Image for WORTH THE WAIT? A Look at the Auditor General’s review of Forestry Tasmania

What on earth was Auditor General Mike Blake doing?

Three years after commencing his investigation into the Financial and Economic Performance of Forestry Tasmania in April 2008 there was still no word.

The Report now tabled in Parliament hints at the reason for the Auditor General(AG)’s tardiness.

The Appendix to the Report reveals details of the 2 previous drafts submitted to Forestry Tasmania (FT), one in April 2009 and another in January 2010.

The April 2009 draft report made no recommendations but offered some pretty damning conclusions.

“Profits have trended downwards since 1995, mainly because of a substantial decline in softwood revenues. Other than softwood, quantities sold had shown a small increase, prices had fallen and costs had not changed substantially.

The return on assets has been consistently poor. Analysis suggested Forestry’s assets were over-valued, but at recent levels of profit, return on assets would only have been reasonable if no value was assigned to the biological assets (trees) or land improvements (roads).

Without stronger financial performance, investment in roads and plantations over the past 15 years will not yield future benefits to Forestry and arguably should be expensed rather than capitalised. On that basis, it can be argued that ordinary operations from 1994 to 2008 have yielded little profit. It also follows that dividends paid had been entirely funded from abnormal receipts such as Commonwealth compensation money.”

The most scathing criticism was that if FT were to continue on the same downward trajectory, the assets that FT were acquiring, new plantations roads etc, weren’t going to produce future profits and might as well be written off straight away, which would severely dent current profits and certainly wouldn’t impress the Feds who have been handing over money hoping it was being used to built a sustainable plantation industry.

The conventional accounting approach is that expenditure on new plantations and roads is capitalised as assets, rather than recorded as expenses in the income statement. When assets become impaired, an impairment charge is recorded in the income statement. But if those assets are impaired from day one, in other words they are a crappy lot unlikely to produce future profits, perhaps they should be written off immediately? That’s what AG was suggesting, in one of his more forthright unequivocal statements.

Equally damning was the suggestion that dividends paid to the State Government were being funded from compensation paid to FT by the Feds specifically to fund new plantations, incidentally described recently by Greg L’Estrange as “the most expensive plantations in the world”.

The Feds wouldn’t be too impressed on that score either, if the State’s Auditor General publicly made such an observation.

The caustic comments have been toned down a little in the final report, but it is interesting that AG has chosen to provide details of his working drafts, altered after consultation with FT.

It appears AG found himself in the slightly unusual role, for an auditor, of pushing management to turn around FT’s fortunes, a role that is normally the preserve of the Board and the shareholder Ministers. After years of seeing his annual reports to Parliament completely ignored, he probably felt an imperative to do something. He should’ve billed them, for non audit services.

So what did AG say in his revised final report.

“Overall ............. Forestry’s financial situation is particularly difficult it being faced with declining revenues, high fixed costs, declining productive forests but increasing obligations for non-productive forests, poor cash flows, long periods before investments in plantation development provide returns, declining local and world markets, increasing Australian dollar, increasing defined benefit superannuation obligations and uncertainty regarding its CSO obligations. Our impression is that Forestry is endeavouring to deal with these matters but may not be able to do so without financial assistance from the State. For example, based on current levels of cash flow, Forestry will find it difficult to fund its defined benefit superannuation obligations.”

Phew! Not too many positives.

Just to take up a couple of the issues.

First “high fixed costs”. There was no attempt to isolate, describe, quantify or explain the level of fixed costs. It was an unsubstantiated conclusion. Which in turn begs the question, what about the variable costs, and wages in particular? A report on the financial performance of FT without a detailed analysis of the costs is very perplexing.

Second “investments in plantations”. The report failed to adequately analyse the relative contributions made by the growing plantation sector and the declining native forests sector and the effects on past returns and ramifications for the future.

This may be due to the lack of available segment data from FT, but it means the project is more a patchy historical review than a basis for analysing future options.

Third “our impression is that Forestry is endeavouring to deal with these matters”. This is the same comment as has appeared in AG’s last 3 annual reports to Parliament.  After 3 years is it not reasonable to expect to be able to gain a more concrete assurance from the Board and management that steps have been taken to redress FTs woes, rather than relying on a mere ‘impression’? This is probably a reflection on FT and not AG?

Maybe it’s best to establish exactly what AG intended to achieve with his review before having a closer look at the not-so-good bits and the good bits.

This audit included both performance audit and compliance aspects.

The objectives were to assess:

• Financial performance: the reasonableness of FT’s profitability, focussing on cash flows, and associated returns to the State government over time

• Economic contribution: the reasonableness of FT’s economic contribution to Tasmania.

• Compliance: The extent to which FT was meeting its statutory, corporate and owner obligations.

The original plan was to make recommendations about structural reform but this proved to be too challenging, because it was apparently too difficult to analyse other comparable structures and well…... it’s really a matter for government policy.

AG attempted to bite off more than he could chew with his review of the economic performance of FT. It always appeared a little beyond his area of expertise.

One of AG’s conclusions was that “the forestry business is cyclical in nature”. Econometric 101 students who offered that sort of conclusion without any substantiation would normally be counselled to seek an alternative calling.

There has been a myriad of changes in the forestry industry over the 16 year period of the study as AG has correctly observed. To merely conclude that things are cyclical is just another way of saying things go up and down. Not particularly perceptive or useful as a predictor.

The contrary impression conveyed to a reader is that the last 16 years has been predominantly a downward slide for FT rather than a series of cyclical movements.

More crucially if things were up and down, there was no attempt to isolate cyclical changes from other changes that have occurred in the demand and supply of forest products.

Again this may be beyond AG’s domain. But at least he should have said so.

The first draft of the Report was completed in April 2009.Amongst the conclusions was “the return on assets has been consistently poor.

Analysis suggested Forestry’s assets were overvalued”.

“Hey Bob the return on assets is a bit low. You better do something.”

“No problems, we’ll write down the value of the assets.”

That’s exactly what FT did.

Who said Bob wasn’t a lateral thinker?

Valuation of forest estate can be complicated. Or at least it can be made complicated by the participants who rarely bother to explain. But some understanding of how valuations can affect profits and the level of assets employed is essential if one is to understand how FT’s performance is measured.

A forest estate consists of land trees and roads. For years the 3 component parts were valued separately by FT. Gunns too, values each separately.

Trees are usually valued on the basis of future harvest receipts net of future holding costs discounted back to a present day value. Land and roads are usually valued at fair value. This may vary from company to company. For example rental arrangements if they exist may form the basis for land value. Roads are usually valued at written down values (cost less depreciation).

Interestingly in the latter case, Gunns with a possible eye to future Government compensation doubled the written down value of its roads in order to calculate a fair value for the 2010 financial statements.

FT’s newly appointed valuer treated the whole forest estate as one integrated enterprise, as one cash generating unit, to use the accounting jargon.

Future income from the estate, net of holding costs, was then discounted in the same way as described above to value trees. The resultant value was the value of the entire forest estate.

A fair value of roads and land was then subtracted to obtain a value of the trees. QED.

FT’s land was split into three——-reserves, special timber zones and general land. The latter includes both native forests and plantations.

The first two came up with negative number so the land trees and roads were worthless. In fact the negative number was recorded as a liability, an estimate of the future liability for looking after non commercial forests. FT no doubt is hoping that a benevolent Government might extinguish the liability by handing over more cash.

In the case of general land, FT considered it too had a zero value and apportioned the forest estate value between roads and trees.

Removing land from FT’s balance sheet was made easier by virtue of the fact it didn’t own the land anyway. The Crown does.

Had FT chosen to double the written down value of roads to calculate a fair value as Gunns had done, the value of roads would have been double that of the ensuing value for all native forests and hardwood plantations.

That wouldn’t have looked too good in the books of the custodian of our forest estate.

It’s a little odd that 2 Boards, Gunns and FT, have such different approaches to valuing forest estates.

But they do have different stakeholders.

However it’s a sobering reminder that accounting standards and subjective judgements can lead to wildly differing values.

Gunns could scarcely have written back the value of its land given it is trying to impress banks and JV partners. FT was able to do so as it doesn’t need to impress a banker. It’s got a backer who will furnish a Letter of Credit whenever required. FT was more concerned with tarting up the abominable rate of return on assets.

What is a little surprising is that AG hasn’t questioned the approach in the case of plantations. Returns from plantations are also calculated on the basis that the underlying land is worthless.

Valuing land at zero might be justifiable by deferring to a particular accounting standard or a more esoteric Soil Expectation Value SEV but from an economist’s viewpoint if we are to build a sustainable plantation industry, omitting the costs of the underlying land will lead to perverse resource allocation outcomes. We’ve had enough of those with the disastrous MIS experiment. Giving plantation land a zero value before calculating rates of return as part of an assessment of economic performance is an absurdity.

Given that 2 drafts were submitted to FT for comment, the final report has pandered to FT. The oft repeated “we wuz robbed” claim from Bob and Hans, referring to the transfer of productive forests into reserves and the sale of a 50% interest in the softwood trees to GMO 11 years ago, is given undue emphasis in the report and estimates are even given as to where FT would be without those changes.

So much so that Bob was able to claim in his recent media release that the report killed of the myth that FT has been subsidised by Government handouts.

Bob claims it was compensation. He’s probably right but it’s essentially a semantic point anyway.

It’s not the most important issue.

The simple fact is FT wouldn’t have been able to survive without the Fed funds. Which have now dried up.

The report didn’t specifically address the question as whether Fed funds were handouts or compensation, so the media release was merely Bob’s spin.

FT is still obligated to spend more on plantations but the TCFA funds have been used for ordinary operations and with current negative cash flows will be difficult to fully replace.

The more important question is where FT will go from here without Fed assistance and with negative operating cash flows.

AG didn’t shed much light on this problem, although he did conclude that $200 million to $250 million will be needed by FT if is to maintain the past level of spending on new plantations.

Don’t tell Bob but this appears to be confirmation that FT is dependent on Government assistance.

The reason why up to $250 million may be needed isn’t exactly explained. It appears to be a figure similar to what has been spent on new plantations from Fed funds over the last 15 years.

But then if the likely profits are as small as AG suggested, a permanent lifeline may be needed.

On the matter of the loss of 50% share of its softwood plantations, AG found that resulting net profits may have been reduced by between $15 million and $30 million. Whatever the figure it certainly wouldn’t have been received by FT in cash, as surplus cash was always spent on replanting. Without a greater cash inflow FT wouldn’t have been better off.

Given that a 50% share worth $50 million 11 years ago is now only worth $71 million when up to $30 million has been spent on replanting, we are less likely to hear the refrain “we wuz robbed.” It’s been a demonstrably badly managed investment and doesn’t fill one with much confidence seeing as plantations are supposed to be our future.

AG should have been a little more unequivocal in his comments about the underperforming softwood plantations.

An asset that has grown from $50 million to $71 million in 11 years and provided zero cash return to an owner has only achieved a growth rate of 3% pa. The inflation adjusted return in NIL.

Rather than dwell on what might have been, AG should’ve offered more thoughtful observation on some of the specifics of FT s financial performance. How has the wood supply agreement with Gunns benefited FT? Would an alternative tendering process have been better for FT? Are the plantations as developed suitable for uses other than pulp? Or has FT bet the house on the pulp mill?

On the matter of inflation adjusted figures, using nominal rather than real adjusted data to assess the economic performance of an entity over a 16 year period is a bold groundbreaking approach. Over the period the CPI has increased by 55%. This means of course than in real terms the early profitable days were quite good for FT. Bu the slide since is even more pronounced.

Accountants are conditioned to using historical cost information and normally for an analysis over a few low inflation years reliable conclusions can still be obtained.

However only the brave would attempt to draw conclusions from nominal data over a 16 year period when inflation rose by 55%.

FT’s income statement each year contains non-operating as well as operating items. In brief, the former are those outside the control of management, but which nevertheless affect the bottom line. Operating profit is the headline measure, the measure most often bandied about as a measure of profitability.

What gets left out of the operating profit calculation often relies on subjective judgements. AG noted 2 items——- certain superannuation expenses and the costs of trees felled and sold——if treated differently would reduce aggregate operating profits over the 16 years by 60%——from $201 million to $79 million, a considerable amount.

The superannuation expenses that FT has been excluding from the calculation of operating profit relate to the costs of superannuation for defined benefit members. An exemption under the Superannuation Guarantee legislation applies to FT so it is not required to put away 9% of wages for those employees. Instead it has to cough up when the time for the payment of benefits arises, whether as a lump sum or as a pension. The current portion that FT needs to find is 75 %. The remaining 25% has already been funded by the employee. When this amount is paid it is treated as a reduction in the unfunded superannuation liability rather than as an expense. The operating profit statement is circumvented. Most convenient.

Accounting conventions nevertheless require an accrued amount for increases in super to be recorded, boosting up the unfunded liability. The salient issue is whether all or part of the accrued amount should be treated as an operating expense. All GBEs and the General Government treat part as an operating expense. Only FT adopts a different approach.

The treatment of trees is a little more contentious. Trees are slightly different from other assets. They are included in the assets known as SGARA (Self generating and regenerating assets). A beef farmer’s livestock is another example of such an asset.

As a general rule as we noted above, spending on new plantations is not written off, but rather capitalised——added to the values of existing trees on the balance sheet.

Other movements in tree values are recorded in the income statement.

Again the issue is whether they affect operating income or non operating income.

Broadly speaking other movements in tree values occur due to growth, price changes and losses from felling and selling.

Arguably increases in value resulting from growth (and natural increase in the case of a beef farmer) are operating income. The better the manager the higher the operating income.

Tree values may rise or fall due to price changes but also from changes in the discount factor used to reduce future harvest proceeds to an acceptable present value. These changes arguably are outside the control of FT management and are a non operating item.

Then there are trees that are felled and sold. It’s a little difficult to argue that these occurrences are beyond the control of management. Therefore the loss of trees in this manner must be recorded as an expense in the operating income statement.

AG in discussing whether to attribute an operating cost to felled timber took the narrow view that this would imply assigning a cost to each tree. Not so. Beef farmers do not value each head of livestock but rather classes of stock. Most financial statements require some subjective judgements. Not to include any costs of trees sold against revenue gives a misleading operating profit figure.

Currently the more that is felled and sold at whatever price the higher the operating profit. Valuable coupes can be chipped and operating profits will increase as no cost is attributed to the fallen timber. Accounting conventions can be interpreted to justify the disposal of high value forests at chip prices.

It was pleasing to see AG recognise at last that FT’s financials could be greatly overstating operating profits.

On the matter of the value of trees, whilst the 50% interest in the softwood plantation is valued separately at $71 million, the rest of the standing timber is lumped together, native forests and plantations at about $250 million.

Yet FT has invested $454 million in assets and plantation development over the 16 year period, with $223 million coming from Helsham RFA and TCFA and the balance from operations. The former has dried up and the latter is no longer a positive figure.

Where to? AG has suggested that $200 to $250 million is required. Where this number came from is not explained——whether AG flipped a coin or consulted the Book of Random Numbers is not known. Certainly there was no analysis of the $454 million spent on assets and plantations. We don’t know anything about the breakup. Plantations vs native forest regeneration? Has it been money well spent? How many hectares?  Are they the most expensive plantations in the world as Greg L’Estrange alleges?

The lack of breakup may well result from the lack of data from FT, although in his Annual Reports AG does refer to % changes in certain segments, both $s and quantities, without specifically mentioning the actual numbers.

To overcome the lack of segment data AG has recommended that FT provide segment information for

• Tourism activities

• Domestic sales

• Export sales

• Plantations

• Forest management services

• Community service obligations CSOs

FT has relied on an exemption in accounting standards to withhold the segment information. Additionally FT argues that too much detail will breach commercial in confidence guidelines.

One weakness of AG’s Report is the complete absence of quantity data. A reader is left with no impression whatsoever as to what is being sold, grown, still on hand etc, surely vital bits of information if as AG said in the Forward “I trust this Report will inform such structural analysis”.

A structural analysis without quantity data is not only pointless, it’s impossible.

Getting back to the matter of unfunded superannuation liabilities, we have already noted AG’s scary conclusion which hints at long term solvency concerns.

“Forestry will find it difficult to fund its defined benefit superannuation obligations.”

The unfunded super liability is $120 million three times the amount owing to Tascorp of $40 million.

AG included both as part of FT’s debt when he pointed out FT’s inability in recent years to achieve the targeted ratio of funds from operations to total debt.

Incidentally Ms Giddings adopts a contrary view by excluding the Government’s huge unfunded super liability when she asserts the Government is net debt free.

In the past 10 years FT has paid $56 million to fund lump sum and pension benefits for departing employees.

At 30 June 2010 the average age of members of the defined benefits fund was 49.5 years causing AG to assert that “this liability is likely to continue to grow for at least another 5.5 years”.

But if FT is in a similar situation to the General Government, things could be far worse.

To start with not all members will retire at 55—-younger member have a preservation age of 60 not 55.

Second, the Government’s unfunded super liability is estimated to grow until the early 2030’s.

And third the annual benefit payments currently about $6 million pa will more than double and peak shortly after the peak of the unfunded liability in the early 2030’s.

If the super liability keeps growing at the same rate and the value of the forest estate keeps falling then there will soon come a time when they are equal.

At that time application should be made to the Nomenclature Board to rename ‘State Forest’ as ‘Bob’s Super Fund’ in recognition of Bob’s outstanding management achievements—his legacy to future generations that has ensured the net receipts from hundreds of thousands of hectares of working forests will be used to pay benefits for many years to come, to Bob and his merry band of tunnel visioned recalcitrant troglodytes who have assiduously managed to hollow out and undermine the entire forest industry.

The economic performance of FT was dealt with in 4 pages.

A figure of $111 million was obtained from a black box at Monash University as an estimate of the annual addition to Gross State Product GSP resulting from FT’s activities over the 3 year period ending in 2008. In other words GSP is $111 million higher compared to a base situation where these activities did not occur. But if the activities hadn’t occurred, the freed resources would have been used in some manner to make an alternative contribution to GSP, unless everyone did a Rip Van Winkle.

In isolation the number doesn’t mean much and AG didn’t bother putting it in context.

The commentary on economic performance was then confused by FT’s obvious insistence that a figure of $563 million be included as the total value of wood products produced from Tasmanian State forest timber, not just by FT itself.

Total value is a different concept than net addition to GSP but readers weren’t offered an explanation.

Loss making businesses still contribute to GSP. This is where some caution is needed with GSP and GDP figures. In the aftermath of the Queensland floods and cyclones there were bullish projections about the effects of the rebuilding on GDP. What was omitted was any mention that many people had suffered huge balance sheet losses which don’t directly impact on GDP. Asset write-downs aren’t included in measures of production.

Whilst unprofitable businesses will continue to contribute to GSP/GDP, the fact that balance sheets are being eroded and cash flow is negative means that the contributions, in part at least, are likely to be both temporary and illusory.

FT is obliged to receive approval annually for a Corporate Plan. The second draft report in January 2010 said:

“Forestry’s approved 2008-09 Corporate Plan anticipates that it will generate low rates of return. However, the Corporate Plan does not deal comprehensively with all of the financial and economic responsibilities outlined in the GBE Act or the Forestry Act.”

The final report said:

“During the course of this audit we reviewed Forestry’s 2009–12 and 2010–13 Corporate Plans. We noted no discussion about the very long-term nature of its business or of the manner in which it was, or is, capitalised. Forestry has advised us that plantation investment decisions taken today can take up to 30 years to result in any financial return. We expected to find in these corporate plans assessments of impacts of these decisions and timeframes on Forestry’s business, particularly its cash flows and balance sheet. Detailed cash flow impacts were provided but not as these relate to the balance sheet or capital requirements.”

In regard to the 2009-12 Corporate Plan AG offered some more observations.

“We also note that the Corporate Plan included no discussion about:

• the relevance of the performance targets set for the business

• the extent to which these performance targets achieve commercial performance levels or

• comparison with any external benchmarks.”

The 2009-12 Plan contained forecasts of increases in operating profits and operating cash flows. The actuals have headed in the opposite direction.

Government approval of a Plan no matter how fanciful probably provides FT’s Board with the necessary “reasonable expectation” that FT will be able to meet its debts as and when they fall due.

The current Plan which must be on the table either approved or about to be would have contained a large black hole going forward as a result of Gunns’ decision to exit native forests. The operating cash flow in 2010 was $12 million negative. There is little reason to believe that the 2011 figure will be any better, a figure that Bob refused to disclose to a Leg Co Committee investigating FT’s financial performance.

Instead Bob provided both verbally and in writing a series of pathetic cost savings measures——-like changing the phone system and restricting photocopying to double sided—-no colour, as examples of FT’s response to its chronic cash flow difficulties.

Like the boy with his finger in the dyke the measures are unlikely to stem the tide.

FT’s Board must be starting to waiver a little on whether to sign the solvency declaration given the gross uncertainty in the industry.

Maybe a new wood supply agreement with a profit share arrangement could be incorporated into a Corporate Plan so that FT can pretend that a basis exists to enable signing of the solvency declaration?

No… that would never work… no lender would be a part of such a deal where an auditor has raised serious doubts about the wood supplier’s ongoing solvency.

But what if the Government lent the money. Good thinking 99. Get Dennis on the blower pronto.

It’s clear AG should have conferred earlier with Dennis and the Tasmanian Development Board (TDB) to enhance his understanding of FT.

The TDB appear to have a unique handle on the way the forest industry operates, which is very odd seeing as forestry isn’t even one of the nominated 17 industry sectors to form part of the soon to be unveiled Economic Development Plan thus enabling bureaucrats to pick winners and guide us into our glorious economic future.

What AG failed to see in 3 years, what the Government needed to refer to a Strategic Review, what the markets have conspicuously failed to appreciate as listed companies have suffered huge market write downs, the TDB managed to detect in just a few weeks———- through all the smoke, dust and debris———- a profitable native forest woodchipping business.

If this is how Lara and Bryan are going to solve the State’s woes it may be best to call in the Administrators immediately.

AG was certainly tardy with the preparation of this Report. But most of the delays appear to have been occasioned by FT responding to earlier drafts.

An appreciation of AG’s role is needed. He is an auditor. His primary task is to advise whether the financial statements fairly represent what has occurred and that FT has complied with its statutory responsibilities. He can draw Parliament’s attention to problems he has encountered but it is up to the Executive, Parliament and eventually the people to fix things.

AG has produced a report dominated by a financial accounting analysis of FT. In other words a look at the income statements, balance sheets and cash flow statements. It mainly uses the publicly available information so there is nothing new. But it is a useful historical exercise and a good summary.

It was disappointing that more management accounting analysis wasn’t attempted and quantity information dissected. Management accounting analysis means having a closer look at the components of costs and revenue. Without a greater understanding as to how the bottom line is made up, planning for the future is impossible.

Readers were left with no idea as to the relative sizes of the plantation and native forest sectors and whether all the plantation expenditure over the last 16 years has amounted to any more than just a row of beans.

Meanwhile the Government continues with its unbelievably lazy approach to urgently needed structural reform, by finally proceeding with a Strategic Review, 12 months after funds were provided in the 2010/11 Budget and 9 months after former Treasurer Aird discussed it with FT.
Perhaps it finally dawned on the Government that AG’s report wasn’t going to provide a blueprint for the future.

The Government seems to believe that someone else is going to solve its problems. Barring divine intervention this is unlikely.

If the Strategic Reviewer experiences similar slow responses from FT as did AG, then no matter what Statements of Principles are agreed by whoever is still remaining in the tent, it’ll be curtains for many more in the industry as they vainly try to find a profitable and sustainable future.

Unprofitable cash negative businesses all eventually meet the same fate. If Ms Giddings believes otherwise then she’s the wrong leader for these troubled times.

Earlier on Tasmanian Times:
John Lawrence: Postscript;  The Time is Nigh
Judith Ajani: The Inconvenient Truth; Forestry is in Crisis
Greg L’Estrange: The Falling of the Sky
Broken Forestry model, Christine Milne’s Senate serve