Forensic Asia Limited

Creative accounting
Gillem Tulloch November 2011

Creative accounting: What, how and where?

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What to look out for

How to uncover it

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

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

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Suspicious behaviour
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Incidence of A/R and Inv day deterioration over 3 yrs

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: W.Europe: Asia: 4.3% 4.9% 9.4%

Suggests a greater number of companies

in Asia are manipulating profits or experiencing deteriorating terms of trade

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Creative Accounting Example 1:

Different jurisdictions, different numbers
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Pick your poison: A or B?

Company Year Prot(US$m) Equity(US$m) Assets(US$m) Freecashow(US$m) ROE(%) Debt/equity(%) PER(x) Co.A 2010 48 1,461 4,022 165 3.3 110 27.4 Co.B 2010 188 2,027 4,777 265 9.6 79 7.0 B/A(%) 2010 +294 +39 +19 +61 +194 28 75

A rational investor would choose A

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 As profit is almost 3x larger ROE is almost three times higher Balance sheet is less geared PER multiple is lower

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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

Creative Accounting Example 1:

Different jurisdictions, different numbers
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Beijing North Star

Company Year Prot(US$m) Equity(US$m) Assets(US$m) Freecashow(US$m) ROE(%) Debt/equity(%) PER(x) 601588CH 2010 48 1,461 4,022 165 3.3 110 27.4 588HK 2010 188 2,027 4,777 265 9.6 79 7.0 B/A(%) 2010 +294 +39 +19 +61 +194 28 75

Exploiting different jurisdictions

Yes, companies A and B are the same but 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

reporting numbers in different jurisdictions

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

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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

Creative Accounting Example 2:

Mark-to-market accounting
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Pick your poison: B or C?

Company Revenue(US$m) OperaQngprot(US$m) Fairvaluegains(US$m) Netinterestexpense(US$m) Other(US$m) PBT(US$m) Tax(US$m) Prot(US$m) Equity(US$m) Assets(US$m) Freecashow(US$m) ROE(%) Debt/equity(%) Marketcap(US$m) PER(x) PERadjustedfordisclosedFV gains(x) Co.B 869 174 160 51 3 280 92 188 2,027 4,777 265 9.6 79 1,310 7.0 16.3 Co.C 458 160 0 28 0 132 30 102 898 1,698 170 12.4 67 890 8.7 8.7

A rational investor would own C

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

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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

Creative Accounting Example 2:

Mark-to-market accounting
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China Everbright (257 HK)

Company Revenue(US$m) OperaQngprot(US$m) Fairvaluegains(US$m) Netinterestexpense(US$m) Other(US$m) PBT(US$m) Tax(US$m) Prot(US$m) Equity(US$m) Assets(US$m) Freecashow(US$m) ROE(%) Debt/equity(%) Marketcap(US$m) PER(x) ChinaEverbrightChinaEverbright Adjusted/ reported adjusted Reported(%) 458 127 72 160 52 68 0 0 0 28 28 0 0 0 0 132 24 82 30 6 81 102 18 82 898 739 18 1,698 1,539 9 170 170 0 12.4 67 890 8.7 2.6 81 890 48.9
79 +22

Exploiting a lack of disclosure

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) .thats 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

0 +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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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

Creative Accounting Example 2:

Mark-to-market accounting
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China Everbrights accounts

The largest asset on China Everbrights 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.

There will never be enough disclosure

Everbright derives a fair value by discounting

future anticipated revenues between 5.94% and 7.83%, well below Chinese inflation (15%) assumptions

We have no disclosure on volume or price Marked-to-market accounting is only useful if

you can re-create the valuation and conduct some form of sensitivity analysis and management want

As it stands, it simply shows what the auditors 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

Mark-to-market accounting: recognising tomorrows profit today Quote from Enron, the musical

subjectivity and you dont need much disclosure

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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

Conclusions
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A quick summary
Look for the usual tell-tale signs of creating

More information
Please visit our website at

accounting such as inventory and receivable day deterioration

There is evidence of a high level of creative

www.forensicasia.com for more information

Principal writing analysts:

accounting in Asia and in particular China

Read the financial statements Try to understand accounting standards

Gillem Tulloch: gillem@forensicasia.com Keith Neruda: keith@forensicasia.com Tim summers: tim@forensicasia.com

and their adoption across markets

Be wary of mark-to-market accounting Different accounting standard in different

Head of Marketing:

Lisa Mangkornkarn: lisa@forensicasia.com

jurisdictions create business models that would not exist otherwise

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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 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 dont make sense EvaluAsia: Analysis of large samples of financials

Regulated by Hong Kongs SFC and 100% owned by Dr Jim Walkers Asianomics Principal writing analysts: Gillem Tulloch, Keith Neruda and Dr Tim Summers For more information, visit www.forensicasia.com or email gillem@forensicasia.com

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