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Bamboo Innovator Weekly Insight – The Urgency for a Composite Measure to Detect Accounting Tunneling Fraud in Asia

 “Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
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Dear All,

The Urgency for a Composite Measure to Detect Accounting Tunneling Fraud in Asia

“This is a huge international scandal,” Wang Donglei, the newly-appointed chief executive of China’s largest lighting and energy-saving lamp manufacturer, roared at a conference call on last Monday 17 Nov about the accounting fraud committed by the firm’s founder and controlling owner. “These banks misled the company and investors with false information. They did illegal things. These are major banks listed in Hong Kong. The embezzlement is being investigated by Chinese police.”

Last Monday is also the opening day of the much-anticipated Shanghai-Hong Kong Stock-Connect “through-train” door, creating direct access for foreign investors to one of the largest stock markets in the world with a combined value of $5.6tr. By expanding beyond qualified foreign institutional investors and sucking in new investment into Shanghai-listed stocks, the Connect was supposed to lower borrowing costs for mainland companies.

Could the prevalence of accounting fraud put the Connect at risk? Through the cases that follow, value investors need to be aware of a particularly brazen form of accounting fraud in which controlling owners use intercorporate loans to siphon off or tunnel out cash. Similarly, in Australia, intercorporate loans helped to facilitate the building (and later collapse) of the Alan Bond empire when the accounting fraud unravel. Descriptive cases detailing chronological events can inform about the fraudulent accounting acts after they happened but are inadequate in staying ahead of the devil who will invariably develop more sophisticated methods to escape detection. Thus, value investors need to out-think the devil – by first going back in time eight years ago to Nov 7, 2006 to understand the importance of the “Eight-Ministry Joint Announcement” that managed to curb accounting tunneling fraud, albeit for a short-while – and importantly, how controlling owners adapted the rule to continue their expropriation acts. Importantly, we spell out the urgency and opportunity for top accounting researchers-practitioners and regulators to develop a composite measure to detect tunneling acts to alert and prevent “live” cases of corporate abuse instead of fighting fire with “forensic accounting” of “dead” companies in which the harm had been done. But first, let’s get back to the recent cases of accounting fraud and examine their hidden footnotes.

NVC Lighting (2222 HK) Stock Price Performance, 2010-2014

NVC

Wang alleged that Wu Changjiang, the founder and former CEO of NVC Lighting (2222 HK, MV $709m) whom he had ousted in August, had embezzled funds totalling RMB623m ($101.7m) on behalf of a company subsidiary. Employees of four leading Chinese banks – Bank of China (BOC), ICBC, China Construction Bank (CCB), Minsheng Bank – who “conspired in the crime of diverting and defrauding” the company’s funds were also under police investigation. NVC stock has been suspended since 11 Aug when Wu was expelled on 29 Aug from the company. NVC’s products are said to be used in the 2008 Beijing Olympics and 2010 Shanghai World Expo, and Wu is also a prominent entrepreneur featured by BBC, thus attracting reputable investors including private equity firm SAIF Partners, Goldman Sachs and French electrical systems giant Schneider Electric (SU EN, MV $46.7bn) when it was listed in May 2010 raising $196m in a deal underwritten by Goldman Sachs and HSBC. Schneider had invested HK$1.27bn ($163m) in Jul 2011 for a 9.1% stake in NVC.

In the week before the official launch of the Stock Connect, Wison Engineering Services (2236 HK, MV $450m) saw its share price plunged by nearly 60% in a day when its suspension for over a year was lifted on 12 Nov. Wison is a vast engineering-services empire controlled by its founder and billionaire Chairman Hua Bangsong, one of Chinese richest man. Wison builds refineries and chemical plants for domestic and international oil companies that include PetroChina and BASF. Wison was said to have obtained China’s highest certification to undertake petrochemical engineering work in 2007 when it bought a licensed, but near-bankrupt, quasi-government institute in Henan province. The 48-year old billionaire has not been seen since he was detained by Chinese investigators in Aug on bribery charges. Since the arrest, the company warned investors that it could post a “significant loss” for 2013 and might default on bank loans that total around $215m. Wison had earlier raised $195m in its IPO in Dec 2012. Similarly, when the billionaire chairman of Agile Property (3383 HK, MV $2bn) was taken into custody at end Oct by authorities, the disclosure was a shock to Western banks that had lent money to the company.

Wison Engineering Services (2236 HK) Stock Price Performance, 2012-2014

Wison

Underlying the accounting frauds at NVC, Wison etc is the use of intercorporate loans to “tunnel out” cash and assets from the firm. During 1996-2006, tens of billions in RMB were siphoned from hundreds of Chinese firms by controlling shareholders. Typically reported as part of “Other Receivables”, these intercorporate loans did not …

<Article snipped>

As we have discussed, intercorporate loans classified under “Other Receivables” have shifted to other accounts in disguised forms that include … Thus, even though the income statement, balance sheet and even operating cash flow may appear healthy, the cash and assets are already tunnelled out and propping acts are continuously fashioned to draw in external funds and cash inflow to carry on the accounting charade. The different legal systems between Hong Kong and China create additional opportunities for expropriation by companies that can shift assets across the border, because rulings by courts in Hong Kong are not enforceable in the mainland. And the Connect could potentially exacerbate the propping-tunneling problem. Thus, there is a sense of urgency to develop a composite measure that captures the true “Other Receivables” that has artificially inflated revenue and earnings.

The tunneling problem in China and Asia has stubborn roots. Until these root tensions are fully addressed, insider tunneling will pose an ongoing challenge to reform in China and the seemingly pretty-looking financial ratios and accounting numbers at the typical firms are potentially propped up to suck in capital for subsequent tunneling acts.

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

To read the exclusive article in full to find out more about the story of NVC and Wison and the accounting and economics of tunneling that can provide an important organizing framework for value investors to navigate the Asian capital jungles, please visit:

·        The Urgency for a Composite Measure to Detect Accounting Tunneling Fraud in Asia, Nov 24, 2014 (Moat Report Asia, BeyondProxy)

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

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About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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