Shuaa’s 2018 Profit due to Negative Goodwill

Shuaa reported a 2018 net profit of AED 28.5 million. AED 31.4 million of that is attributed to negative goodwill, an intangible asset and not part of recurring ordinary operating income. This means that if you use the market values of assets as opposed to their accounting treatment based on appraisals of the value, then Shuaa’s P/L could be considered a loss of AED -2.9 million.

In effect Shuaa uses the theory of accounting to override the experience of investors in the Kuwaiti stock market so as to turn a loss into a profit.

But don’t take my word for it. Only a coward would say things without supporting it with credible arguments, based on known facts, and reliable public sources.

Auditors are not Stupid

The job of an auditor is legally defined but a good general definition of their responsibilities includes:

An independent auditor is engaged to give an opinion on whether a company’s financial statements are presented fairly, in all material respects, in accordance with the financial reporting framework.

It is important to understand that an auditor must opine on not only fairness but also on all material respects. This has nothing to do with correct reporting, which is captured in the phrase in accordance with the financial reporting framework but has to do with providing actual and potential investors, as well as the regulators, with a full picture of the financial position of the company. 

Every single statement in the financials can be accurate but the picture as a whole might not be reflective of the actual financial position of the company. This is why the notes to the financials are so important. They highlight the issues that the reporting company and their auditors feel an investor should be aware of in assessing the financial position of the business. This way the auditors protect themselves and provide a service to readers of the financials. Make use of this service.

Market Price versus Accounting Value

Accounting recognition of income, expense and the value of assets / liabilities is codified, i.e. it is a set of rules with some human decisions that need to be applied. The problem is that many times businesses enter into transactions based on market price which rarely is the same as the accounting value. For example a company that is the target of an acquisition will usually be bought at a value far different from the audited equity value. As a simple example just compare the market cap of companies to their book (equity) value, usually called the price / book ratio. For a price / book ratio of anything other than one there is a gap between market and accounting. This doesn’t create an issue until there is a transaction at the market value.

Take as an example a company ABC acquires, for cash, a target for 100 but the equity value is recorded on the books as 80. On the balance sheet there will be a cash reduction of 100. This is matched by an increase in decrease of 80, in accordance with the accounts. But there is a gap of 20. How is that accounted for? Warning: This is not goodwill. Yet.

The Use and Abuse of Goodwill

As a first step in reconciling the difference between market value and book value an appraisal is performed on the assets of the target. This appraisal is performed by an independent certified market professional to estimate the market value of the assets. This appraisal is then used to record the value of the acquired asset. Goodwill is simply the difference:

Goodwill = Purchase Price – Appraisal Estimate

Goodwill sits on the asset side of balance sheet. It is also intangible, it is not a real physical or financial asset. It is an accounting treatment that is subjective. As such it has been the subject of much heated debate as its usefulness in providing a useful financial picture of a company. One of the more readable discussions was published in the Harvard Business Review under the title Where Financial Reporting Still Falls Short. The article covers multiple topics including fair asset valuation and is well worth a read.

For a more detailed analysis The Tangle of Intangible Assets and Business Combinations published in The CPA Journal is of interest. In particular it sheds some light into the question of using a subjective appraisal to value a company that was objectively valued by the Kuwaiti stock market. Simply put, why use the opinion of a single person to change the price of an asset as set by the whole market?

Usually goodwill is positive, i.e. a company pays more for an asset than its accounting value. The issue in these cases is usually related to how the goodwill is treated post the acquisition. Every year companies have to do what is called an impairment to test to decide if they should writedown some of the goodwill. Companies resist this as any writedown is treated as an expense. Again, due to the subjectivity involved this can lead to controversy. Once high-profile case involving the global giant General Electric was recently covered in the Financial Times: GE’s $23bn writedown is a case of goodwill gone bad. The article shows how intangibles can be easily manipulated, in this case to the tune of an astonishing USD 23 billion.

The Rise of Negative Goodwill

Negative goodwill is a rarer phenomenon. This arises when the price paid is less than the appraisal value. On the face of it this sounds great – buying something at below the appraised price. Better yet, this negative goodwill gets recognized immediately as profit.

For Shuaa the details of the negative goodwill can be found in note 33 (f) for Amwal International Investment Company KSCP, in AED thousands:

Total consideration 146,810

Less: Fair value of identifiable net assets acquired (178,256)

Negative Goodwill (31,446)

Some questions come to mind:

The first question that comes to mind is why appraise the value of the assets of Amwal if it is a listed stock? It could be argued that trading volumes are low, but this is still a public market. There are multiple actual and potential buyers and sellers. Isn’t that enough to trust the actual acquisition price?

How could the market price be at a 17% discount to the appraised value? That’s AED 31 million that investors in the Kuwaiti stock market left on the table. I’m not talking just about existing Amwal shareholders, but all other investors because if they agreed that the actual value was the appraised value they would have bid up the market value. For example, an investor who believed that the real price was equal to the appraised value of AED 178 million could have paid existing Amwal shareholders the higher value of AED 160 million instead of the AED 147 million paid by Shuaa, and still made an immediate 10% profit.

Note 33 also discusses the combined accounting for two other companies that Shuaa acquired: Integrated Securities LLC and Integrated Capital PJSC. These two companies were not listed but privately held. According to part (f) of that section Shuaa paid AED 40 million over the appraised value. In other words Shuaa recognized positive goodwill of AED 40 million. Somehow Shuaa underpaid AED 31 million relative to accounting valuation for Amwal but overpaid by AED 40 million relative to accounting valuation for the Integrated companies. Puzzling. Disclosure: The two Integrated companies were acquired from a related party.

If Assets can be Intangible can Profits be Intangible Too?

The question here is not whether or not Shuaa’s accounts adhere to legal, regulatory and accounting standards. The question is whether they are useful to an investor. In goodwill there is large subjective latitude in deciding on the goodwill. Indeed Shuaa shows how on one acquisition positive goodwill of AED 40 million is recognized and on another negative goodwill of AED 31 million. Are markets that out of touch with reality? Or is it possible that accounting standards are not best equipped to provide a financial picture consistent with that of the market?

More glaring is the difference in how positive versus negative goodwill is accounted for post recognition. The AED 31 million of negative goodwill on Shuaa’s books was recognized immediately as profit. The AED 40 million of goodwill sill only be expensed in future years and then only based on an impairment test.

The answer to what the useful financial picture is depends on the point of view of Shuaa’s current and potential investors. They each have to individually analyze the financials and draw the conclusions that are relevant to them.

A good test is checking the cashflow from operations (before changes in operating assets and liabilities). It is negative at AED -9.3 million.