Friday, January 21, 2011

GAAP Rubes

Allegations of impropriety and outright fraud continue to swirl around China-based companies listed on U.S. stock exchanges. Most of the finger pointing has come from short seller research firms such as Muddy Waters Research led by Carson Block and, an on-line outlet for the research of John Bird, among others. Even mainstream media has joined in. Herb Greenberg, a commentator for CNBC news, has been harping away for weeks on the perils of investing in China-based operations that have become public U.S. companies through the reverse merger process.

Chances are pretty good that there are improprieties and perils in investing in China-based companies. However, it is doubtful that Block, Bird or Greenberg have done sufficient research to really ferret out where or to what extent such offenses actually exist.

There have been several articles about th qualifications of Block and Bird. Jamz Unlimited provides an interesting evaluation of their qualifications and research methods in a Seeking Alpha article. Herb Greenberg was hit head on a couple of weeks ago by Dave Gentry of Red Chip, which specializes in investor relations and sponsored research coverage of China-based companies. Gentry questioned Greenberg’s journalistic ethics.

Of course, articles exposing the biases of short-sellers and the weak journalism of television commentators have been met by even more articles. Timothy Sykes, the penny stock guru, uses some powerful language in his expose on Dave Gentry and Red Chip.

The hashing back and forth is not particularly informative. It is not even very entertaining. My first suggestion to investors is to ignore all of them. None of them have offered much to aid the investor in discerning truth from fiction.

The second suggestion is avoid being a “GAAP rube” and do a bit of homework on accounting standards. At the heart of all the allegations against China-based companies are the financial reports and how there are discrepancies between those filed with the U.S. SEC and those filed with authorities in China. Investors need to learn that there a significant differences in U.S. General Accepted Accounting Practices (GAAP) and those in China. An article posted by The Traveler in July 2010, provides a quick, easy to read lesson on China accounting standards and why there might be differences between China financial statements and those reported to the U.S. SEC in U.S. GAAP. Scroll down to the comments from John Bird following the article to get a glimpse at the distorted logic of the short-seller.

If you want more detail, try a presentation by Deloitte Touche that compares China GAAP with International Financial Reporting Standards. Deloitte also compares other country standards to the IFRSs. Even if you are not an accountant, it is clear that there is plenty of room for fudging the numbers by China-based operations. There are also solid reasons why there could be honest differences in financial reports filed in China and those filed with the SEC. For example, and this is a simple one in a very complex array of tax rules, China GAAP allows for revenue recognition when a significant portion of a contract has not been performed such as installation or post-sale services. Such revenue would be excluded under U.S. GAAP.

The complexity provides plenty of opportunity for unscrupulous short-sellers to use investors’ lack of knowledge in accounting practices to execute on a “short and distort” campaign.

What is perhaps even more important to understand is the origin of China financial reporting in that country’s history of sovereign owned enterprises. China’s Ministry of Finance and the China Securities Regulatory Commission have made several reforms of China accounting standards. However, China’s tax reporting practices have not kept pace with that reform. For example, China’s Value Added Tax (VAT) is due when a customer actually pays for taxable goods or services not at the time of shipment. Then the actual tax payment is due the following month. The variance between accounting and tax reporting requirements in China result in significant deferred and current tax adjustments in China financial statements and more when those statements are translated to U.S. GAAP.

Even a cursory review of China’s accounting standards and tax reporting requirements, would provide an investor with enough insight to discriminate between the fact and fiction of self-interested investor groups. So when a short-seller says a China company paid a lower amount in VAT in 2009 (calendar-based on collections) than was implied in their 2009 U.S. GAAP financial statements (accrual-based on reportable revenue), such as Carson Block did in his reports on Orient Paper, Inc. (ONP: NYSE AMEX) and RINO International, Inc. (RINO: PK), an investor would know much more information would be needed to determine whether negligence or even fraud is involved.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has a Hold rating on RINO.

1 comment:

Waldo Mushman said...

It is unfortunate that you have ignored the forest for the tree. GAAP vs the Chinese system has virtually no relevance when a company such as CSKI reports $3mm in annual revenue to the Chinese authorities during the same fiscal period that American investors are told they had sales of over $100mm. You also make a crucial error by granting the SEC filings any credibility. The fraud that is being willfully perpetrated is not a matter of simple reconciliations between accounting standards.

Understanding the financial reports that are filed with the SAIC requires a substantive amount of effort that I have certainly expended. I suspect that most of the names you mention actually are more conversant with the details of the system than you are.

The threshold question you ignore is how does an investor justify investing where purposeful financial misreporting is documented? Maintaining dual sets of books is an expensive proposition when it requires the corrupt participation of a licensed Chinese CPA (who risks his livelihood and freedom). Why go to the trouble and expense of filing false financials when accurate reports would be free, honest, expeditious, and what your American shareholders would expect? Those of us familiar with the Chinese system are aware that between 80-85% of all corporate taxes are paid in the form of VAT which eliminates virtually all of the opportunity presented by tax avoidance.

My shorts start with the presumption that the massive revenue differences indicate that the company is lying. From that point it is a matter of determining how. A certainty from the short side will be exhaustive documentation and rational arguments.

As much as your comments seem intended to be helpful you are in fact providing a disservice. Explaining the correct entry position when performing a swan dive is useless information to someone who can't swim. Suggesting the problem might lie with with reconciliations falls far short of warning investors that the crooks are stealing the money.