AVOIDING PITFALLS WHEN
INVESTING IN ASIA –A FORENSIC
ACCOUNTING FRAMEWORK
Tom Robinson, CFA, CPA
CFA Institute
Tan Chin Hwee,
Hwee CFA,
CFA CPA
Apollo Global Management
May 2012
AGENDA
• Forensic Accounting Framework
- Articulation of Financial Statements
- Typical Irregularities
- Some Warning Signs and Red Flags to Look For
• Asia Pacific Case Studies
- China Forestry
- Chaoda
•Q&A
2
FINANCIAL STATEMENTS
Balance Sheet
I
Income
St t
Statement
t
Statement of Cash Flows
Statement of Owners’ Equity
Footnotes/Management Discussion
FRAMEWORK: THE ARTICULATION
OF FINANCIAL STATEMENTS
Beginning Balance Sheet
Assets
Cash
Accounts
Receivable
Inventory
Investment
Seccurities
=
Property
(Net)
Liabilities
Short
Term
Other
+
Long
Term
Owners' Equity
Contributed
Capital
+/- Net
Cash
Flow
Retained
Earnings
+/- Net
+Earnings
Contributions
Other
Comprehensive
Income
+/-Other
-Dividends
Ending Balance Sheet
Assets
Income Statement
Revenues
Cash Flow +/‐
Statement
Cash Flows From +/‐
Operating Activities
‐
Expenses
Cash Flows From Investing Activities
=
+
Gains
+/‐
Cash Flows From Operating Activities
Liabilities
‐
Losses
=
Net Cash Flow
=
+
Earnings
Owners' Equity
TYPICAL IRREGULARITIES
Overstating
g Earnings
g
Overstating Financial
Position
Use of Reserves/Provisions
Impacting Multiple Financial
Statements & Years
Overstating Operating
Cash Flows
Corporate
Governance/Related
Party/Auditor Issues
OVERSTATING EARNINGS
Aggressive Revenue
Recognition (Too soon)
Classification of nonoperating income or nonrecurring income as
revenue
Deferral of Expenses
Classification of operating
expenses as nonoperating or “special”
• Examine revenue recognition policy in footnotes relative to peers
• Are customer receivables growing faster then revenues?
• Is operating cash flow significantly lower than accounting
earnings?
• Did significant revenues occur late in the year?
•
•
•
•
Were “gains” included in revenue?
Is the company’s operating description appropriate?
Were one-time or non-recurring items included in revenue?
Were anyy g
gains or revenue based on re-valuation of assets?
• Are depreciation/amortization periods longer then peer
companies?
• Are there anyy deferred expenses
p
listed as an asset on the balance
sheet (other than deferred taxes)?
• Are there any unusual assets or unexplained large increases in
assets such as inventory– particularly relative to revenues?
• Were any expenses or losses listed as “special”, extraordinary or
non-recurring at the bottom of the income statement?
• Are there unusually high margins relative to peers (also applies to
Deferral of Expenses)?
OVERSTATING FINANCIAL POSITION
Off Balance Sheet
Financing
• Scrutinize the footnotes for off balance sheet borrowing
or guarantees
• Does the company utilize operating leases more than
peers?
p
Unconsolidated
Special Purpose
Entities/Joint
Ventures
• Scrutinize the footnotes for use of the equity method of
accounting (versus consolidation)
Intangible
g
Assets/Valuation of
Assets
• Does the company have unusual increases in intangible
assets?
• Does the company have assets which are subject to
significant estimates and assumptions ? (e.g., reserves,
securities without market values)
USE OF RESERVES, PROVISIONS,
ACCRUALS & DEFERRALS
Revenue
Expense
Cash flows occur
later than reflected
in earnings
Asset
Accounts
Receivable
Liability
Accrued Expenses
Deferred Tax Liability
Contingencies
Contra Asset
Allowance for Doubtful
Accounts
Cash flows occur
before reflected in
earnings
Liability
Asset
Unearned Revenue
Property & Equipment
Deferred Revenue
Prepaid Expense
Deferred Tax Asset
Deferred Expenses
OVERSTATING OPERATING CASH FLOWS
Expenditures improperly
classified as capital
expenditures
Borrowing transactions
treated as operating
cash inflow
Acceleration of Cash
Received for Revenues
or Deferral of Cash Paid
for Expenses
• Are there abnormal increases in long term assets?
• Are there unusual assets?
• Any abnormal changes in capital expenditures?
• Are there contingent or other off-balance sheet
liabilities disclosed (or not disclosed).
• Look for reciprocal or repurchase
agreements/insurance type contracts.
• Is there any revenue from an unusual type customer
(financial services firm)?
• Look for factoring, sales of receivables or other
transactions to bring
g cash flow in early
y
• See if the company is delaying of payments to
suppliers and others – such as an increase in
accounts payable
CORPORATE GOVERNANCE/RELATED
PARTY/AUDITOR ISSUES
Insufficient external
representation on board
Management use of
excessive compensation,
perks or disproportionate
expenditures
Related p
party
y
transactions
Auditors
• Examine
E
i board
b
d membership
b
hi for
f external
t
l members
b
• Examine possible interlocking directors
• Disclosures of compensation or perks in excess of
those in similar companies
• Excessive use of stock based compensation/options
• Business transactions between company and management
(Sales/Leasing)
• Family
y members involved in company
p y or other companies
p
that the subject company does business with.
• Are there significant loans to management either from the
company or related entities?
• Resignation of
• Frequent changes in
• Disagreements with
CASE STUDIES
1) China Forestry Case Study
2) Chaoda Case Study
FORENSIC ACCOUNTING CASE STUDIES
(2009 - 2011)
China Forestry
y
Seeing the Forest for the Trees
BACKGROUND
¾ One of three largest privately held forest operators in China with 172,000 hectares of
reported forest land. Started operations in 2003, when the government allowed forest
assets to be transferred
¾ Founder and Chairman Li Kwok Cheng is a member on the China Council for Promotion
of Environment and Forestry. Mentioned in prospectus that his position gives the
Company first-hand information on the latest developments in the industry and helps
identify suitable forestry assets
¾ Raised US$85 million in pre-IPO financing from well known private equity investors
between December 2007 and June 2009
p y listed on HKSE and raised US$230
$
million. In
¾ On 3 December 2009,, the Company
November 2010, the Company issued US$300 million in high yield notes
Source: Company filings
WHAT HAPPENED?
¾On Jan 31 2011, the company announced that possible irregularities have been identified
by the auditor KPMG. The shares have been suspended from trading since
¾The CEO (Li Han Chun) was removed from his position on Feb 2011 and detained for
the embezzlement of $5 million
¾After a p
preliminary
y investigation,
g
the auditor discovered that cash p
proceeds from sales
transactions were not deposited into the company’s bank accounts. Not all sales
transactions were recorded. Pilferage was happening on a wide scale
¾The management had maintained more than one set of accounting records and falsified
documents, including management accounts, harvesting records, logging permits, bank
statements
Was there anything that could have triggered suspicions that all was not
as it seemed?
THE P&L – WHAT IS THE RED FLAG?
Source: IPO prospectus
FINANCIAL ANALYSIS – THE WARNING
SIGNALS
¾ Company generated significant
positive net profits almost entirely
from non-cash revaluation of
plantation assets at the time of
acquisition
¾ Timing of the bulk of the revaluation
i 2008 coincides
in
i id with
ith th
the main
i
relevant reporting period for the IPO
in 2009
¾ Given how politically sensitive the
ownership of farmland is in China,
would any business have been
allowed to get away with buying
f
farmland
l d on th
the cheap
h
and
d th
then
booking a RMB 6.6 billion (c.$900
million) profit due to revaluation right
away?
Source: IPO prospectus
LESSONS LEARNED
¾
Businesses based on biological assets with long-dated harvesting periods are more
susceptible to earnings manipulation
¾
¾
The lack of an independent third party or regulator who can verify transactions and
h ldi
holdings
should
h ld raise
i iinvestor
t skepticism
k ti i
Knowledge
g of intangibles
g
like the p
political landscape
p can help
p draw attention to red flags
g
¾
For example, the revaluation of farmland during a period when income inequality has
become a politically sensitive issue would have led to further questions on the veracity of
the business model
FORENSIC ACCOUNTING CASE STUDIES
(2009 - 2011)
Chaoda Modern Agriculture
The Bigger they are
are, the Harder they Fall
BACKGROUND
¾ Chaoda is the largest public agricultural company with a production base of
44 000 hectares
44,000
hectares. It was listed on the Hong Kong main board in 2000 with a peak
EV of US$ 3.7 bn and pre-suspension EV of US$ 75 mm.
¾ Business model: Consolidates small pieces of farmland from farmers into large
parcels increasing yield by upgrading infrastructure
parcels,
infrastructure, diversifying the product line
and by-passing the middle-man; Farmers are hired back and paid a salary to grow
a variety of vegetables on the new and improved land.
¾ Key shareholder: Chairman 20
20.6%,
6% Janus Capital 8
8.9%
9% and Blackrock 5
5.5%
5%
¾ Business Performance: Company reported revenue of US$ 600 mm with
EBITDA US$ 300 mm for the 6 months ending December 2010. Both revenue and
EBITDA grew at a compound rate of 30% since 2001
2001.
¾ Capital Structure:
• Cash US$ 607 mm
• Convertible bond US$ 200 mm
Issued August 2010, 5 year 3.7% coupon with strike 5% discount to market
and 7% premium to equity offering
Source: Company filings
CHAODA EQUITY PERFORMANCE – 2001
TO 2011
Source: Bloomberg Data
WHY IS THE STOCK SUSPENDED?
¾Chaoda Chairman Kwok Ho
Ho, Chief Financial Officer Andy Chan and Fidelity
Management’s George Stairs were accused by the Hong Kong Market Misconduct
Tribunal of insider trading on September 23 2011
¾On September 26 2011, the Company requested for a trading halt and trading of the
shares has remained suspended since
¾Previously
¾P
i
l on M
May 26
26, Next
N t Magazine
M
i had
h d putt outt a reportt alleging
ll i th
thatt Ch
Chaoda
d h
had
d
overstated the farmland under its management and Anonymous Analytics subsequently
made a similar accusation
STABLE MARGINS WERE A RED FLAG
Margins were too stable
¾ Chaoda
Chaoda’s
s gross margins were ~67%
67%
from 2007 to 2009, vs. Minzhong (a
similar company) where margins fell
from 63% to 45%.
¾ Chaoda was able to manage its
gross margins very well compared to
competitors
¾ Margins remained stable > 65% for 8
y
years
compared to China Green
where margins declined from 64% to
below 50% over the same period
(see chart)
Chaoda margins extremely constant vs.
comps
CORPORATE GOVERNANCE WAS
SUSPECT
Four auditors since listing
¾ PWC resigned in 2001. CCIF was the 2nd auditor and was replaced in 2007
by Grant Thornton. BDO took over in December 2010.
¾ The Company has yet to release its financials for 30 June 2011 and 30 Dec
2011. This along with the frequent change in auditor is a strong signal that
the Company might have some financial issues
Related-party transaction
¾ Fertiliser is the largest component of raw material costs (~30%). Unlike its
competitors, Chaoda’s fertiliser is sourced from a single source – Fujian
Chaoda, which is owned by the Chairman and is outside the listco. Since
2001, ~US$ 500 mm of fertiliser has been purchased from Fujian Chaoda
¾ While there is no evidence that Chaoda overpaid for its fertiliser, it is difficult
to authenticate the payment with the Chairman controlling both companies
and this is an easy way for management to pilfer cash
LESSONS LEARNED
¾ Frequent
auditor resignations are a red flag that should not be ignored.
It can point to some fundamental difficulty with the company’s
company s internal
controls
¾ Related
party transactions are always something that investors should
look out for. The supply chain or distribution network of a company is
the easiest way for management to funnel cash out, so a check on the
ownership
hi is
i a mustt during
d i d
due dili
diligence
¾ A comparison
of the gross margins to peers should have called the
business model into question due to the divergence in performance
Common Themes from the Case Studies
SOME KEY TAKEAWAYS TO WRAP UP
¾The numbers tell only half the story. Understanding the local situation on the
ground both economically and politically can help you see the ‘forest’ for the
‘trees’
¾The alignment of interest with a key stakeholder is always important.
partnership
p with the key
y stakeholders and their
¾ We view investments as a p
commitment and desire for the business to succeed is a critical measure
of how successful the investment will eventually be
¾Distribution networks and supply chains are potential avenues for pilferage
of cash.
¾ Ascertaining the ownership structure of a company’s support network can
help investors avoid falling prey to fraud via related party transactions
COMMON THEMES
Fibrechem
Celestial
Chaoda
Large cash reserves and low
dividend pay-out ratio
9
9
9
Poor cash generation / working
capital management
9
9
Regular one-off P&L items / M&A
activity
Oceanus
9
Sino
Forest
Egana
g
Peace Mark
9
9
9
9
9
9
9
9
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Regular capital raisings
9
9
Company undergoing fast growth
9
9
Small / mid cap company
9
9
Complex organizational
structures
9
9
Promoter has influence over
management
9
9
Promoter has significant
investment in other companies
9
S
Susceptible
tibl b
business
i
model
d l
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
9
QUESTIONS & ANSWER SESSION
谢谢