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vii

Contents

Foreword xi

Genesis of This Book xiii

Acknowledgments xv

Introduction 1

Why Focus on Scandals in Asia? 2How This Book is Organized 4As You Begin 5Notes 5

ChApTer 1A Framework for evaluating Financial Irregularities 7Articulation of Financial Statements 8Accruals and Deferrals 12Typical Accounting Games 13Parting Comments 22Note 22References 22

ChApTer 2Detecting Overstated earnings 23Aggressive Revenue Recognition 24Understatement or Deferral of Expenses 29Classification of Non-Operating Income 31Classification of Non-Operating Expenses 31

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http://www.wiley.com/buy/9781118486528


Parting Comments 32Case Studies 33

Longtop Financial 33Sino-Forest 37Oriental Century 42

References 46

ChApTer 3Detecting Overstated Financial position 47Excluding Both Assets and Liabilities 49Other Off-Balance-Sheet Financing/Liabilities 53Overstating Assets 54Parting Comments 59Case Studies 60

RINO International Corp. 60Olympus 66Oceanus 69

Notes 72References 72

ChApTer 4Detecting earnings Management 73Accruals and Deferrals Revisited 74Accounts Receivable (Accrued Revenue) and the Allowance

for Doubtful Accounts 75Deferred (Unearned) Revenue 80Accrued and Deferred (Prepaid) Expenses 80Deferred Taxes 81Contingencies and Reserves 86Parting Comments 87Case Studies 88

Harbin Electric 89West China Cement 98China Biotics 101

References 105

ChApTer 5Detecting Overstated Operating Cash Flows 107Understanding the Cash Flow Statement 108Using Cash Flow to Assess the Quality of Earnings 113Cash Flow Games 116Parting Comments 118

viii Contents

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Contents ix

Case Studies 118Renhe Commercial Holdings 118Duoyuan Global Water 123Winsway Coking Coal Holdings 131

References 136

ChApTer 6evaluating Corporate Governance and related-party Issues 137Board Governance and Independent Directors 138Shareowner Rights 139Interlocking Ownership or Directorships 140Related-Party Transactions 140Excessive Compensation 142Personal Use or Expropriation of Assets 143Lack of Transparency 143Auditor Issues 143Parting Comments 144Case Studies 146

China Valves Tech 146PUDA Coal 149Sino-Environment Technology Group Limited 153

Note 157References 157

ChApTer 7Summary and Guidance 159Putting It All Together 160A Recipe for Detecting Cooked Books 163Parting Comments 168Case Studies 168

Celltrion, Inc. 169Real Gold Mining 170Fibrechem Technologies Ltd. 175

References 177

About the Authors 179

Index 181

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1

IntroductIon

It was like riding a tiger, not knowing how to get off without being eaten.

Ramalinga Raju, founder and former chairman of Satyam

Satyam, founded in 1987, was one of the largest information technology (IT) consultancies in the world. Then a stock darling of India, the company boasted of board members from the “who’s who” of the Indian community; nevertheless, its fall from grace was swift and terminal with this letter:

Dear Board Members, it is with deep regret and tremendous burden that I am carrying on my conscience that I would like to bring the following facts to your notice. . . .

So began Ramalinga Raju, founder and former chairman of Satyam, in his res-ignation letter as he confessed to cooking the books in January 2008, admitting that real profit and cash positions of Satyam were over 90 percent lower than the figures in the accounts. Satyam’s share price collapsed about 90 percent within days. There is an idiom in Chinese, Qi Hu Nan Xia (骑虎难下) telling of the difficulties of dismounting a tiger—clearly, the tiger got the better of Raju.

Today, Satyam operates as a subsidiary of Tech Mahindra Limited after its takeover, subsequent to the unraveling of its fraudulent accounts, by the Mahindra Group in 2009. The company’s consolidated 2013 revenues exceed US$2.7 bil-lion, making it one of India’s five largest IT services companies. The combined firm today employs 84,000 employees serving 540 clients across 46 nations. Current management holds fast that they have put the past behind them and asserts that “by 2015 [Satyam] will be a US$5bn company.”

In their classic book, Security Analysis, now in its sixth edition, Benjamin Graham and David Dodd highlighted the importance of a careful and fundamen-tal evaluation of a company’s business and financial statements. Based on this book and his other works, Benjamin Graham became known as the “father of value

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2 Introduction

investing.”1 Value investing focuses on buying good companies at good prices—starting with the question of whether an investment is cheap and then why is it cheap. If it is cheap because the market has overlooked an important aspect of the future prospects for the company, then it may indeed be good value. Some stocks, however, are cheap because they deserve to be, and the market may properly rec-ognize that the future business and cash flow prospects are poor. However, some stocks are richly priced by the market when in fact these are merely the result of management inflating earnings, cash flow, or the financial position of the firm.

In hindsight, it turned out that Satyam belonged to the latter category. Its story was simply too good to be true: bogus customer receipts and fictitious cash balances were created to balance the double-entry accounting books so as to conceal the overstatement of profits, similar to Parmalat, the Italian dairy and food corporation, whose collapse in 2003 resulted in one of the largest fraud cases in Europe’s history.

So how does one detect accounting games such as those played by Satyam and Parmalat?

Fingerprints were first used in 1905 as a forensic tool in the trial of a South East London murder case. It was the maiden use of forensic science to establish guilt or innocence. The double-entry accounting system, which traces its roots back to the fifteenth century when Luca Pacioli first penned his encyclopedia of math-ematics, has been called “one of the greatest advances in the history of business and commerce.”2 More important, it is to investment professionals what fingerprints are to crime scene investigators and has been aptly identified as the building block of forensic accounting. This system, which underlies even the most sophisticated accounting systems today, creates a framework of checks and balances that enable the discerning analyst to detect fraudulent accounting.

This book is written to provide a practical guide to performing forensic finan-cial analyses of the financial statements of Asian companies. It is written with the global investor in mind, and we hope it will help you to avoid investing in compa-nies that are not in as strong a financial condition as their reported financial state-ments may appear or to identify companies that may be overpriced relative to their true profitability (presenting a potential short sale opportunity). With this book, we hope to share our experiences in financial statement analysis globally and Asia spe-cifically. The disparity of business practices, both intraregionally and intranationally, is a hallmark of Asia; we hope this book will be the start of your journey to navigat-ing the intricacies of investing in Asian businesses.

Why Focus on scandals In asIa?

As previously noted, accounting scandals, such as Parmalat in Europe and Satyam in India, can occur globally. Much has been documented about the international nature

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Introduction 3

of these scandals, from Europe’s Ivar Kreuger, the “Swedish Match King,” to Canada’s Bre-X fraud, to the Worldcom case in the United States. However, significantly less has been written about cases in the Asia region, many of which are quite recent.

Furthermore, corporate governance has been the Achilles’ heel for minor-ity equity shareholders in Asia. Despite being publicly traded, many companies are still effectively controlled by the founder or his family; there is nothing inher-ently wrong with this, but the real winners in many companies are not the minor-ity shareholders. For example, in China, despite the strong economic growth that saw its gross domestic product (GDP) more than double over the past decade, the domestic Shanghai Composite index, which represents the largest listed companies in China, has virtually stayed at the same level since 2001 as shown in Exhibit I.1. This is similar to that of Korea from 1990 to 2005, when the KOSPI stayed flat despite a 3.5 times rise in the country’s GDP.

Underperformance of key Asian equity indices in spite of resounding economic growth in both countries may be, in part, attributed to the lack of corporate gov-ernance in these markets. There is a strong need for forensic accounting in Asia to help tackle this issue, as well as to raise Asia’s standards of corporate governance, going beyond accounting manipulation to include board structure, compensation practices, and the like. This will ultimately unlock value for minority equity hold-ers. While some would argue that stock market returns are not a suitable proxy for GDP growth, the fact is that many companies (and their founders) were big win-ners in the GDP acceleration and became very rich overnight—something that failed to trickle down to minority shareholders.

2,103 2,269

9,922 10,966

13,582 18,494

21,631

47,310

51,894

10,000

20,000

30,000

40,000

50,000

60,000

2,000

4,000

6,000

8,000

10,000

12,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Shanghai Stock ExchangeComposite Index—CNY China Annual GDP—CNYBillions

− −

ExhIbIt I.1 Chinese Stock Market Returns Have Lagged Behind GDP Growth

Sources: Bloomberg, National Bureau of Statistics of China.

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4 Introduction

hoW thIs book Is organIzEd

This book begins by presenting a framework that enables those analyzing financial statements to detect irregularities where the company may be overstating their prof-its, financial position, or cash flow. Subsequent chapters drill down to show detailed evaluation techniques and warning signs for the most common games that com-panies play. In each of these chapters, we provide practical applications using real Asia-based companies throughout the chapter. Each chapter also presents a checklist of analysis techniques and warning signs to look for. At the end of each chapter, we present full case studies of real Asia-based companies to demonstrate the techniques in a holistic manner.

Chapter 1, “A Framework for Evaluating Financial Irregularities,” provides the key to the book. In this chapter, we present the basics of the accounting system, which creates the checks and balances essential to creating financial statements and detecting irregularities within them. Some of you may have studied accounting in college and may (but more likely not) recall the dreaded “debits” and “credits.” Fear not—this is not your typical accounting text, and we will not muddy the waters with such minutiae. Instead, we demonstrate how the primary financial statements fit together and how this information can be used to detect problems and highlight where more questions are warranted. In this and subsequent chapters, we provide real-life examples of accounting games that companies play in Asia. It is important to note, however, that the framework and techniques we present are equally appli-cable to companies globally. In fact, the techniques were developed by the authors’ study and experience with companies operating worldwide, not just in Asia.

Chapter 2, “Detecting Overstated Earnings,” examines one of the most com-mon goals of unscrupulous managers: overstating profits relative to the underlying reality. We address cases that range from aggressive reporting (premature revenue recognition) to outright fraud (reporting nonexistent revenues). In this chapter, and in Chapters 3 through 7, we detail cases of companies that have been accused, but not necessarily ascertained guilty, of manipulating their reported results. Do note that these cases may overlap with material in other chapters due to the often plural nature of accounting manipulation.

Chapter 3, “Detecting Overstated Financial Position,” takes a look at com-panies that attempt to make their financial position look stronger than it really is. While commonly associated with the overstatement of assets, that is not always the case. The company may want to understate both assets and liabilities, which improves profitability ratios (such as return on assets) or debt ratios (by making them look smaller).

Chapter 4, “Detecting Earnings Management,” takes the material in Chapter 3 one step further, addressing multiyear manipulation. In a bid to smooth the vola-tility of earnings or manage the perceived trajectory of earnings, a company may

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Introduction 5

purposefully understate earnings in the current year with the expectation of using this “cookie jar” reserve to boost earnings in later years.

Chapter 5, “Detecting Overstated Operating Cash Flows,” examines how com-panies may massage reported numbers to inflate some measure of cash flow such as operating cash flow. Often, but not always, this accompanies an overstatement of earnings, as presented in Chapter 3.

Chapter 6, “Evaluating Corporate Governance and Related-Party Issues,” examines the impact of weak corporate governance on reported results. Weak cor-porate governance provides opportunities for the activities presented in Chapters 3 through 5 by permitting managers or majority shareholders to engage in related-party transactions to enrich themselves at the expense of other shareholders.

Chapter 7, “Summary and Guidance,” pulls it all together and summarizes things to look out for when evaluating the financial statements of Asian companies—the so-called red flags of corporate accounting.

as you bEgIn

This book is designed to teach you practical techniques that you can keep in the back of your mind as you review financial statements for potential investment, whether you suspect irregularities or not. It is also designed as a more permanent reference to use when you suspect problems at a company. Read the chapters thor-oughly now—particularly Chapter 1—and use the checklists at the end to help guide you in the future.

notEs

1. Benjamin Graham is also notable in that he was one of the earliest proponents of a rating system for financial analysts, which became the CFA Program. The first CFA examination was offered in 1963 in North America, and exams are administered globally by the CFA Institute today.

2. Jane Gleeson-Shite, Double Entry: How the Merchants of Venice Created Modern Finance (New York: W. W. Norton & Company, 2012), 93.

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Extracted from Asian Financial Statement Analysis: Detecting Financial Irregularities published in 2014 by John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk,

#07-01, Solaris South Tower, Singapore 138628.

Copyright © 2014 by Chinwee Tan, Thomas R. Robinson

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning

or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance

Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, Tel: 65-6643-8000,

Fax: 65- 6643- 8008, email: [email protected]


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