Fiscal forensics

Category: Asia, Global

Detecting irregularities in Asian financial statements

A number of accounting scandals involving Asian companies in recent years have left investors with costly lessons about financial reporting failures. Why did savvy institutional investors fail to see through the falsified financial statements of Satyam Computer Services, Sino-Forest, Olympus Corporation, and others? As global investors set their sights on Asia, and particularly China, there is greater need for professionals to master how to detect accounting fraud and make solid investment decisions.

Tom Robinson, CFA, managing director of the Americas at CFA Institute, and Tan Chin Hwee, CFA, founding partner of Apollo Global Management in Asia, have written a book that is the first in-depth study into detecting financial irregularities specifically in the international financial reporting of Asian companies. Asian Financial Statement Analysis: Detecting Financial Irregularities (Wiley, 2014) draws on real-life lessons from Asian case studies to help professionals navigate the intricacies of investing in Asian business ventures. The authors, both seasoned accountants and analysts, drill down to show detailed evaluation techniques and warning signs for the most common accounting games that companies play.

Weak corporate governance provides opportunities for accounting irregularities to happen. Managers or majority shareholders may engage in related-party transactions that enrich themselves at the expense of other shareholders. The authors note that the underperformance of key Asian equity markets in spite of rapid economic growth may be partly attributable to poor corporate governance. Thus, forensic financial analysis in Asia plays an important role in tackling the issue and raising the overall corporate governance standards in the region.

Mr. Robinson and Mr. Tan explain the essentials of rigorous due diligence and the need for wider corporate governance reform in Asia beyond accounting issues, including board composition and separation of ownership and control.

Why must investors be even more vigilant in performing due diligence on Asian companies? How does due diligence in Asia compare with that in the United States and Europe?

The financial markets have a long history in the United States and Europe. On the one hand, that means there are more regulations and checks and balances in place to screen out companies with problems. On the other hand, there is also a longer history of accounting scandals, such as Kreuger & Toll (the Swedish Match king) in Europe or McKesson & Robbins in the United States. Because markets in many places in Asia are newer, regulations are in the formative stage and some markets may not be directly accessible by investors. The latter has led to the listing of companies on foreign exchanges. For example, in the last decade, many Chinese companies became public in the US and Canada through reverse mergers with public shell companies. This enabled more investors to invest in them and allowed these companies to raise capital. However, a reverse merger does not involve the same level of due diligence as a traditional initial public offering (IPO). As a result, investors need to perform a higher level of due diligence themselves.

What are the tell-tale signs of financial irregularities? Can you cite examples from your book?

In our book, we point out that there is a system of checks and balances built into every accounting system. The most common accounting fraud involves an overstatement of profits on the income statement. The checks and balances result in an offset appearing on the balance sheet of the company – most typically, an overstatement of assets and, less often, an understatement of liabilities. The tell-tale sign of financial irregularities is, therefore, a large increase in one or more asset accounts – most importantly, accounts receivable or inventory. So, the analyst should compare incomes statement trends with trends on the balance sheet to look for abnormal increases in assets relative to revenues.

Why do most investors miss these signs?

Most investors focus on a single financial statement: the income statement. Irregularities are less likely to be discovered when analysing only a single statement. An investor must simultaneously analyse the income statement, balance sheet, and cash flow statement to see where the disconnects are and what accounting games are being played.

What is the single most important thing that an analyst should do when analysing Asian financial statements and why?

The analyst should place the three primary financial statements side by side and perform a ratio and common size analysis on them to discern trends (such as accounts receivables growing much faster than revenue) that need further investigation. These ratios should also be compared with those of peer companies to see where there are differences for further investigation (such as abnormally high profit margins).

How do accounting scandals affect market integrity and shareholder value?

Accounting scandals lead to distrust in financial markets. This leads to a couple of issues. If investors distrust the markets, they are less likely to save and invest for the future. This will make it less likely that they will accumulate sufficient wealth to achieve their lifelong goals such as retirement. This increases the burden on governments and other social welfare programmes. Those who still invest will require a higher expected return from their investments because of the higher perceived risk. This means that they will only be willing to invest at a lower price, which reduces the valuation of companies.

Some case studies in your book involve Chinese companies that obtained a back-door listing in the US. What are the unique challenges for investors in Chinese companies, if any?

Indeed, many companies in China wanted to raise capital in the United States and a convenient and low-cost way to do so is to merge with a pre-existing public shell company (a company that remains publicly traded but has already exited its normal business or has existing business activities that are not significant). The challenge for investors is that there is a much lower level of due diligence in a reverse merger than in a normal IPO, in which there is an enormous amount of due diligence by underwriters and auditors. The investor is, therefore, required to do much more analysis to get the same level of comfort as in an IPO.

Related-party transactions are common among listed companies in Asia. What should investors look for when evaluating corporate governance issues?

It is quite common for public companies in Asia to have a high level of ownership by the founding family. This is beneficial in that the family has a vested interest in the performance of the company, but it can also result in related-party transactions where the family enters into business transactions that benefit them more than the other shareholders. As a result, investors should examine any related-party transactions and the overall governance structure of the board. In particular, it would be good to see a high proportion of outside directors unrelated to the founding family or management to look after the interest of minority shareholders.