DFSA Calls for Audit Improvements

Apparently heeding the comments of  The Rageful Cynic on this blog,  Paul Koster, CEO of the DFSA called for improvements in local auditing as reported by Tom Arnold at The National.

“Are auditors doing enough in that respect? I don’t think so,” said Mr Koster. “I think one of the key areas where auditors right now can gain momentum in the level of trust they provide to the financial market is to increase the level of scrutiny and scepticism in regard to the judgement of management in valuations.”

There's the usual commentary as well about the  need for auditors to get more training so they can understand complex financial instruments.

But the most telling quote of all is at the end of the article.

Auditors speaking to The National have previously accused Gulf companies of using similar accounting practices to mask bad assets and called for greater safeguards to avoid such methods.

Accounting in the GCC is based on IFRS which is a principles and not a rules based approach (the latter being the system in the USA).

Under a rules-based system, the accountant and auditor merely ticks the boxes.  If enough boxes are ticked, the transaction passes the test.  Form may over rule substance.

Under a principles-based accounting system, accountants and auditors are to look behind the form of a transaction to the substance.  The Lehman Repo 105 was a very clear scheme to get around the rules.

That local auditors are whining about violations and doing nothing to stop their clients is a very clear indication that the problem isn't training.  It isn't greater skepticism (or scepticism).  It isn't a lack of scrutiny.  

Very simply put, it's a lack of professional ethics.

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.

CitiGroup and Its Magical US$50 Billion in Deferred Tax Assets

While many in the Developed West are liable to ascribe magical powers to those from the East, the Hindu Fakir, a guru at an Ashram, a bank in Bahrain, there is magic aplenty - particularly of the accounting sort- all over the world.

Today we look at one of the USA's major banks with US$50 billion worth of  DTAs (roughly one-third its capital).  Under accounting standards, Citi has to earn some US$99 billion in taxable income over the next 20 years to fully utilize the DTAs.

Like me I'm sure you're thinking surely there must be an "Islamic" equivalent.  Perhaps a Deferred Zakat Asset.  I'll be watching my favorite financial institutions in Bahrain and Kuwait to see if this shows up in their financials.

In response to a comment from Chapter 11, I'd note that of Citi's US$50 billion in tax credits, approximately US$31.5 billion are disallowed from computation of regulatory capital.  See Note #4 on page 36 of its 2Q10 10-Q.

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.

Repost: AAOIFI May Limit Shari'ah Scholars' Role

An interesting article from Haris Zuberi over at The Islamic Finance Portal.

The guidelines may address whether Shariah scholars can own shares in the institutions they serve and how many advisory boards they join, said Mohamad Nedal Alchaar, secretary-general of the Accounting & Auditing Organization for Islamic Financial Institutions, whose standards have been adopted in countries including the United Arab Emirates and Qatar.

Gulf Finance House Secures Extension of US$100 Million West LB Facility

GFH announced on the BSE today that it had secured an extension of the US$100 million "stub" remaining from the US$300 million West LB syndicated murabaha.

The "new" facility is for a tenor of two years with a further one year extension at GFH's request.  The "profit rate" (interest rate) is reportedly lower.

This helps GFH avoid an immediate crisis as the full US$100 million was due this month.

An interesting question, if the banks have refinanced GFH because it could not pay and have reduced the interest rate, do Paragraphs 58 and 59 of IAS #39 require that the lenders book a provision?  See here for an earlier discussion of the requirements of IAS #39.

The Investment Dar – Review of 2008 Financials

Further to my earlier post, in which I discussed primarily the auditors' report on TID's financials, here are some additional comments.

Treasury Shares

The Consolidated Statement of Changes in Equity and Note 18 (Page 30) shows that TID and its associates owned 60,708,612 in Treasury Shares with a cost of KD45.224 million and a market value of KD6.192 million (13.7% of cost!). 

This is significantly larger than the holdings disclosed in TID's 3Q08 financials of KD9.820 million or 14,097,720 shares. 

Two reasons for the change. 

1. First, the inclusion of holdings of associates. 
2. Second, some minor 4Q08 buying by TID itself. 

Of the two, the associates' holdings were the most important factor. 

1. As at 31 December 2007, they held 35,019,092 shares at a cost of KD21.630 million and at 31 December 2008, 45,135,892 shares at a cost of KD34.993 million. 
2. As of the end of 2008, TID itself held "only" 15,572,720 shares.
   

Let's take a look at trading activity. Unfortunately, TID has not restated its interim financial reports for 2008 so we cannot determine quarterly trading patterns for the associates. 

1. In 4Q08 TID purchased net KD0.411 million. And for the entire year actually sold some KD1.2 million worth of Treasury Shares.  
2. For all of 2008, TID's associates purchased 10,296,800 shares for KD13.363 million. That would mean an average purchase price of KD1.321 per share. When I look at the KSE records for 2008, it seems that March 16 and 17 are the only two trading days with a price of KD1.320 when some 12 million or so shares traded.

Assuming that TID's associates bought their 2008 shares at market and looking at TID's own trading position, it seems there were no significant 4Q08 share transactions by the Group to influence its price – a time when one might have expected an effort to prop up the market value. 

Notable high volume days were 25, 26, and 27 November when 31.4 million, 14.4 million and 15.2 million shares traded roughly in the KD0.220 range. And then again on 17 December when 31.4 million shares traded at KD0.203. And finally on 23 December when 42.3 million shares traded at KD0.157.

Investments at Fair Value through Profit or Loss

In Note 5, Page 19 we learn that "Unquoted local funds with a fair value of KD55,575,647 as of 31 December 2008 (200&7: KD60,710,023) are in funds managed by the Group. Approximately, 52% of the assets of these funds of KD65,287,835 are held by the Group under Murabaha and Wakala payables."

Murabaha and Wakala Placements

Note 7 Page 20. A couple of points here. 

First, as you'll see M&WP with non financial institutions jumped from KD12.7 million in 2007 (7.3% of all M&WP) to KD43.3 million in 2008 (37.6%). From the Note these do not appear to be with related parties. However, TID has some KD51.2 million placed with a related party as of FYE2008. 

We also learn that as of 31 December 2008, it did not hold any collateral on these placements but subsequently acquired KD33.9 million of collateral (exact nature unspecified). 

KD51.2 million represents 44.4% of M&WP which seems a "bit" excessive in terms of risk concentration, especially since collateral seems to have been an afterthought. This amount is roughly 25.4% of FYE08 equity, though year end equity has been depressed by losses and fair value declines so it may be fairer to look at 30 September 2008 equity when the ratio was 11.3%. This analysis assumes of course that TID had no other exposure to this same related counterparty.

Financing Receivables

Note 8 Page 21. TID advises that subsequent to 31 December 2008, it acquired 8.7% of the equity in Bahrain Islamic Bank (an associated company) as settlement of a finance receivable of KD21,237,253. The market value of the shares was KD12,256,833. 

Somehow TID determined that it should recognize KD10,706,237 in goodwill on the transaction. 

And somehow TID's auditors signed off on this. When AA learned his accounting, a transaction was valued by the "boot" received. When there was a market price, that was the "boot" (value). So it's unclear what the basis was for recognizing this rather substantial amount of goodwill.  I guess it's a stark lesson of the need to stay current.  Back to the books for AA!

Investment Properties

Note 10 Page 22. TID advises the subsequent to 31 December 2008, it settled an outstanding Murabaha of KD16,763,386 by transferring property worth KD15,797,730. As a result it recognized a profit of KD965,656 on the transaction! The identity of the "wise" lender in this exchange was not disclosed. Perhaps, the "discount" was the price of an early exit and an excuse from the restructuring. It's unclear how the property was valued.

Investments in Associates

Note 12 Pages 23 -26.

Stehwaz Holding and Rehal Logistics

Page 23. During the year, TID reclassified investments in Rehal Logistics and Stehwaz Holding from investments available for sale to investments in associates where it could use the equity method of accounting instead of the previously used fair value (market price in this case). This reclassification magically created provision goodwill of some KD73.5 million which TID notes it wrote down to KD23.0 million. You may recall from an earlier post of mine that 47 shareholders in Stehwaz had raised some serious charges against TID and the management/board of Stehwaz.  Related to, if I remember  correctly, allegations of manipulation of fair values.  Allegations I'd hasten to note are not judicially proven. Also if I haven't mentioned it before Mr. AlRabah - the peripatetic director at Commercial Bank of Kuwait elected in what was portrayed at the time as a successful campaign to enhance corporate governance was Chairman at Stehwaz during this period.

Boubyan Bank Shares

Page 24. The Note also contains TID's side of the Boubyan Bank share dispute with Commercial Bank of Kuwait. 

Let's let TID speak for itself here.

"The Group's investment in Boubyan Bank (KSC) was transferred to a local bank under a repurchase agreement as part of an agreement with that bank to act as an advisor for restructuring of the Group's debts. The Group revoked the repo agreement when the local bank terminates the advisory agreement. However, the bank did not transfer title of these shares back to the Group but set off its value of KD94,103,965 against amounts due from the Parent Company of KD74,616,098 which is included in Murabaha and Wakala Payables as of 31 December 2008. The Group is pursuing legal action for recovering ownership of these equity shares. The Group carries the investment at its adjusted acquisition cost under equity method of accounting. The fair value of this investment as of 31 December 2008 was KD88,311,406. Subsequently, the Group ceased to have significant influence over Boubyan Bank since it is no longer represented on its Board of Directors when it was reconstituted in April 2009, and has reclassified it as investment available for sale from that date. On 16 June 2009 the court issued a verdict to suspend dealing on those shares temporarily, pending a ruling on the dispute."

This particular disclosure is intriguing, though its wording is obscure. My understanding was that that repo was a new transaction. In 4Q08 CBK bought the shares and gave TID some US$250 million. TID was supposed to buy the shares back in early 2009. On that basis, it's unclear to me how this transaction is related to the restructuring assignment. TID could retrieve the shares (at least theoretically) by giving CBK the cash on maturity. It did not. To be fair, it could not due to lack of funds. 

One other potential reading of this paragraph is that TID gave the shares to CBK in a non cash transaction. That is, it made CBK a secured creditor so it would lead the restructuring. That would seem to be what I'd call a preference (though careful readers aware from my above comment that I lack familiarity with the intricacies of Kuwaiti accounting standards may have drawn a similar conclusion about my knowledge of Kuwaiti laws).   Since this has not mentioned in anything I've seen, I am discounting this second explanation and not as TID did using a 3% perpetual growth rate in my valuation.

Taking the relative share prices of BB at 31 December 2008 of KD0.400 per share and the current price of KD0.540, the shares should be worth roughly KD127 million. If we assume CBK and TID settle for CBK's principal plus additional interest since the setoff, TID should get roughly KD49 million or so in return.

Prodrive

Page 24. During 2008, TID exercised an option to acquire 40% of Prodrive for KD11.2 million of which KD7.1 million is payable and the remaining KD4.1 million is a liability. TID has provisionally recognized some KD8.7 million in goodwill on the transaction. It's unclear what the timing is for TID's payment of these amounts is. Presumably, failure to pay might affect its ownership rights or the acquisition price.

Various "Investment Properties"

Page 25. Again another quote from TID. 

"The underlying assets of certain associates carried at KD237,502,699 in these consolidated financial statements are investment properties in Bahrain and Dubai carried at fair value. The Group's share in associates' results, includes gains on revaluation of these investment properties of KD60,657,096 based on the average of the range of values of independent valuation experts. Subsequent to the balance sheet date, these associates have reported a significant decline in the carrying value of these investment properties. Consequently, the carrying value of the investment in these associates has declined by KD60,622,492 as of 30 September 2009. The associates have not yet determined the impact of change in market values after that date and up to the date of these financial statements."

Impairment Testing

TID has recognized some KD61,560,335 for impairment in associates. It is unclear to me if this amount includes the KD60.6 million related to Various Investment Properties referred to above. Or whether it is before this number? Meaning that additional fair value decreases may be required.

Murabaha and Wakala Payables

Note 16 Page 28-29. This note is interesting for what it tells us about The Investment Dar Bank Bahrain (in which TID has roughly 79% shareholding and so therefore effective control). It seems TIDBB placed some KD253 million with TID on an unsecured basis. This seems a rather large amount / risk concentration by TIDBB with TID. 

Earlier press reports suggest to me (but don't prove) that some of these funds may have been customer investment accounts – in effect Islamic "trust" accounts either RIA (Restricted Investment Accounts where the client designates the investment) or URIA (Unrestricted Investment Account the client does not).

If I'm not mistaken the Central Bank of Bahrain amended one of its regulations for Islamic Banks to limit exposure to a single counterparty of the Islamic Banks own funds, RIA and URIA to 35% of regulatory capital. Often (but not always) when a Central Bank amends a regulation it is dealing with a problem that has occurred. No way to know for sure here. Post hoc does not necessarily mean propter hoc.

Final Comments

After reading TID's 2008 financials, I have some questions about he valuation of  some assets. As later financials are released, this topic will hopefully become clearer.

Global Investment House –Commentary on 2009 Financials & Rescheduling

Earlier yesterday when I saw that GIH had posted summary 1Q10 financials, I decided to do a quick comment while waiting for the full report. 

That reminded me that I had not taken a close look at their audited 2009 annual report. So as a way of preparing to comment on 1Q10 I did. 

Now instead of commenting on 1Q10, I've decided it's preferable to first make some comments about 2009 FYE as a way of providing a basis for later comments. And, as you quickly see, spouting off on a topic or two along the way.

Cash and Banks  - Less Than Appears

Note 12 Page 48: At year end, Cash and Banks was a robust KD101.2 million. A closer look at Note 12 discloses that KD55.1 million was cash at subsidiaries. That is, this cash is in separate legal entities (at least KD28 million at Al Thouraia) and not necessarily at the disposal of GIH. 

AlThouraia -A Strange Saga

Note 24 Page 57: It seems that a KD43.3 million deposit that AlThouraia Properties placed with a local bank was offset by that bank against a loan made by that bank to the Parent, GIH. It's unclear to me what the legal basis for this offset is. Did AlThouraia guarantee the loan made by the bank to GIH? If not, how does the bank cross legal entity lines? 

Particularly, when GIH only owns about 83.36% of AlThouraia, what is the basis for stiffing the minority shareholders on the offset? By the way GIH "recognized" the offset in its financials.   No skin off its nose as they say.

Note 25 Page 57: This discusses the acquisition of Al Thouraia through an asset swap – non cash. The assets are described on Page 58. In effect through this transaction, GIH acquired control of this company, added KD28 million or so to its cash balance, and removed KD83 million in borrowings (from Al Thouraia) from its balance sheet on consolidation. Note GIH does not necessarily have control over the new cash. And it's likely that the KD83 million in debt remains a legal obligation of GIH so that impacts GIH's (the Parent's) cash position contrary to the impression from the consolidated numbers.  It's not only down KD28 million but another KD83 million.  This transaction may also be a very convenient way of dealing with a troublesome issue as discussed below - Saudi Mazaya.

Page 58 reveals that Al Thouraia Project Management Company was established in 2008. Having raised a large amount of capital for no doubt worthy investments, it decided to place most of it with a single financial institution – which technically was not a bank but a entity with an investment firm license. Now why would Al Thouraia's highly responsible board do something like that?   Of course, some out there asked similar impertinent questions about the placements by Global MENA Financial Assets with GIH.

Well, it knew the credit of GIH intimately as this press release shows. And as we learn there: 

"Global announced the launch of Al-Thouraia Project Management Company's capital increase to KD180 million.  Al-Thouraia shall be utilized as a Special Purpose Vehicle (SPV) to invest its whole capital in Mazaya Saudi for Commercial Investment Company "Mazaya Saudi", which has been incorporated in the Kingdom of Saudi Arabia, and will be managed by Mazaya Holding Company "Mazaya". Global Acts as Lead Manager Al-Thouraia Project Management Company." 

If you've been reading the readers' comments to this blog (where you will often find more informed comment than in the main articles), you have seen The Rageful Cynic's link to a post on the saga of Saudi Mazaya.

Debt Rescheduling - "The Most Short-Sighted Unrealistic Deal of 2009"

Note 29 Page 61-62 details the debt rescheduling.  To put my comments in context, note that this US$1.7 billion equivalent deal is secured by US$1.4 billion in principal investments and US$0.3 billion in real estate.  All conveniently hived off into separate companies so that that the lenders should have an easier time of taking ownership.  They merely have to take the equity in the holding companies.  No need to re-register a plethora of individual assets in their own name.

This transaction, as GIH constantly reminds us, won the "Most Innovative Deal" by Euromoney for the Islamic tranche. And you can read more praise on pages 20 and 21 of GIH's 2009 annual report.  Earlier GIH also issued a brochure full of self praise.

After looking through the terms of the deal, I'd like to belatedly award the entire transaction "The Most Short Sighted Unrealistic Deal of 2009". 

A charitable soul would be likely to give GIH's management the benefit of the doubt – that they were coerced into signing this deal.   In evaluating this it would be useful to know just how hard they fought these terms, if at all.

I'm at a loss to find even a single kind word to say about financial institutions that would impose such a deal on a borrower. Banks are not to be faulted for trying to get back the amounts they loaned. But the terms of a rescheduling should be designed to minimize the damage to the borrower.  Milk the cow don't kill it.  

This deal, as you'll see from the details below, does not do this but sets a thoroughly unrealistic repayment schedule and then couples it with interest rate step ups and other onerous clauses. 

Repayment Schedule:

1. Year 1: 10% 
2. Year 2: 20%. 
3. Year 3: 70%. 15% in the first six months, 20% in the next six months and 35% at year end. 

Did anyone in their right mind think this was achievable without causing great damage?  That markets would recover that fast?  Did anyone notice that GIH has almost KD41 million in bonds maturing during Year 3 on top of this debt service? Even if markets have recovered a sale of that size - a literal fire sale - is likely to burn a lot of value up.

Interest Rate: 

1. Year 1: 1.5% plus Libor, EIBOR or Central Bank of Kuwait discount rate). 
2. Year 2: An additional 1% on the margin, taking it to 2.5%. 
3. Year 3: An additional 1 % on the margin, resulting in 3.5%. 

The interest rate step-up is designed to put pressure on GIH to meet the unrealistic repayment schedule. It's hard to see the rational rationale for this.  If the term were longer, say 7 to 10 years, this might make sense (though with the step ups a little more spread out).  But with the short tenor, it doesn't make a lot of sense. How many whips do you need to apply to the horse?   And, if GIH can't sell its assets, another 1% is not going to suddenly cause them to do so.

Fees: 

1. A 1% flat fee on the amount of the rescheduling.
2. Plus 0.25% of the amount rescheduled starting on 15 December 2008 to the date of signing. Both amounts to be capitalized. 
3. Then 24 months after signing another 1% flat fee on the amounts outstanding. Also to be capitalized.   A third whip?  Same comment as above.  If GIH is in a tough spot, an extra 1% on the debt isn't going to move them one way or the other.

Covenants:  

GIH commits to maintain: 

1. Asset value to debt outstanding of .75x. 
2. From 30 June 2010 a minimum Capital Adequacy Ratio of 5% increasing to 7% from 1 July 2011 through final repayment 9 December 2012. 
3. If GIH fails to repay 40% of the original facility amount by the second anniversary, the banks have the right to convert the shortfall into GIH shares. 
4. Finally, the proceeds of any new equity raised must be used to prepay the rescheduled debt. Funny I must have missed that point in previous discussions about GIH's approval of its Rights Offering. Did anyone (including GIH's wise creditors) think that potential shareholders are going to be excited about buying new equity in a firm that can't pay dividends and where the proceeds of the offering will not be used to build the business but to pay back apparently rather greedy lenders? Might it not have been a better idea to let GIH raise capital without requiring that it be used for debt prepayments? On the theory that additional capital would build the business capacity which would strengthen the banks' position.  And of course once the cash was in the till, it could be used for cash shortfalls on debt repayments?  Looks like a case of "wise" bankers shooting themselves in the foot.  One wouldn't use the expression "shoot themselves in the head" here as it's pretty clear there would be more damage caused by a bullet in the foot than one in the head to this wise collection of lenders.

No wonder the lenders were besides themselves with effusive praise for GIH and its management. It seems that GIH gave them everything they asked for. Or perhaps just about everything.  Whether this is all achievable or makes the best sense for the banks is debatable.

The only thing I can think of that would justify such terms would be a profound lack of faith in management - probably based on an adverse assessment of fundamental ethics.  That clearly can't be the case here.  Can it?

Ernst and Young "Fully Stands By" Its 31 March 2009 Audit of Damas

The National Abu Dhabi reports that E&Y has issued the following statement.

“We fully stand by our audit report on the financial statements of Damas International Limited for the period ended 31 March 2009,” the company said.

You can read the Auditors' Report in the 31 March 2009 financial statements here and draw your own conclusions.