Dear Friends,

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 →

Related:

• ACCT004 Course Video – Mickey to Rocky: “And I will watch you make good. And I’ll never leave you until that happens. Because when I leave you, you’ll not only know how to fight. You’ll be able to take care of yourself outside the ring, too, is that okay?”
• ACCT004 Course Video – Virtuous wife Adrian to Rocky: “You’ve got to want to do it for the right reasons.”
• ACCT004 Course Video – It’s the Dawn: I don’t know what are the risks and dangers I will encounter in my future; I need to learn to be strong by myself in this world; I am willing to build for my loved ones a beautiful Garden.
• Singapore’s pedantic and rigid education: Only one right answer to science questions?

“ARPA’s mandate – to support smart people in a variety of areas – was carried out based on the unwavering presumption that researchers would try to do the right things and, in ARPA’s view, over-managing them was counterproductive. ARPA’s administrators did not hover over the shoulders of those of us working on the projects they funded, nor did they demand that our work have direct military applications. They simply trusted us to innovate. This kind of trust gave me the freedom to tackle all sorts of complex problems, and I did so with gusto. Not only did I often sleep on the floor of the computer rooms to maximize time on the computer, but so did many of my fellow graduate students. We were young, driven by the sense that we were inventing the field from scratch – and that was exciting beyond words. For the first time, I saw a way to simultaneously create art and develop a technical understanding of how to create a new kind of imagery. Making pictures with a computer spoke to both sides of my brain. To be sure, the picture that could be rendered on a computer were very crude in 1969, but the act of inventing new algorithms and seeing better pictures as a result was thrilling to me. In its own way, my childhood dream, was reasserting itself. At the age of 26, I set a new goal: to develop a way to animate, not with a pencil but with a computer, and to make the images compelling and beautiful enough to use in the movies. Perhaps, I thought, I could become an animator after all.”

– Pixar’s founder Ed Catmull

Part 1: https://asianextractor.com/2015/02/10/potential-accounting-tunneling-fraud-at-china-environment/

Part 3: https://asianextractor.com/2015/02/23/potential-accounting-tunneling-fraud-at-china-environment-part-3/ 

Posted by LIN Liye, Year 4 undergrad at the School of Economics, Singapore Management University

Recently, there was a prospective IPO by Red Sena, which is a F&B SPAC led by former Fraser & Neave Holdings Bhd (F&N) chief executive officer (CEO) Datuk Tan Ang Meng. This caught my attention as I was scouring through the net looking for risky corporate structures that could be misused against minority shareholders

Given that there are no assets, nor businesses, nor profits nor cash flows, investors that bought into the IPO are essentially buying into the execution abilities of the management team to acquire companies and build them up, much alike to private equity businesses. To me, I cannot understand why minority investors would want to take so much execution risk, in an unproven entity by a new management team as well. Continue reading →

Dear Friends,

Survival in the Asian Capital Jungle: Who Knows What When – Remembering Accounting Superhero Abraham Briloff

December is an unrelenting month – December last year took away from the world an accounting superhero, Professor Abraham Briloff. Right up until about a month before his death on Dec 12 at age 96, Abe was unrelenting in alerting Barron’s about some accounting fraud he had uncovered that was hidden in corporate America’s financial statements – a lifelong endeavor he persisted for 45 years since his enlightening “Dirty Pooling” article on July 15, 1968. When financial crisis strikes, Abe’s words become the Generally Accepted Accounting Principles. Even though Abe was legally blind, he could see clearly the accounting issues, having memorized pages of the company’s financials that had been read to him by his daughter Leonore or his grad students at City University of New York’s Baruch College. When asked about his thought process, the grandmaster said, “It begins with some sensitivity as to where the problem might be. Somehow, there’s a serendipity where I know that there’s an issue out there.” Abe elaborates his Process in a Barron’s interview:

“The numbers reverberate in my mind, and then I turn to Leonore and say, ‘Get for me the data in these areas,’ or ‘Read such-and-such to me from whatever document you might find.’ He records his thoughts on tape, on one of the several recorders that he keeps on the desk in his study, and then he reflects further. When he goes to bed, the numbers still dance in his mind, and he keeps a tape recorder beside his bed. It is as if he can see the numbers, much as Beethoven could hear the melodies even though deaf. As new numbers come in, he incorporates them into his thinking, to confirm or reject his original hypothesis. “Something hits. You say, ‘Why is it there?’ Or something that should be there, isn’t there,” he says. He performs the most critical calculations in his head.”

Abe’s heroic commitment to exposing accounting frauds has been a source of inspiration for us when crafting out Accounting Fraud in Asia, an official course in the Singapore Management University (SMU) degree curriculum that will be launched in January 2015. Continue reading →