recognised in the profit and loss statement. This is an odd outcome given that the forestry assets are acquired and/or grown with the objective of making a profit.

This ‘lock-up’ of profit is inequitable because it disadvantages the industry on adoption of the Standard. Transitional provisions which require adjustments to opening retained earnings will, in these circumstances, have a considerable negative impact on the reporting of operating results and the reported financial performance of forestry entities over an extended period.

Directors of companies which control forestry assets are concerned that the potential market consequences of this distortion of the reporting of performance will include a misunderstanding by financial report users (including shareholders, analysts, rating agencies and lenders) of the performance of forestry businesses and a consequent mispricing of securities and debt for entities which control forestry assets. The Group of 100 does not believe that, in this circumstance, disclosure or display alternatives would overcome the fundamental deficiency in the reporting of performance which would be caused by transitional provisions of this type.

Whilst the ‘lock up’ problem will particularly affect the forestry industry, it will also have an impact on other agricultural activities such as livestock.

Yours sincerely,

Bryce JH Denison
National President

c.c. Mr Ken Spencer, Chairman, Australian Accounting Standards Board
Mr Ian Hammond, Member, IASC Board