Rio Tinto recently announced a massive write down of $11 Billion of its aluminum producing assets. I’ve written about asset write downs before related to RIM’s (oops, Blackberry’s) inventory, BHP Billiton’s oil and gas assets, and Talisman’s gas assets. They all have one thing in common – someone paid too much for some assets and has to eat crow and admit that those assets are now worth substantially less. I will point out that at the time they bought those assets they had reason to suspect that they were getting a real deal, in fact the purchasers thought it was a bargain. Only after the fact, as new information came to light or commodity prices fell or consumer interests changed, did the overvaluation come to light. We all do something similar – just look in your closet and find your (literal or metaphorical) red cowboy boots. They seemed like a good idea at the time but then reality (and fashion) stepped in and there they sit, unused, collecting dust.
Those three asset write downs I have previously blogged about and the Rio Tinto situation are similar to those red cowboy boots. At the time you had great reasons to justify their purchase so you paid whatever price they were asking, in Rio Tinto’s case they paid $38 Billion for Alcan, a company focused on producing aluminum. In late 2007 when aluminum was trading for$2,640/ton and certain Rio Tinto executives were certain that the price of aluminum could only increase, they felt paying $38 Billion to increase their stake in the aluminum market made sense. It’s worth looking at the 2007 financial statements since this purchase shows up very clearly in Rio Tinto’s statement of cash flows as an investing activity (purchase of long term assets including subsidiary companies) [in particular look at page 48, note 41 for the full valuation details].
Unfortunately for Rio Tinto, the price of aluminum has not increased as they expected and in fact has decreased by 12%.
IAS 36, the impairment standard for IFRS, requires that an asset write down occur when the assets cost ($38 Billion) exceeds both of the value-in-use (the revenue less costs from using the asset) and a reasonable amount if the asset was sold to another party. Value-in-use is fairly easy to calculate (see another of my projects) for mining companies and no surprise, as the commodity price falls with no reasonable increase in the future, the value-in-use declines rapidly. Note that a 12% decline in the aluminum price does not mean that the aluminum production assets decline by 12% as well. In fact mining assets are incredibly sensitive to the commodity price. Assume that the cash production cost for aluminum is somewhere around $2,000/ton. If the commodity price falls from $2,600/ton to $2,000/ton, a 23% decrease, the value-in-use for the production assets falls to zero, a 100% decrease.
In 2011, Rio Tinto recorded an almost $10 Billion write down related to the Alcan purchase. They just announced a further $10 Billion write down. Essentially they paid $38 Billion for an asset group that they now believe to be worth about $18 Billion. A portion of the 2011 financial statements is below showing the initial write down (“Impairment charges less reversals”). The 2012 write down will be obvious once they release their 2012 financial statements in a month or so.
I don’t mean to imply that Rio Tinto’s management di anything fraudulent or made bad decisions. In hindsight they clearly made a poor decision but playing sideline quarterback doesn’t count. At the time, using the information they had, they made a reasonable decision. They can’t be expected to forecast the future with certainty, life and business are not that easy. The purpose of blogging about this story is to reinforce how financial accounting and reporting is dominated by uncertainty and the future. Virtually every asset on the balance sheet requires accountants to forecast into the future and hence every balance sheet value involves uncertainty. Anyone who believes that financial statements are perfect and accurate has completely missed the boat. Financial statements are simply a set of estimates, hopefully good estimates that are not biased. Kudos to Rio Tinto accounting staff and auditors for at least being honest about the necessary write down. There are plenty of stories where such overvaluation goes unreported for years. As an investor and financial statement reader we may not be happy about an asset write down but its better than management hiding it from us.
Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)