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Friday, June 2, 2017

8990 Holdings Inc.'s 2016 Annual Report: What a Difference an Auditor Makes!

On May 18, 2016, 8990 Holdings Inc. finally filed its 2016 Annual Report with the Philippine Securities and Exchange Commission as well as the Philippine Stock Exchange. The said Annual Report looked fine, albeit slightly disappointing. The company's "problem accounts," meaning both Past Due But Not Impaired as well as Impaired Installment Contract Receivables had gone down by almost 40% (39.54% to be exact) or Php 1.39 billion since 2015.  The pig was almost out of the python!

It was all good. Except for one thing. The so-called "problem accounts" for 2015 had undergone a major revision as well in the 2016 Audited Financial Statements. What was once in the "Impaired" column was reclassified as "Past Due But Not Impaired", resulting in an astounding 95.80% reduction in Impaired Installment Contract Receivables in 2015. (Note: This is not the first time this has happened)

What could account for the difference? For one thing, there was a change in external auditors last July 29, 2016 from Sycip Gorres Velayo & Co. (SGV) to Punongbayan & Araullo (Punongbayan).

"The appointment of the external auditors of the Company is presented for approval of the stockholders annually. In the last annual stockholders' meeting held on 25 July 2016, the Management considered the options available to the Company in relation to the appointment of external auditors. Instead of renewing the engagement of the former external auditors, the Management recommended the delegation to the Board of Directors of the authority to appoint the external auditors for the fiscal year 2016. Pursuant to such authority, the Board appointed Punongbayan & Araullo."

And Punongbayan saw things differently. They largely deferred to management's judgment on the matter, subject, of course, to their own audit procedures.

From Punongbayan's 2016 Auditor's Report:

Realizability of Installment Contract Receivables 
Description of the Matter 
As at December 31, 2016, the Group's installment contract receivables amount to Php 21.1 billion, net of allowance of impairment of Php 143.5 million, which details are disclosed in Note 9 to the consolidated financial statements. The installment contract receivables, which represent 44% of the total assets, are the most significant assets of the group at the end of the reporting period. The Group's management exercises significant judgment and use subjective estimates in determining when and how much to recognize impairment loss on receivables. These judgment and estimates, which are detailed in the Group's significant accounting policies, judgments and estimates in Notes 2 and 3 to the consolidated financial statements, including the identification of objective evidence that such assest is impaired (e.g. indications of significant financial difficulty, default or delinquency in interest and principal payments, etc. of the buyer) and estimation of future cash flows based on payment history, past due status and term, including the net realizable value of the related real estate inventory, which serves as collateral. 
Because of the significance of the amounts involved and subjectivity of managment's judgment and estimates used, we identified the valuation of installment contracts receivables to determine its realizability as at the end of the reporting period as a significant focus area during our audit. 
How the Matter was Addressed in the Audit 
Our audit procedures to determine the realizability of installment contract receivables and the adequacy of the allowance for credit losses on installment contract receivables included, among others, the following:
  • obtaining an understanding and testing the application of the Group's policy on impairment of installment contract receivables; 
  • checking the mathematical accuracy of the aging of installment contract receivables and testing the accuracy of the aging classification of selected buyer's accounts; and 
  • determining the net realizable value of real estate inventories collateralized against selected past due or delinquent buyers' accounts.
And this is how management makes those judgments:

From Note 2 of the 2016 Audited Financial Statements:
Impairment of Financial Assets 
The Group assesses at each reporting date whether there is objective evidence that a financial asset or group of financial assets is impaired. A financial asset or a group of financial assets is determined to be impaired if, and only if, there is objective evidence of impairment as a result of one or more events that has occurred after the initial recognition of the asset (an incurred loss event) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or the group of financial assets that can be reliably estimated. Evidence of impairment may include indications that the borrower or a group of buyers is experiencing significant financial difficulty, default or delinquency in interest or principal payments, the probability that they will enter bankruptcy or other financial reorganization and where observable data indicates that there is a measurable decrease in the estimated future cash flows, such as changes in arrears or economic conditions that correlate with defaults. 
Loans and receivables 
For loans and receivables, the Group first assesses whether objective evidence of impairment exists individually for financial assets that are individually significant. If there is objective evidence that an impairment loss has been incurred, the amount of loss is measured as the difference between the asset's carrying amount and the present value of the estimated future cash flows (excluding future credit losses that have not been incurred). The carrying amount of the asset is reduced through the use of an allowance account and the amount of loss is charged to profit or loss in the consolidated statement of comprehensive income. Interest income continues to be recognized based on the orignal EIR of the asset. Financial assets, together with the associated allowance accounts, are written off when there is no realistic prospect of future recovery and all collateral has been realized. If subsequently, the amount of the estimated impairment loss decreases because of an event occuring after the impairment was recognized, the previously recognized impairment loss is reversed. Any subsequent reversal of an impairment loss is recognized in the profit or loss, to the extent that the carrying value of the asset does not exceee its amortized cost at the reversal date. 
If the Group determines that no objective evidence of impairment exists for an individually assessed financial asset, whether significant or not, it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses for impairment. Those characteristics are relevant to the estimation of future cash flows for groups of such assets by being indicative of the debtors' ability to pay all amounts due according to the contractual terms of the assets being evaluated. Assets that are individually assessed for impairment and for which an impairment loss is, or continues to be recognized are not included in a collective assessment for impairment. 
For the purpose of a collective evaluation of impairment, financial assets are group on the basis of such credit risk characteristics as type of counterpary, credit history, past due status and term. Future cash flows in a group of financial assets that are collectively evaluated for impairment are estimated on the basis of historical loss experience for assets with credit risk characteristics similar to those in the group. Historical loss experience is adjusted on the basis of current observable data to reflect the effects of current conditions that did not affect the period on which the historical loss experience is based and to remove the effects of conditions in the historical period that do not exist currently. The methodology and assumptions used for estimating future cash flows are reviewed regularly by the Group to reduce any differences between loss estimates and actual loss experience.
From Note 3 of the 2016 Audited Financial Statements:
Significant Accounting Judgments and Estimates 
Impairment of Loans and receivables 
The Group reviews its receivables at each reporting date to assess whether an allowance for impairment losses should be recorded in the consolidated statement of financial position and any changes thereto in profit or loss. In particular, judgment by management is required in the estimation of the amount and timing of future cash flows when determining the level of allowance required. Such estimates are based on assumptions about a number of factors including, but are not limited to payment history, past due status and term. Actual results may also differ, resulting in future changes to the allowance. 
The disclosures on the carrying values of trade and other receivables, and amount of impairment losses recognized and the details of receivables written-off are in Note 9.
The Group had directly written-off receivables amounting to Php 3.8 million in 2015  (nil in 2016 and 2014), recorded as Write-off of assets under Operating Expenses in the 2015 consolidated statements of comprehensive income (Note 23).

As of December 31, 2016 and 2015, trade receivables used as collateral to secure borrowings from banks amounted to Php 4.4 billion and Php 3.8 billion, respectively (Note 18). 
Had those impairments continued in 2016, 8990 Holdings most likely would have been forced to write-off a significant chunk of the impaired assets. After all, the longer an asset is impaired, the lower its realizability.

It could very well be the case that a fresh new set of eyes was all that was needed to settle the matter. Maybe 8990 Holdings Inc.'s fortunes are improving and these assets have improved in their realizability. But there are also some indications that these impaired assets have begun to hamper the company's liquidity and growth.

 For instance, the company barely grew in 2016. For all of last year, the company grew by 2.31% from Php 10.63 billion in revenues in 2015 to just a smidge over Php 10.87 billion in 2016.  This happened despite being a dominant player in mass housing in a red-hot economy which grew by 6.8% in real terms, the fastest in three years. Moreover, the housing market itself was robust both in terms of sales volumes and house prices.

The company likes to blame delays in securing permits as a major factor in its anemic growth in 2016. That may very well be true. But liquidity could also be a factor. The money that was supposed to be sloshing around in the company's financial ecosystem may have been severely reduced by the impaired assets that could still be present on its balance sheet.

In 2017, this has already translated to a 21.91% dip in sales for the first quarter of 2017 when compared to the same period in 2016. Revenues now amount to Php 2.04 billion as of March 31, 2017 vs. Php 2.61 billion as of March 31, 2016.

The company is already talking about "sacrificing growth for liquidity" because it expects its interest expense to double this year as interest rates rise. What has been left unsaid is that the company has already breached some of its debt covenants on its bonds. Its debt to equity ratio now stands at 1.65 to 1.0 vs. a maximum of 1.0.  It is also dangerously close to breaching another debt covenant - that of a minimum current ratio of 1.0. That ratio now stands at 1.06 to 1.0 as of March 31, 2017, which is a drop from the already low level of 1.10 it posted at the end of 2016.

For all we know, the company may already be in technical default as we speak.  The company has around Php 7.6 billion in loans due this year. That money can be raised but it can induce a nail-biter of a cash crunch throughout the year.

The company is already talking of partially abandoning its much-vaunted Contract-To-Sell (CTS) In-house financing (the very business model that propelled it to the top of the mass housing market) for buyers funded by housing financing agencies like Home Development Mutual Fund (HDMF) or PagIBIG fund - all in the name of efficiency and cash generation. That model made it easier for its buyers to obtain homes with very little equity and bypass the bureaucracy of the housing finance agencies. But the CTS model also exposed the company to a whole lot of credit and liquidity risk. Under this model, the company spends a large chunk of money upfront to build and sell the homes and gets back a trickle of that each year in terms of monthly installments that can go on for as long as 25 years.

What's worse is that the company recognizes revenue from these sales up front using the full accrual method at the discretion and judgment of management. Any error in the application of these judgments could result in a material misstatement of the company's financial statements.

While this post may be characterized as unduly alarmist and 8990 Holdings may very well muddle through its challenges, the Philippine real estate market has been littered with the bodies of once high flying real estate companies. Fil-Estate, anyone? If 8990 Holdings falters, it could very well become the proverbial canary in the Philippine real estate coal mine.

Related Posts:

8990 Holdings Inc.'s Impaired Installment Contracts Receivable (ICRs): The Pig Has Finally Broken Out of the Python!

The Philippine Real Estate Bubble Has Already Burst for HOUSE (8990 Holdings, Inc.)

8990 Holdings, Inc.: The Case of the Disappearing Past Due Installment Contract Receivables

Has the Philippine Real Estate Bubble Already Burst?

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