Forensic Asia Limited. Creative accounting. Gillem Tulloch November 2011

Transcription

1 Forensic Asia Limited Creative accounting Gillem Tulloch November 2011

2 Creative accounting: What, how and where? What to look out for How to uncover it 2 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 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 Growth through acquisitions Shell companies for acquisitions Busy/complex accounts or structures Super-normal profitability Where to find it Cash based businesses such as agriculture Capital intensive businesses such as infrastructure and property China

3 Suspicious behaviour Incidence of A/R and Inv day deterioration over 3 yrs 3 What evidence of profit manipulation? 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

4 Creative Accounting Example 1: Different jurisdictions, different numbers Pick your poison: A or B? A rational investor would choose A 4 Company Co.A Co.B B / A (%) Year Profit (US$m) Equity (US$m) 1,461 2, Assets (US$m) 4,022 4, Free cash flow (US$m) ROE (%) Debt/equity (%) PER (x) 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

5 Creative Accounting Example 1: Different jurisdictions, different numbers Beijing North Star Exploiting different jurisdictions 5 Company CH 588 HK B / A (%) Year Profit (US$m) Equity (US$m) 1,461 2, Assets (US$m) 4,022 4, Free cash flow (US$m) ROE (%) Debt/equity (%) PER (x) 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

6 Creative Accounting Example 2: Mark-to-market accounting Pick your poison: B or C? A rational investor would own C 6 Company Co.B Co.C Revenue (US$m) OperaQng profit (US$m) Fair value gains (US$m) Net interest expense (US$m) Other (US$m) 3 0 PBT (US$m) Tax (US$m) Profit (US$m) Equity (US$m) 2, Assets (US$m) 4,777 1,698 Free cash flow (US$m) ROE (%) Debt/equity (%) Market cap (US$m) 1, PER (x) PER adjusted for disclosed FV gains (x) 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

7 Creative Accounting Example 2: Mark-to-market accounting China Everbright (257 HK) Exploiting a lack of disclosure 7 China Everbright China Everbright Adjusted/ Company reported adjusted Reported (%) Revenue (US$m) OperaQng profit (US$m) Fair value gains (US$m) Net interest expense (US$m) Other (US$m) PBT (US$m) Tax (US$m) Profit (US$m) Equity (US$m) Assets (US$m) 1,698 1,539 9 Free cash flow (US$m) ROE (%) Debt/equity (%) Market cap (US$m) PER (x) 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 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 nonconstruction 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

8 Creative Accounting Example 2: Mark-to-market accounting China Everbright s accounts 8 There will never be enough 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 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

9 Conclusions A quick summary More information 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 Please visit our website at 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] Different accounting standard in different jurisdictions create business models that would not exist otherwise

10 A bit about us Forensic Asia is an independent research provider 10 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 or [email protected] and terms of use are available on our website at