In the study, parts of which are featured in this month’s issue of CFO magazine, Greg Rogers, president of consultancy Advanced Environmental Dimensions, estimates that the fair value of Tronox’s environmental contingent liabilities was $1.2 billion — far beyond the $224 million reserve the company reported — on the date it went public. That is more than twice the company’s equity of $556 million, as valued by investors in the IPO.
Rogers used a proprietary set of financial analytics and what he characterizes as a conservative 6.5 multiple applied to the $224 million reported reserve to calculate the fair value of the company’s liabilities. His study, which is based on public financial data for 24 oil, gas, and chemical companies, illustrates that despite spending millions each year on environmental cleanup, most of the companies take charges every year to replenish their environmental reserves.
If the study’s calculation for Tronox is a reasonable estimate of fair value, that would put its contingent environmental liabilities for 2005 at just over $1.4 billion, while total liabilities would add up to about $2.69 billion, far above its total book assets ($1.27 billion), and probably much higher than any reasonable fair-value estimate of the company’s assets.
To assure that an apples-to-apples comparison is being made, the bankruptcy judges would have to look at not only the fair value of Tronox’s liabilities but also the fair value (rather than the book value) of its assets. One quick way to scratch out a fair-value asset calculation is to look at the IPO proceeds, considered by most valuation experts as an observable market price.
In the IPO, investors valued the company’s total equity at $566 million, about 15% higher than its reported equity of $490 million. So assuming investors accepted the $1.27 billion book value of the company’s liabilities as a reasonable proxy for their fair value, they considered the fair value of the total assets to be at least $1.76 billion, or at most 15% more than that — meaning that Tronox was carrying more liabilities than assets.
Still, agreeing on which fair-value calculation to use is a complicated matter. And trying to figure out which models and methods a bankruptcy judge will deem useful is even tougher. For instance, John LaLiberte, a partner with the law firm Sherin & Lodgen, says bankruptcy judges will also consider “a probability analysis” related to contingent liabilities to figure out what percentage of the estimated losses the company will likely book in the future.
Complicating matters further is the fact that the concept of fair value has been vilified over the past year by bankers and their lobbyists who hate the idea that accounting rule-makers were requiring mark-to-market measures of financial liabilities during a credit crisis. On the other hand, critics with more conservative views said fair-value accounting didn’t go far enough to rein in abuse because it was open to a significant amount of management discretion. To be sure, the accounting rule known as FAS 5 allows a healthy dose of discretion with regard to booking contingent liabilities.
The controversy surrounding the fair-value calculation is just one more stumbling block in an already complicated family feud that the judges will have to sort out without the help of accounting rules. “GAAP is a method to keep score, but it doesn’t necessarily have anything to do with valuation,” says Manning.