Counting in Plain Sight: Natural Capital and Biodiversity in Financial Statements for Accountants

​The below specific standards were reviewed during the analysis.

IAS 1: Presentation of Financial Statements (section 1.69: Liability Prescription)

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It prescribes conditions under which liabilities are to be classified as current; that is, owed in the near term. Companies affected: Eagle High Plantations.

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IAS 17: Leases

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It prescribes the accounting policies and disclosures applicable to leases, both for lessees and lessors. Leases are required to be classified as either finance/capital leases or operating leases. Finance leases transfer substantially all the risks and rewards of ownership and give rise to asset and liability recognition by the lessee and a receivable by the lessor. Whereas operating leases result in expense recognition by the lessee, with the asset remaining recognized by the lessor. Companies affected: Astra Agro Lestari, London Sumatra.

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IAS 39: Financial Instruments: Recognition and Measurement

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This section provides that guarantors of liabilities shall report the portion of the liabilities secured as their own liabilities even though affiliates will make repayments – similar to IFRS 4 for insurance contracts. Companies affected London Sumatra, Indofood Agri Resources.

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IAS 41: Agriculture

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It details the conditions to be present for assets to be classified as agricultural or biological and how to measure. Companies affected: Eagle High Plantations, Noble Group.

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IAS 41 can inform if a company is valuing its biological assets and agricultural produce accurately given the natural capital risks faced. Specifically, IAS 41 requires companies to reassess the fair value of these assets given changes in thier natural capital risks. These risks include climate change, diseases, or other natural risks:[x]

 

“climatic, disease and other natural risks … If an event occurs that gives rise to a material item of income or expense, the nature and amount of that item are disclosed in accordance with IAS 1 Presentation of Financial Statements”.[xi]  

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IFRS 4: Insurance Contracts

 

This section applies, with limited exceptions, to all insurance contracts that an entity issues and even to reinsurance contracts that it holds. Companies affected: Astra Agro Lestari.

 

IFRS 7: Financial Instruments

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It requires disclosure of information about the significance of financial instruments to an entity, and the nature and extent of risk arising from those financial instruments, both in qualitative and quantitative terms. Companies affected: London Sumatra.

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IFRS 9: Financial Instruments

 

This is IASB's replacement of IAS 39 Financial Instruments: Recognition and Measurement. The Standard includes requirements for the recognition of and measurement of impairment, derecognition and general hedge accounting for financial instruments. Companies affected: London Sumatra.

 

IFRS 13: Fair Value Measurement

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It covers biological assets (including agricultural assets and livestock). Both standards require that Fair Value Measurement be the result of an exit price, make use of a fair value hierarchy (level 1,2 and 3 inputs), resulting in a market-based value, rather than entity-specific. Companies affected: Eagle High Plantations.

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IFRS 16: Lease Disclosures
 

It specifies how leases will be recognized, measured, presented, and disclosed. Companies affected: Eagle High Plantations, London Sumatra.

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PSAK 30: Leases

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Has been superseded by PSAK 73 as of 1 January 2020. Companies affected: Astra Agro Lestari, London Sumatra.

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PSAK 60: Financial Instruments: Disclosures

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Similar in all respects to IFRS 7. Companies affected: London Sumatra.

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PSAK 71: Financial Instruments

Similar in all respects to IFRS 9. Became effective 1 January 2018.

PSAK 73: Leases

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Similar in all respects to IFRS 16. Became effective 1 January 2020. Companies affected: London Sumatra.
 

SFRS 16: Lease Disclosures

Similar in all respects to IFRS 16. Companies affected: Indofood Agri Resources.

SFRS 39: Financial Instruments: Recognition and Measurement

Similar in all respects to IFRS 39. Companies affected: Indofood Agri Resources.

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SFRS 41: Agriculture

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Similar in all respects to IFRS 41. Companies affected: Indofood Agri Resources.

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Astra Agro Lestari

This case study concerns IAS 17 and PSAK 30.
 

As of 2017, Astra Agro Lestari had a total planted area of 290.961 hectares[xii] in Indonesia. By 2017, Astra had entered into nucleus-plasma partnerships (Plasma Scheme) involving a total of 73,099 individuals, subdivided into 2,736 farmer groups[xiii], and covering 178,379 hectares[xiv] of the 297,000 hectares of landbank controlled by the group.[xv] Our study suggests that Astra Agro’s financial reports may not have been applied correctly relative to IAS 17 Leases (in Indonesia the regulation is PSAK 30).

 

Thus, Astra’s reported Plasma Plantation assets 2013–2017 may have been required to be accounted for as operating leases amortized over the course of the length of time to produce palm oil into marketable inventories (typically 5 to 7 years). Astra’s 2015–2017 notes[xvi] to its financial statements over this period concerning the recognition of long-term assets as originally presented partially read:

 

• “In accordance with Indonesian government regulations, the nucleus is granted plantation land rights if the nucleus develops plantations for local plasma farmers.” These usage rights have specific expiration dates between 2021 and 2099 at which point legal ownership revert to its lawful owners.”

• Under the “scheme, the cooperation agreements are signed by the plasma farmers through local cooperatives. When the plasma plantations are mature and meet certain criteria required by the government, the plasma plantations will be handed over to the plasma farmers.”

• “The handover value is generally determined at the inception of the cooperation agreement agreed by the nucleus and the plasma farmers.”

• “After the handover of the plasma plantations, the plasma farmers are obliged [emphasis ours] to sell their corps to the subsidiaries as nucleus. The funded plasma plantations will be repaid through certain percentage amounts withheld by the subsidiary on the related sales.”

• “The funded plasma plantations are secured by plasma plantations and all assets located on the plantations, future receivables from sales of the plasma crops.”

• The development of plasma plantations is self-funded or can be financed by investment credits, the funds for which are given directly to the subsidiary by the banks.

 

Meanwhile, IFRIC notes that the accounting treatment of certain arrangements requires substance over legal form depending on which party maintains the right of control. IFRIC 4[xvii] defined the right to control if any of the below conditions are present (IFRIC 4 was superseded by IFRS 16: Leases on 1 January 2019):

 

• “The purchaser has the ability or right to operate the asset or direct others to operate the asset.” Based on the notes above, because the plasma farmers must pass the plasma plantations’ crops upon maturity and receive instructions from the nucleus, then the nucleus seems to have control.

• “Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement, and the price that the purchaser will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.” The above explicitly indicated that a previously agreed price is reached at the signing of the cooperation agreement, which is further proof that not only will the nucleus buy the entire plantation yields, but also at a lower than market price.

 

All expenses pertaining to the cooperation agreement, in our opinion, should have been accounted for under the requirements of IAS 17 or PSAK 30 Leases. Since the crops are expected to be handed over upon maturity and because it takes 4 to 7 years for oil palm trees to mature, these expenses, in our opinion, should have been amortized over 4 to 7 years.

 

Thus, Astra’s approach to accounting for its leases may have resulted in it overstating its retained earnings and income 2013–2017. This, in turn means that investors might have overstated their financial strength as measured by debt to equity, debt to total capital, and return on equity ratios. Additionally, increases in income would inflate net income (e.g., profits), and have the effect of increasing the return on equity ratio.

 

Eagle High Plantations

This case study concerns IAS 1, IAS 41, IFRS 13, and IFRS 16.

 

In 2015, Felda Global Ventures – now FGV Holdings – (FGV) hired KPMG to conduct a fair market valuation due diligence on Eagle High in connection with FGV’s acquisition of a minority stake in Eagle High. KPMG’s report[xviii] found that Eagle High generated over 80% of its revenues by selling crude palm oil (CPO) at the time.

 

It also noted that Eagle High, a large publicly traded firm, was in urgent need of cash to fund its operations; had violated loan covenants due to poor past performance; and, that 17 of its plantations’ permits and land rights had expired. KPMG advised FGV to revise down its valuation to $680 million to better account for the reported ESG, sustainability, and credit risks.[xix]

 

In 2015, KPMG warned Eagle High Plantations about its material concerns[xx] regarding the company’s proposed partial sale, inability to pay smallholders, not paying the Government of Indonesia income taxes payable, and other financial concerns. At issue was Eagle High Plantation’s potential misapplication of IFRS 16: Leases. [Note: IFRS 16 replaced IAS 17 on 1 January 2019.]

 

IFRS 16 specifies how leases are to be recognized, measured, presented, and disclosed within financial statements. IFRS 16 stipulates that leases are required to be classified as one of the two following types:

 

• Finance leases: These transfers substantially all the risks and rewards of ownership and give rise to asset and liability recognition by the lessee and a receivable by the lessor; in some jurisdictions, such as the United States, these are known as capital leases.

• Operating leases: This results in expense recognition by the lessee, with the asset remaining recognized by the lessor.

 

KPMG noted that Eagle High Plantations’ proposed sale of 37% to FGV Holdings for $680 million was based on Eagle High’s listed planted area of 136,677 hectares valued at $17,400 a hectare. However, KPMG noted that the 136,677 hectares were overstated by the inclusion of smallholders’ land of (est.) 3,259 hectares. KPMG went on to conclude that the information provided by management identified a potential shortfall of 8,000 hectares.[xxi]

 

Eagle High Plantation noted that the deficiency in hectares[xxii] related to Indonesia’s plasma program stating: “[T]here are planted nucleus areas to be allocated for plasma programmes, pending the formation of plasma cooperatives, which can take up to a few years to complete.”

 

Eagle High’s 2016 annual report clarified its holdings after accounting for its leases within the plasma program under IFRS 16. As part of its new reporting,[xxiii] Eagle High Plantation lowered its reported land holdings from 136,677 to 133,457 hectares. The leases are also secured by the Plasma farmers’ crops and the company’s inventory of crops.

 

KPMG stated:[xxiv]

 

“We noted potential breaches of financial ratios for certain subsidiaries as of 31 December 2014. Total outstanding loan balances in relation to these facilities amounted to $239.7 million.”

 

“Total planted area for certain entities were higher than the land concession area, which may result in land disputes (e.g., claims made by third parties) – KPMG comment – FGV to adjust their valuation as appropriate.”

 

Eagle High’s issues involving IFRS 16: Leases resulted in an understatement of its total liabilities. In turn, this would result in investors underestimating its leverage and financial position, overestimating its operating performance, and overestimating its valuation.

 

IAS 1.69 requires that, if an “entity does not have an unconditional right to defer settlement beyond 12 months,” then liabilities should be classified as current. The KPMG due diligence report found violations of covenants, which essentially strip Eagle High’s right to defer settlements. Therefore, long-term notes with violated covenants should have been reported as short-term liabilities. The classification as long-term caused the company to misrepresent its liquidity risk and long-term solvency. Consequently, all investors, not just FGV were likely to understate the risks to the company, and to overvalue Eagle High’s equity.

 

IAS 41 falls within the general definition of assets, which only includes the resources from which the entity has full title and rights. The fact that plantations with expired rights were reported as assets undermined the company’s legal risk exposure, which generally would allow Eagle High to borrow at a lower rate. Because valuation models for financial assets take as key inputs market borrowing rates, investors were likely to, again, misunderstand the financial condition of Eagle High.

 

IFRS 13 requires the disclosure of information that permits companies to arrive at the amounts reported for biological assets in their financial statements. Had Eagle High disclosed this information, readers would have been able to independently verify the assumptions and results of valuation models.

 

Indofood Agri Resources

This case study concerns IAS 17, IAS 39, IAS 41, IFRS 16, SFRS 16, SFRS 17, SFRS 39, and SFRS 41.

 

IFRS 16/SFRS 16

Singapore’s Accounting Standards Council (ASC) has in recent years aligned itself in synch with all IAS/IFRS standards. Some firms continue to report under the previous standards, however. SFRS 16 paragraph B9 defines a lease as any contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

 

Indofood participates in Indonesia’s Plasma Scheme and has many relationships with Smallholder farmers. Under both the terms of Indonesia’s PIR Trans and the KKPA (e.g., credit granting) arrangements:

 

• The Inti (Indofood) is committed and contractually required to buy all inventories produced by its plasma scheme farmers

• Farmers are required to sell all their production to the Inti by law, and by extension

• The Inti controls or advise on the process – from seedlings to inventories.

 

Indofood reported Plasma Receivables of Rp 1,209 billion[xxv], which represents the sum of the development costs extended to farmers over the years. Based on SFRS 16, the capitalization of these costs (in part or full) appears to be inappropriate and may have resulted in an overstatement of assets and income over the years such expenditures incurred.

 

SFRS 16 Paragraph B9 of the standard further outlines 5 requirements that must be present before a lease can be classified as a finance/capital lease. The plasma scheme does not seem to include any of these requirements.

 

A PWC report issued in 2009 also supports this analysis. It concludes that the plasma scheme does indeed contain a lease arrangement for accounting purposes. Consequently, the development costs reported under plasma receivables most likely fall under the criteria for operating leases and should have been expensed by Indofood in the period incurred.

 

IAS 39/SFRS 39 SFRS 39

This establishes standards for loan guarantee reporting. Indofood’s 2017 and 2016 disclosure appropriately noted the circumstances under which recognition would be required. However, our investigation did not come across evidence that the Plasma Scheme loan principal amounts collectively guaranteed by the group of Rp 805 billion in 2017[xxvi] and Rp 719 billion in 2016[xxvii] were recognized as liabilities. Instead, the group seems to have treated these amounts as off-balance sheet items requiring more disclosures.

 

IAS 41/SFRS 41

 

Indofood’s accounting disclosures acknowledge that the group employs SFRS 41 as the basis for reporting agricultural and biological assets. Identical to IAS 41[xxviii], the standard describes the conditions required for assets to be classified as biological assets or agricultural produce. The standard also specifies how these assets should be valued.

 

Specifically, IAS 41 requires companies to assess the fair value of their natural capital over time, including revaluing for gains and losses.

 

IAS 41’s guiding principle[xxix] is that the increase in value associated with capital assets should be recognized as the asset grows, and not solely at the date of harvest or sale. In determining value of the future agriculture crops, agriculture companies can outsource this estimation of the value to external experts who apply a three-level approach to estimating the fair value of these agriculture assets:

 

• Level 1 assets: Assets whose value is measured according to readily observable market prices. These assets require a liquid market with multiple and consistent pricing sources, such as stocks, bonds, or any assets, which have a regular “mark-to-market” mechanism for setting a fair market value. Level 1 assets “mark-to-market” values must be easily observable, have transparent prices and therefore are a reliable, fair market value.

• Level 2 assets: Assets who lack a liquid market with multiple and consistent pricing but can be given a fair value based on quoted prices in inactive markets, such as interest rate swaps or securities that are not actively traded including loans, municipal bonds, currency swaps, loans and derivatives.

• Level 3 assets: Assets that are not actively traded and are the least “mark-to-market” of the three levels, where assets are priced based on expert opinion, estimates, mathematical models and unobservable inputs. Level 3 uses a process called “mark-to-management” to value assets. Examples of level 3 assets include complex derivatives, mortgage-backed securities, distressed debt, land, private equity shares and many assets valued under IAS 41.

 

Companies that employ a Level 3 approach to agriculture asset valuation typically value their natural capital using discounted cash flow (DCF) models. DCF modelling estimates the fair value of natural capital by reference to the expected future cash flows generated from the use of this capital.

 

Applying DCF modelling lets companies account for direct costs, such as maintenance, harvesting, overhead and transportation. However, these additional considerations can introduce uncertainty into concluded valuation if they are based on unreliable assumptions. The risk can be greater for agricultural firms who also need to incorporate assumptions relating to the impact of weather and environmental changes, such as global warming, into their forecasts.

 

SFRS 41 states that the biological assets shall be measured initially and at the end of each reporting period if 3 distinct conditions are present:

 

• the entity controls the asset as a result of past events

• it is probable that future economic benefits associated with the asset will flow to the entity

• the fair value or cost of the asset can be measured reliably.

SFRS 41 identifies level 1 inputs (quoted market prices) as the most reliable set of data for that purpose. By contrast, Indofood in its valuation of biological assets uses level 3 inputs. These require highly subjective economic and market assumptions about outcomes many decades into the future.

 

With regard to IFRS 16/SFRS 16: Leases, it is our belief that Indofood’s capitalization of development costs spent on plasma farmers were likely inappropriate and may have resulted in overstatement of assets and income over the years such expenditures incurred. Consequently, investors would have misunderstood the financial position, operating profitability, and overvalued Indofood.

 

A lack of evidence of Indofoods’ loan principal guarantees to plasma farmers of Rp 805 billion in 2017[xxx] and Rp 719 billion in 2016[xxxi], as required by IAS 39/SFRS 39, probably means the firm classified this as off-balance sheet. Consequently, liabilities were likely underreported. This, in turn, would have led to an overestimate of its financial position as measured by ratios such as debt to equity, or total debt to total capital, among others.

 

Finally, with regard to IAS 41/SFRS 41, our assessment concluded that Indofood’s choice of Level 3 reporting likely relies on flawed assumptions in its valuation models. These include unexpected crude palm oil (CPO) price movements; a frequent need to restate financial information after issuance; and the need to book impairment losses after increasing asset value. We do not believe management’s use of fair market value is appropriate under the circumstances.

 

London Sumatra

 

This case study concerns IFRS 7, IFRS 9, IFRS 16, PSAK 30, PSAK 60, PSAK 71, and PSAK 73.

 

A PwC report comparing Indonesia’s Financial Accounting Standards Board (DSAK) and its PSAK standards with IFRS standards found mostly consistency between the two sets of standards. But there continue to be notable differences which have material effects on comparability.

 

London Sumatra, an Indonesian palm oil company, prepares its financial statements in accordance with the Indonesian Financial Reporting Standards (PSAK). These standards use historical cost accounting, rather than fair value accounting. Indonesia’s partial adoption of IFRS and London Sumatra’s use of PSAK not only affect comparability with peer companies, but also means that their financial reporting makes comparisons more difficult, or even risky. For this example, we assume that the standards employed to produce London Sumatra’s financial statements were consistent with IFRS, unless otherwise specified.

 

IFRS 9 and PSAK 71

IFRS 9 is an accounting standard for financial instruments. It includes guidance for accounting for their recognition, measurement, impairment, and derecognition. It also covers hedging assets which are important in agricultural production.

 

IFRS 9 improves disclosure, requires earlier recognition of impairment losses on receivables and loans, and trade receivables, and requires that more assets be measured at fair value. Changes in fair value are recognized in profit and loss as when occurring. IFRS 9 seeks to improve the reporting accuracy of a company’s current condition.

 

Between 2013 and 2017, London Sumatra’s “other receivables – related parties” rose from Rp 5,772 million[xxxii] to Rp 103,930 million[xxxiii]. However, these balances include loans made to related parties. The company discloses that this increase is partly attributable to additional loans issued and accrued interests.

 

As an example, a loan was extended to PT Sumalindo Alam Lestari (SAL), a related party, to assist with funding their operational needs. London Sumatra disclosed that among the features of this loan is the ability of either party to terminate it at will, and to automatically extend it as often as needed.

 

Likely the company employed Indonesia’s IFRS 9 equivalent – PSAK 71 – for classifying this loan. Yet, there are no specific disclosures on cash flows from prior interest payments and principal amounts received.

 

These missing important disclosures make it nearly impossible to objectively determine whether the economic substance of these transactions constitute a loan or equity investment. In turn, this means the firm’s balance sheets are likely not representative of its true financial condition, especially with regard to liabilities. Investors relying on these amounts would be likely to underestimate their levels of debt and overestimate their creditworthiness.

 

IFRS 7 and PSAK 60

PwC’s comparability report[xxxiv] also found that PSAK 60, an additional financial instruments standard having to do with disclosure is equivalent to IFRS 7. The standard requires that companies provide quantitative and qualitative details about the nature and extent of exposure to risks arising from financial instruments. More specifically, under IFRS 7.33 and 7.34[xxxv], management should disclose, among other things:

 

• Valuation inputs, including discount rates, forecasted period and cash flows

• Risks involved (credit, liquidity & market risks)

• And disclosures about management’s objective policies and processes for managing those risks

 

These disclosures allow investors and other stakeholders to evaluate the quality of the underlying assumptions for estimating the fair value of a firm’s financial instruments.

 

In 2016, London Sumatra reported a Rp 60,027 million[xxxvi] ($5 million) debt stake in a US non-public company, Heliae Technology Holdings. In 2017, the company reduced its investment in Heliae to Rp 19,439 million[xxxvii]. When reducing the value of the notes London Sumatra did not provide an explanation for the change in reported value.

 

Further, they did not provide details on their Level 3 inputs which are needed to check the restatement of value of its investment in Heliae as required under IFRS 9’s Fair Value Through Profit & Loss method (FVTPL) method. This omission is a potential violation of IFRS 7 and PSAK 60.

 

Without the required disclosures mandated by IFRS 7 and PSAK 60, it is not possible to verify the appropriateness of the reduction in value of Heliae Technology Holdings. It could be that the values reported should have been higher, or lower. Financial statement effects would include: the balance sheet, including assets reported; as well as the income statement, most likely in other comprehensive income.

 

IAS 17 and PSAK 30

IAS 17 and its PSAK 30 equivalent relate to the reporting of leases. London Sumatra reported Plasma Scheme Receivables of Rp 68,935 million[xxxviii] and Rp 66,620 million in 2017 and 2016, respectively. These amounts are the sum of the development costs extended to farmers under the plasma scheme over the years. in 2017 and 2016, respectively. These amounts are the sum of the development costs extended to farmers under the plasma scheme over the years.

 

According to IAS 17 (PSAK 30), the capitalization of these costs (in part or full) appears to be inappropriate because they do not meet the conditions necessary for capitalization. Instead, they appear to be operating leases. This is because, while the farmers are legally required to ultimately reimburse the financial institutions by selling their harvests to the intis, London Sumatra remains the ultimate owner and beneficiary of their labor and their land. As such, we can conclude that these costs represent a lease, which gave London Sumatra legal right to the crops, the land, and to manage production both directly and indirectly.

 

The plasma scheme does not seem to include the conditions that must be present for a capital lease under IAS 17 (now IFRS 16). Consequently, the development costs reported under plasma receivables most likely fall under operating lease and should have been expensed as incurred. Consequently, profitability of London Sumatra was likely overreported. Furthermore, common financial ratios that measure performance, such as return on equity would have been overstated, too.

 

IAS 39 and SFRS 39

SFRS 39[xxxix] (equivalent in all ways to IAS 39) also relates to financial instruments and their recognition and measurement. With regard to a financial guarantee contract, it states:

 

“[A] contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.”

 

The standard further requires that an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.

 

These loans which were intended to fund the operations of plasma farmers actually benefit intis, like London Sumatra. This is because the company maintains legal title to harvests with plasma farmers legally required to pass all the harvests to London Sumatra, and at below market costs.

 

Yet, our analyses did not find evidence that the loan principal amounts of Rp 71,199 million in 2017[xl], and Rp 65,371 in 2016[xli], issued under the plasma scheme, and collectively guaranteed by the group were recognized as liabilities to London Sumatra. Instead, the group treated these amounts as off-balance sheet and only required disclosures. By contrast, the inventories and biological assets which these loans help funded were recognized.

 

Granted, financial reporting grants discretion to companies and their executives. However, it seems that the financial guarantees arising from the legal and contractual requirements of the Plasma Scheme represent a liability under SFRS 39 for the Intis. If so, London Sumatra’s liabilities are underreported, and their balance sheet quality is overstated.

 

Noble Group

 

This case study concerns IAS 41, IFRS 5, IFRS 7, IFRS 9, and IFRS 13.

 

A complex transaction conducted by Noble Group in 2014 serves as a good case study for understanding multiple accounting standards and how they impact the values recorded in financial statements. Here is a timeline of the events with discussion.