Department of Technical Quibbles: The Arabtec Liquidity Crisis and Basic Accounting

Last Conference:  Abu Arqala's Name Tage

A 1 June Gulf News article on liquidity problems at Arabtec caught Abu Arqala’s lately reopened eye last week. 

http://gulfnews.com/business/sectors/construction/arabtec-running-out-of-options-for-liquidity-1.1839055 

I don’t have an issue with the contention that Arabtec’s liquidity is strained.  Nor that the company is struggling.

The firm’s financials show it is indeed having financial difficulties.  The auditors’ qualified opinion for 2015 made even “less pretty” by the “matter of emphasis” comments and the income and cash flow statements paint a rather unhappy picture.   

But I do have a beef with two statements in the article. 

These appear to be based on less than a solid knowledge of accounting or UAE laws.  Because they are coming from “experts” I think they could well mislead readers.  Those concerns prompted this post and the start of a new feature on this blog “The Department of Technical Quibbles” or DOTQ for short.  

       Here are the two “offending” quotes.

• “Analysts questioned whether Arabtec would be able to break even this year after the company held a general assembly on Wednesday to get shareholder approval to pull Dh1 billion out of its statutory reserve.” [This may sound like the company can lay its hands on AED 1 billion in “cash”. It also seems to infer that accounting entries about past events can affect the future].

• “He said that having such massive losses also makes banks more reluctant to give out loans, which leaves the statutory reserve as the only resort for immediate liquidity.” [The “found cash” theme again.]

Let's drill a bit deeper into what Arabtec is doing.

First, what Arabtec is proposing is an accounting entry.   

1. If shareholders approve, Arabtec will debit the statutory reserves by 1 billion AED and credit retained (accumulated) losses with the same amount.   
2. This accounting entry will take place solely on the liability side of Arabtec’s balance sheet.  Assets will be unaffected.  Keep this in mind as it will be a central idea in the "fourth" main point below.    

Second, a glance at the shareholders’ equity account as of 31 March 2016 shows that the statutory reserve is included in shareholders’ equity along with other equity accounts resulting in total shareholders’ equity of 3.2 billion AED.   

1. What that means is that after the entry, the balance sheet total shareholder’s equity will not change. In effect the statutory reserve has already been netted against the accumulated losses on an economic basis.   
2. If bankers and financial analysts do not understand this, may God protect them from their lack of knowledge and from making duff loans or investments.  
3. http://www.arabtecholding.com/FinancialReports/FY16Q1_English.pdf

Third, if there isn’t a cash benefit, why is Arabtec taking this step?  For legal reasons.  

1. Like other GCC states, the UAE requires (Article 285 Commercial Companies Law 1984, as amended) that companies take action when accumulated losses are greater than 50% of statutory or legal capital.  At that point, companies have two choices:  dissolve the company or continue.  In the latter case the situation must be rectified. 
• Article 285:   If a joint-stock company sustains loss amounting to one half of the capital the Board of  Directors shall convene an Extra-Ordinary General Meeting and resolve whether the company shall be maintained or dissolved before the term fixed in its Articles of Association.  Should the board fail to invite the Extra-ordinary General Meeting of it was impractical for the General Assembly to adopt a resolution on the matter in question, any interested party may file an action demanding dissolution of the company.”  http://niemands.ru/files/uae_law/uae_companies_law_niemands.pdf 
• The rectification takes place via raising new capital or by reductions in legal capital, offsetting reserves against the loss, or merger.  The following two cases illustrate the process.  
• Takaful Emarat Insurance (2014).  http://feeds.dfm.ae/documents/efsah/2014/May/22/611c52f3-1780-4c38-9cc5-41d9f35e3eff  /TAKAFULEM_FS_Q1_E_13_05_2014_0607PM_NM.pdf    
• United Insurance Company (2015) http://www.asiainsurancereview.com/News/View-NewsLetter-Article?id=33206&Type=MiddleEast 
• Reducing legal capital raises a host of inconvenient issues, e.g., redenomination of nominal share price/par value, reduction in the number of shares, etc.  Raising new capital is expensive and difficult at such times, though perhaps not when one has a motivated government shareholder. Using existing reserves is relatively painless.
2. As of 31 March 2016, Arabtec’s legal capital was 4,615,065,000 AED.  Its accumulated losses at that point were 2,273,762,000 AED.  A further 33,770,501 AED—a relatively small amount--would trigger the operation of Article 285.  
3. By acting now, Arabtec “buys” itself legal breathing room by pushing the 50% trigger further out.  It’s also much easier to take this step at an AGM than at an EGM.  
• Last year the company had to postpone its AGM/EGM by a week due to lack of a quorum at the first meeting.  http://gulfnews.com/business/sectors/markets/arabtec-postpones-egm-agm-ue-to-lack-of-quorum-1.1497868   
4. Does Arabtec need breathing room?  Sure looks like it.

• A modest 34 million AED will trigger Article 285.
• 1Q 16 losses were 48 million AED. 
• There is no evidence of dramatic turnaround in the last few months. 
• The company’s management is privy to to-date undisclosed 2Q16 performance. 
• Perhaps, the limit has been breached already, but since the AGM voted 1 June to use the reserves, the problem is solved.  For now at least.  

Fourth, but what about the liquidity the second quote refers to? 

1. Liquidity generally refers to two things. 
• The ability to convert assets to “cash” quickly and at or very close to their carrying values on the balance sheet. 
• The ability of a firm to pay its current debts and obligations as they come due. This is different than “solvency” which deals with long term obligations and debt.  
• The more quality current assets one has and the fewer current liabilities the more liquid the firm. 
• But Arabtec’s proposed action has no effect on non-equity liabilities or on assets.  When the entry is made, the same assets and non-equity liabilities will be on the books after the entry as were there before.  The entry will not change their characteristics or values. 
2. Often individuals not familiar with accounting believe that if there is a “reserve” on the liability side—particularly one called a “statutory” or “legal” reserve--there is an account with “cash” of an equivalent amount on the asset side in a proverbial “lock box” that can’t be touched. That is not the case.  Liabilities merely show how assets were funded.  
3. As the company’s financials show there is no “pot” of “cash” sitting on the balance sheet that is equivalent to the statutory reserve amount and that will be freed up by accounting entry proposed by the company.  http://www.arabtecholding.com/FinancialReports/ARTC_FS_Ann_E_2016.pdf      

Fifth, how would the company’s accounting entries regarding past accumulated losses and accumulated statutory reserves affect its ability to turn a profit or generate cash in the future?  The entry doesn’t provide additional cash.  It doesn’t change the value of assets or non-equity liabilities. It doesn’t change current economic conditions.  In short, it doesn’t.