What is a Consolidated Financial Statement and Why You Should Care

Arqala Minor with the Prep School's
Beloved Accounting Teacher Mr. Debits
I studied hard then so I could answer your questions today.

At first blush this topic no doubt sounds like it will be a recitation of arcane accounting principles and standards complete with multiple examples of journal entries and the tracking of matching debits and credits.

I promise you it won’t be. Can’t promise much on length though.

The real point of this post is the second part of the title.

You may be thinking why should I care?

After all the accountants will do their job and “account”. 

“Why should I care anymore about this than the recipe the hummus chef at Hummus Express uses?

The reason you should care is that consolidated financials are not the financials of a legal entity rather they are the financials of an “economic entity”. 

An economic entity that the accountants have “constructed” according to certain (accounting) principles. 

From a legal standpoint, this entity exists solely on the pages of a financial report.

Consolidated financials are designed to give a picture of the position and performance of the economic entity or group.

But they can also be misleading, if one doesn't know what they represent.

In the real world, one conducts business with legal entities not accounting constructs.

One buys the stock or debt of a legal entity. One signs other contracts with a legal entity.

Contracts with legal entities are enforced against legal entities and their assets.

Not against economic entities.  

One only gets protection from the "group" if subsidiaries of the parent guarantee the obligations of their parent.

What are the benefits from understanding consolidated financials?

First, the “ships” of many a credit officer or “wise” investor have floundered on the conflation of “consolidated” financials with legal entity financials. Legal entity financials look much different than those of a consolidated group.

Assets (including cash) that appear in the consolidated financials that one thought were available to the Holding or Parent Company are not.  Because they are  assets that belong to a separately incorporated company.

One which is likely to have other shareholders (NCIs) whose permission would be required to "use" them for the Holding Company. And whose reluctance/refusal to give permission to use their "money"   to bail out the Holding Company is probably a safe bet.

Absent a guarantee from the operating subsidiaries, if you lend to the parent company or invest in its securities, you have a claim against the parent company and its assets and cashflow as reflected in its legal financials.

Second, if you understand what you’re looking at, you will be able to get a better sense of the performance of the legal entity whose stock or debt you own. And whether you should accumulate or divest. 

Sometimes you can get an insight into problems in the "group" merely by looking at the NCI share of income.  

In 2019 the NCI share of income at GFH was minus $13 million.  If we assume a 50% split between GFH shareholders and NCIs, this means that GFH also experienced a similar loss. But in GFH's case there was other income that absorbed that loss. The size of the total loss would suggest that there were problems in a major subsidiary.  KHCB would be a likely candidate.

How does consolidation work?

Consolidated financials include not only 100% of the assets and liabilities of the subsidiaries and associated companies that meet the accounting tests for consolidation, but also 100% of their revenues and expenses (thus, their net income). 

Any transactions between the "group" companies are eliminated, i.e., removed from the financials.

When subsidiaries are not 100% owned by the Holding Company, two adjustments are made to reflect the non controlling shareholders’ interests (NCIs).

On the balance sheet a single line adjustment is made on the liability side by creating a component of total equity called Non Controlling Interests. 

No adjustment is made for assets and liabilities of the NCIs on the balance sheet. If you're looking to the consolidated financials as an indication of the assets the "group" has you should not "count" those belonging to the NCIs.  But you have no idea what assets and liabilities "belong" to the NCIs.

A similar approach is taken on the income statement. A single line adjustment is made in net income for the 100% of NCI revenues and expenses by distinguishing a component called “net income attributable to NCIs” from “net income attributable to shareholders of the group”.

Keep in mind that this is a single adjustment across all the subsidiaries. If NCIs have net income of $104 in some subsidiaries and a net loss of $100 in other subsidiaries then the amount shown will be $4.  Again the absence of detail is not particularly helpful for analysis.

Also keep in mind that NCIs are unlikely to be exactly the same parties across all subsidiaries.

Let's turn to Citigroup to get real life examples of these key points with the intent to make them more concrete.

To be very clear there is no negative connotation in the choice of Citigroup.

Rather there is a rich vein of information in their 2020 FY annual report. (Form 10K) 

Compare this to Note 33 in JPMorgan’s FY 2020 Annual report. (Form 10K) which has less detail.

2020 Revenues (Page 301)

Citi Parent’s net income is shown on the extreme left. Citi consolidated on the extreme right with adjusting entries in the middle.

There are wide differences in amount in each revenue or expense category.

In the end the net income for both Citi Parent and Citi consolidated is equal at $11.047 billion. 

But the details show that there are two critical differences between the two sets of financials.

First, Citi Parent does not conduct significant business on its own as reflected in the individual revenue and expense items. Its cashflow is largely secondhand and dependent on payments from the subsidiaries.

Second, subsidiary dividends drive Citi Parent’s cashflow. And, thus, are (a) volatile and (b) subject to constraints on payment.

In 2020 Citi Parent did not receive $9.894 billion of that year’s net income in cash (roughly 90%).

And will not until the subsidiaries pay it dividends.  Until it receives the cash it cannot use it to settle obligations, make investments, etc.  

Government agencies or regulators have the right to restrict the amount of dividends that a regulated firm—think primarily FIs--may pay under various measures to "protect the financial system". 

In all firms shareholders must approve the payment of dividends through formal processes, e.g. AGM.  So one can't simply ring up the subsidiary and ask for $1 billion in dividends by tomorrow.

As to volatility, in 2019 and 2018 (pages 302 and 303), Citi Parent received dividends 10x those in 2020.  In both of those cases the dividends were more than 100% of those years’ net income.

Also look at the penultimate column on the left "consolidating adjustments".  That will give you an idea of intragroup transactions "eliminated" on consolidation.  You will also see this on the balance sheet, statement of cash flows. 

2020 Balance Sheet (Page 304)

Here the difference is even more stark.

Citi Parent had total assets of $386.134 billion, while Citi consolidated had assets of $2,260.090 billion (almost 6x Citi Parent).

Even more telling, 95% of Citi Parent’s assets were equity in subsidiaries (55%) and advances to subsidiaries (40%). Probably most holding companies look like this. They after all are “holding” equity in subsidiaries.

Compare that to the consolidated financials where there is a greater range of asset types and a greater range of liquidity as well as much larger amounts..   

That has implications when there is corporate distress.

Distress at the subsidiary level is usually but not always the cause of distress at the Parent. 

At this particular time the Parent will be even more dependent on the subsidiary for cash because it most likely has no significant operations of its own. In such a case dividends are unlikely.  Selling the equity in the subsidiary or pledging it as collateral is unlikely.  

The most likely scenario is that the Parent will have to wait for its share from the liquidation of the subsidiary's assets.

Because the Parent holds equity in the subsidiaries, it is last in the priority of payments. Senior creditors get paid first, subordinated creditors next, and equity holders get what’s left. Usually that’s nothing or close to nothing.

There is also a risk that Parent extensions of credit to the subsidiaries may be equitably subordinated to other subsidiary creditors or recharacterized as equity. This of course depends on jurisdiction and the specific circumstances/form of the extension of credit.  

If this happens, the cash flow from the subsidiary to the Parent will be even less.

Even if it doesn't,  Parent Company creditors and investors are likely find themselves at the very end of the cash "waterfall".  

Not where they thought they would be when they extended credit or invested. 

Wirecard - Why Income Statement Manipulation Results in Balance Sheet Manipulation

R^2 -Not Affiliated with Wirecard or Hin Leong

As you will recall, Financial Times articles reporting that Wirecard’s (WC) revenues and thus net income had been deliberately overstated triggered the unraveling of the company. Here is an article from early 2019.

If these allegations are true, then it should be no surprise that a significant amount of WC’s assets (most likely cash) does not exist.

And like AA’s “missing” Maybach S 850 Luxury Edition never did.

What that means is that Wirecard’s “billions” have not be misappropriated.

Nor have they been misplaced. Not left, perhaps, in the German equivalent of the Victoria Station Brighton Line cloakroom in a handbag or handbags.

Furthermore, we should have expected to learn that assets were inflated when we first read that income had been.

Since it seems that there is some confusion on this matter, (example here) I’m writing this post to explain why income statement manipulation necessarily requires manipulation of the statement of condition (balance sheet) by the same amount.

Similarly if there is misstatement of a company’s balance sheet, then it’s a very good “bet” that company’s income statement has been misstated as well as discussed further below. 

Why is this?

The answer comes the fundamental accounting identity: Equity = Assets – Liabilities.

If net income is overstated, then equity must be similarly overstated because the results of operations – net income or net loss – are added to equity.

As the balance sheet identity above demonstrates, if equity is overstated, then so must A-L.

Inflating net income then requires that one:

1. overstate assets or 
2. understate liabilities. 
3. Or some combination of 1 and 2.

But there’s more.

There is a very close relationship between the income statement and balance sheet.

In general every entry on the income statement is mirrored in an equal but opposite entry or entries on the balance sheet.

If one reports USD 100 in revenues (a credit), then a debit or debits for the same amount must appear on the balance sheet, e.g., in cash and/or accounts receivable.

If one reports USD 100 in expenses (a debit), then an equal amount credit or credits appears in the balance sheet, e.g., in cash and/or in accounts payable (a liability).

Non-cash revenues (e.g., revaluation of assets, reversal of provisions) must be accompanied by debits to the assets concerned or to existing provisions (contra accounts or liabilities).

Non-cash charges (e.g. depreciation, amortization, provisions) must be accompanied by credits most often to contra accounts to assets or in some cases creation of liabilities, e.g., reserve for litigation.

There’s no escaping this – if one’s balance sheet is to balance.

A dollar’s worth of “fiddling” the income statement, requires a dollar’s worth of “fiddling” the balance sheet.

As noted above, when one hears that a company's assets have been manipulated - usually to make them larger, then one should know that so has income.

By way of example is the case of Hin Leong Trading Singapore.

At this time, reports are preliminary not final.

Details remain “sketchy”--in both senses of the word.

Based on these three articles, CNBC, The Independent (Singapore), and AsiaOne, it appears that HLT hid some USD800 million in derivatives losses (oil futures), and fabricated some USD 2.2 billion of accounts receivable.

As well, the company's inventory is "short" USD800 million.

What that means in layman speak is that HLT’s inventory is overvalued. In this case the value of the actual (physical) inventory is USD800 million less than the value shown on HLT’s balance sheet.

HLT seems to have had two goals with the manipulation of its financials.

Creating fictitious income to cover losses.

Because the amount of the “inflated” receivables is much greater than the USD800 million derivatives losses it’s clear that HLT has been unprofitable for some time as well as cashflow negative.

HLT’s unrecorded sale of USD800 million in pledged inventory to obtain cash for its general operations not only supports the latter conclusion (negative cashflow) but shows just how serious it was.

Maintaining/expanding its “borrowing base”

Most banks lend to commodity traders on a secured basis, with the maximum loan expressed as a percentage (borrowing base) of receivables and inventory.

The “base” is always less than 100% to provide a margin of additional protection because typically one doesn't realize the face value of collateral.

When the outstanding loan is equal to the allowed borrowing under the “base”, the bank will make no further loans.

If outstandings are greater than the amount allowed under the "base", the bank will demand a repayment in the outstanding loan to bring it within the base.

Account Receivables

Banks generally tier the lending percentage according to the days outstanding of receivables, the credit standing of the obligor, etc. The quicker a receivable is collected the better credit quality it is. The longer a receivable is outstanding the lower the quality and therefore the "base".

The nature of the goods being sold is also a factor.

HLT fabricated multiple transactions to replace “aging” bogus receivables with new ones to maintain the borrowing base.

And critically as well to create additional amounts of receivables to expand its “base” and fund its cash “burn”.

Banks also monitor the turnover (inflows and outflows) in borrowers’ balance sheet accounts as well as the borrower's cash account with the bank, particularly those borrowers involved in trading.

If a borrower’s account is “stagnant”, it is a sign of distress in its business. If receivables are turning over (being collected) at a glacial pace, another red flag.

HLT round tripped cash through its accounts to give the appearance of robust cash flow, e.g. collection of receivables.

Inventory

Banks perform a similar borrowing base calculation with inventory, factoring in price volatility, nature of the commodity/goods, costs of sale, etc. 

For example, in general crude oil inventory would be considered “better” than specialty manufactured goods that could be used by only a limited set of potential buyers.

HLT needed cash and didn’t want to reduce its borrowing base which would prompt a demand for reduction in its loans. So it sold pledged inventory without recording it in the income statement or its balance sheet.

GFH's USD 300 Million Sukuk - Success Has a Price

And Sometimes It's High as Well

On 29 December 2019 GFH’s shareholders approved GFH issuing up to a USD 500 million sukuk through an SPV in one or more tranches.

On 22 January 2020—less than one month later—GFH announced that it had “successfully priced” a USD 300 million 5 year sukuk. 

Strangely, GFH didn’t disclose what the successful price was. 

An inadvertent lapse in " شفافية "? Modesty or something to hide?

AA will tell you later as I want to let GFH have the first change to explain its success.

GFH’s press release outlined several key takeaways. Italics are AA’s. 

This is a landmark transaction for GFH, placing it in the international debt capital market. 

The successful issuance was supported by a ‘B’ rating from each of S&P and Fitch with strong demand from international investors reflecting market confidence in GFH and its subsidiaries (the Group) and recognition of its healthy financial position, sound strategy and business model.

The order-book for the Certificates was oversubscribed 2.5 times exceeding US$750 million. The Certificates saw strong demand from international investors who were allocated 47% of the issuance with the additional 53% taken up by regional investors.

In terms of the types of investors, 61% were fund managers and 39% were financial institutions.

The proceeds of the Certificates will be used to enhance the financial position of the Group and to fund its next phase of growth.

GFH’s CEO, Hisahm AL-Rayes summed it all up by saying

This is another important milestone for GFH and further recognition from the market of the success of GFH’s transformation into a sound and well diversified financial group. The strong uptake from both regional and international investors attests to the strength of our strategy, our financial health and performance and, importantly, to our future prospects as we push forward in further building our business and position as a leading regional and international investor. The proceeds of the Certificates will enable us to continue to build and deliver even greater value to our investors, shareholders and the economies in which we invest.

Italics in above quote are AA’s and set the stage for some observations below.

First, the successful price was a fixed rate of 7.5% per annum.

You can look over a list of indicative sukuk quotes from Emirates Islamic Bank to get an idea just how successful the pricing was.

Perhaps, GFH is thinking about the success of the investors?  Perhaps relieved that it didn't have to pay 10%?

Of course, the pricing looks “generous” before consideration of credit risk. Then maybe not so rich.

It’s unclear to AA how a low non-investment grade rating of B supported issuance, though it does justify the price. Rather AA suspects that this very generous successful price certainly drove interest and the oversubscription.

One might speculate if at this pricing, oversubscription should have even been higher.

In issuing its ratings announcement, Fitch made the following points.

1. Its rating of B/RR4 was based on GFH’s credit rating as Fitch sees GFH’s obligation under the transaction as the source of repayment.
2. It has not assigned any collateral value to the Trust Assets.
3. It does not express an opinion on compliance with Shari’a principles.

For those who don’t know, a Fitch Recovery Rating of “RR4” represent a historical average recovery 31% to 50% of principal and related interest on securities in the “B” category. Page 24 in Fitch’s Ratings Definitions publication. Be sure you read Fitch’s complete explanation of Recovery Ratings, including limitations.

To AA that sounds like GFH has less than a strong “financial health”.

As to being well diversified, perhaps GFH’s CEO is thinking about the future.

The Offering Circular contains the following contrary comments.

The Group has significant exposure to the real estate sector (page 13)

As at 31 December 2018 and on an original basis, 54.1 per cent. of the Group’s total assets were concentrated on the real estate sector, principally in the form of the development properties (which constituted 26.4 per cent. of the Group’s total assets as at 31 December 2018), its investment properties (which constituted 10.5 per cent. of the Group’s total assets as at 31 December 2018) and its financing assets and assets acquired for leasing (which constituted 8.7 per cent. of the Group’s total assets as at 31 December 2018).

Real estate concentration at KHCB. (page 13)

In addition, 50.5 per cent. of the Group’s commercial banking business’ assets exposed to credit risk as at 31 December 2018 were concentrated on the real estate and construction sectors and 93.9 per cent. by estimated fair value of the collateral accepted by the Group against financing assets and assets acquired for leasing including lease rentals receivable was in the form of real estate as at 31 December 2018.

Real estate valuation is inherently subjective and uncertain, and real estate investments are illiquid (page 9)

Real estate assets are inherently difficult to value. As a result, valuations are subject to substantial uncertainty and subjective judgments and are made on the basis of assumptions which may not be correct.

Temporary forbearance from CBB regulations (page 16)

1. The Group currently benefits from a CBB exemption that permits it to exclude the assets acquired through litigation settlements and by way of a share swap from the CBB’s large exposure and connected counterparty limits. This exemption is re-assessed by the CBB on an annual basis. If the CBB decides to no longer grant the exemption, this will negatively impact the Group’s capital adequacy ratio which may lead to non-compliance with regulatory requirements and result in the Group becoming subject to potential enforcement measures and/or significant penalties. 
2. The Group also has an exemption from the CBB related to its exposures to certain large real estate projects which are higher than 15 per cent. of its regulatory capital. This exemption is also re-assessed by the CBB on an annual basis. If the CBB decides to no longer grant the exemption, this could require the Group to reduce its exposure which could result in significant losses.

From the above AA does not see a picture of strong financial health or the diversification that others see.

One further comment: Know Your Obligor

Under certain conditions GFH is obliged to make full repayment of the sukuk. Fitch considers GFH to be the source of repayment.

It’s critical to understand exactly “who” is on the hook here.

In an indirect way, the Offering Circular does this, but AA fears not clear enough so investors understand.

On page 13 the OC states:

The claims of Certificateholders against GFH will be structurally subordinated to the claims of the creditors of GFH’s investees.

What that means then is prospective investors in the sukuk should have looked at the financials of the parent company of the GFH Financial Group BSC, not the consolidated financials.

Why?

The consolidated financials reflect an accounting construct not a legal entity.

One signs contracts, including debt contracts, with legal entities.

One enforces one’s contractual rights against legal entities not accounting constructs.

Unless GFH’s subsidiaries and investees separately legally committed themselves under this transaction, they are not obliged to repay the sukuk.

Therefore, one needs to look at the parent company’s financials.

These will look quite different than the consolidated group financials.

For example, all of KHCB’s assets and liabilities will not appear in the parent only financials. They will be replaced by a single number representing GFH’s investment in KHCB stock.

All KHCB’s income and expenses will be not appear in the parent only financials. In their place will be dividends received and perhaps a change in value of the stock investment, depending on the method used to account for KHCB.

In this respect it’s important to understand that as a shareholder in KHCB or any other investee, GFH is subordinate to the creditors of the investee.

Also that any cashflow from KHCB or another investee—which AA would venture to claim is critical to repaying the sukuk—will come via dividends or perhaps loans. There are various controls on the amount of dividends an investee may pay and generally limits on intragroup transactions. Thus, funds may not be available.

Here’s an example using Bank of America’s FY 2018 AR. 

Compare the Income Statement and Balance Sheet for the parent company in Note 24 with the Consolidated Income Statement and Balance Sheet. 

Quite a difference. You’ll see each of the points made above reflected in the parent only numbers.

The OC doesn’t contain parent only financials. Yet the parent is the Obligor.

Why? 

How could this critical piece of information be lacking?

Rather than rely on the issuer/obligor, legal advisors, or investment banks to ensure that this information is provided, regulators should require that parent only summary financial information be included.

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.