When the rock of directors judgement meets the hard place of auditing standards…

Auditors play a key role in providing shareholders with assurance as to the reporting surrounding their investment. From an investor perspective, there is plenty to take away from an audit report; the handy summary of “Key Audit Matters” (KAM’s) is a helpful guide to determining what matters when it comes to a company’s financial statements.

There’s often a degree of conflation between the role of the auditor as compared with the role of directors. Ultimately, decisions relating to financial reporting and the policies that support them are determined by the directors – it is their judgement that underpins assumptions and methodologies used to determine the content of financial statements. It is also their judgement that determines whether relevant accounting and reporting standards have been followed.

The key role of an auditor is to obtain sufficient audit evidence that the financial statements are not materially mis-stated and report the findings back to shareholders. Their findings may or may not support the judgements made by directors.

In New Zealand, there are professional and ethical standards governing auditors themselves – determined by the External Reporting Board (XRB), with auditors regularly reviewed by the Financial Markets Authority (FMA). This is in addition to auditing standards that determine how various aspects of the audit should be conducted. Unsurprisingly, these New Zealand standards are based on those set by the  International Auditing and Assurance Standards Board (IAASB).

The XRB also governs and administers New Zealand’s Accounting Standards, determining the ‘content’ of financial statements. Again, there is a clear link to the International Accounting Standards Board (IASB) to make sure that our outcomes here in New Zealand are consistent with international practice.

Judgement vs Evidence

Of course, when it comes to the auditor’s opinion, there is a ranking hierarchy of language that is certain to pique investor interest. If the auditor’s report uses language like “a material uncertainty exists about the entity’s ability to continue as a going concern“, a potential investor would do well to understand why the auditor has made that statement.

As noted above, however, it is the director’s responsibility to determine whether or not a company has prepared its accounts on a “going concern” basis. Usually, that director’s judgement is buried in the notes to the accounts, under a heading labelled “basis for preparation” or similar. Most of the time, it isn’t a statement that is sought out by investors in most listed companies.

The auditor, however, does not have the simple luxury of relying on judgement. They need to find evidence to support that judgement. There is a key difference between those words; ‘judgement’ allows directors to consider future actions, a forward projection or forecast. When it comes to evidence, however, an auditor must be more circumspect – looking at historical events or trading ‘actuals’ to support such forward-looking statements.

We can’t help but observe that this appears to be the very situation currently playing out at Black Pearl Group, with the company having prepared its accounts on a ‘going concern’ basis given forecast increases in revenue, cost efficiency and (if required) a capital raise. Auditor, William Buck, however, has pointed to current cash reserves of $1.9m compared with (historic) operating cash outflows of -$5.4m in declaring a material uncertainty as to going concern.

Perverse as this may sound to many, both opinions are entirely compatible. It’s up to investors to determine which carries more weight: history or future.

Of course, assessing evidence to support the “going concern” concept is only one part of what an auditor does. They also play a key role in informing investors that the numbers, claims and methodologies underpinning the financial statements are supported by appropriate evidence (or otherwise). In this context, they are looking for evidence that the accounts have been prepared in line with New Zealand’s accounting standards. Where this evidence cannot be identified, this may lead to a qualification on the financial statements.

A qualification relates to one or more particular characteristics of the financial statements, where the auditor cannot find evidence to support director’s judgement. Similar to the example above, there are cases where director’s judgement can co-exist with a different, evidence-based opinion expressed by the auditor.

Recently, this difference between ‘judgement’ and ‘evidence’ impacted the NZ Rural Land Company (NZL) at the curious intersection of investment property valuation, forests and carbon credits.

The company is clear in its mission, operating as an investment company focusing on rural land. The nature of NZL’s business model has perhaps led to the first implicit judgement made by NZL directors: to treat their forestry estates as an “Investment Property”, governed by accounting standard NZ IAS 40, as distinct from an “agricultural” business ruled by NZ IAS 41. In the context of NZL’s business model, this seems a reasonable judgement.

‘Fair Value’

Under the standard for investment property, an entity needs to value all its investment properties at “cost” or “fair value”. So once determined that NZL holds investment properties, and selects the “fair value” model (as any self-respecting investment company would), it is required to value all investment properties – both land and forestry assets – at fair value. And therein forms another judgement – determination of fair value (NZ IAS 40, para. 33). Back to the XRB, this concept is governed by standard NZ IFRS 13. The standard defines fair value in a simplistic manner, although the length of the standard is perhaps a clue as to the inherent complexity involved:

…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

paragraph 9, NZ IFRS 13

IFRS 13 highlights three “hierarchies” of valuation:

• Level 1: Unadjusted quoted prices in active markets for identical assets
• Level 2: Other “observable” inputs (eg, similar assets or inactive market)
• Level 3: “Unobservable” inputs (eg, discounted cashflow forecasts)

When it comes to traditional property investment companies, investors are well-used to the concept of “unrealised gain” commonly reported in financial statements. In addition to Net Profit, many investors in the investment property sector will look closely at the underlying operating cashflow and/or earnings when assessing their investment (commonly reported as ‘AFFO’ – adjusted funds from operations). In a traditional property investment setting, the company is likely to commission an independent valuer to determine the value of the property; the unrealised gain (or loss) on investment properties is derived from comparing the valuation with the carrying value in the company’s accounts.

This is considered a “Level 3” determination of fair value, as there is no “observable” data applicable to an individual, unique property. Similarly, NZL’s valuer has utilised unobservable inputs to determine value for both its land and forestry assets. For its land assets, this is based on an ‘income’ approach (ie, rental), with an assessment of sale value at the end of the lease term. NZL notes that it believes its leases are priced ahead of market yields, resulting in an increase in market value. This has piqued NZSA’s curiosity slightly, given the recent unwinding of similar price-based asset valuations at Ryman Healthcare.

NZL’s forestry assets are also valued at “Level 3” hierarchy, but using different inputs. The forests and associated land were purchased by NZL in April 2023, and were then leased to tenants. While the forests can be harvested (at the discretion of the tenant), they also generate value from storing carbon, with the associated carbon credits (NZU) sold under the NZ Emissions Trading Scheme (NZ ETS). NZL believes this is the most likely outcome:

The tenants of both sites have leased the land to derive income from either carbon or timber. It is assumed based on the current pricing and outlook that carbon will be the most likely income source, it is therefore assumed that the forests will not be harvested and will slowly revert to native forest.

NZ Rural Land Company Annual Report, Note 5.1, Page 27

To determine fair value, NZL adopted a similar “income” approach utilised for its land investment assets, but then also incorporated the post-lease benefit that would be derived from the future sale of carbon credits. The directors commissioned an independent report from Deloitte to determine a range of future values based on a range of NZU prices – directors then applied the “mid-point” of the range to determine the forestry valuation.

Phew. If you’re still reading, well done.

Audit evidence

It’s at this point in the story where audit firm William Buck steps in once again. It’s clear from the outline of events above that NZL directors have made numerous forward-looking judgements in assessing the fair value of the forestry assets.

It’s noteworthy that NZL pointed out the valuation of the forestry assets is highly sensitive to changes in the estimated future NZU prices, with a significant valuation variance resulting from adopting the “high” or “low” price paths (+/-$25m difference). This degree of uncertainty does not form sufficient audit evidence around future values. Perhaps it was also weighing on William Buck’s mind that the forest re-valuations contributed $18.1m to the $10.9m Net Profit, thereby triggering the materiality threshold for the financial statements.

William Buck chose to qualify their opinion in relation to the revaluation of the forestry assets.

We have been unable to obtain sufficient appropriate audit evidence to provide assurance over the estimated future NZU prices which form a significant part of the valuation.

William Buck, Audit Report, NZL Annual Report FY23

In the context of a carbon environment that is still finding its feet in New Zealand, this is hardly surprising. It’s hard to find precedent for “bleeding edge”.

It is worth highlighting that the qualification of the accounts does not, in and of itself, highlight issues in decision-making by NZL directors. William Buck’s report (indeed, any audit report) should simply form another information source in the rich tapestry of information available for investors. For investors, though, recognising the difference between forward-looking judgement and evidence-based audit helps to place that information in context.

Oliver Mander

Post-script: It isn’t every day that we see a relatively small player in the listed company audit space stand up to one of the big four. Kudos to William Buck for having the courage to highlight the issue.