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Why Management Manipulates Earning?

By Kofi Duan
Source: www.chinastockadvice.com
Updated: Jan 8, 2009

For a listed company, a late filing is a violation of the listed rules which would raise great negative result, the worst of which is delisting from that exchange. I have asked one auditor, “If the management would not intend to manipulate earning, say all the auditor adjustments are completely accepted, then the audit can be completed in the planned time schedule and late filing would not happen. Is it true? “. “Absolutely”, the auditor said.

However, the management would not give up the efforts to manipulate earning. As a result, the audit is doomed to be a battle between the management and the auditors, and the result (the audit report) is a compromise between them.

When I was a student in one business school, I was taught that the management’s earning manipulation is a “bad” behavior. But why management would manipulate? The prior reason is the stress from the investors, especially the institutional investors. I have heard a story from an IR that one day when their financial information released, the unexpected loss made the share price crush, one investor phoned the IR, crying. However, the emotional pressure is not the most difficult thing the company faced, the investors would vote by foot, meanwhile they have other arms, such as selling short. The battles between the investors and the management are frequent games in the capital market.

As a result, management has great motivation to manipulate the earnings. There are two directions to earning manipulation. One is borrowing income from future (increasing current revenue or decreasing current expenses); the other is banking income for the future (decreasing current revenue or increasing current expenses).

To better analysis the earning quality, so as to recognize the possible earning manipulation, you should follow the following advices:

• Understand the business
• Understand the accounting policy
• Understand the business areas where accounting quality is most doubtful
• Understand situations in which management are particularly tempted to manipulate

Under some Institutional Situations where Manipulation is More Likely, I list some below:

• The firm is in the process of raising capital or renegotiating borrowing. IPO; SEO
• Debt covenants are likely to be violated
• A management change
• An auditor change
• Management rewards (like bonuses) are tied to earnings
• A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all
• Management buyout
• Transactions are with related parties rather than at arm's length
• Special events such as union negotiations and proxy fights
• The firm is "in play" as a takeover target
• The firm engages in exotic arrangements (structured off-balance-sheet vehicles)

Finally, I would like to say that, for an auditor, earning manipulation is the greatest challenges in their career life. They must seek the balance between GAAP and the clients’ demand. They should know clearly when they should insist, and when to compromise. It’s both art and science.

For an analyst, the existence of earning manipulation puts great difficulties on their analysis; but it‘s just the recognition of the earning manipulation and the proper treatment in their financial analysis tells who is a better financial analysts. To read the financial data more effectively, the analysts need a pair of wise eyes, and years of experiences.


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www.chinastockadvice.com -----Leading provider research on stocks traded in China’s A-share market.

 

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Viewpoint: How to Survive in This Winter for a Traditional Website

By Kofi Duan
Source: www.chinastockadvice.com
Updated: Dec 19, 2008

For most websites, winter of 2008 is really cold. In China, it is the tenth year of the internet sector, most of the famous websites such as Baidu, QQ, SINA, ALIBABA and NetEase, etc, were not born in 1998, not to say the newly-appeared stars, such as YOUKU, TUKOU and some SNS. All these websites were supported by VC capital in the early stage of their development. Just like in other countries, VC capital is the most important power to push this emerging internet and information technology industry.

But for now, it’s more difficult for a traditional websites to get VC in China. Below are the three main reasons.

Firstly, liquidity shortage is a widespread problem under global finance crisis and recession. America is the biggest supplier of VC capital, but under current situation, the US financial institutions are facing the biggest trouble, most investors are suffering huge losses in their investment. As a result, they would not invest in VC fund but the more- safe treasury securities, treasury bonds or treasury bills.

Secondly, China increased governmental regulation on internet sector in the past year. In December 2007, government banned all websites operating online lottery sales, which made more than 700 websites dead or hibernated until now; and for the same day, China's State Administration of Radio, Film and Television (SARFT) and Ministry of Information Industry (MII) have co-published the new Regulations for Online Audio and Video Services, according to which, all online audio and video service providers were required to apply for an "Online Audio-Visual Broadcasting License", key qualifications for which include: being majority STATE-OWNED and possessing a comprehensive program censoring system, legal program resources, legal funding sources, and "standardized technology". This regulation made some famous online video service provider illegal . All these are considered as potential risks for investors, which make many VC hesitating on investing in the traditional websites.

Thirdly, the emergence of wireless mobile internet attracts more VC’s attention. Since traditional internet has developed in China for more than 10 years, this is a red sea in many people’s eyes. However, the wireless mobile internet is a blue sea and only in its seed stage.

As analyzed above, it’s difficult for a traditional website to get VC capital now. Under such circumstance, how could a traditional website get through this cold winter? I give the following four suggestions:

I. Be confident. Some websites can develop well without VC’s investment, and after the capital market reboundwhich is estimated in 2H2009, the VC would be active involved in the investment again then.

ii Cut cost. Lower cost can make the project survives longer, and more competitive among the peers.

iii Strengthen basic skills. During fierce completion, basic skills are always ignored; in this winter, the project can focus on basic skills of the team. For a content website is to increase content and attract visits; for web-game website is to learn players’ demand and improve the game design; and for B2C website is to learn the potential clients’ demand and maintain these clients.

iv Promotion. Internet is a media in a broad sense. For a media, finding the target audience is the most important thing,andattracting the audience and keep their interest comes the second. The value of a website greatly depends on its effective visits, of which the visits are the precondition. Don’t stop promotion even in the winter, although you can choose a lower-cost option.


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The Economy Slowdown Continues in China

By Kofi Duan
Source: www.chinastockadvice.com
Updated: Dec 18, 2008

The speed and intensity of the global recession evolution is beyond many people’s imagination.

China’s economy is influenced more greatly by this financial crisis. This judge is based on the following three reasons. Firstly, the import and export has a great proportion in China’s GDP, 6.8% and 8.7% respectively, as a result, the decrease of the external demand has a great downside pressure on China’s GDP increase; secondly, the real estate industry in China is in its downturn now, which gives larger pressure on China’s economy growth. Real estate is one of the pillar industries in China; it has some 40 relevant industries and absorbs millions of employment workers. Thirdly, for the past 30 years, China’s economy growth follows an imbalanced path, and now this path seems difficult to continue.

China’s GDP growth is 9% in this third quarter, and it’s estimated that it’s under 8% in the last quarter of 2008. Other data gives more pessimistic pictures. According to National Bureau of Statistics figure released on Dec 16, 2008, value-added of industrial enterprises above designated size (i.e. all state-owned enterprises and those non-state-owned enterprises with an annual sales income over Rmb5mn ) grew 5.4% year on year, the lowest point since 1998.

The unemployment is some 11 million now, meanwhile, millions of students flushed in the labor market. There would be 6.1 million students graduating from colleges and universities, adding those who were graduated before but are still searching for a job, this amount comes to 10 million. The situation is serious now. If the economy cannot see a rebound next year, the unemployment would increase continuously.

China seeks to depreciate RMB to increase its exports. The depreciation would have little effect but deteriorate China’s trade conditions. The decrease of exports is because of the great decrease inthe purchasing power of external world. In fact, China’s exported goods are cheap enough from the past to now.

The economy is slowing down now, an atmosphere of anxious spreads in China. Government has released many policies to rescue the economy, but it needs time, and it depends on many other factors, such as whether the policy can retrieve people’s confidence, and then stimulate the internal demand. The real estate is the biggest internal demand market, it’s estimated that the government would firstly try to start it up.

Christmas Day is only one week away, then comes the New Years’ Day, and several weeks later, is China’s biggest festival, i.e.the spring festival. The financial crisis and the economy slowdown would shadow the festivals inevitably. Many are expecting a more difficult year in 2009.


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Hot CFA Examination and Cold Financial Industry Employment

By Kofi Duan
Source: www.chinastockadvice.com
Updated: Dec 23, 2008

Just before the December CFA exam, 2008, all China CFA program candidates received a letter from CFA institute, the first sentence of which is” Practically overnight, it seems, the world has changed. ” In this letter, CFA institute reaffirms the basic investment principles: diversifying assets, taking a long-term view, holding a steady course, and resisting the urge to overreact to the inevitable ups and downs of economic cycles. Finally, CFA institute emphasized that in this upheaval in the global financial industry, “the path to professional excellence represented by the CFA charter is now more important than ever: it’s precisely during periods of market turmoil that dedicated, ethical investment professionals are more urgently needed.”
The CFA institute’s statement is verified in the coming CFA exam on Dec 7, 2008. CFA institute rented two big halls in Beijing to organize the exam; one is in Haidian Exhibition Center, and the other in International Trade Center. Besides Beijing, China has another two examination locations in Shanghai and Guangzhou. It’s estimated that above 6,000 candidates take part in the exam in China. 6,000 is not a small number, compared with the total 1,200 Chartered Financial Analysts in China as of December 2008, and 80,000 in the whole world.
Three years ago, participating CFA exam is not popular even in the top Chinese business schools. The examination fees are rather costly; meanwhile, only a few joined fund management companies consider the CFA qualification important in the job application. Many in domestic financial institutions hadn’t even heard of the CFA exam.
However, things are different now. Students in business schools and in financial department, employees in the financial institutions, especially in the asset management firms and funds all realized the importance of getting the CFA qualification in their career life. The hot financial industry also attracts many smart people in other industries flooding in.
In 2007, China stock market sees the historical increase, of which, Shanghai Composite Index increased 97%; meanwhile, direct finance booms for IPO and SEO, for share issues and bond issues. In 2007, there were 227 IPO cases in China, financing about Rmb447bn. All investment banks, fund management companies and financial institutions had a good harvest, which supported their aggressive expansion whereafter.
Only one year later, just as what is said in CFA institute’s letter, the world has changed. At least 166 thousand employees in global financial industry lost their jobs since the beginning of Sub-prime Loan Crisis in July 2007. Although China hasn’t such big-scale layoff, the whole industry is in its downturn. More job seekers are competing for fewer positions. Under such circumstances,, CFA exam attracts more and more people. In the recession periods, the CFA qualification is more important for job seekers.

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China: 760 Billion Yuan Newly Increased Credit in December 2008

By Kofi Duan
Source: www.chinastockadvice.com
Updated: Jan 13, 2009

It’s said that the newly increased credit was 760 billion Yuan, or 112 billion USD in December, which is greatly beyond the imagination of market observers. In the first three quarters, China’s credit increase was 1.33 trillion Yuan, 1.12 trillion Yuan and 1.03 trillion Yuan respectively, a monthly average of 386 billion. Considering the increase of Short-term Financing Bills and mid-term notes, the credit expansion in December was even bigger.

The great credit expansion reflects the determination of China Central Government to protect the economy from slowing down. As the export decreases and the foreign demand are weaker and weaker in the foreseeable months, China must rely on its internal demand to keep economic growth. Internal demand includes consumption and investments.

To stimulate consumption in China is not an easy thing. Although the young generation has great consumption desire, their purse is not that full now. China’s social security system is far from complete, which greatly restrains people’s consumption ability---they should save for their education, medical care, old-age pension. Now they face another difficulty, unemployment. As of November 2008, about 11 million Chinese workers lost their jobs; meanwhile, another 10 million students graduating from high schools are heading into labor market. These days, some posts spreads in leading Chinese websites, saying that to consumption is a patriotic action.

As the consumption would not be stimulated in the short term, investment becomes the prior option to support the economy. This is a method China has been using since 1998. Months ago, China Central Government released the ambitious 4 trillion economic stimulation plans, the effect of which would be seen in the second and third quarter in2009.

Most of the 4 trillion would be from bank credit. As a result, each bank has great burden to increase credit. Agricultural Bank of China’s newly increased credit in the fourth quarter exceeds the total credit in the first three quarters in 2008. The Central Bank uses the “window guidance” to guide the Chinese banks. Although most of Chinese banks have been listed in foreign or domestic exchanges, the window guidance by Central Bank is still quite effective. The reason is that in China, the bank management are governmental officials rather than bankers, they care their political future more than the bank performance. As a result, it’s not surprise that the Chinese banks have produced trillions of nonperforming loans before, it’s estimated that the nonperforming loans would be greatly increased during this economic cycle.


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