Asian Financial Statement Analysis – Detecting Financial Irregularities…

Book Review Of: Asian Financial Statement Analysis – Detecting Financial Irregularities
Authors: ChinHwee Tan and Thomas R. Robinson
Publisher: John Wiley & Sons. www.wiley.com (2014)
Pages: 192
Price: INR 3065 (Kindle Edition)

Reviewed by Chetan Shah, CFA

In Asia it is difficult for an analyst to come out with “Sell” rating on a listed company for fear of backlash from the company’s founders and management.  Consequently, financial reporting manipulations, though analyzed and discussed in-house, rarely get reported in print or come to the attention of the general public. Under such backdrop, it is commendable that authors Chin-Hwee Tan and Thomas R. Robinson have taken the step of publishing on the important topic of detecting financial statement irregularities in the Asian region. There are many popular books covering financial irregularities amongst the listed corporations in the developed economies of the US and Europe. But hardly any on corporates in this part of the world. Howard Schilit, author of Financial Shenanigans, has written the forward for this book.

After presenting a framework for analysis the authors show how to detect earnings management and overstatement of financial positions, earnings, and operating cash flows.  Each chapter begins with a brief description of the financial statement under consideration and its interaction with the other statements, which is beneficial to both beginners and professionals. This is followed by checklists for conducting analysis, along with case studies involving companies that in some cases have been formally accused, but not necessarily found guilty of, manipulating their reported results.

Each case study begins with a company overview, a chronology of events, warning signs, and key lessons for investors. Most refer to research findings of firms that specialize in detecting financial misreporting, such as Muddy Waters, Glaucus, Citreon and others.  The case studies convey a sense that such firms and their clients— the short sellers who act on their findings—fulfill a very important role in the capital markets. Their activities, instead of being frowned upon, should be encouraged as a means of keeping fraudulent practices in check.

Chapter 6, “Evaluating Corporate Governance and Related Party Issues,” highlights the problems associated with interlocking ownership and directorships in Asia, excessive compensation, personal use or expropriation of assets, lack of transparency, and auditor independence. The case of a coal company P1 Coal (name changed for this review) shows how blatantly 90% of its ownership in its primary operating subsidiary S1 Coal (name changed for this review) was secretly transferred to its chairman. Later, 49% of S1 Coal was transferred to unrelated & independent Trust owned by an investment bank (C1 Trust). These transactions were neither disclosed to the shareholders nor their permission/ approval sought. SEC, on February 22^nd 2012, publicly announced they were charging its Chairman & CEO for (1) failure to disclose transfer of P1’s 90% stake in S1 to Chairman and later selling 49% of that stake to C1 Trust (2) fraud by both Chairman and CEO in forging letter from C1 and (3) defrauding investors into believing they were investing in a Chinese coal business, when it was in fact an empty shell company.

Common size analysis and comparisons with peer groups are key elements of the authors’ analysis. One lesson that emerges from these investigations is that excessively high gross or operating margins should raise a red flag.  A good illustration of why this is so is provided by another Chinese’s company L1 (name changed for this review).  By transferring a large portion of its staff expenses to company X1, L1 raised its margins far above those of its industry peers. As of March 31, 2010 X1 employed 80% of L1’s 4,258 workers.  Management repeatedly claimed that X1 was an unrelated party. This deception continued until Citreon Research reported that L1’s legal staff was signing off on X1’s administrative filings and that the two companies were located in the same office building and using the same email server.

Goodwill is an item frequently used to inflate assets and thereby overstate a company’s financial position. The board of O1 (name changed for this review) fired its first non-Japanese CEO in October 2011, who was with the company since 1981 and was appointed to this position only a few days earlier. The reason. He questioned payments of excessive price for acquisition and abnormally high advisory fees to obscure companies for facilitating the same. The scandal led to resignation of the entire board and several senior executives. The story goes like this. In 1990 when the Japanese market plunged, the company incurred sizable financial losses. The losses ballooned in 1997-1998. For several years O1 kept these losses off its own books by transferring the financial assets at cost instead of market value to a series of unconsolidated companies. Funding for the purchase of the deteriorated assets came from bank borrowings arranged by O1. These entities as well as others were later purchased at prices far above their true market value (thereby making up for their embedded losses). O1 recorded the excess of the purchase prices over fair value as goodwill.  Impairments to the goodwill were then reported little by little over time to spread out the losses. Apparently, O1 was also paying high fees to brokers and bankers that helped engineer these schemes.

Even though the cash flow statement is popularly regarded as a check against companies’ exploitation of the malleability of earnings, it is subject to manipulation in its own right. A misleading picture of cash flow can be created by such devices as incentivizing customers to pay balances sooner than required or selling accounts receivable at discounts and without recourse or delaying payments to suppliers, employees, and others. These accelerate cash received and has positive impact on cash flow from operations. D1 (name changed for this review), however, used none of these ruses. Instead, the company classified property transfers under operating cash flow instead of cash flow from investing activities. In addition, a loan repayment by its chairman was classified under operating cash flow instead of cash flow from financing activities. Both instances of incorrect reporting occurred in 2008, just before the company’s initial public offering in 2009. The auditor, G1 (name changed for this review), had failed to detect these incorrect classifications. In November 2010 G1 separated from its Hong Kong member firm and over 600 partners and professionals moved to rival B1 (name changed for this review). This followed the disappearance of G1’s managing partner amid allegations that he stole over US$12.1 million from friends and clients.

Many such jaw-dropping incidents are covered in Asian Financial Statement Analysis. They not only make for thrilling reading, but also prepare one to examine financial statements with professional skepticism. Practitioners will start scrutinizing & questioning each line item on the financial statements as well as footnotes and not take them at face value irrespective of the reputation of the auditors. They will start (a) comparing them with the peers and talking to them (b) talking to customers and suppliers, (c) verifying reports filed with different regulatory agencies if required in different jurisdictions (like the US SEC & the Chinese SAIC), (d) doing ground work of visiting factory, mine, store, or facilities as the case may be, (e) evaluating related party transactions, corporate governance standards, complex cross-holdings and conflict of interests, and so on. They will be able to easily raise red flags for their investment team or the investment community at large. Hence this book is highly recommended.

-CGS