WITHOUT trust in the capital markets, investors will not invest. Nonetheless, trust could be the mother of deceit in the case of Chinese companies that have gone for listing abroad.
Malaysia is not the only stock exchange that has witnessed accounting scandals among the Chinese companies, which are generally known as red chips elsewhere. Such financial impropriety at Chinese companies across the globe has turned investor enthusiasm for the country’s economic boom into mass scepticism about the stocks, sending them tumbling and drawing the scrutiny of regulators.
A common thread among these fraudulent Chinese companies is the simplicity of their accounting techniques to manufacture earnings vis-à-vis Enron Corp, which used complex derivative transactions to hide its losses. The easiest method to increase profits is probably inappropriate revenue recognition or fake revenue, followed by understated expenses through the capitalisation of certain expenditure, understated liabilities via off-book loans and inflated assets by exaggerating hard-to-value investments (see table).
The first two methods, however, result in inflated assets as the fake profits flow into the balance sheet. If the company records fake revenue, it will need to find some place for it on the asset side of the balance sheet, either in receivables or cash balances. Nonetheless, cash is generally preferred as receivables will become overdue one day and auditors may insist on impairing these uncollectible accounts. This is likely to lead to unusually large cash piles with incredibly low interest income that does not match the prevailing deposit rates in the market. To make it harder for auditors to verify these non-existent cash balances, these companies then claim that they have invested the money with relatively unknown asset management companies, made huge prepayments to suppliers or advanced loans to business associates.
In other cases, the companies incur significant capital expenditure for business expansion while reporting a sharp decline in revenue and profitability. As these fictitious assets are not verifiable, qualified auditor opinion or heavy impairment charges are inevitable, eventually resulting in drastic swings in their financial position and performance.
Among over 100 Chinese firms that were delisted on North American exchanges due to accounting irregularities, one classic case study is perhaps RINO International Corp, which was first listed in the US through a reverse takeover. RINO’s stock performed quite well until Muddy Waters, an investment research firm famous for short-selling cross-listed Chinese companies, accused RINO of substantially overstating revenue by fabricating client relationships.
Based on Chinese regulatory filings and its own channel checks, Muddy Waters believed that the wastewater treatment company’s revenue in 2009 should have been less than US$15 million and not the reported US$193 million. To complete the whole cash flow process, RINO chose to inflate its cash and accounts receivable, which increased by US$15 million and US$54 million respectively in the first three quarters of 2010. RINO’s gross margins were also abnormally high, at 34% to 49%, compared with its peers’ 9% to 23% from 2008 to 2010.
On Jan 18, 2013, US-based Caterpillar Inc recorded a goodwill impairment charge of about US$580 million on ERA Mining Machinery Ltd, a Hong Kong-listed Chinese firm it had acquired in June 2012. The world’s largest construction and mining equipment maker said its internal investigation revealed “deliberate, multi-year, coordinated accounting misconduct” concealed by the senior managers of its Chinese unit.
Merely four months after the acquisition of ERA Mining, Caterpillar discovered the discrepancy between the inventory recorded in the company’s accounting records and the actual one. This means the Chinese firm was capitalising inventory costs instead of expensing it in the appropriate accounting period, resulting in overstated inventory and profits.
Over at Sino-Forest Corp, Muddy Waters pointed out in a June 2, 2011, report that the Chinese forest plantation operator massively exaggerated its assets by over US$800 million by significantly falsifying its investments in plantation trees. Sino-Forest managed to pull this off by feeding the fraudulent data to Finland-listed engineering and industrial services firm Poyry to produce valuation reports while giving the latter access to only 0.3% of its purported timber holdings.
At Lixil Group Corp, the Japan-listed building material and housing equipment maker faced losses of at least ¥41 billion or US$337 million after it uncovered a significant amount of off-book debt obligations at its Chinese subsidiary Joyou. Lixil said the amount of the off-book loans, arranged by the founders of its Chinese unit, was unclear due to the destruction and deletion of historical data. As a result, the management decided to apply for the commencement of insolvency proceedings due to the over-indebtedness of Joyou.
While excessive cash balances and huge impairment losses could provide some red flags, hard-to-value assets and off-balance sheet debts are not easy to identify, especially for outside users of financial statements. Besides company financials, investors could also turn to external signals, such as the frequency of change in principal officers and external auditors, consistency in filings with regulators and the corporate governance structure (whether the company is controlled by a few individuals), for warning signs of earnings manipulation.
Capital markets rely on a broad ecosystem of professional advisers, equity analysts, brokers and regulators to function effectively and efficiently. Some attribute the underperformance, if not collapse, of the cross-border listings of Chinese firms ultimately to the underdevelopment of China’s capital markets where regulatory frameworks and ecosystems are still being developed.
Given the limited legal and administrative powers that foreign regulators can exercise over China-based firms (besides delisting non-compliant firms), the most effective way to restore confidence in red chips is perhaps by China closing the gaps in its accounting and disclosure standards with those of developed markets.
Save by subscribing to us for your print and/or digital copy.
P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.