A level 2 problem | China Accounting Blog | Paul Gillis

A level 2 problem

Muddy Waters continued its assault on U.S. listed Chinese companies with an attack on NQ Mobile. As is typical of short seller attacks, Muddy Waters has made a number of allegations, but the one that has been filing up my inbox relates to a disclosure of cash and short-term investments. 

This is the table from NQ Mobile’s 20F that has everyone worked up. You will find a similar one in every financial statement.   

What got Muddy Waters worked up was a comparison of this table to the prior year’s table.

As you can see, NQ Mobile has moved its cash and cash equivalents from Level 1 to Level 2 in 2012 and did not tell us why. That is a self-inflicted wound since an explanation probably would have headed off this part of the Muddy Waters attack. Instead, Muddy Waters suggests that the change implies the cash might have been diverted and is not there. 

Financial assets like cash and short-term investments are reported at fair market value on the balance sheet, rather than at their original cost. This valuation is done at every balance sheet date, and the assets are “marked to market” to reflect the current valuation. Differing approaches to doing this led to great confusion during the financial crisis of 2008, and the FASB and IASB conformed US GAAP and IFRS in 2011 to get consistency. Included in those reforms were expanded disclosures about how investments were priced, and it is those expanded disclosures that are getting all the attention in China today. 

For assets and liabilities that are measured at fair market value, companies have to disclose the valuation techniques and inputs to valuation. The table in question categorizes cash and investments by category of input. There are three categories of inputs, ranging from the most reliable to the least reliable.

Level 1 inputs are the most reliable pricing data. They are quoted prices for identical assets and liabilities that the reporting entity can access at the measurement date. Traded securities have bid/ask prices and are level 1 inputs. While these prices may be volatile, they are reliable evidence of values at a particular point. Some would argue that even current account bank deposits couldn’t be priced with level 1 inputs, since there are no identical assets that have quoted prices (although cash is the basic unit of pricing).

Level 2 inputs are other than quoted prices that are directly or indirectly observable. NQ Mobile has released a list of major certificates of deposit. These are all classified as Level 2 inputs. It appears that they have done this correctly in 2012 and were wrong when they classified them as Level 1 inputs in 2011. For example, NQ Mobile has a one-year term deposit with a face value of 100 million Yuan  maturing 9/14/2014 with the Industrial Bank Co. Ltd Beijing Branch. This is correctly classified as a level 2 input. At December 31, 2013 there will be no quoted price for CDs with a maturity of eight months and 14 days, so the necessary quoted prices will not exist. But the CD can be valued by reference to other CDs that do have quoted prices. 

Level 3 inputs are for the most difficult to value assets, such as interests in untraded securities, derivatives, or private equity funds. I think Chinese wealth management products and entrust loans belong in this category. 

A small sample of U.S. listed Chinese companies finds no consistency in how inputs for cash and short-term investments are reported. It is my view that they should all priced using level 2 inputs, as NQ Mobile has done. The change from 2011 to 2012 was probably the correction of an error. . It sure would have helped if they had explained that, but companies and accountants hate to admit errors. 

P.S. I have had a lot of questions about whether current account deposits should be level 2.  I think they should, but I can make a case for level 1.  Here is a good analysis of FAS 157 by Union Bank.  You will note that they consider bank deposits to be level 2. 

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