The Net Asset Value (NAV) of a company at a certain moment is defined as:
NAV = Assets minus Liabilities
That makes sense. But there is another way to look at NAV:
NAV = Equity plus Retained Earnings
With the Equity being the amount that has been put in the company by the shareholders (initially, and later possibly through rights issues or an IPO) and Retained Earnings being the accumulated Earnings minus the accumulated Dividends over the lifespan of the company up to that certain moment.
If we combine the two above formula's:
Assets minus Liabilities = Equity plus Retained Earnings
A simple and beautifully balanced formula.
Assets 40M Equity 10M
Liabilities -15M Retained Earnings 15M
NAV 25M NAV 25M
However, there is one group of companies which might not be too happy with this formula, and that is the group of companies which makes persistent losses. For them things might look like:
Assets 30M Equity 40M
Liabilities -20M Retained Earnings -30M
NAV 10M NAV 10M
It is rather obvious that future investors can see that this company might have a problem (especially if no or very little dividends have been paid out in the past, which is often the case).
Financial engineers (of the kind that I don't like, to put it mildly) have come up with a creative solution. What would happen if the Retained Earnings (or losses, as is often the case) could be lowered?
Since the Assets and Liabilities (and thus the NAV) would stay the same, the Equity has to be lowered. So this is the solution they came up with:
Assets 30M Equity 10M
Liabilities -20M Retained Earnings 0M
NAV 10M NAV 10M
This suddenly looks a lot more healthy than example 2. The reduction of the equity is done by reducing the par value or a transfer from the reserves (accumulated profits).
Needless to say, I like this kind of financial engineering as much as I like a toothache. This is the kind of "innovation" that is not helpful at all, brings no economic benefit, is not transparent but only distracting and costs money and effort that should be used to build the business.
There are many examples on Bursa of companies which have used the above accounting "trick", for instance MAS.
The above is from the 2013 audited accounts from MAS:
- MAS had accumulated losses of RM 8.2 Billion as of January 1, 2013.
- It lost again money in 2013 to the tune of RM 1.2 Billion.
- One would expect accumulated losses of RM 9.4 Billion as of December 31st, 2013.
Because of this, in my opinion, the meaning of the term "accumulated profits" (or losses) has completely lost its meaning, at least after any capital reduction exercise. The definition as used in Wikipedia, doesn't seem correct, there is no mentioning of the "accounting magic" which might distort the numbers.
One recent example is XOX Bhd, The Star wrote an article "XOX unveils plan to cut accumulated losses of RM50m" on their website.
When I read this headline, I thought (rather naively, I admit) that XOX would cut the losses by making profits. At least, that would make sense to me.
But I was rather surprised when I read the rest of the article:
XOX Bhd has announced several proposals to reduce its accumulated losses amounting to RM50.05mil as at end-June. The mobile virtual network operator, which has a market cap of RM33.2mil, told Bursa Malaysia that it was proposing to reduce up to RM32.73mil from its share premium account. “The credit arising therefrom shall be utilised towards setting off against the accumulated losses of the company,” it said. On top of that, it has proposed to halve the par value of its shares to five sen each, subsequently consolidating every two XOX shares of five sen each into one new XOX share of 10 sen. The par value reduction would give rise to a credit of RM16mil, which would be used to reduce its accumulated losses, it added.
XOX is one of the worst performing companies on Bursa, I will write soon a separate blog posting about all the issues.
Request: is there any accountant who can comment on this (anonymous is fine). I also would like to know: is the above a global convention?