One of the cornerstones of accounting is the concept that a business is a going concern. Financial statements are premised on the assumption that a business will continue to operate for the foreseeable future. That is important because the recovery of the value of the assets on the balance sheet usually is premised on their being used in the business and not sold at liquidation value.
Auditors are required to assess whether there is substantial doubt about a companies ability to continue as a going concern. Ordinarily this assessment centers around the issue of whether a company has sufficient resources to meet its obligations as they come due without a major restructuring. Auditors are to look forward one year from the date of the financial statements in making this assessment.
When auditors conclude that there is substantial doubt about a companies ability to continue as a going concern, they are required to include an explanatory comment in their opinion on the financial statements. That opinion is commonly referred to as a going concern opinion, and the issuance of such an opinion usually sets off an alarm in the financial markets. A bankruptcy filing often happens within days.
Most of the time, going concern issues arise when there is a question of whether the company will be able to raise enough cash during the succeeding year to pay its bills when they come due. But the rules go further than that. AU Section 341 The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern says that the auditor needs to consider legal proceedings, legislation, or similar matters that might jeopardize an entity’s ability to operate. In other words, if the government might put you out of business, then you might not be a going concern.
That brings us back to VIEs. As explained in earlier postings, U.S. listed Chinese companies frequently use VIEs to operate in China. A VIE is an entity that is not owned by the public company, but is allowed to be consolidated in the financial statements because it is controlled through agreements. The assumption that the U.S. listed company is a going concern may rest on whether those agreements are enforceable.
Let’s look at this issue in detail, using the case of CNINSURE (NASDAQ:CISG). I am not picking on CISG – the language here is typical of most VIEs in China. When we go to the 20F filing for CISG, we find the following opinion of legal counsel about the viability of the legal arrangements surrounding the VIE structure:
“In the opinion of Commerce & Finance Law Offices, our PRC legal counsel:
• the ownership structures of Meidiya Investment and Yihe Investment, their subsidiaries and our subsidiaries in China comply with all existing PRC laws and regulations;
• the contractual arrangements among our PRC subsidiaries, Meidiya Investment, Yihe Investment, their shareholders and their subsidiaries governed by PRC law are valid, binding and enforceable, and will not result in any violation of PRC laws or regulations currently in effect; and
• the business operations of our PRC subsidiaries, Meidiya Investment and Yihe Investment and their subsidiaries comply in all material respects with existing PRC laws and regulations.”
All fine so far. The agreements are valid, binding and enforceable and do not violate any laws or regulations. There is no going concern issue evident here. But then, CISG, like most companies using VIEs, adds this qualification:
“We have been advised by our PRC legal counsel, however, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the above opinion of our PRC legal counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our PRC insurance intermediary businesses do not comply with PRC government restrictions on foreign investment in the insurance intermediary industry, we could be subject to severe penalties including being prohibited from continuing operation.”
Yikes! To paraphrase, “despite what they said, our lawyers have told us there is substantial uncertainty about what they said and they might be wrong. If they are wrong we might be put out of business.”
I have not found a single instance of an auditor issuing a going concern opinion because of the substantial uncertainty surrounding the enforceability of the VIE agreements. Does substantial uncertainty about the enforceability of an agreement lead to substantial doubt about a companies ability to continue as a going concern? It certainly has not in practice. They are not called ‘generally accepted auditing standards’ for no reason. The approach of ignoring the ‘substantial uncertainty’ related to the VIE agreements in assessing ‘substantial doubt’ about the company continuing as a going concern has become ‘generally accepted’.
There appear to be two ways that a VIE structure might collapse. The first would be an outright attack by the Chinese government. Many of the VIEs were constructed to circumvent government restriction on foreign investment in certain sectors. The government could simply prohibit any agreement that transfers control, directly or indirectly of any company in prohibited industries to foreigners. Such an attack would follow the Western concept of voiding contracts that are contrary to public policy. I don’t think they are going to do that. Many of these companies bring significant benefit to China. Baidu, which uses a VIE structure, is considered China’s Google even though it is actually a Cayman Islands company. China has known about Baidu’s VIE structure for a long time, and if they wanted to shut this down they could have already done so. In reality, the uncertainty of the VIE structure probably gives Chinese regulators extra leverage over these companies.
The other way a VIE structure might collapse is if the legal owner of the VIE decides to take his company back and breach the VIE agreements. This is unlikely to happen in most cases, since the legal owner of the VIE is also the majority shareholder, and typically the CEO, of the listed company. But if the VIE owner were forced out of the public company, it is possible that he or she may choose to take the VIE with him/her. The public company would then have to sue in Chinese courts to enforce the agreements. We will then learn how substantial the substantial uncertainty might be. I would not want to be in the shoes of a foreigner trying to sue a politically connected local businessman in a provincial court for enforcement of an agreement that arguably circumvented public policy. Several of the recent accounting frauds of U.S. listed Chinese companies have used the VIE structure and we may soon get a chance to see how this scenario plays out. Suppose the public company loses the class action lawsuit that was filed against it after the disclosure of the fraud. The CEO might just decide to abandon the public company, particularly if he is facing further actions by the SEC. So he just takes the operating company and goes off on his own, challenging the shareholders to sue him to enforce the VIE agreements. One case like this would undermine confidence in any company using the VIE structure.
Back to accounting. All of the disclosures about the risk of VIEs are included in the annual filing on Form 20F in the risk section. The filings also include the financial statements, which appear on the “F” pages. The financial statements are supposed to stand alone. Yet, I find no discussion in any financial statements about the risks of VIEs. I encourage companies to expand the discussion of the VIE arrangements in financial statement footnotes and include an assessment of risk.
Other postings in this series: