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Detecting Accounting Fraud in Asia (Part 4): Introducing Six New Measures

Earlier articles in the Accounting Fraud in Asia series:

• Detecting Accounting Fraud in Asia (Part 1), Sep 11, 2013
• Detecting Accounting Fraud in Asia (Part 2), Sep 16, 2013
• The Urgency for a Composite Measure to Detecting Accounting Fraud in Asia, Nov 24, 2014

“What seemed to be wrong with this income statement?” I would ask and engage value investors in a conversation discussing the limitations of western-based screening tools and techniques in financial statement analysis to analyze Asian companies.

“It was generated by a listed Chinese zipper company who claimed to be the ‘YKK of China’ with a diversified customer base of over 900 customers. Its zipper products are used in fashion and sports apparels, camping equipment, shoes, and bags by renowned brands. It also received the ‘PRC Top Ten Famous Zipper Brands’ in China. To perhaps make your job easier, a simple table of financial ratios from profit margins, ROE, cash conversion cycle (CCC) is provided. Interestingly, you might note that it is a company generating a ROE of 20.2% on profit net margin of 22.3% and trading at a modest valuation of Price-Earnings ratio 6.2x and Price-to-Book Value 1.6x, with downside protected by a seemingly healthy ‘net cash’ balance sheet with net cash comprising 27% of the market value of the company.”

“And we would stay on this income statement for whatever time it takes before someone points out the dog that didn’t bark,” I added.

Sometimes, there would be one or two people, often those who are open-minded and intellectually curious in their learning approach, who would point out: “The selling and distribution expense of RMB3m seems awfully low for a company generating RMB882m in sales for truckloads of zippers to be transported to over 900 of their customers’ factories in the different provinces.”

This zipper company is SGX-listed Fuxing Zipper (SES: DC9, Bloomberg: FUXC SP), down over 90% in market value. We will later illustrate how accounting tunneling fraud is carried out and the six new measures for value investors to employ to avoid such statistically-attractive fraudulent stocks. From the case of Fuxing, one of the apparent measures is based on the opportunistic shifting or deferring of operating expenses out of the income statement to boost profits artificially – often into the balance sheet items. But how do we can capture this? A possible measure is that of the “OP/OL ratio”, or “Other Payables/Operating Liabilities ratio” which we will elaborate upon later with the cases that we have observed to be a systematic phenomenon. In essence, we have observed that an OP/OL ratio over 40% leads to subsequent and future acts of accounting tunneling fraud in which corporate wealth and cash is tunneled out.

Fuxing Zipper (SES: DC9) – Stock Price Performance 2007-2015

As we have shared in earlier articles, transportation and logistical cost is a nightmare in China and emerging markets, estimated to account for 15 to 20% of the cost of doing business and of the GDP too by various sources that include World Bank and the Li & Fung group in an insightful presentation. The problem lies not only because of the geographical woes but also due to the regulatory licensing bottlenecks: “China’s logistics system is governed by nine separate ministries and commissions, which prevents the central government from regulating cross-provincial transport across China’s 31 provinces. Instead, local governments manage their transportation systems as provincial fiefdoms, often using local license rules and tolls to raise revenue. Thanks to high transaction costs, no trucking firm has yet established a nationwide network.”

The emerging Asian and Chinese companies engaging in accounting fraud often push operating expenses and overheads off the listed entities to related-party companies to boost artificially-high profit margins and ROE. For instance, an Asian consumer “brand” selling its “visible” products in supermarkets would usually shift the substantial expenses related to shelf-space placement to undisclosed related-party “distributors” and “agents” (called “tong lu” 通路 in the local language) to achieve the high profit margins and ROE that are attractive to investors. Most value investors focusing on financial ratio analysis do not realize that logistics, distribution and marketing costs in emerging Asian markets is around 15-20% of sales, instead of the 0.34% that this zipper company incurred. Like-minded value investors are often amazed that they have not seen what was now obvious to them. Thus, one simple new measure is to use the “Selling and Distribution expense as % of Sales” (Measure #1) as a sanity check on unrealistically low operating expenses that were deferred or shifted out of the income statement. Continue reading →