Alibaba’s record IPO overcame concerns about Chinese stocks. Investors had been badly burned by Chinese stocks in the past few years, but they were en-thusiastic about Alibaba. There was considerable discussion of the risks of Chin-ese stocks, and in particular the variable interest entity (VIE) structure used by Alibaba and many other overseas listed Chinese stocks. These risks remain, al-though Alibaba’s offering might have changed the picture.
Variable Interest Entities
At the top of the list of concerns about Alibaba was the variable interest entity structure. I just searched Google news for variable interest entity and found 881 results. When I first wrote about VIEs in March 2011 nobody was talking about VIEs. It seems difficult to find anyone who is not aware of the structure today. The Alibaba IPO called considerable attention to the structure, including a report from a congressional commission and a letter from Senator Casey to the SEC. Certainly Chinese officials heard an earful about VIEs.
Carson Block of Muddy Waters is shorting 500.com (NASDAQ: WBAI), which did an IPO at the end of 2013. One of the reasons for his short position is the un-usual tax position of the company, which recorded a tax benefit in 2013 equal to 84% of net income.
The tax benefit comes from reversing deferred taxes related to the retained earnings of the companies VIEs. EY is 500.com’s auditor, and I have previously written about how EY clients follow the unusual (although probably correct) ap-proach of providing deferred taxes for the tax cost of transferring profits out of the VIEs.
500.com has revised its VIE agreements and now argues it no longer has to provide those taxes, so they have been released to income.
500.com did this by having its wholly foreign owned enterprise (WFOE) assign certain of these contracts to its Cayman Islands company. It argues that assign-ment makes the Cayman Islands company the principal beneficiary of its VIE. It then takes advantage of an old accounting standard known as APB 23 to argue that the profits are indefinitely invested in the VIE and do not require deferred taxes to be recorded. APB 23 only applies in cross border situations, so it was unavailable when the WFOE was the principal beneficiary of the VIE. but by making the Cayman Islands company the beneficiary, it creates a cross border situation.
BDO’s China member firm, Lixin (BDO China), is currently the fourth largest CPA firm in China, ahead of both KPMG and EY. Lixin is not to be confused with BDO Da Hua, a Chinese firm formerly affiliated with BDO that withdrew from the BDO network and abandoned U.S. listed client audits after being sued by the SEC in the working papers dispute.
BDO China is currently in a tussle with BDO’s Hong Kong member firm. BDO China set up two firms in Hong Kong – Shu Lun Pan Union (HK) CPA Limited and BDO China Shu Lun Pan (HK) Management Limited. BDO HK argues that setting up these companies clearly violated BDO’s territorial regulations and has insisted that the companies be closed immediately.
Why would BDO China need an operation in Hong Kong when there is already a BDO member firm there? It is because the two firms do not share profits. They are separate firms with different owners.
BDO China needs to have a Hong Kong CPA firm sign off on Red Chips (state controlled mainland companies with offshore holding companies listed on the HKSE like China Mobile) and P Chips (privately owned companies with offshore holding companies listed on the HKSE like Tencent). A 2011 deal between China and HK allows BDO China to sign off on H-shares, but not Red Chips or P-Chips. Why not use BDO HK to sign off? This is probably because BDO HK probably wants to do the audit and keep all the fees.
Revenue recognition is always one of the most important accounting issues under US GAAP. Management is often under pressure to book sales before the end of a period, and salesmen are usually not paid commissions until the sale qualifies to be booked as revenue by the company.
Present US accounting standards (Concept Statement No. 5) require that four conditions exist before revenue is recognized:
1. Persuasive evidence of an arrangement exists;
2. Delivery has occurred or services have been rendered;
3. The seller’s price to the buyer is fixed or determinable; and
4. Collectability is reasonably assured.
This post focuses on the first condition – persuasive evidence of an arrange-ment. The SEC has provided guidance on this point in SAB Topic 13 – Revenue Recognition. The SEC says that if a company has a business practice that uses contracts, then persuasive evidence of an arrangement means a final agreement that has been executed by properly authorized personnel of the customer. In other words, before you can recognize income, you need a contract that is sign-ed by someone with the authority to sign.