March 21,2008

New Accounting Standards Lift A-share Performance

By Ma Wenluo

On March 10th, 330 A-share companies, accounting for over 20% of total listed companies, disclosed their annual reports, showing an average earnings per share

(EPS) of 0.51yuan, almost double that of the 0.26 yuan for 1254 listed companies in 2006.  In 2007 the net income of these 330 companies grew 101.37 % over 2006, ten times China’s GDP growth that year. In 2006, the average EPS of total listed companies the number was only 21.52% over the previous year’s.

To say that profits of China’s listed companies are apparently growing at an impressive clip, faster in 2007, even, than in 2006, is like saying the sun shines in the Sahara. This is massive.  But it’s not merely a matter of sales success in the market or a phenomenon of the factory floor. Besides   China’s continuously growing economy, increasing operating income and exchange gains led by RMB appreciation, the newly issued China Accounting Standards (CAS) are somehow contributing to many a listed company balance sheet.

Re-evaluation of listed companies

Fiscal year 2007’s accounts are the first to come under implementation of the new accounting standards. On February 15, 2006, the Ministry of Finance issued the newly revised Accounting Standards for Business Enterprises (ASBE) with 39 items in total involving the revised version of Basic Standard, 22 new accounting standards and 16 adjustments to former standards.

The new CAS have led to large-scale asset revaluation in China, in convergence with the revaluation on the global markets of RMB assets. ASBE are introducing into China the concept of "fair value," measuring asset and liability by market value or present value of future cash flow, and applying this measurement to financial instruments, investment-oriented real estate, debt restructuring, and non-monetary transactions, providing new standards for evaluation of A-listed companies.

Investments of listed companies in each other one can be divided into three categories, i.e. long-term equity investments, tradable financial assets and salable financial assets. For investments labeled as "salable financial assets", changes in the market value of the stocks a company invests in will only affect the company’s capital accumulation, and its impact on the company’s income will only be represented when final disposal is done. ASBE require that "tradable financial assets" should be calculated according to their ending market value in the investment period, and change in fair value should be accounted for as current profit or loss. Even if companies don’t sell these assets, they can still make considerable book profit or loss from them. Incomplete statistics show that over 30% of the A-listed companies are holding shares of other listed companies.

UFIDA, a Chinese financial software provider, bought 55.125 million shares in the Bank of Beijing (BoJ) for 85 million yuan in 2003. Under former accounting standards, if UFIDA didn’t sell these shares to take the profit, only that 85 million yuan could be accounted for as assets. Since BoJ closed at 20.36 yuan at the end of 2007, with a one-year non-trade period, UFIDA set its fair value at 17.31 yuan per share. Under the new accounting standards, these assets can be counted as "salable financial assets" totaling 954 million yuan. After deducting the tax levied when it is sold, UFIDA’s capital accumulation rose 780 million yuan. Thanks to the increase both in the company’s investment income and fair value income from tradable financial assets, UFIDA’s earnings per share in 2007 reached 1.6 yuan, almost double that of the previous year which was only 0.83 yuan per share, and is much higher than its 21.5% growth in operating revenue over the previous year. Encouraged, the company launched a favorable dividend distribution plan, awarding shareholders with 10 shares and 10 yuan cash dividends for every 10 shares held. Similarly, Minsheng Bank, a shareholder in Haitong Securities, counted those shares at 54.92 yuan per share, Haitong’s closing price at the end of 2007. The end fair value of these shares reached 10.46 billion yuan. If Mingsheng Bank sells these shares, its earnings per share will increase 0.2 to 0.3 yuan, making its value one of the highest among Chinese banks.

Shining assets-holding companies

Market professionals are now interested in the performance of Youngor Group, to be disclosed in its annual report by the end of next month. Tax rebates for the textile industry have been sharply cut, the US and Europe have set limits for textile imports, and RMB is appreciating. As a result, textile industry profit margins have fallen lower than interest rates, so it’s obviously not clothing, Youngor’s main business, which is drawing people’s attention. In fact, Youngor is the holder of shares of 10 listed companies, including 150 million shares in CITIC Securities, China’s biggest listed brokerage, 150 million shares in Haitong Securities, and 179 million shares in the Bank of Ningbo, a regional bank in China. Since financial stocks zoomed last year, it is roughly estimated the market value of these shares has reached 24 billion yuan, and that Youngor’s net assets per share in 2007 will rise at least 100% over 2006. This huge income from assets reevaluation provides strong financial support for Youngor‘s development in the real estate industry, and its market value will move even higher if the large quantity of land it has acquired is measured by fair value.

The spiral rise in the asset value of some companies is inevitably producing some froth. At the end of 2007, the average P/E of companies listed on the Chinese stock market reached 59, while in developed countries this number likes to be between 10 to 15.

Some negative effects

Fair value, in accordance with market evaluation, represents the "time point value" of a company in a dynamic way, and is thought to be comparatively reliable. Since changes in the share price of tradable financial assets will directly affect the current income of a listed company, there will be larger and more constant fluctuation in its assets?values. Ping An Insurance Group announced on November 29, 2007, that its subsidiary Ping An Life had bought 95.01 million shares, i.e. a 4.18% stake, in Fortis for Euros1.81 billion, directly from the secondary market, and thus became Fortis?largest single shareholder. Due to a number of factors, however, and like many financial firms in Europe and the US, Fortis?share price has slumped. PingAn’s investment has now suffered a Euros 120 million book loss. Overseas equity investments have now affected the domestic operating performance of a number of other Chinese listed financial companies, also. Similarly, the Chinese stock market’s slump of as low as 1/3 from its peak will reduce asset values of listed companies calculated by fair value. However, under the former accounting standards, such loss in investment would not be represented in a company’s operating performance as long as the company still held the assets. This has allowed top officers of some listed companies to ignore changes in the market that affect investors?interests. Not any more.

Fair value is also likely to become an instrument for listed companies to make up profits. In the past, profits coming from non-monetary transactions, for instance, could only be accounted for in capital accumulation. Under the new standards, they can be directly accounted for as current profit or loss in the company’s income statement. So selling real assets will become a common way for listed companies to lift profits. Shanghai Maling Aquarius Co., a food producer based in Shanghai, released its annual report for 2007, showing a 1.12 million yuan loss in operating profit due to the sharp pork price hike, but, benefiting from 30.14 million yuan of "investment returns from its subsidiaries," still realized 5.944 million yuan net profits. Calculated by fair value, a single investment netted 14.5 million yuan over its costs. Doubts have arisen among market observers. "Who calculated the fair value-themselves or others? Accounting professionals worry there is too much flexibility in the calculation.

In the former accounting standards, real estate owned by listed companies was accounted for as fixed assets, and its appreciation would not be represented in financial statements. As real estate in China has appreciated sharply in recent years, if listed companies calculate their property investment by fair value their net assets and current net profit may increase dramatically. So divining what kind of value is fair value and how to prevent listed companies from releasing inflated financial reports have become challenges for supervisory authorities. The China Securities Regulatory Commission requires listed companies to disclose in a "Board of Directors?Report" the change in value of projects measured by fair value such as financial instruments and real estate investment, and its influence on company’s profit, including the proportion of profit, and to analyze effectively the sustainability of profit-making ability, risks and future trends.

Other ASBE may also help to increase a company’s financial performance. According to the new CAS No.2, Long-term Equity Investments, when a listed company consolidates financial statements, the annual profit of its wholly controlled subsidiaries should be accounted for in the company’s consolidated statements, so the performance of the subsidiaries, who may be out-operating the parent company, when represented in the consolidated financial statements may show a situation to be better than it actual is. Meanwhile, since equity investment differences will no longer be amortized, performance of companies with large equity investment differences may increase after implementing the new standards. The new CAS No.1, Inventories, requires all inventories to be measured by "first-in-first-out" method, abolishing the former "last-in-first-out" method. Since the prices for steel, nonferrous metal and mineral resources rose sharply in 2007, under this method, companies who bought these raw materials at earlier lower prices stand to gain. And for those industries with long production terms such as shipbuilding and some machinery industries, allowing the capitalization of borrowing costs for inventory products helps to bring down costs and increase a company’s gross profit rate as well as accounting profit.

The new CAS will be first promoted to state-owned enterprises in 2008, and to all remaining enterprises in 2009. For China to maintain its development as a big player in the foreign investment market it needs to continually update its business practices, which have yet to sync up with the rest of the world. To bring China more in line with other countries, the ASBE cover almost all of the major topics found in the International Financial Reporting Standards (IFRS)  literature. On November 8, 2005, Wang Jun, Secretary-General of the China Accounting Standards Committee, signed a joint statement with Sir David Tweedie, chairman of the International Accounting Standards Board, declaring the substantial convergence between Chinese standards and IFRS. In 2008 the EU will treat China as a country with substantial convergence with IFRS, so financial reports made by Chinese companies listed in Europe in line with ASBE will be accredited. At the moment, since Chinese listed companies have to make different financial statements for the A-share and H-share markets, the operating performance represented by the two statements differs, and there are differences between the A-share and H-share prices for the same company. The convergence in accounting standards will greatly reduce companies?costs and provide convenience for investors investing in QDII and QFII products. With China’s continuous economic development and RMB appreciation, the new CAS fair value measurement will result in the reevaluation of many Chinese assets, and more objective reporting of companies?operating performance will attract more FDI into the Chinese market.

More importantly, this will greatly facilitate efforts of Chinese enterprises to expand internationally. Cross-border capital flow is greatly hampered by lack of agreement between accounting standards. Against a background of economic capital market globalization, the new CAS will join the international accounting language, easing the way for capital financing, capital operation and business cooperation between Chinese firms and foreign enterprises. Both the Ministries of Commerce and Finance are encouraging the member companies of the Chinese Institute of Certified Public Accountants to accelerate their entering of the international accounting market to better serve "going out" enterprises.

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