When 'fair value' isn't so fair

Fair value is one of the more complicated and controversial areas of accounting. Some assets and liabilities are initially recognized at their fair values, and some of those are subsequently adjusted to account for changes in fair value. Other assets are initially accounted for at cost, and fair value only enters into the equation if the value of the asset dips below its cost (or amortized cost).

Many of the rules involving fair value require the application of a great deal of judgment, and that's where the risk of fraud comes into play. As I've written before, the greater the required use of judgment, the greater the risk of fraud.

In this column I'll use three recent cases to illustrate the risk of improper applications of fair value. These cases also share another characteristic — each involves fraud charges based on violations of the U.S. Securities Act of 1933. (See the sidebar, "Fraud and securities laws" for details.)

Miller Energy Resources

A January 2016 enforcement release from the U.S. Securities and Exchange Commission (SEC) describes how Miller Energy Resources Inc. committed a financial accounting and reporting fraud scheme in connection with particular Alaskan oil and gas assets it acquired in December 2009. (See Accounting and Auditing Enforcement Release [AAER] 3731.) Miller acquired the assets in a court-approved auction for $2.25 million in cash plus the assumption of $2 million of liabilities from an entity that was going through bankruptcy.

When Miller filed its financial statements for the quarter ended Jan. 31, 2010, it reported the acquired assets at a value of $480 million ($368 million for the oil and gas properties and $110 million for fixed assets). The increase in book value resulted in an after-tax "bargain purchase gain" of $277 million, which incidentally resulted in net income of $272 million for the quarter. This had a dramatic effect on the price of Miller's stock, which soared from 61 cents per share on Dec. 10, 2009, the date of the asset acquisition, to $6.60 on March 31, 2010.

The recording of a bargain purchase gain is allowable under U.S. Generally Accepted Accounting Principles (GAAP). In Accounting Standards Codification (ASC) 805 on business combinations, entities purchased in non-orderly transactions like this should nonetheless be measured at fair value, resulting in a possible large gain to be reported in the income statement. Under ASC 805, the Miller acquisition qualified for this treatment.

The fraud occurred in Miller's methodology for arriving at the value of $480 million. Miller based its valuation on a reserve report prepared by an independent firm. However, the report itself clearly stated that its calculations did not represent a fair value measurement (consistent with Financial Accounting Standards Board [FASB] comments on the methodology used by the independent firm in preparing its report).

It would've been acceptable for Miller to use its independent reserve report as a starting point for measuring fair value. But Miller made no efforts to do this. In fact, in the SEC's opinion, Miller took deliberate steps to mislead the independent firm that prepared the reserve report. For example, Miller directed the independent firm to use an unrealistic discount rate in discounting cash flows — a rate that failed to properly consider assumptions that external market participants would make. (A critical requirement of measuring the fair value of an asset is that it must be based on what an unrelated third party would pay for the asset, not the internal rates and risk considerations of the owner.)

Additionally, Miller inflated future cash inflow estimates and understated projections of future operating and capital expenditures. Miller also ignored the required asset retirement obligation costs associated with the assets. (These are the costs associated with any legal obligations that come along with owning an asset — a potentially material cost for oil and gas assets.)

The SEC doesn't indicate the extent to which Miller's assets were inflated. Rather, the AAER simply states that they were overvalued. But the SEC saw enough to conclude that this asset inflation was no accident. The SEC stated that Miller violated the fraud provisions of Section 17(a) of the Securities Act of 1933.

The St. Joe Company

Whereas the Miller case involves assets that are measured at fair value at the time of their acquisition in a business combination, the next case involves assets accounted for at cost. In this case, The St. Joe Company — a Florida-based real estate developer and manager — acquired various real estate properties for development. Fair value comes into play for this type of asset in the form of impairment testing. (See the October 2015 SEC AAER 3716.)

The basic concept of an impairment loss is fairly straightforward — if an asset isn't worth the amount that it's carried at in the financial statements, it should be adjusted down to the lesser value. But the rules addressing when and how the testing for impairments should be performed vary depending on the type of asset involved, and that's where things start getting tricky.

Normally, real estate would only require a formal impairment test be performed when evidence of a "triggering event" was present (i.e. something comes to the owner's attention suggesting fair value has declined below book value). St. Joe handled this part perfectly. The company was performing quarterly impairment testing at the time involved (2009-2010) because it considered the financial crisis and the 2010 oil spill in the Gulf of Mexico to be ongoing triggering events. (I mention the triggering event issue here because that can also be an area subject to fraud in the form of failing to recognize a triggering event, but it wasn't in this case.)

However, St. Joe failed to recognize significant impairment losses. The primary factor that led to this was the exclusion of certain anticipated cash outflows from the models used in measuring fair values of the properties. In this respect, there are similarities with the Miller case. But an important piece of evidence in the St. Joe case is that the costs that were excluded from the values calculated for impairment testing were included in the economic models used for planning purposes by the company's investment committee. And the same individuals oversaw both calculations.

Another factor in the St. Joe case was the company's failure to consider the possibility that the company would sell its projects off in bulk, which would be at an even lower value in all likelihood, given the time period involved. Yet St. Joe had already made substantial efforts to pursue and achieve such a bulk sale. The accounting standards require that impairment testing take into account the likelihoods of all possible outcomes, such as this one.

St. Joe paid a $2.75 million civil penalty for the violations described in the SEC ruling. This case has numerous other interesting facets regarding additional failures in the company's impairment testing. But one final bit of information harkens back to a column I wrote last year — in October 2010 a short-seller publicly alleged that St. Joe was failing to take material impairment charges. Turns out this short-seller was right. (See my column in the January/February 2015 issue of Fraud Magazine.)

Trinity Capital Company

Our final case involves the allowance for loan and lease losses (ALLL) of Trinity Capital Company. This is another in a long line of rulings involving improper accounting in connection with the financial crisis — an admittedly difficult time for estimating fair values. In Trinity's case, the September 2015 ruling concerns its 2010, 2011 and first two quarters of 2012 loan portfolios. (See SEC AAER 3706.)

Among the many findings in this ruling are those involving the improper valuation of collateral. Accounting rules permit impairments to be measured based on the fair value of the underlying collateral of a loan, and Trinity took this approach. However, Trinity manipulated the collateral appraisal process to inflate fair values, which resulted in an understatement of ALLL.

Trinity's standard engagement letter required appraisers to utilize the "as is" approach to measuring fair value. This is consistent with the accounting standards' definition of fair value, which is the price that would be received in selling the asset at the date of measurement.

There are two other approaches that are commonly used in appraising properties. The "as completed" approach estimates what a property will be worth upon completion. This is often used for properties under construction. The "as stabilized" approach is used to estimate what a property's value will be once it achieves a stabilized operating income (i.e. when it reaches its expected occupancy, etc.). Both of these methods are useful from an economic perspective, but neither is allowed in measuring current fair value for accounting purposes.

Trinity's senior management sometimes improperly directed appraisers to use one of the latter two methods for accounting purposes, when the "as is" approach should've been used. In one case, what Trinity called an "as is" value in fact wasn't. The bank obtained an "as stabilized" value and simply subtracted the estimated costs to complete the project provided by the borrower to arrive at a figure, then falsely labeled it "as is."

In addition to improperly using "as completed" and "as stabilized" values, Trinity also engaged in a variety of other tricks to falsely inflate the value of collateral. In one case, the bank relied on an outdated appraisal when a newer one reflected a significantly lower value.

Trinity's management engaged in numerous other activities designed to conceal under-performing loans, well beyond the fair value gimmicks described so far — all done to avoid having to classify loans in a category that would subject them to scrutiny in arriving at ALLL. Some of management's tricks included:

• Allowing borrowers to overdraw checking accounts to make it appear they were current on loan payments.
• Granting additional credit solely for purposes of making payments on delinquent loans.
• Granting extensions of time to make payments on delinquent loans.
• Ignoring concerns expressed by employees regarding the manner in which the company was managing loans.

For some of the schemes, Trinity's management also took explicit actions to try to trick its internal audit department. For instance, in at least one case, management backdated documents to make it appear as though additional credit had been granted to a customer before internal audit downgraded the loan. As part of its settlement with the SEC, Trinity paid a $1.5 million civil penalty for the violations described in the ruling.

Fair-value accounting (and fraud) endures

Fair value measurements have always been a hot-button issue. Some think that fair value has no place in accounting, while others believe its use should be expanded. One thing is certain: Fair value accounting isn't going away any time soon. And this will continue to be an area of financial statements that requires close examination.

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Email me your links, news or information on public reports of alleged fraud.

Regent Emeritus Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He's an ACFE faculty member and was also the 2015 chair of the ACFE Board of Regents. His email address is: gzack@bdo.com.

Fraud and securities law

Financial reporting fraud can be prosecuted under a variety of laws. For public companies, the principal laws are securities laws at the national level, as well as those at lower levels of government. In the U.S., the Securities Act of 1933 includes Section 17(a), which makes it unlawful to engage in “fraudulent interstate transactions.” Section 17(a) describes the offense as follows:

It shall be unlawful for any person in the offer or sale of any securities (including security-based swaps) or any security-based swap agreement (as defined in section 3(a)(78) of the Securities Exchange Act) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—

1. to employ any device, scheme, or artifice to defraud, or
2. to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
3. to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

All three rulings in this column include charges by the SEC that the companies violated Section 17(a). The Miller and St. Joe rulings each specifically cite subsections (2) and (3), while the Trinity ruling simply refers to violations of Section 17(a).