GFH 2019 EGM – A Timely Accounting Lesson for Shareholders of All Companies

Not Available, You'll Have to Make Do with AA's Tuition

Note this post concerns the EGM held in March 2019 for FY 2018.

As promised earlier, AA has prepared a translation of the EGM Minutes which are available elsewhere in Arabic only.  

The contents of this meeting are certainly interesting in their own right.  

But AA thinks there’s something more significant here. 

That there is an important lesson for shareholders of all companies to learn.  That is, shareholders need to look at more than just the Balance Sheet and Income Statement.

According to the formal published minutes of the EGM, there does not appear to have been any shareholder comment or discussion, except on two points. And that discussion was in AA's opinion sorely off point.  

So AA will focus on those two and draw the lessons to be learned from the second point – the discussion or lack thereof on the cancellation of Treasury Shares.  

You can use the English or Arabic very brief summaries of the EGM available on the GFH or DFM website for the other points.  

First point:  Mr. Ali Tariif asked why HSBC acting as representative of investors holding 1.68% of GFH’s shares had objected at last year’s EGM to the proposals in Agenda Items #2 and #3 to amend the Memorandum and Articles of Association to comply with changes to Bahrain Company Law and requirements of the Central Bank of Bahrain with any such changes subject to CBB approval (#2) and authorize the Chairman or CEO to delegate authority to another person to implement such changes (#3).  Agenda here.  

AA couldn’t find 2018 EGM or AGM minutes for FY 2017 to see if these would shed any light on the topic.

Mr. al Seddiqi responded that the majority of shareholders present at the EGM voted for the proposals.  

Essentially he did not answer the question directly.  Perhaps, he did not know. In any case these actions were forced on GFH by operation of law and changes were subject to CBB approval.  

Second point:  Regarding the cancellation of 207,547,170 Treasury Shares, Mr. Tariif asked about the mechanism for deleting the shares.  Mr. al Seddiqi responded that GFH’s lawyers would provide him a complete explanation about the mechanism after the meeting in the case the shareholder needed more details. 

That's the end of AA's translation of the EGM Minutes.  

It’s clear to AA from this that shareholders did not understand that GFH had purchased the Treasury Shares using GFH’s cash (ultimately shareholders’ money) and that by cancelling them the money “invested” in Treasury Share would be lost. 

Why is it so clear to AA?  

In the AGM the shareholders evidenced a serious concern about “money points”, e.g., the increase in expenditures, Board remuneration, dividends, etc. So it’s unlikely they would be indifferent to this spending of their money.  Thus, they must not have known. 

Given the amount concerned, they missed the elephant in the room. 

1. That is, a cancellation of Treasury Shares would cost them perhaps between 12x and 20x the USD 3.5 million proposed as 2018 compensation for the Board. 
2. Or that it is an amount equal to 1.4x to 2.3x the USD 30 million cash dividends to be paid in 2019. 
3. The two data points used to compute those ratios are the FYE 2018 USD 0.33 average price per Treasury Share and an estimated 1Q19 USD 0.22 average price. 

Why?  (Tuition bit starts here). 

Because the gain or loss on Treasury Share transactions does not appear in the income statement. 

And because the decline in equity due to purchasing Treasury Shares occurs upon purchase. It occurs gradually over time.  Not all at once. 

Cancellation of Treasury Share involves accounting entries within the equity account alone.  There is a credit to the Treasury Shares sub-account offset by a debit to Retained Earnings.  There is no net resulting change in the amount of shareholder equity. Thus, the loss is “invisible” to shareholders. Cancellation may, therefore, appear as a “costless” transaction.  It is not. 

Earlier in the AGM meeting Mr. al Seddiqi mentioned the purchases of Treasury Shares as one reason why shareholders’ equity declined along with dividends. Clearly, the implications did not register sufficiently with shareholders.  

AA’s observations. 

1. Investors would be well served by knowledge of the information available in the various financial statements provided in an annual report. One doesn’t need to be a CA or CPA to glean information from these. 
2. Paying close attention to what is said in meetings can also be of benefit. 

To address the first point AA will provide some tuition about sources of information in financials that can help shareholders and others track and understand the impact of non income statement events.  

AA sadly is unable to help on the second as Madame Arqala will testify. 

As noted the Income Statement and Balance Sheet do not provide the information that would be useful to shareholders in analyzing the cost of cancelling the Treasury Shares or the profit and loss earned from trading in them. 

However, the Consolidated Statement of Changes in Owners’ Equity (CSCOE)--also known as the Consolidated Statement of Changes in Shareholders’ Equity--and the Consolidated Statement of Cash Flows (CSCF) do contain useful information.  Information that can be used to analyze other non income statement transactions that affect the value of a company not just those involving Treasury Shares. 

In the CSCOE the total value of purchases and sales of Treasury Shares during the reporting period are clearly stated.  Also one can determine the profit or loss on sales of Treasury Shares during the period.  The value (cost of acquisition) of all Treasury Shares held by the company as of the statement date is also clearly stated. 

Information on how many Treasury Shares are held is disclosed in the Equity Note, at least in the FYE report.  One can use that information to compute an average purchase cost of a Treasury Share and then compare it to the market price to see if there are potential losses or gains in the Treasury Shares account and their magnitude.  And, perhaps, whether Treasury Share transactions appear to have been in the shareholders’ interests. 

To start some accounting basics. 

Entries on the liability and equity side of the balance sheet are the mirror opposites of those on the asset side.  This is to maintain the logic of double entry bookkeeping.  Assets = Liabilities + Equity.  

A purchase of a Treasury Share is recorded as a negative (a debit because it decreases equity). 

A sale is a positive number (a credit because it increases equity).  

A loss on a sale must therefore show up as a negative entry because like any loss it decreases Shareholders’ Equity.  

Keep these basic points in mind as we proceed. 

To make this clearer via some examples.

Open your textbooks (GFH’s FY 2018 AR) and turn to GFH’s 2018 CSCOE on page 9.  

During 2018, GFH purchased Treasury Shares in an aggregate amount of USD 160.973 million (shown as a negative). This is the total price paid for Treasury Share purchases during fiscal 2018 and is recorded in the Treasury Shares sub-account in Shareholders’ Equity. 

GFH also sold an aggregate of USD 133.966 million of Treasury Shares (shown here as a positive number).  Similarly recorded in the Treasury Share sub-account.  This amount ascribed to sales is the original purchase cost of the Treasury Shares sold not the cash received for them. It therefore does not reflect profit or loss but merely the equivalent of the cost of goods sold. Keep that point in mind.

The net of these two resulted in the value of Treasury Shares increasing from USD 58.417 million to USD 85.424 million as shown in the opening and closing negative balances of the Treasury Share sub-account. 

How did GFH do on the sales of Treasury Shares in 2018?  Did it sell them at a profit?  Or a loss? 

It had a loss which was recorded as a decline of USD 3.058 in Share Premium and USD 24.818 million in the Statutory Reserve Account (SRA). Note both figures are presented as negatives in the CSCOE because a loss on the sale of Treasury Shares is the same as any other loss it reduces equity.  

Side comment:  AA is puzzled by use of the SRA to reflect the loss on sale of Treasury Shares.  AA also notes that starting in 1Q2019 GFH began reflecting losses on Treasury Share sales directly to Retained Earnings. This is certainly more transparent regarding profit and loss than the previous year’s entries. There’s that word again (شفافية ). Keep it in mind.  I’m sure we’ll hear it again. It often comes up in regard to GFH. 

From this information we see that the total loss in FY 2018 was some USD 27.876 million.  Or in other words, GFH sold Treasury Shares it previously purchased for USD 133.966 million but only received consideration (presumably cash) of USD 106.090 million. 

You will note that this amount appears in the “Total Change Attributable to Shareholders of the Bank” (TCASB) (on the right on the page) on the line for Treasury Share sales. Looking at the amount shown in TCASB and comparing it to the amount shown as "sales" in the Treasury Shares column gives a very quick insight whether there was a profit or a loss.  If the number in TCASB is less than "sales", there has been a loss.  If it's greater, there is a profit..  

Note: The sub-accounts are displayed vertically as columns, e.g. Share Capital, Share Premium, Treasury Shares, etc.  

We can use a similar method to analyze the cost or loss of cancelling the Treasury shares.  There will be a positive number shown (remember this is the cost of the shares)  in the Treasury Shares sub-account and the same amount though a negative number shown in the Retained Earnings sub-account.  No cash received.  No revenue. The loss equals the cost of shares that are being canceled.  This should appear in GFH's 2Q19 interim financial statements. 

But we can estimate the "loss" now.   Calculate an average price per Treasury Share and multiply times the number of shares to be canceled.  See earlier post here.

This technique can be used with other sorts of transactions. 

Take a look back in the CSCOE in GFH’s 2017 AR to examine the issuance of USD 314.530 million in new shares in exchange for GFH assuming ownership of certain infrastructure and portfolio investments.  That amount (USD 314.5 30 million) appears in the Share Capital sub-account. You’ll notice in the Total Change (again attributable to bank shareholders) column for the line “Issuance of Share Capital” that GFH received value of USD 293.106 million which indicates that shares were issued at a discount. More on that in a post to follow. In the interim some preliminary thoughts from an earlier post.

Here’s another way to think of a Treasury Share sale to understand losses and gains. 

Recall that the original cost of the purchase of a Treasury Share is recorded in the Treasury Shares sub-account (within Shareholders Equity).  When the company sells a Treasury Share it must remove the cost of that share from the Treasury Shares sub-account.  Think of this operation as the equivalent of determining the Cost of Goods Sold (COGS).  Cash or consideration received is the Revenue.  If COGS is greater than; Revenue, there is a loss equal to the difference Revenue – COGS.  If Revenue is greater than COGS, there is a profit equal to the difference Revenue – COGS. 

But unlike other gains or losses which flow through the income statement, including the "comprehensive statement of income" which usually follows the traditional income statement in financial reports, the gain or loss on treasury share transactions is  directly deducted from equity in the case of a loss or added to equity in the case of a profit.  

Now open your other textbook (GFH’s 1Q19 interim statement) and look at the CSCOE on page 4 at Treasury Sales, the negative number appearing in the Retained Earnings Column means the GFH had a loss on a sale of Treasury Shares of some USD 9.574 million.  GFH sold USD 40.86 million of Treasury Shares (COGS) but received only USD 31.286 million (USD 40.86 million less USD 9.574 million) in Revenue (Cash). Notice that USD 31.286 appears in the Total Column Attributable to Shareholders of the Bank (appearing on the right side of the page). 

Let’s turn to the Consolidated Statement of Cash Flows.  In the CSCF one gets the net flow for the year – purchases offset by any sales.  The point here is that if one can see the net cash going out of the company (a net purchase) or cash coming into the company (a net sale).  One can compare the amount to the other cash inflows and outflows during the year. One can do this with Treasury Share transactions and other non-income statement items. 

But of course, you’ll want to look at the detail shown in the CSCOE as a net of USD 10 million could be that there were only USD 10 million in purchases.  Or it could be the net of USD 1,010 million in purchases and USD 1,000 million in sales.  

For example, in GFH’s 2018 AR the CSCF shows net purchase of Treasury Shares of USD 54.883 million in the section “Financing Activities”.  Referring to the CSCOE, we see there were USD 160.973 million in purchases and net sales (after loss) USD 106.090 million.  Confirming our earlier analysis that GFH lost USD 27.876 million on the sales. If you were to merely look at the Treasury Shares sub-account and ignore this number, you'd think that net purchases were USD until you remember that the "sales" shown are cost of goods sold not revenues or proceeds of sales. 

Other Uses:  Under accrual accounting, a firm recognizes income when earned (creating an account receivable) and expenses when incurred (creating an account payable). These recognition events often occur prior to the movement of any cash.  So it’s not uncommon for revenue and thus income to be recognized in one period and received in another in the future.

The CSCF will also show which revenues have been received in cash during the reporting period and which expenses have been paid in cash.  One can also look at revenues that have not been collected to determine whether there will be a cashflow in the future. 

Let's start with expenses and then turn to revenues.

For example, a provision for a legal case is a non-cash charge for estimated future cash payments which may or may not occur. 

A reversal of a provision, e.g., the USD 35.3 debt settlement gain on AHC in FY 2018 (a reversal of a previous legal provision), will never result in a cash inflow. 

A loan provision is established to cover the possibility that the borrower will not pay the loan in full.  It is an estimate of the amount of non-payment.  

A depreciation charge is not paid in cash during the reporting and won’t be paid in the future.  It is the expensing of a purchase of a machine or other “hard” asset made in the past.  That cost is expensed according to estimates of the useful life of the “hard” asset. And there may be more than one depreciation method.  Methods that stretch the charges over many years make income higher.  Methods that accelerate depreciation will make income lower. 

To track receipt of revenues one can use the CSCF to if there are any adjustment to net income.  For example in GFH's 2018 AR, we see that USD 113.1 million in "debt settlement income" was not received in cash.  We can also see adjustments for other items, such as depreciation which is added back.  In general when income is recognized, an account receivable is created.  As the money is collected, the receivable will decrease.  Of course, if there is new income recognized, then that decrease may be partially or fully offset depending on the amount collected and the new amounts recognized. 

How does one dig further?   

One should go to the notes to the balance sheet to see if money was collected. 

Looking at GFH’s 2018 AR we see they booked some USD 121 million in revenue in 2017 for Investment Banking Fees.  A look at Note 16 indicates that this was either all or largely received in 2018 – the receivable for IBF is down some USD 100 million from FYE 2017.  If one looks at GFH’s 2017 AR, Note 11 there is a footnote that USD 104.6 million was received in January 2018. 

If there is a decline in receivables, one can’t just assume that cash was received.  One needs to read the Note (usually Other Assets) to see if there was an impairment provision that accounts for the decline.  Or that these receivables were settled for non-cash consideration, e.g., shares or other investments.  

And then one might want to look at just what that non cash consideration is and whether there is any question about the “value” of these non cash assets both in terms of their credit/investment quality or the time it will take to realize them, that is, to receive cash from them.  

Delayed receipt of payment is a discount in present value terms.  A $100 receivable paid today is worth a lot more than $100 paid five years from today as AA expects the hapless shareholders of Dubious Gas know all too well. 

Knowing these additional sources of information and how to use them can help shareholders and others better understand the performance and health of companies.  And help guide them as to questions to pose to management.

The "Developed" West - A New Kind of Forthrightness

A quote from the Financial Times on JPMorgan Chase's 3Q10 earnings conference.

Switching between annoyance at one analyst’s use of a “squawk box” to terse replies on JPMorgan’s soaring reserves against litigation and passionate perorations about the bank’s role in society, Mr Dimon displayed his customary forthrightness even if he was not always forthcoming about some of the details.

This was just too good a quote to let pass without comment.  Positively brilliant. 

And, I'd note it sets a high standard for this blog's favorite investment bankers in Kuwait and Bahrain to aspire to.  (And, yes, each word in that sentence has been deliberately chosen).

"Islamic" Property Financing in Syria "This Time It's Different. Really, It Is."

Rasha AlAss over at The National has an interesting article on how the pricing on "Islamic" banks' real estate financing in Syria and Lebanon is much higher than at conventional banks.  While she doesn't give a reason, I'm guessing that it's their much higher cost of funds and not any desire to earn an outsize profit.  The latter of course would run afoul of prescriptions to deal fairly.  Wouldn't it?

A couple of quotes from "wise" local bankers:

Some bankers are pleased with this, pricing their products on the speculative idea that property prices will continue to rise. Explaining why the traditional mortgage rates are so high, one banker says: "Well, real estate in Syria keeps going up. So even with a high interest rate, the appreciation will still be higher." Mr Darkazally echoes this sentiment. "Real estate prices in Syria will never go down," he says.

So does this constitute aggressive lending? And could the speculative behaviour by customers and bankers on a property boom that has not yet gone bust lead down the same road that brought the world to its knees in the recent credit crunch? "Not in our day," says Mr Darkazally .

Normal financial laws apparently don't apply in Syria.  This time it really is different.

Oh, and if you want a real surprise on your "Islamic" real estate loan, buried there in the fine print is a "prepayment penalty" or perhaps something called a profit rate protection clause. 

The Investment Dar - Rumor of Restructuring Bombshell: Request for 50% Hiarcut

Major Al-Musallam Rides to Glory

Before we go further to be very clear this is an account which neither the Company, the Central Bank or the creditors have confirmed.
Update:  TID has denied this story.

Al Qabas reports that TID has submitted a completely new restructuring plan to the Central Bank of Kuwait which calls for lenders to forgive 50% of the existing debt, i.e. KD500 million.   According to the report, lenders were not consulted or advised prior to TID sending the proposal to the CBK.

What's going on here is anyone's guess.

Mine is that the Company and the lenders are jockeying from (what I think is) the fallout from the Ernst and Young report.  As you'll see below. TID and its lenders appear to have been discussing alternatives /modifications to the original plan. From the Al Qabas account these seem predicated on the fact that the Company cannot repay all the debt.  The unpayable quantum seems around a 50% or so.

I suspect that Ernst and Young came back with a very negative assessment of  TID's ability to repay in full and, thus, case serious doubt on the Company's ability to continue as a going concern.  As you're aware, the Financial Stability Law is designed to give protection to viable companies.  It is not intended as a mechanism to provide legal cover for disguised liquidations.  If I'm right (and as Umm Arqala will tell you that's a rare occurrence), a report like this would have thrown quite a large "wrench" into things, complicating the CBK's acceptance of the already agreed restructuring.  How could the Central Bank recommend to the Court that the Company be allowed under the FSL under such circumstances?

I'm also guessing this occurred prior to the end of the first four month period the CBK had for evaluation of the suitability of the original plan and of TID to enter finally under the FSL.

What leads credence to both assumptions are reports in the article that the lenders have floated some  proposals or modifications of their own and the timing of those negotiations.  One was the conversion of  roughly half the debt to equity with some preservation of the rights of the existing shareholders.  Presumably, the lenders could quite easily make the argument that if a debt conversion were required, the old equity has been lost .  And thus the old equity holders should be wiped out.  Their proposal is reported as more generous, though it's not clear what percentage they would allow the old shareholders in the post conversion equity.  Leaving 10% or 20% might for example be considered highly generous by the lenders and an "outrage" by the existing shareholders.  Negotiations on this proposal supposedly took place between July and September.  The story goes that TID's Board went back on a tentative agreement because some of the existing major shareholders did not want their equity interests diluted.  (Unclear to me how you dilute something worth nothing.  There's also a hint here that the major shareholders are very important people.   And, if you know Al Q's politics, you might suspect they are pointing the finger at regal personages).

As a second alternative, the lenders suggested taking some assets in exchange for the debt.  The article says  that E&Y determined that this proposal was acceptable under international principles.  Dar supposedly made a counter offer that brought things back to zero. 

At this point, the two sides are in a deadlock.  I think that TID's proposal (assuming the report is accurate) is more a negotiating tactic than a viable proposal.  Rather it is an attempt to break the logjam by setting forth a maximum position.  One they probably know both the lenders and the Central Bank would have a hard time accepting.  What this proposal does, though,  is shift the parameters of the debate.  While lenders may reject a 50% discount, it may be harder to avoid some meaningful haircut - particularly, if the choice is bankruptcy.  And in order to get itself out of having to make a decision that may prove wrong or hurt its and the country's reputation, the CBK may be inclined to lean on the parties to compromise.  TID has just set one bound on the compromise.

It could be that they are trying to play for time - hoping for a miracle.  Realistically playing for time  hurts all parties - TID, the lenders, Islamic Banking, and Kuwait.  But maybe that's the goal - to maintain the status quo.

The article describes the choices in front of the Central Bank as:

1. Issue a conditional acceptance of the proposal subject to conformity with accounting principles and the agreement of the lenders.  (Or in other words neatly pass the buck.  Or is that the dinar? As Al Q elegantly puts it, getting the lenders to agree may be very difficult given the Company's breach/violation of the existing agreement.  That raises AA's first law of underwriting and due diligence "know your customer".)
2. Reject the proposal.  In which case it's expected that TID will sue the CBK in an attempt to confuse the issue and buy more time.  As Al Qabas elegantly puts it الى ما لا نهاية . (Probably not a first choice. More likely is forcing the Company and its creditors back to the negotiating table.  Or putting them in a situation where they will decide the fate of TID, if that fate is to be bankruptcy).
3. Push the lenders to bankrupt the Company - which will lead to all sorts of negatives for all parties and harm the financial sector, Islamic Banking and the reputation of Kuwait. (I'm guessing not an alternative high on the CBK's list).
4. Convert TID to a holding company.  This would remove it from Central Bank supervision so that the lenders can apply the restructuring deal agreed.  Also the CBK's June ratios would not apply.  (This seems to me to be a bit of red herring.  The CBK can grant an exemption to TID as a finance company from the regulations.  Supposedly the lenders will reject this because they don't think the administration of the company is really interested in solving the problem.  The lenders have on more than one occasion made it quite clear what they think about management's ethics.  They began by asking the CBK to place a minder in the Company.  Then they pushed for the appointment of a Chief Restructuring Officer).
5. Force TID back to the negotiating table with the lenders to find a solution and return to the original plan.  (This seems contradictory.  The original plan is probably moot at this point.  I think the lenders are going to have to accept some changes - and these will be against their interests.  From the report of the alternatives they've offered already it seems pretty clear that they've accepted this - even if it was no doubt reluctantly.  The CBK may well force the parties back to the negotiating table but there will be a new deal.  Perhaps the CBK could impose a time limit for reaching an agreement using as the deadline some date prior to the date it's required to give a recommendation to the FSL Court).
6. Give TID an exemption from the new ratios saying the old plan was devised based on Central Bank advice to the lenders and thus it's not fair to change the rules on them.  As per the article, TID has apparently been saying that the original restructuring plan doesn't conform with the CBK's  "new rules".  The implication being the plan must be modified.   (I don't think that the CBK new rules are the real issue here.  The sticking point is TID's ability to pay and to continue as a going concern.  If the new rules were the only point, then I think the CBK would have given the exemption.  This could be quite easily fudged as an agreed plan to implement the new rules. And so it could be presented not so much as an exemption but a granting of additional time to achieve the goal.  When the debt is paid in full, TID will clearly be in compliance).
7. Exit TID from the FSL and leave it to its fate.  (The CBK probably doesn't want to be the one who puts down this dog.  Better to have the lenders do so.  The "trick" is to find a way to put the parties in a situation where they either come up with a solution or fail - a way which keeps the CBK's hands pristine.  The time limit for the CBK to give its recommendation to the FSL Court is a neat escape hatch.  If the parties haven't agreed by then, the CBK can tell the Court it cannot make a recommendation.  The Court should then refuse to allow TID final entry into the FSL.  Since this is the last extension allowed, the matter is out of the CBK's hands.  Nature and the courts then take their course.  That should be quite a frightening thought for the lenders .  As they stare into the abyss  of almost a complete loss, all sorts of discounts and compromises may become possible).

Finally to close out this post, a recap from the Creditors' Committee official letter to the Central Bank rejecting TID's new plan "in whole and in detail":

1. TID's proposal makes a gift of the money of others (the lenders) to the Company and strengthens (supports) the rights of equity at the expense of the lenders who have not received a single fils since the beginning of the crisis but only promises.  (But they were some really nice promises. Perhaps, even said with one's hand on the Qur'an).
2. TID's proposal is contrary to international and global practices (customary usage) and puts the lenders in the situation of a fait accompli with the proposal being put forward without their agreement or consultation.
3. TID's management is "hitting" (harming) the interests of the creditors and shareholders.  Therefore the lenders reject the idea of a discount which is unjust.
4. The Committee considers that TID's proposal ignores the repayment schedule already agreed.  10% in Year 1, 20% Year 2, 20% Year 3, 30% Year 4 and 20% Year 5.  (There seems to be an argument of a breach of faith here.  And, yes, while the lenders may be thinking of a breach of the agreed business contract for the rescheduling, AA also is thinking that in this context the term applies as well to  religion).
5. TID's proposal prefers (in the sense of giving priority) the shareholders over the lenders contrary to what was agreed previously.
6. The Company has wasted the shareholders' money hiring financial and legal advisors and wasted the banks time negotiating the past 18 months.  

This has been a bad situation from Day #1.  The passage of time has not made things better.  It's likely to get worse.

The lenders face a real dilemma.  Do they compromise to try and get back as much as they can?  Or at some point do they just bring down the house of cards?  With 18 months of time on their hands, lenders may have built rather hefty provisions against this name.  That may give them a bit more negotiating room.

The Central Bank is in the most uncomfortable of positions.  It's got to be hoping that third parties or events are dispositive and that it doesn't have to make a difficult decision.

Gulf Finance House - Ted Pretty Sees Pretty Good Times Coming

Al Watan has an interview with GFH"s Group CEO Ted Pretty.  They noted that he was a bit more optimistic with them than with the Western media he had met with.  Perhaps, things have improved.  Perhaps, it's a bit of market segmentation.

Here are the main points. My comments are in italics and contained within parentheses.

1. GFH faces difficulties but will regain health at the beginning of 2011.
2. In the past we bit off more than we could chew.
3. The current strategy is to focus on existing investments and projects, complete these and realize value. (AA:  More on strategy later this is not the complete picture).
4. GFH took action early and is starting to see the benefits.  Our 1H10 loss is smaller than 2009's.  Because of its wise actions, the bank is well positioned for profitability and growth in 2011.
5. GFH's 2010 priorities are:  restoring its operating model, reestablishing sources of income, cost control and rescheduling debt.
6. Going forward business activities will comprise as well raising financing, providing consulting services, managing assets, and the development of private capital (private equity), particularly in forming Islamic financial institutions.  He then noted that GFH had raised some US$2.5 billion in capital for a variety of firms:  First Energy Bank, Khaleej Commercial Bank, Bank Q Invest, First Leasing Bank, Asian Finance House, Arab Finance House and others.
7. He said that new capital is not required for and  will not be used to repay debts.   There's no need because the WestLB syndicate and LMC syndicate have been rescheduled.  (AA:  No doubt wishing to reassure investors.  The proceeds of the 2009 new capital were used to repay debt).

He also commented that fear was depressing economic and market activity.  However, he noted that several countries had proven that they were able to restart their economies without being dependent on recovery of the US economy.  And called for SWFs to do more to support and develop economic activity in the region noting that the average investor had a predilection to invest in Europe or the USA.

If you believe his pitch, this would be an excellent time to buy GFH shares.  They're selling below par.  Way below par.  US$0.125 on the BSE versus a par value of US$0.33.  The upside potential is unlimited as they say.

And since GFH has yet to publish its Basel II Pillar 3 disclosures as of 30 June 2010 as mandated by the Central Bank of Bahrain, many of you may be forgiven for assuming this means the bank has no risks to report - which, if true, could be a very positive "buy" signal.

Who Audits the Auditors?

A great deal of reliance is placed on auditors by Boards, regulators and the providers of debt and equity capital.   But how can these parties know the quality of the auditors' work?  Particularly, those not inside the firms being audited?

Understanding What Auditors Do and What They Don't

The first step is understanding precisely what is the role of the auditor.  A "clean" audit opinion does not mean that there was no fraud in the company.  Nor is it a guarantee that the financials are 100% correct.  If you think about it, to get to that level of certainty, the auditor would have to be present at every business discussion and follow each transaction at the company from "cradle to grave".

What the auditors' work should mean ("should" because it doesn't always) is that the auditor has determined that there is a proper system in place that is functioning reasonably.  That includes determining that  proper accounting principles are applied on a consistent basis, that the assumptions and estimates which affect preparation of the financials are reasonable and that a check of assets and transactions (on a sample basis) doesn't raise any red flags.  And finally that the results of operations (income, assets etc) are reported fairly in sufficient detail.

Several factors influence the performance and results of an audit:

1. Interpretation of accounting standards and principles:  strict, moderate or lax
2. Level of skill, experience, knowledge of the partners and staff
3. Management of the audit process, e.g., audit plan design, management of staff and workflow, quality of the review process
4. Ability and willingness to challenge management's assumptions and estimates
5. Ability and willingness to stand-up to pressure from the client or outside parties
6. Ethics

The second is understanding that the international firms are structured as partnerships, generally at the country level.  So Firm XYZG in the UK is not exactly Firm XYZG in Bahrain.  For one thing each has its own dedicated staff with their own level of skills, knowledge and experience.  What that means is that there can be differences between one office and another of the same firm.  

Auditing the Auditors

So, how can an outsider audit the auditors?

Three ways:

1. Use the work of regulators and others who review auditing firms' work.
2. Review the end product (the financial report) for quality.  While management is ultimately responsible for the content of financials, the auditors have a role to play as well.  Is the report clear?  Or is the true nature of transactions difficult or impossible to figure out?  Does the auditor seem to be condoning presentation at the edge or beyond in terms of accounting for transactions?  Do you see a repeated pattern of "easy audits"?
3. Prepare a list of auditors for distressed firms.   Then identify those companies where the problems were outright fraud, improper valuation of assets, aggressive booking of profits.  You're looking for  major occurrences and a repeating pattern. 

Let's turn to these examples one by one.

Using Regulatory Reports

Unfortunately, such regulatory or other review reports aren't available for every country.  To a large extent that limits the utility of this method.    But where they are available one may gain some insights.  While firms are separately incorporated national partnerships, there is some level of quality control, sharing of expertise among offices as well as tone setting from the top.

It's important to know that public reports of this nature are written in diplomatic language.  So it's important to understand the "code" used.  The concept is similar (but not identical) to that in the IMF Public Information Notices.   It's also very important to understand the basis for the reports conclusions.  In some cases the sample of audits reviewed is small in terms of the total number of audits done.  And may not have been selected using statistical sampling techniques.   In such cases one has to be careful not to draw a conclusion about just how widespread a failing is.

Reviewing the specific issues for a firm can give an idea of that firm's overall approach and perhaps pinpoint particular areas of concern.  One can usually classify the shortcomings as due to (a) lax interpretations of accounting principles, (b) staff inadequacies, (c) work process failures (design, implementation, monitoring and review of the audit), etc. 

This exercise can provide another level of insight.


Besides information on a specific firm, these reports may also disclose common problems.   If the reports on almost or all of the firms repeat the same themes, this can indicate both the relative frequency and severity of a problem.  So, for example. if all firms are being criticized for  audit failures on revenue recognition,  that's a much different situation than if only one firm is. 

On this topic today the UK's Financial Reporting Council, Professional Oversight Board released its  annual public reports on the audit work four major international accounting firms in the UK.  There's a very important word in that last sentence:  "public".  We can infer from this that there were private reports.  No doubt much more direct and to the point.

One firm has been singled out in the press.  But if you look at the individual reports you'll see shortcomings in such central areas as:

1. Obtaining audit confirmations for assets (one would think in the post Parmalat world this wouldn't be occurring)
2. Failure to attend the physical count and inspection of inventory - a very key step in understanding the financials of a manufacturing or retailing company.  If inventory is overstated so are profits.  
3. Technical issues such as going concern qualifications
4. Failure to complete partner performance/competence reviews

But note that the sample of audits reviewed was not chosen according to statistical sampling techniques.

What's potentially disturbing here is that these sort of things are being discovered in the UK.  One might assume that with the existence of the FRC POB, a legal system that makes it easy for lawsuits, the firms would be on their best behavior.  If this is the case, and it may well not be, what then is the standard in other less regulated more opaque markets like the GCC?

Reviewing the Financials Yourself

The second method, reviewing the financials yourself, is admittedly tricky.  You've got to have a bit of knowledge about accounting standards and presentation.

Here by way of example are some things that caught my eye.  And which two different observers might draw different conclusions.

1. The 2009 report of an investment bank in Bahrain.  Late in 2009, in what some might see as a vindication of its proven business model, it announced the successful issuance of a US$100 million convertible murabaha.  It's only when one reads further into Note 16 that one learns that the murabaha was issued at a discount, though you won't see that word used in the financials.  Nor was it in the press release.  It's only at the end of Note 16 we learn that proceeds were only US$80 million.  Technically, is the information there? Yes.  But it must be teased out of the Note.   Like that table you bought from Ikea, some assembly is required.  Is this really in the spirit of  شفافية ?  Isn't this material information important to the readers of the financials, particularly shareholders? Shouldn't it be disclosed in plain unambiguous language?  Apparently, management and the bank's auditors thought otherwise.
2. The 2009 annual report of a conventional investment bank in Bahrain, who some might describe as the grande dame of the industry.  During the year, it issued some US$500 million in preferred equity which is duly reflected in its books as of the end of its fiscal year.  But a look at Note 6  (Cash and Banks) shows that some US$381 million of that amount is as "cash in transit".  What this means is that the funds were received after the statement date.  They were not in the bank on the statement date.  Reflecting the full US$500 million as paid in equity seems a bit premature.  Perhaps this post balance sheet event is more properly reflected in a "Subsequent Event" Note.   Note 7  (Receivables) discloses that another US$110.5 million of the US$500 million was also not yet received.  So paid in equity has increased by US$500 million but only 1.7% of the amount was received by the statement day.  As in the case above, management and the auditors agreed on this presentation.   
3. The 2006 annual report of the same investment bank.  A change in IAS #28 led to a US$354 million charge to retained earnings which dropped from US$528 million to US$170 million.  Previously, the bank had valued some of its investments in associates at "fair value" using only comparable transactions using an exemption for assets held for sale in the "near term".   The bank noted that "near term" was not precisely defined in the Standard.  It reasoned  that since private equity and similar investments are held for three to seven years, that period  must be what was meant by "near term".  Like the cash in transit  treatment above this seems a rather conveniently elastic determination.  The firm's auditors apparently had no real problem with this approach because they countenanced it for years.   But there's more.  With that exemption no longer applying, the assets became Fair Value Through Profit and Loss with the methods for determining fair value now also including comparable market values (not just actual transactions).  The result of this additional method?  A US$359 million charge (68% of 2005 retained earnings).  Whether this was properly classified as a prior period adjustment (direct to equity by passing the income statement)  statement) is a matter of debate.  But the size of the required adjustment does suggest that tests for impairment may also have benefited from generous assumptions.   You'll recall that when the restatement occurred (June 2006) macro economic conditions were not particularly depressed.  And that over the next two years (a relative boom particularly in the markets where the investments were concentrated) there was no subsequent write up of these assets, lending further credence to the adjustment being more of an impairment.

Involvement in Distressed Situations

1. This is fairly straightforward.  The initial list can be compiled from the well known names in distress.  
2. One then looks for cases where there was particularly egregious behavior.  And then sees if the same firm's name is turning up repeatedly. 
3. Two very important points. 
4. First, firms get into financial distress without there being any defects in audit or any unethical behavior on the part of management.  Bad things do happen to good people.   
5. Second, everyone makes mistakes.  It's when one makes a lot of them that the red flag should go up.
6. Over the past few years, we've seen some spectacular falls from grace.  While some of these were due to (a) poor management or (b) the global economic crisis (lower case "g", please), in others there was apparent manipulation of financials.
7. In some of these cases, there have been allegations that loan portfolios were fictions of the imagination, that outside parties controlled the entities overriding what is described as a compliant/supine management, that internal documents, loan files,  minutes of board meetings were forged, etc.  If these allegations are true, there was massive sustained fraud.  Financial institutions may have been run as criminal enterprises.
8. In other cases fair values turned out to be vanish with astonishing rapidity.  Often in  companies that engaged in a high volume of obviously dubious transactions with related parties - buying and selling stock in one another, playing musical chairs with assets.  On a scale to suggest that this behavior was the usual mode of conducting business.
9. In some other cases, companies abused positions of trust and expropriated client and investor funds for their own use, stuffing those unfortunate parties with the losses or using assets of uncertain quality to extinguish amount certain liabilities.  Yet, the audit reports solemnly aver "We are not aware of any violations of local laws".  Though perhaps to be fair in some countries local law may not prevent such behavior.  It may instead be a sanctioned national sport as some of my "Southern" GCC friends claim is the case in one "Northern" country.

All of the above are of course indirect and not conclusive proof.  

But like the mosaic theory of research analysis (in which a bright analyst takes lots of little bits of information about a company to develop a powerful insight into its value), one can potentially do the same here.  And a sense of the quality of financials and audits can be a powerful (though not sole) input to an investment decision.

In the process one also has to apply appropriate weights to behavior.  So, for example, one might be more forgiving of  some shortcomings than others.  It's a bit easier to "understand"  an auditor  letting some window dressing pass than countenancing related party schemes to pump up investment values.  Though it's probably a good idea to be a bit more wary of an auditor who repeatedly demonstrates a "flexible" or "accommodating" approach than one that does not.  Each crossing of a "line" makes the next easier.

Kabul Bank, Mohammed Karzai, Sherkhan Farnood and Palm Jumeirah

Photograph Ivanlo  Released to the Public Domain 

How often do you hear about companies that advertise services that they really don't offer?  Where managements talk the talk but don't walk the walk?

Well, that's not the case at Kabul Bank where management takes seriously the slogan "The Easiest Way to Earn Millions" as we learn from Bradley Hope over at The National.

And what could be easier than real estate investments in Dubai, particularly in the prestigious Palm Jumeirah development.

One chap made a quick AED3 million, though he can't remember what he did with it.

And what can you say about a Chairman who's so solicitous of his bank's investments that he registers them in his and his wife's name?  No doubt in order to keep a close personal eye on them?  Sadly now, the former Chairman due to some onerous new banking regulations in Afghanistan. 

16 or so villas on Palm J and two plots of land in Business Bay reportedly worth some US$150 million.

As per KB's 31 December 2008 financials (the latest posted on its website), that amount being twice the Bank's shareholders' equity and 21% of total assets (assuming of course that the properties are reflected in the balance sheet). 

Bahraini Regulatory Quiz: When Do Bahraini Banks Have to Publish Their 30 June Basel II Pillar 3 Disclosures?

As if there weren't enough excitement here at Suq Al Mal with compelling analyses of zakat payments, magical provisions, we're going to have a contest to liven things up a bit more.

My understanding was that locally incorporated banks in the Kingdom of Bahrain are required to publish their Basel II Pillar 3 disclosures concurrent with their 30 June financials.

But one firm noted for its unwavering verbal commitment to disclosure and transparency has yet to do so.  That obviously means that my understanding is wrong.

Hence, this competition.  

The first one to post the chapter and verse from the CBB's Rulebook will receive the grand prize --  a slightly worn "proven business model" formerly the property of a self-proclaimed world class "Islamic" investment bank.  Early responders may be eligible for a bonus prize - a half baked business plan for a US$4 billion energy city/financial and day care center.

Multiple entries are permitted.

The Investment Dar - Al-Musallam Denies Problems

This Thursday (26 August) TID held its 2008 shareholders' annual meeting (delayed because of the delay in finalizing its financials).   Both AlQabas and AlWatan have accounts of that meeting.  Some 73.11% of shareholders' interests were represented.  As per the KSE, the only disclosed major shareholders of TID are the Kuwaiti General Organization for Social Insurance (7.7%) and Efad Real Estate Company and associated companies (18.21%).  So there appears to have been broad shareholder participation.

AlQabas notes that the meeting was held in an atmosphere of "impressive calmness".   All items on the agenda were approved, including agreement with the Board's recommendation that no dividend be declared for 2008. (TID reported a net loss of  KD80.3 million for 2008 of which KD78.6 million is attributable to TID shareholders.  From 2007 to 2008 TID's total shareholders' equity declined from KD349.6 millionn to KD168.5 million due to KD52.9 million of 2007 dividends, KD 37.4 million of losses recorded directly in equity and net purchases of treasury shares of some KD12.2 million.)

The tenor and results of the meeting no doubt a clear reflection of shareholders' confidence in Mr. Al-Musallam's stewardship and performance.

Mr. Al-Musallam also took the opportunity to "set the record straight" on several points, including most of the assertions in a recent AlQabas article:

1. As he has on several earlier occasions, he noted that statements that TID was going to be liquidated were not true pointing out the strength of TID's assets.
2. The CCC is not discussing resigning.
3. In that connection he commented that TID is happy to have the Central Bank of Kuwait's supervisor, Dr. Abid AlThafiri, stay on, but that decision is solely the CBK's.
4. There are no differences with the CBK.  The CBK poses questions and TID answers them.
5. More than 83% of the creditors have agreed to participate in the rescheduling.  The remaining 17% represent only KD110 million.
6. He expects to achieve success with Commercial Bank of Kuwait and Cham Islamic Bank (Syria)  and then will have 89% agreement.
7. He's optimistic about obtaining the Central Bank of Kuwait's approval for TID to enter under the protection of the FSL.  
8. He noted that many of the creditors who have indicated they intend to pursue legal claims (the 17% soon to be 11%) were waiting to see the results of the current stage (presumably whether TID gets under the FSL) before proceeding.  The unspoken point here being that if TID enters the FSL, then perhaps some or all of these holdouts may join the rescheduling.  Not an unreasonable assumption.
9. Contrary to rumors, there is no raise for any senior member of TID's management.  Apparently, not even an "unrealized" one! 
10. TID is not late with its prior year's zakat.  Though the wording used here seems to imply that perhaps the committee has not yet distributed it - which would qualify as being "late" for a simple minded guy like me.  وأكد المسلم أنه لا يوجد تأخير في دفع الزكاة عن الشركة، مستشهداً برأي لجنة الفتوى والتشريع التي أكدت على ان الشركة لم تتأخر ولكن هذه الزكاة تعود الى السنوات الماضية، منوهاً الى ان اللجنة تقوم باخراج الزكاة من وقت الى آخر حسب الحالات التي تقوم بدراستها من وقت الى أخرى
11. Perhaps, the answer is that "class is not yet over" and the studies continue?  Anyone who can confirm or amend my translation, please jump in with a post.
12. He did take the time to point out that the 2008 loss (largely due to provisions of KD89.5 million) was not realized.  
13. Asked about 2009's financials and the CBK's requirements for additional provisions, he declined to answer, commenting that the Company respected its regulator's (the CBK's) views, would have the auditors review them. But in the final analysis will do what the CBK requires.
14. One other important "bit" he stated that the Company had appointed new auditors (dual case used).  In 2008 TID used the local incarnations of Deloitte and Touche and KPMG.  
15. The Ministry of Commerce and Industry raised comments during the meeting that the Board did not meet during 2008 (I take this to mean regarding 2008 financial performance not that there were no board meetings that year) and that TID failed to properly register its shares in Bahrain Islamic Bank,.  These shares (8.7% of BIsB) were acquired by TID in satisfaction of a financing receivable and are discussed in Note #8 to its 2008 financials. Mr. Al-Musallam said that the Board did not meet because the financials were not approved (presumably he's referring to the auditors and CBK).  The BIsB shares are in the process of being registered.

A new Board was elected as follows:

1. Adnan Abdul Qadir Mohammed Al Musallam, Chairman and MD
2. Rajam Al Roumi
3. Ghanem Al Ghanem
4. Adel Behbehani
5. Adnan Nisif
6. Musa'id AlMukhaytar
7. Nabil Abdul Rahim

And "reserve" directors (in case of need for a replacement of a sitting director):  Nabil Amin, and Abdul Muhsin Al Kandari.

Hopefully, this impressive performance (there's that word again) will silence the unfounded criticism of TID in the market, leaving only the founded sort.

Gulf Finance House - 1H10 Financials: Now You See It Now You Don't -- The Magical US$137 Million Provision

GFH has finally posted its 2Q10 interim report.

Let's get straight to the heart of the analysis and our headline, Note 15:

"During the period, the Group's credit enhancement amounting to US$ 102 million issued to financial institutions against credit facility arrangements for a project managed by the Group were enforced by the lenders due to contractual defaults by the project company.  Further, based on the Group's assessment of the likelihood that another project will be able to meet the financing when they fall due, the Group has estimated that its financial guarantee of US$ 35 million may be enforced.  In accordance with the requirements of IAS #37, Provisions, Contingent Liabilities and Contingent Assets, the Group has recognised a provision of US$ 137 million towards these liabilities until revised/ renegotiated terms are agreed with the lenders of the project companies.  The Group has recognised an equivalent amount of reimbursement right which has been included in other assets (note 8)."

Presto, changeo with a bit of Accounting Magic a potential US$ 137 million addition to 1H10's net loss is transformed into an asset!  What's even more astounding is that these projects that cannot meet their debt commitments (to the apparently impatient lenders) will nonetheless be able to honor GFH's reimbursement claim upon them.  Now that is truly magical!

(Side Note:  According to my copy of KPMG's Third Edition of "Insights into IFRS" page 635 commenting on IAS 37.35 (about the recognition of Contingent Assets), KPMG states:

"When realisation of a contingent asset is virtually certain, it is no longer considered contingent and is recognised.  In our view, virtually certain generally should be interpreted as a probability of greater than 90 percent."

Unfortunately, I don't have the latest edition so I would caveat that there may have been some new thinking on the topic of what constitutes "virtually certain".)

Taking this amount to the income statement would roughly triple GFH's loss.  It would also breach the US$400 million minimum shareholders' equity covenant.  But there's one more adverse effect making this US$137 million truly a "triple threat".

As we learn in Note #2 during the discussion of the going concern issue, GFH's capital adequacy ratio at 30 June was 12.92% - leaving little room for maneuver or in the words of KPMG "which restricts the Group's ability to absorb further losses or undertake additional exposures".   (Note to KPMG:  You need to amend the reference in your report to the matter of emphasis from Note #1 to Note #2.)

And I suppose -- to add a fourth reason -- such a loss and such consequent events might make a difficult capital raising exercise just a "wee bit" more difficult.

Where there is a need and a will, there is a way -- as the old saying goes.

Turning to the rest of the financials:

1. Note #5: US$115.4 million (95%) of 1H10's US$121.4 million of Placements with Banks and Other Financial Institutions is pledged against commitments and facilities of projects of the Group.   And so should be excluded from liquidity.  You'll notice it is in the Cashflow Statement.  Some might suggest that proper presentation would be to have these amounts in Other Assets.  And well they might but to no apparent avail.   Some of this cash may be pledged to those adversely affected projects discussed in Note #15.
2. Financing Receivables US$14 million decline (which took place between FYE09 and 1Q10) is still a mystery to me.  It's not in the cashflow statement so it must have been offset against something else?
3. Receivable from Investment Banking Services declined from US$85.3 million at 1Q10 to US$40.5 million at 2Q10.  I can find a provision of US$20 million but am unable to locate the remaining US$25 million in the cashflow statement.  Another magical offset?
4. Note #6:  Assets held for sale include Bahrain Financial Harbour Company (US$175 million), $50 million of GFH's long outstanding Receivable from Sale of Investments (now reduced to US$44.5 million and carried in Other Assets) plus US$35 million of Financing to Projects.  The first two items will be settled "against receipt of consideration in the form of cash and land plots."  Well, when you can't pay cash why not settle your obligation with a highly valuable piece of (no doubt) blank land.  The upside potential is, well, enormous, especially at current depressed prices! 
5. Other Assets - As noted above there are reductions of some US$85 million (See Point #4 above), against the introduction of reimbursement rights of US$137 million whose collection is no doubt at least virtually certain if not certain to a much higher degree.
6. Note 9 updates on the financing.  The LMC US$100 million facility (US$80 million outstanding) carries a "profit rate" (read interest rate of 8.5%!).   The rescheduled West LB facility a 3.75% profit rate (reduced from 5%).  This facility is now secured by GFH's shares in Khaleeji Commercial Bank, which no doubt explains why the promised sale of this asset suddenly was postponed.  Perhaps, the collateral will be sufficient cover to prevent an impairment under IAS #39. Also of note during 2Q10 some "wise" and brave lender has provided a US$16.64 million Murabaha financing due in November 2010.
7. Note #10:  Some 69% of Other income (1H10: US$8.6 million) is composed of income declared because certain liabilities were no longer payable (US$4.2 million) and from recoveries of project expenses (US$1.7 million).  

All in all quite a performance in 2Q10.  For those curious that's not a reference to financial performance but the magic of accounting.