gillem tulloch - creative accounting (china companies) 2011 11.01

Forensic Asia Limited

Gillem Tulloch November 2011

Creative accounting

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


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


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


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


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


China Everbright (257 HK) Exploiting a lack of disclosure


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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


China Everbright’s accounts There will never be enough disclosure


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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


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]

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]

gillem tulloch - creative accounting (china companies) 2011 11.01

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