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.

R.I.P. Dame Lynn

18 juin 1940

"Le Gouvernement français a demandé à l’ennemi à quelles conditions honorables un cessez-le-feu était possible. Il a déclaré que, si ces conditions étaient contraires à l’honneur, la dignité et l’indépendance de la France, la lutte devait continuer."

Bahrain Middle East Bank - Successful AGM, No EGM = Future Remains Bleak

At the Third AGM, a Quorum Can Be Rather Small

BMB “successfully” held its FY 2019 AGM on 9 April after two previous unsuccessful tries. Minutes here.

But just barely.

Only one shareholder holding one share was in attendance.

That’s 0.00000025% of outstanding shares according to the AGM Minutes.

As per Bahrain’s Commercial Companies Law, there is no required minimum quorum for a third meeting.

All AGM agenda items were approved.

The EGM – which is needed to address the critical issue of continuity of BMB – failed for lack of a quorum. 

See below for the main focus of the AGM:  a discussion of the implications of failure to hold an EGM on BMB's ability to legally continue as a "going concern".

As noted in an earlier post, because AN Investments was excluded from voting in the EGM, if their shares are excluded from the total number of BMB shares, only 4.81% of shares would constitute a quorum for the EGM.

As also noted in that post, that would require AlFawares (ALF) to be present to vote its shares because in the event that AN Investments' shares are excluded a minimum of 4.81% of total outstanding BMB shares would have to be present and all other shareholders own only 4.51% of BMB. 

ALF was not in attendance for the EGM.

It’s unclear what the reason is for their failure to participate.

Earlier the Board noted that certain members of senior management and the Vice Chairman were under investigation for an alleged fraud. None of these individuals were directly associated with ALF.

Also, ALF’s two directors on the Board resigned "just before" the CBB ordered that the Board resign.

I have interpreted the timing of these events as an early warning from the CBB to the ALF directors to exit before being forced to resign.

In which case ALF should have nothing to fear from attending the EGM unless it fears (a) other legal exposure of some sort, (b) being forced to participate with new equity, or (c) the "sting" of unpleasant comments from other shareholders.

Re the first point, it would seem that the CBB’s actions—if my assessment is correct—indicate that ALF’s hands are “clean”, though see the potentially troubling reference to the difficult situation with “majority shareholders” below.

What might be the "sticking point" is ALF's own obligation to the Bank for the Installment Sale Receivable (ISR) loan which BMB has provisioned in full.

Re the second point, I don’t think Bahraini law gives the CBB or another Bahraini authority the power to compel a shareholder to invest additional equity. Participation in rights issues is voluntary and rights entitlements may be waived and in some cases traded.

And if the good sheikhs at ALF are sensitive to criticism, they can always give a party with thicker skin their proxy. The proxy holder can turn away questions regarding new capital or any other matter, including the ISR, with a simple “I don’t know”.

Given ALF’s own financial “difficulties”, their absence seems strange as restoring value to BMB increases the assets they need to meet their own obligations.

Given that the CBB appears to have given ALF's directors advance warning so they could keep their "thoubs" clean, it seems downright ungrateful of ALF not to cooperate.

Beyond that, Kuwaiti investors often use OPM to fund their investments as a tried and true method of limiting their downside risk.

If the investment goes bad, they hand the "keys" to the investment to the lender with a smile.

One might therefore expect there could well be a lender holding the BMB shares as collateral. 

An institution one would hope would be motivated to see the value of those shares preserved, or, in this case, increased from zero.

In such a case it would seem that at a minimum that lender would demand that ALF give it a proxy,  assuming it does not already “own” the shares through realization of its collateral.

The main focus of the meeting was a discussion of the implications of the failure to hold the EGM this year, following a similar failure earlier.

Mr. Yusuf Taqi a member of the Board asked the “regulators to provide directive on this issue {continuity of the bank} given that it may not be possible to hold at EGM in the future”.

BMB’s counsel opined that failure to convene an EGM and take the legal steps to maintain continuity of the Bank could lead to the bank being wound up or placed under administration.

Mr. Isa al-Motawaj, Director of Wholesale Banking at the CBB, noted that the CBB understands that BMB is in an “abnormal situation’ vis-a-vis its majority shareholders. (Note the plural in the minutes).

Is ALF included in the phrase “majority shareholders”? 

And, if so, is their inclusion a reference to their own significant financial difficulties? 

Or is there something more here?

Or is it an inadvertent slip? A reference to the fact that AN Investments is owned by the three Turkish “amigos”?

Mr. al-Motawaj stated that the CBB had evaluated that directing the bank to liquidate or be put under administration “would not be in the best interest of the stakeholders” particularly as there are other financial institutions exposed to the same defaulted parties as BMB is trying to recover funds from.

He also went on to assure the Board that they were duly constituted and operating in line with legal requirements, noting the importance of the asset recovery efforts underway.

He also responded to a board question about the legality of the AGM, noting that the representative of the MOIC&T had vouched for compliance wiht Bahrain's Commercial Companies Law, even though only one share was in attendance.

The CBB has gone on the record that it is willing to give BMB some leeway given its unique situation.

That being said, even with a successful EGM, BMB’s future is bleak.  

Recovery is highly unlikely to be in full.  

Additional capital will be required.  

Hard to see investors rushing to commit equity.

As a wholesale bank, BMB is unlikely to benefit from rescues afforded retail banks in the Kingdom.

Finally, kudos to the one shareholder who apparently believes in exercising his or her corporate governance responsibilities.

All markets, not just those in the GCC, need more shareholders like this individual.

Bahrain Middle East Bank - Apparent Way Forward to Hold EGM

A while back I wrote that it was highly likely that ANI (BMB's Turkish-owned) major shareholder would not attend Extraordinary General Meetings (EGMs) and that given their roughly 81% shareholding there could not be a quorum for the EGM. 

This would frustrate the ability of BMB to comply with the Commercial Companies Law (CCL) requirements to enable it to continue as a “going concern” given the bank’s negative capital.

It seems that a “solution” has been found in the CCL Section 203 as outlined in BMB’s announcement on the Bahrain Bourse of its upcoming AGM and EGM.

For the purposes of discussing and passing this Resolution, AN Investment W.L.L. shall not be entitled to count in the quorum or to vote on said Resolution, on the basis that the Bank’s total outstanding exposures which has caused the said loss of capital are to one or more related parties of AN Investment W.L.L. Such shall be in accordance with Article (203) of the Commercial Companies Law No. 21 of 2001, as amended.

This appears to be based on a broad reading of the last sentence in Section 203.

No member may vote for himself or on behalf of whoever he represents on issues in which he has personal interest or on a dispute existing between him and the company.

As outlined here, the minimum acceptable quorum for a BMB EGM (third meeting) is 25% of shareholders.

Eliminating ANI’s 80.77% from the base, means that to get a quorum at a third meeting, shareholders with 4.81% of BMB’s shares would have to attend. 

AlFawares is the registered owner of 14.48%.

If AA has done his sums right, always a concern, then unless ALF participates, an EGM cannot proceed.

Why?

Netting out ALF’s shareholding, all other shareholders comprise 4.75% short of the 4.81% required.

It’s almost certain that all of them will not attend as attested by past history. As well the substantial unclaimed dividends indicate many are sleeping, perhaps eternally. Note 27 in BMB’s FY2019 Audited Report.

If ALF or its proxy participates, then it’s likely the call for the first EGM will be successful because ALF’s 14.48% would be over 75% of BMB outstanding shareholding after exclusion of ANI’s shares.

What this means is that it is likely BMB will cross one hurdle to remain a going concern.

One step forward.

However, the key issue is finding new capital. And that will be a journey of more than 999 li.

Probably at least 200 million li.

The proverb cited above gives no guidance on the success of so long a journey.

GFH Announces FY2019 AGM - Time for Shareholders to Review Suggested Questions for AGM

What Did Umberto Say About the Ignorant?

GFH has announced its FY2019 AGM date and agenda on the BSE. 

The meeting will be held 23 March.

If there isn’t a quorum, the second meeting will be on 30 March and, if necessary, a third on 6 April.

Shareholders will certainly benefit from a close reading and re-reading of my previous posts on GFH’s FY 2019 performance and as well my analysis of what is behind GFH’s rather expensive foray into Treasury Shares as preparation for the upcoming AGM.

Of note from the agenda is GFH’s recommendation that shareholders approve a 5.57% cash dividend (approximately US 50 million).

That represents some 63 % of GFH’s FY 2019 income attributable to GFH shareholders.

In that context, I’d remind shareholders and readers that in February GFH “successfully priced” a USD 300 million sukuk at 7.5% fixed per annum. Quel succes.

 

In my post I noted that during FY 2019 GFH engaged in purely discretionary uses of cash of some USD 140 million.

If it had forgone these, it could have raised USD 140 million less saving USD 52.5 million in interest over the life of the Sukuk.

Adding in the USD 50 million in dividends, adds another USD 18.75 million to interest, bringing the total to USD 71.25 million.

AA is frankly stumped to come up with a sound business rationale for such an action.

It would, however, neatly fit with the theory that GFH’s Treasury Share and Dividends are designed to prop up its share price rather than build new value for GFH’s shareholders.

KHCB Announces OGM and EGM Dates and Agenda More Questions for the OGM and EGM

KHCB has issued the announcement that its FY 2019 OGM and EGM will be held on 25 March 2020.

If a quorum is not reached, the second meeting will be held 1 April. 

If a third meeting is required, the date is 8 April.

Time for shareholders to take another look at AA’s earlier post with questions for KHCB’s Board and Management.

This post adds some new questions on the proposed meeting agendas.

Ordinary General Meeting

1. Item 10 Authorize Board to appoint a “market maker” who will use up to 3% of GFH’s shares. 
2. Item 11 Authorize the Board to take necessary steps to delist from the DFM.

It’s pretty well known that as a general rule, the BSE has liquidity issues so appointing a market maker makes sense.

Shareholders, however, should make certain that “market making” doesn’t become a cover for costly transactions designed to prop up the share price as is the case at GFH. 

A cautionary tale here.

KHCB’s shareholding is concentrated: four shareholders hold just over 75% of shares and would likely have to trade their shares in “off market” transactions (BSE Special Order Market). 

What then is the appropriate amount of Treasury Shares that the market maker needs to provide liquidity to retail shareholders?

Extra-ordinary General Meeting

1. Item 2- Approve capitalization of losses via a reduction in paid-in-capital to BHD89,211,948 from BHD105,000,000.
2. Item 3: Approve issuance of Sukuk in an amount up to USD 200 million as Additional Tier 1 Capital.

Shareholders should probe on why the amount being raised is roughly 5 times the BHD 15 million capital shortfall. 

Is this a sign of an extremely serious problem at KHCB?  Recall that as of FYE 2019 the CAR was a respectable 16.5%  

Or is KHCB planning a major acquisition?

If fully issued, the impact on existing shareholders ability to receive dividends and the market price of shares is going to be significantly adverse because given its size and required tenor to quality as AT1 capital, this is going to be a very costly instrument.  

There may be very little left of net income for ordinary shareholders.

Given the pattern and concentration of shareholding, retail investors are going to have no real say in the outcome, unless they can persuade representatives of the Bahraini authorities that their rights are being ignored. 

However, GFH shareholders may have more ability to influence things because GFH has more diverse shareholding. That is, there are not one or two shareholders who control a majority of the shares.