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As of October 31, 2,304 Chinese companies listed on the Shanghai and Shenzhen stock exchanges had released their third quarter earnings reports, posting the total quarterly profits of 479.62 billion yuan ($75.53 billion), down 6.13 percent from the previous quarter.

 

Although most of the companies that reported poor performance had seen their businesses substantially hit by the economic slowdown in China, a recent report on the China Securities Journal pointed out that some companies had deliberately written down the value of some of their assets and accounts for the third quarter in order to book higher profits later.

 

For example, Sichuan Hongda Co, nonferrous metal product manufacturer, announced on October 25 that to better reflect their financial situation, it wrote off 429 million yuan for the first nine months this year, including 52.06 million yuan in bad debts owed to the company that it no longer expected to collect and 377 million yuan of losses on inventory that had declined in value.

 

As a result of such write-downs, the company reported a loss of 270 million yuan in the third quarter, with its January-September profits shrinking to 89.15 million yuan.

 

As Hongda's proportion of inventory depreciation to revenue is much higher than that of most companies in the sector, the report speculated that it, like other listed companies, may be underestimating profits while the stock market is bearish so their performance will surge later when the markets recover. 

 

However, some experts have a different view. "These companies are not hiding anything. Commodities prices have been falling, so it is reasonable and necessary for companies to lower the value of their inventories," Qian Qimin, deputy head of market research at Shenyin & Wanguo Securities, told the Global Times. "In Hongda's case, it may just be that they bought too much high-priced inventory in the past."

 

The two different perspectives highlight the lack of financial transparency that stems from the subjective accounting methods that listed companies in China employ when creating their earnings reports.

 

These opaque reports, which are supposed to be investors' window into a company's performance, instead serve to hinder their ability to make informed decisions, said Su Yu, a financial writer and MBA professor at Chongqing Technology and Business University. "Because of accounting manipulation, investors are no longer able to know the real value of a listed company from its financial statement because it has become a common practice for Chinese companies, listed or unlisted, to manipulate how much profit they report to avoid taxation and get financing," Su told the Global Times.

 

List, then lose

The current accounting principles employed by China's listed companies allow enterprises to estimate accounting changes by applying fair market value as well as forecast revenues and bad debts. However, the lack of supervision has made it easier for Chinese accounting professionals to abuse these principles, thus giving company management a lot of leeway to control what investors see.

 

Moreover, the management can learn all the financial information at first, while investors can only get limited access to a company's performance when it reports earnings.

 

Su said that about 60 percent of companies on the ChiNext board have reported sharp drops in profits or even losses in their first year on the board, even though initial earnings disclosures looked very promising.


According to the financial data provider Wind Information, 38.55 percent of the 236 ChiNext companies listed before 2011 have reported drops in net profits since listing.

 

"Undoubtedly, a majority of these companies must have goosed their initial earnings reports," Su said.

 

These kinds of adjustments are allowed. "Ideally, the purpose of adjusting accounts is to objectively reflect a company's financial status. Therefore, in real practice, appropriate estimation is allowed as long as accountants can justify a reason for accounting changes," Diao Yong, the manager of Shanghai Shu Lun Pan Certified Public Accountants Co, told the Global Times.

 

Furthermore, such forecasts are usually excusable and exempted from liability even when accountants incorrectly forecast the value or earnings of an asset, causing a discrepancy between the projection and reality, Diao said, as long as they amend their earnings within specific period.

 

Facing fraud

"Because these accounting practices tend to fall within legal bounds, the China Securities Regulatory Commission (CSRC) doesn't usually bother with these companies," Su said. "It will only launch an investigation if it gets tipped off by an insider or obtains sufficient evidence of wrongdoing, but the investigations usually come far too late."

 

For example, more than three years after Yunnan Green-Land Biological Technology Co got listed in December 2007, the CSRC finally confirmed on March 21, 2011 that the company had reported fraudulent assets, income and profits before its initial public offering. The investigation found that the company had intentionally inflated its profits with expected business revenues based on false orders.

 

"China's accounting practice is still undergoing development, so in the short term, regulatory authorities should work to set up better and more detailed information system to prevent false statements," Su said.

 

For investors, the regulatory situation has left them more or less on their own. Su suggested that individual investors need to learn how to read financial reports to better recognize these suspicious practices. "Since what authorities can do is limited, investors must learn to identify risk for themselves."

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