Saturday, 11 October 2014

Cutting accumulated losses through financial engineering

[updated version, with a request at the end]

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.

Example 1

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:

Example 2

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:

Example 3

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.
But through sheer "accounting magic", MAS "only" needs to report accumulated losses of RM 1.5 Billion. The reason is the RM 8 Billion capital reduction by transferring money from Share Capital and Share Premium.

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?


  1. Goodness. You are absolutely right.

    Thank you. Red flag up for companies that have taken this route.

  2. Hi, M.A. Wind, I have been a fan of your blog. Nice writing and in depth discussion. Really broaden my mind from another perspective. I'm currently in the accounting profession. Not an accountant yet though.

    Sadly, it is a global accounting treatment. Just google "accumulated losses write off", you can see lots of same treatment for this situation. Mitsubishi, Yamaha, United Bank of India and etc. I suppose this is a grey area in the accounting standards.

  3. Thanks for your comments. That is indeed sad. It seems we cant take "accumulated losses" anymore on face value, we have to dig deeper if there was any restructure that impacted the number in the past.

  4. Dear M.A. Wind,

    Email me if you have any questions as I am an accountant.

    I'll be slightly more brief here. What you have illustrated above is a good example, so I'll use that simple one. I'll try to state the issues in a more simplistic manner.

    1. A clean slate or forever blacklisted
    To put it simply, just like a ex-convict that has been released and is looking for a job, is it fair to forever label him as an ex-convict when the prospective employer searches his records through some database?

    Similarly, in this situation ~ the so-called accounting 'innovation' (it's not btw) goes along the same line of thinking. Since the company has made substantial losses, it weighs down on the mind of any future investors, same as the employer with the ex-convict. That's why most companies go down this route to wipe out the past bad track record, so to speak. In this time where first impressions count, I don't blame them.

    2. The cat has flown the 'coop' so to speak
    The accumulated losses is just a summary or 'report card' of all the bad decisions made by the company, so to speak. It doesn't really matter whether it's netted off against the share premium of share capital, as more importantly, the cash is already gone. You are right though, keeping it there, lets the investor see all the bad decisions that have accumulated throughout the years, but a good investor can always look at the losses throughout a 5 or 10 period anyways.

    3. Companies Act 1965 and SC
    There are some safeguards before companies are allowed to set off their losses against the share capital and premium, especially if they are listed on the Bursa. It's not a difficult thing, but there are some procedures to be followed, so it's on some whim and fancy. Probably it's pursuant to some restructuring and injection of new share capital and such.

    As to your last question, YES! It's a perfectly legitimate technique though there are safeguards in the UK Companies Act to prevent share capital from being reduced in this manner, which was exported to the Commonwealth Countries such as Malaysia and Singapore.

    Kind rgds

  5. Thanks, fill follow up on this in a later stage