Forensic Asia Limited

Creative accounting
Gillem Tulloch November 2011

advice and comments in this presentation are given in good faith but without legal responsibility. talk to management Speak to competitors. customers and.asianom.Creative accounting: What. in particular the prospectus Visit the company. if possibly. suppliers. how and where? 2 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. 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… Copyright © Forensic Asia Limited IMPORTANT: All information. Our full disclaimer.com . privacy statement and terms of use are available on our website at www.

Our full disclaimer.9% 9.4%   Suggests a greater number of companies in Asia are manipulating profits or experiencing deteriorating terms of trade Copyright © Forensic Asia Limited IMPORTANT: All information.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.asianom. privacy statement and terms of use are available on our website at www.3% 4. 9.Suspicious behaviour 3 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.Europe: Asia: 4.com . advice and comments in this presentation are given in good faith but without legal responsibility.

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.027  4. privacy statement and terms of use are available on our website at www.6  79  7.4  Co.A  2010  48  1.asianom.3  110  27. 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 Copyright © Forensic Asia Limited IMPORTANT: All information.022  ‐165  3. advice and comments in this presentation are given in good faith but without legal responsibility.Creative Accounting Example 1: Different jurisdictions. Our full disclaimer. different numbers 4 Pick your poison: A or B? Company  Year  Profit (US$m)  Equity (US$m)  Assets (US$m)  Free cash flow (US$m)  ROE (%)  Debt/equity (%)  PER (x)  Co.461  4.B  2010  188  2.777  ‐265  9.com .

022  ‐165  3. 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.777  ‐265  9.com . IFRIC 12) Chinese property companies prefer to list in HK Copyright © Forensic Asia Limited IMPORTANT: All information.4  588 HK  2010  188  2. Our full disclaimer. privacy statement and terms of use are available on our website at www. IAS 41.6  79  7.g.027  4.Creative Accounting Example 1: Different jurisdictions.3  110  27. advice and comments in this presentation are given in good faith but without legal responsibility.0  B / A (%)  2010  +294  +39  +19  +61  +194  ‐28  ‐75  Exploiting different jurisdictions   Yes.461  4.asianom. 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. different numbers 5 Beijing North Star Company  Year  Profit (US$m)  Equity (US$m)  Assets (US$m)  Free cash flow (US$m)  ROE (%)  Debt/equity (%)  PER (x)  601588 CH  2010  48  1.

310  7.3  Co.C  458  160  0  ‐28  0  132  ‐30  102  898  1.698  ‐170  12.027  4.7  8.777  ‐265  9.6  79  1.B  869  174  160  ‐51  ‐3  280  ‐92  188  2.4  67  890  8. advice and comments in this presentation are given in good faith but without legal responsibility.0  16.Creative Accounting Example 2: Mark-to-market accounting 6 Pick your poison: B or C? Company  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)  Free cash flow (US$m)  ROE (%)  Debt/equity (%)  Market cap (US$m)  PER (x)  PER adjusted for disclosed FV  gains (x)  Co.asianom. Our full disclaimer.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. privacy statement and terms of use are available on our website at www. Company C trades on less than half the PER multiple Copyright © Forensic Asia Limited IMPORTANT: All information.com .

advice and comments in this presentation are given in good faith but without legal responsibility. Our full disclaimer.698  1.7  2.7x       0    +459  We have adjusted profit based on actual tax paid as disclosed in the cash flow statement.6  81  890  48.asianom.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. revenues have been adjusted by excluding construction revenues and finance income. company trades on 48.9  ‐79  +22  Exploiting a lack of disclosure     Company C is China Everbright Revaluation gains are not separately disclosed but….4  67  890  8. not 8.Creative Accounting Example 2: Mark-to-market accounting 7 China Everbright (257 HK) Company  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)  Free cash flow (US$m)  ROE (%)  Debt/equity (%)  Market cap (US$m)  PER (x)  China Everbright  China Everbright   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. privacy statement and terms of use are available on our website at www.539  ‐9  ‐170  ‐170  0  12. other numbers are implied   Copyright © Forensic Asia Limited IMPORTANT: All information.   …“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)… ….com .9x PER.

Creative Accounting Example 2: Mark-to-market accounting 8 China Everbright’s accounts 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 5.000) relates to BOT and TOT arrangements with operation commenced. The amount for BT arrangements will be settled according.389.389. privacy statement and terms of use are available on our website at www.com .477.94% to 7.94% to 7. There will never be enough disclosure   Everbright derives a fair value by discounting future anticipated revenues between 5.960.000 (2009: $3.477. 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.545. 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. the musical subjectivity and you don’t need much disclosure Copyright © Forensic Asia Limited IMPORTANT: All information.94% and 7. $3.912. it simply shows what the auditors   Once again. Among the total of $4.000). Our full disclaimer. advice and comments in this presentation are given in good faith but without legal responsibility.000 (2009: $3. accounting standard is creating a business model (Hyflux.asianom.979.83% (2009: 5.83%.83%) per annum. 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 tomorrow’s profit today” Quote from “Enron”. Sound Global.

com Keith Neruda: keith@forensicasia. advice and comments in this presentation are given in good faith but without legal responsibility.Conclusions 9 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.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… Copyright © Forensic Asia Limited IMPORTANT: All information.forensicasia. Our full disclaimer.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. privacy statement and terms of use are available on our website at www.com .com Tim summers: tim@forensicasia.asianom.

visit www.com or email gillem@forensicasia.A bit about us… 10   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.forensicasia.forensicasia. Keith Neruda and Dr Tim Summers   For more information. privacy statement and terms of use are available on our website at www. Our full disclaimer.com Copyright © Forensic Asia Limited IMPORTANT: All information. 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.com . advice and comments in this presentation are given in good faith but without legal responsibility.

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