gillem tulloch - creative accounting (china companies) 2011 11.01
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Forensic Asia Limited
Gillem Tulloch November 2011
Creative accounting
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
What to look out for How to uncover it
Creative accounting: What, how and where? 2
Read the financial statements, in particular the prospectus
Visit the company, talk to management
Speak to competitors, suppliers, customers and, if possibly, employees
Be cynical
Employ specialist risk consultancy to do background checks
Where to find it Cash based businesses such as agriculture
Capital intensive businesses such as infrastructure and property
China…
Deteriorating inventories
Deteriorating receivables
Large “other” assets and liabilities
Related party transactions
Persistently high capex and free cash outflows
High income statement tax relative to cash flow tax
Inappropriate accounting standards
Growth through acquisitions
Shell companies for acquisitions
Busy/complex accounts or structures
Super-normal profitability
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
Incidence of A/R and Inv day deterioration over 3 yrs What evidence of profit manipulation?
Suspicious behaviour
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There is greater probability of Asian companies reporting deteriorating inventory and receivable days than in European and US counterparts
In Asia, 9.4% of companies have seen a deterioration in five of the six metrics (inventory and receivable days) over the past three years (China is more than 10%)
US: 4.3%
W.Europe: 4.9%
Asia: 9.4%
Suggests a greater number of companies in Asia are manipulating profits or experiencing deteriorating terms of trade
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
Pick your poison: A or B? A rational investor would choose A
Creative Accounting Example 1: Different jurisdictions, different numbers
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There is a need to understand the impact of different accounting jurisdictions
Which company would you rather invest in, assuming they are in the same industry?
Most investors would prefer Company A over Company B: Company A’s profit is almost 3x larger
ROE is almost three times higher
Balance sheet is less geared
PER multiple is lower
Company Co.A Co.B B / A (%)
Year 2010 2010 2010
Profit (US$m) 48 188 +294
Equity (US$m) 1,461 2,027 +39
Assets (US$m) 4,022 4,777 +19
Free cash flow (US$m) ‐165 ‐265 +61
ROE (%) 3.3 9.6 +194
Debt/equity (%) 110 79 ‐28
PER (x) 27.4 7.0 ‐75
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
Beijing North Star Exploiting different jurisdictions
Creative Accounting Example 1: Different jurisdictions, different numbers
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Yes, companies A and B are the same but reporting numbers in different jurisdictions
Under HK accounting standards: Greater flexibility on cost capitalisation
Can revalue a wider range of assets
As a result, profit 3x higher and assets 19% larger
Under Chinese reporting standards: Can reclassify interest expenses in the cash flow
statement from operating cash flow to financing cash flow
Impact is to flatter cash conversion cycle and overstate free cash flow
Creating business models around account standards (E.g. IAS 41, IFRIC 12)
Chinese property companies prefer to list in HK
Company 601588 CH 588 HK B / A (%)
Year 2010 2010 2010
Profit (US$m) 48 188 +294
Equity (US$m) 1,461 2,027 +39
Assets (US$m) 4,022 4,777 +19
Free cash flow (US$m) ‐165 ‐265 +61
ROE (%) 3.3 9.6 +194
Debt/equity (%) 110 79 ‐28
PER (x) 27.4 7.0 ‐75
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
Pick your poison: B or C? A rational investor would own C
Creative Accounting Example 2: Mark-to-market accounting
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No amount of disclosure will give investors meaningful insight into mark-to-market accounting
Which company would you rather invest in, assuming they are in the same industry?:
Most investors would prefer Company C over Company B (Beijing North Star): Company C generates a higher ROE and has
lower debt/equity
After adjusting out revaluation gains, Company C trades on less than half the PER multiple
Company Co.B Co.C Revenue (US$m) 869 458 OperaQng profit (US$m) 174 160 Fair value gains (US$m) 160 0 Net interest expense (US$m) ‐51 ‐28 Other (US$m) ‐3 0 PBT (US$m) 280 132 Tax (US$m) ‐92 ‐30 Profit (US$m) 188 102 Equity (US$m) 2,027 898 Assets (US$m) 4,777 1,698 Free cash flow (US$m) ‐265 ‐170
ROE (%) 9.6 12.4 Debt/equity (%) 79 67 Market cap (US$m) 1,310 890 PER (x) 7.0 8.7 PER adjusted for disclosed FV gains (x) 16.3 8.7
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
China Everbright (257 HK) Exploiting a lack of disclosure
Creative Accounting Example 2: Mark-to-market accounting
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Company C is China Everbright Revaluation gains are not separately disclosed
but…. …“real” revenues and profit less than 30% of reported
Revaluations represent the present value of future cash flows from assets currently being constructed (IFRIC 12)…
….that’s recognising a profit from capex to you and me (an intercompany transaction)
Revaluation gains are labelled as construction revenues and included in top line
No margin breakdown disclosed so unable to work out underlying profitability of non-construction business
Management refuse to disclosure and under no obligation to do so
Once stripping out gains, company trades on 48.9x PER, not 8.7x
Company China Everbright
reported China Everbright
adjusted Adjusted/
Reported (%)
Revenue (US$m) 458 127 ‐72
OperaQng profit (US$m) 160 52 ‐68
Fair value gains (US$m) 0 0 0
Net interest expense (US$m) ‐28 ‐28 0
Other (US$m) 0 0 0
PBT (US$m) 132 24 ‐82
Tax (US$m) ‐30 ‐6 ‐81
Profit (US$m) 102 18 ‐82
Equity (US$m) 898 739 ‐18
Assets (US$m) 1,698 1,539 ‐9
Free cash flow (US$m) ‐170 ‐170 0
ROE (%) 12.4 2.6 ‐79
Debt/equity (%) 67 81 +22
Market cap (US$m) 890 890 0
PER (x) 8.7 48.9 +459
We have adjusted profit based on actual tax paid as disclosed in the cash flow statement; revenues have been adjusted by excluding construction revenues and finance income; other numbers are implied
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
China Everbright’s accounts There will never be enough disclosure
Creative Accounting Example 2: Mark-to-market accounting
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Everbright derives a fair value by discounting future anticipated revenues between 5.94% and 7.83%, well below Chinese inflation (15%)
We have no disclosure on volume or price assumptions
Marked-to-market accounting is only useful if you can re-create the valuation and conduct some form of sensitivity analysis
As it stands, it simply shows what the auditors and management want
Once again, accounting standard is creating a business model (Hyflux, Sound Global, etc)
Is not “illegal” but that does not make it “right” Better to have a system where there is limited
subjectivity and you don’t need much disclosure
The largest asset on China Everbright’s balance sheet is described as:
“Gross amounts due from customers for contract work” represent revenue from construction under BOT (Build-Operate-Transfer) and BT (Build-Transfer) arrangements or upgrade services under TOT arrangements and bear interest at rates ranging from 5.94% to 7.83% (2009: 5.94% to 7.83%) per annum. Among the total of $4,979,960,000 (2009: $3,477,389,000), $3,545,912,000 (2009: $3,477,389,000) relates to BOT and TOT arrangements with operation commenced. The amounts for BOT and TOT arrangements are not yet due for payment and will be settled by revenue to be generated during the operating periods of the arrangements. The amount for BT arrangements will be settled according.
“Mark-to-market accounting: recognising tomorrow’s profit today” Quote from “Enron”, the musical
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.asianom.com
A quick summary More information
Conclusions 9
Look for the usual tell-tale signs of creating accounting such as inventory and receivable day deterioration
There is evidence of a high level of creative accounting in Asia and in particular China
Read the financial statements
Try to understand accounting standards and their adoption across markets
Be wary of mark-to-market accounting
Different accounting standard in different jurisdictions create business models that would not exist otherwise…
Please visit our website at www.forensicasia.com for more information
Principal writing analysts: Gillem Tulloch: [email protected]
Keith Neruda: [email protected]
Tim summers: [email protected]
Head of Marketing: Lisa Mangkornkarn: [email protected]
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Copyright © Forensic Asia Limited IMPORTANT: All information, advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer, privacy statement and terms of use are available on our website at www.forensicasia.com
A bit about us…
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Forensic Asia is an independent research provider
No investment banking + no fund management + no commission-based model = no conflicts of interest
Two product lines:
OnSite: Company and sector research focusing on profit relative to cash flows, accounting issues and business models that don’t make sense
EvaluAsia: Analysis of large samples of financials
Regulated by Hong Kong’s SFC and 100% owned by Dr Jim Walker’s Asianomics
Principal writing analysts: Gillem Tulloch, Keith Neruda and Dr Tim Summers
For more information, visit www.forensicasia.com or email [email protected]