Mockingjay and IFRS 10/FRS 110 in Asia 2014: Changing Balance Sheet and The Rebellion Year for Accounting Frauds?
November 25, 2013 Leave a comment
The following article is extracted from the Bamboo Innovator Insight weekly column blog related to the context and thought leadership behind the stock idea generation process of Asian wide-moat businesses that are featured in the monthly entitled The Moat Report Asia. Fellow value investors get to go behind the scene to learn thought-provoking timely insights on key macro and industry trends in Asia, as well as benefit from the occasional discussion of potential red flags, misgovernance or fraud-detection trails ahead of time to enhance the critical-thinking skill about the myriad pitfalls of investing in Asia at the microstructure- and firm-level.
The weekly Bamboo Innovator Insight series brings to you:
- Mockingjay and IFRS 10/FRS 110 in Asia 2014: Changing Balance Sheet and The Rebellion Year for Accounting Frauds? Nov 25, 2013 (Moat Report Asia, BeyondProxy)
Dear Friends and All,
Mockingjay and IFRS 10/FRS 110 in Asia 2014: Changing Balance Sheet and The Rebellion Year for Accounting Frauds?
“Fire is catching! And if we burn, you burn with us!”
― Katniss Everdeen in Mockingjay, series #3 of The Hunger Games
“When you’re in the arena … you just remember who the enemy is.”
– Haymitch in Catching Fire, series #2 of The Hunger Games
Audit firms that show up year after year to express their “true and fair” opinion on the financial statements to be free of material misstatements run the risk of getting complacent and, worse still, in cahoots with their clients in their chemical dependence on the comfortable audit fees, like the victors of previous Hunger Games who show up annually at the event and spend the rest of their time in the relative comfort of the Victor’s Village in each district. Last week on Nov 19, an arrow struck into the client-auditor nexus that perpetuates frauds in Asia: The Seoul Central District Court ordered Samil-PwC, the largest auditor in Korea, to pay a $13 million fine to a group of 137 shareholders for failing to conduct its audit in Kosdaq-delisted software firm Forhuman with due care. The shareholders filed the lawsuit to claim compensation for their losses after the company was delisted from the Kosdaq exchange over embezzlement and accounting fraud scandals. Lee Yong-hee, the company’s CEO, was ordered to pay more than $23 million on charges of embezzling $9.4 million. Forhuman was listed on the Kosdaq market in 2002. From 2008 to 2010 it recorded $15.5 million of net losses. However, the software developer forged its accounting records, recording $39 million of net profit instead. During that period, Samil-PwC consistently gave Forhuman high evaluation scores.
This is the first time that a court has ruled to hold big accounting firms such as Samil-PwC responsible for poor auditing, whether in Korea or in Asia. And this ruling came despite the financial regulator defending Samil-PwC, arguing that it would be wrong if an auditor should assume responsibility for what was perpetrated by a client company. Both retail and institutional investors in Asia have frequently fallen prey to the negligence of auditors in terms of their duties or collusion with companies, as has been seen in the savings banks and Tongyang Group scandals which prompted the unprecedented ruling in Korea. Over the last three years in Korea, accounting firms had to pay a total of only $3.2 million for partial responsibility and settlements in accounting scandal cases. Incorporated accounting companies also came up with clever ways to escape responsibility over charged of negligence. The ruling against Samil PricewaterhouseCoopers was the second decision made by the same court in the same month that an accounting firm is responsible for negligence. The Seoul Central District Court ruled on Nov 9 that BDO-Daejoo is partially responsible for compensating investors of the failed Samhwa Mutual Savings Bank.
Accounting fraud has long been a prevalent and deep-seated problem. There had been various measures to tackle it, but fraudulent practices continue. In Hunger Games, the mockingjay bird becomes a symbol of rebellion in the second series Catching Fire. Hopefully, the Forhuman is the “mockingjay” symbol that can spread throughout Asia to unravel more accounting frauds with the various colluders from auditors to financial advisors/dealmakers with the company’s insiders. The S-chip (or Singapore-listed Chinese companies) scandals have also cases of auditor partners directly or indirectly involved, such as Ziwo in which the Deloitte Singapore audit partner was advertised to have invested in the company as one of the largest shareholders. As explained in our series on Detecting Accounting Frauds (Part 1 and Part 2), Ziwo is a typical case in employing the capex inflation (“Grand Capex”) and consolidation trick in accounting by using balance-sheet items in the “Subsidiary”, “Amount Due from Subsidiary” and “Prepayment/Advances” accounts (“Roll-Away Loans or Advances”) to generate artificial sales and mask possible acts of tunneling and expropriation of cash and assets. Since the media blitz which includes the audit partner’s investment, the all-expense-paid IR trip and bullish sell-side research piece, share price of Ziwo is down nearly 90% from S$0.42 to S$0.05.
Like Ziwo, the fraudulent accounts of Korea’s Forhuman are detected via their affiliate overseas business partners in Japan. These are all part of the related-party transactions atypical of Asian firms. Noteworthy for Forhuman, Ziwo and Prince Frog is that if their hidden “related-party” entities (subsidiaries, associates, SPEs/VIEs (special purpose entities/ variable interest entities), JVs, pool arrangements, financial assets/instruments) are consolidated into the balance sheet as they ought to be, a far clearer picture on the financial health, particularly the hidden liabilities and debt, of the group (of companies) can be analyzed and evaluated. Value investors would be able to observe the explosion in the hidden debt and liabilities for Korea’s Forhuman at the group level once the Japanese affiliated entities are consolidated into their balance sheet and not be misled by the nice quant numbers of just the listed vehicle at the company level.
What are the implications of the new IFRS 10 Consolidated Financial Statements (the outgoing IAS 27), effective for annual periods beginning on or after Jan 1, 2013 but delayed in Singapore to allow more time for implementation. In Singapore, the FRS 110 will be effective for annual periods beginning on or after Jan 1, 2014. The power of control is one of the most difficult questions to answer in accounting since it involves subjective judgment, leading to diversity in practice related to consolidation. What is the impact on family business groups such as Jindal, Jaypee/Jaiprakash, Essar, Adani, JSW, GMR, Lanco, Videocon, and GVK? Or the chaebols in Korea such as Doosan, Dongbu, Hanjin and Kolon? Or to the REIT/real estate/construction industry and shipping industry? Yet, all these accounting standard changes are not impactful if the auditors are not held accountable for any material misstatements and fraud revelation. Hence the importance of the mockingjay symbolized by the court ruling case for delisted Kosdaq tech firm Forhuman last week. The auditors are now in the fire. What are the 4 key Bamboo Innovator takeaways?
Bamboo Innovator 