The accounting environment in China is famously opaque at best. This has led to cases of manipulation at listed Chinese companies, which have sometimes cost investors dearly. But there is also another way to consider accounting manipulation in China – as a trading opportunity.
Stock market trading in China takes place in a complex environment, much different to that in say London or New York. Existing laws are practically useless in protecting small investors. Regulators face conflict of interest when state-owned-enterprises (SOEs) are involved in manipulation – executives and controlling shareholders are rarely punished severely for violations. Market players tend to be short-term speculators, ignoring most signs of accounting manipulation.
Compared with share prices in the equities markets of developed economies, share prices in China have a much higher synchronicity with the overall market, suggesting either a lack of valuable firm-specific information, less informed traders and investors, or both.
In economic theory, such an environment creates pricing inefficiency and therefore the potential for abnormal returns. A 2010 study led by Yu Tong, a professor at the University of Rhode Island, demonstrates that investment strategies based on fundamental analysis do not perform well in China. This is because of the manipulation of accounting numbers and the noise introduced by a large number of speculators.
To arbitrage the pricing errors in the Chinese equities market, investors need instead the ability to see controlling shareholders’ and executives’ incentives, and to predict the accounting manipulation that can take place.
Companies listed in China manipulate their accounting in a variety of ways. These include recognizing revenue or expenses either too early or too late; artificially adjusting non-cash expenses, such as provisions and depreciation; and manipulating asset purchase prices. Reporting false operating cash inflows or untrue investment cash outflows is also a manipulation tactic.
These following cases illuminate the ways that manipulation can work, and the trading opportunities that may make themselves available.
In October 2008, Anshan Steel Group, the second-largest steel maker in China, announced an issue of put options to holders of a previous set of put options for Panzhihua Steel (000629.SZ), with an exercise price of RMB10.55, and an exercise period in April 2011. A put option is a contract between two parties to exchange an asset at a specified price and by a predetermined date.
The goal was to prevent Anshan from having to buy the original options at a price of RMB9.59 per share at a time when Panzhihua’s stock was trading at about RMB8 apiece, a result which would have cost the company roughly US$2.9 billion (RMB20 billion). But to escape from an even greater financial loss, Anshan and its subsidiary were then faced with the need to somehow get the stock price above RMB10.55 sufficiently in advance of the April 2011 exercise period.
The first step in their strategy was to take what’s commonly called a ‘big bath’ (pulling lots of expenses and losses into the current year, and deferrring revenue and income into the following year for full-year 2009). The second was to report a dramatic income rebound for full-year 2010, with the results to be made public in March 2011, in time to drive up the stock price before the exercise period. They acheievd the first step in April 2010, reporting a record US$234 million loss for 2009.
To achieve the second step, they manipulated 2010 earnings in several ways. Most dramatically, they reported a 25% reduction in administration and other expenses, claiming more than US$150 million in savings.
However, the manipulated earnings alone might not have been good enough to drive the stock price above the RMB10.55 exercis
e price. So at the end of 2010, Anshan announced a restructuring plan to swap its overseas iron mine assets with the steel manufacturing assets of Panzhihua, a classic related party transaction with consequent opportunities for manipulation.
Anshan exaggerated the future profitability of the overseas iron mines, driving the share price of Panzhihua above RMB14 before the exercise period. By the end of 2011, the stock had dropped to about RMB5 and hasn’t regained its previous levels since.
How to profit from such a situation? The trajectory of the stock was rather predictable from the time of the second put option, because the controlling shareholder and the executive committee had fortunes or political futures at risk if they didn’t deliver on their two-step strategy.
Therefore, traders could have bought the stock in the six to 12 month period before the exercise, benefitting from the downturn following the company’s engineered big bath. Or they could have sold or shorted shortly before the exercise period, by which time the company would have safely inflated the stock price.
The two heavies
Another reason that companies occasionally engineer big baths in China is that the securities regulators put severe trading restrictions on firms that report two consecutive years of loss. Those that see three consecutive years of losses are delisted.
Therefore, if a company can’t avoid taking a loss in a fiscal year, they may try to delay revenue recognition and pull expenses forward, or inflate or deflate outright, engineering a big bath. Doing this is aimed at improving their chances of being in the black in the following year; if a company is on the edge, they may do the opposite to stay in the black for the current year.
An example can be seen in the case of two state-owned construction machinery makers. In April 2013, China First Heavy Industries (601106.SH) and China Second Heavy Industries (601268.SH), both with similar declines in operating cash flow due to weak conditions in their sector, reported dramatically different results for full-year 2012. Why?
First Heavy was ‘on the edge’, so the company used similar accounting manipulation to that discussed above to boost 2012 reported income: Exaggerating revenue and non-operating income, while finding ways to deflate reported costs. Second Heavy had no way to manipulate its way into the black, so the company did precisely the opposite: Engineer a big bath.
Therefore, the period just after the fiscal year earnings announcement presented a trading opportunity: A sell signal for First Heavy, which reported artificially inflated earnings, and a buy signal for Second Heavy, which reported artificially reduced earnings.
In November 2008, Hisense Electric (600060.SH) approved a stock incentive plan for executives and directors, granting them options for up to 1% of the company’s total equity. The plan aimed to incentivize company performance for the fiscal years 2009 through 2011. At a glance, the incentive plan worked: Net income and return on equity grew during the three years under evaluation. But a closer look reveals corporate manipulation, with two features.
The first is manipulation across the years. Particularly revenue for the last quarter under evaluation was pushed up by recognizing sales early and under-reporting expenses. The second involved manipulation within those three years to influence stock prices on a quarter-by-quarter basis, aiming to capture extra money for the executives and directors because of the timing to exercise options and offload shares.
Because the period under evaluation was announced, and because the quarter-by-quarter variances in the exercise and sale timings of the options were also known, traders could have profited from the manipulation in two ways.
Longer term: Buying Hisense stock on the announcement of the option plan, selling after the first sale of executives’ granted stock was announced. Sorter term: Acquiring shares around the time options are granted, selling after the release of the FY results.
There’s one more short-term trading opportunity created by the company’s manipulation: Buy before the end of 2013, and sell on the full-year 2013 earnings announcement in April 2014, which should be high to give the executives an opportunity to sell. After that, unless the company creates another incentive to manipulate, look for the real earnings situation at Hisense to become clearer, and a dramatic drop in the stock price.
Given the weak institutional environment in China, there is little that investors can do to prevent listed firms from accounting manipulation. Thus, it is very important for investors to understand the motives of managers or controlling shareholders. Investors should in particular pay attention to scheme of stock incentive plans, unlocking of restricted shares held by private controlling shareholders, potential special treatment of stocks and seasonal equity offerings.
With such alerts in mind, investors can better understand financial statements of Chinese listed firms and make smart investment decisions.
Dr. Chen Xin is Associate Professor of Accounting at the Antai College of Economics and Management, Shanghai Jiao Tong University (SJTU), and a lecturer for the Global Executive MBA in Shanghai, a collaboration between SJTU and the University of Southern California.