The aluminum can gets crushed

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].

Screen Shot 2013 01 18 at 8 16 09 AM

Unfortunately for Rio Tinto, the price of aluminum has not increased as they expected and in fact has decreased by 12%.

Screen Shot 2013 01 18 at 8 19 06 AM

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.

Screen Shot 2013 01 18 at 8 32 29 AM

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(

Fracking government

The Quebec government’s decision to extend the moratorium on natural gas hydraulic fracturing (commonly referred to as “fracking”) has certainly raised some eyebrows within Canada and internationally.  Fracking has been used to access natural gas reserves that were previously thought to be inaccessible or at least not economically feasible to access.  The science is pretty simple: pump water at great pressure into rock with cracks and natural gas and viola, the water pressure opens the cracks up letting the natural gas be captured.  I’m not convinced that this does not carry substantial health risks but I will admit that the research is not conclusive.


Screen Shot 2012 11 25 at 9 55 23 PM

As a result of some mixed results, the Quebec government introduced a temporary moratorium on all natural gas fracking in the province.  In the middle of September, there was some indication that the government was considering a permanent ban.  While this has clear political repercussions, and potentially some health benefits, it also has some substantial accounting implications.  There are a number of companies that had started natural gas fracking operations or exploration within Quebec prior to the moratorium, most notably Talisman Energy and Lone Pine Resources.

Talisman just reported their third quarter results and included a substantial impairment charge related to their Quebec fracking operations.  An impairment charge is a non-cash write down of an asset.  Over the past two or three years, Talisman had purchased exploration rights (an asset), done some successful drilling and exploration (an asset), and started to building capital infrastructure to support fracking (an asset).  Now that Quebec is considering a permanent ban, those assets are virtually worthless.  Under generally accepted accounting principles (IAS 36, IAS 16), that decline in value is referred to as an “impairment”.  The asset must be written down to its value-in-use (pretty much zero if you can’t pull natural gas out of the ground) or its recoverable amount if you can sell it (pretty much zero since no one will buy those assets with a government strongly considering a permanent ban).  The asset write down creates an expense for the same amount – a non-cash expense but an expense nonetheless.  This expense is typically large and commonly results in a loss for the period.  Check out Talisman’s third-quarter financial statements, particularly the income statement (page 2) and note 9 (page 9) for more information on this impairment.  For another example of an impairment charge see the post about Microsoft.

This is another great example of how accounting is a pretty good reflection of real life or at least economic reality.

Note: this blog was originally posted on my site hosted by Pearson Education(

A gas purchase explodes into thin air

An interesting story came out the other day about BHP Billiton’s CEO refusing his bonus since the company was going to record a $3 billion write down of some of its oil and gas assets.  $3 billion sounds like a lot to you and me but when you look at the last few years of BHP’s performance, total revenue over the past three years: $175 billion; total net income over the same period: $43 billion.  If the write down seems insignificant to you, that’s partially a result of seemingly massive government debts that has transformed the scale of money for us – for instance look at the US debt ($15 Trillion!!) or the Greek debt (at the time of writing, €355 billion ~ $436 billion Cdn).

Screen Shot 2012 08 08 at 7 46 08 AM

Nonetheless, Mr. Kloppers, the CEO of BHP, is willing to give up his bonus of a few million dollars, presumably as a sign of solidarity with the shareholders.  It’s a nice gesture although I suspect he’s not suffering too much from the financial hit.  Still, leadership should involve a bit of sacrifice and personally I like his forfeiture.

Millionaire bonuses aside for a minute, where did the write down actually come from?  Similar to the post about Microsoft, BHP’s write down is related to recent acquisitions.  In this case, BHP purchased significant oil and gas companies in the past few years, particularly Fayettville in the US for $4.75 billion last year (2011).  When you look at the natural gas commodity price, you see that prices have fallen roughly 25% in the past year.  

Screen Shot 2012 08 08 at 8 11 43 AM

The sage advice, “buy low, sell high” rings true for all corporate acquisitions, even when we’re talking billions of dollars.  Let’s break this down into smaller steps:

  • Feb 2011: BHP purchases the Fayettville project when natural gas is trading at $4.50 per mmbtu (a million BTUs – the common measure for gas) and pays $4.75 billion.
    • DR Long Term Asset $4.75 Billion, CR Cash $4.75 Billion
  • July 2012: The commodity price has fallen, BHP does not expect it to rebound in the near term.  They must believe that the Long Term Asset cannot recover the full price paid, in fact they believe they will only recover approximately 1/2 the price.  Accounting rules require them to write the asset down:
    • CR Long Term Asset $2.8 Billion, DR Writedown expense $2.8 Billion

I’ve seen many of these commodity-based massive write downs and corporate crises.  For instance, take a look at Inco Ltd.’s write down (or lack thereof) on its Voisey’s Bay nickel project or Teck Cominco’s crisis after purchasing Fording Coal in 2008.  While these are massive dollar amounts on fairly complex business deals involving huge tracts of land, the accounting concept is relatively simple and applies equally to mining companies and all other businesses equally.  Assets cannot be shown on the balance sheet (statement of financial position) for more than they are likely going to earn.  We refer to this concept as impairment (see for example IAS 36 and ASPE 3063) – its a fundamental concept of financial accounting.  Research in Motion may have inventory it can’t sell?  That’s impairment.  BHP has millions of BTUs of natural gas that it will sell for less than it expected?  That’s impairment. In my opinion, impaired asset write downs are one of the most important concepts.  Unfortunately the information required to determine if an asset is impaired is usually highly asymmetric; that is, management has much better information than most other stakeholders.  Hopefully management is ethical and takes their financial reporting responsibilities seriously. Without that level of trust, the value of financial statements quickly falls apart.

Note: this blog was originally posted on my site hosted by Pearson Education (