U.S. accounting standards with respect to VIEs were changed effective for years beginning after November 15, 2009 – for most Chinese companies that means calendar year 2010. The new standards require increased disclosures with respect to VIE arrangements. Fredrick Oqvist and I have been examining the 2010 disclosures on Chinese companies using the VIE structure. I will be doing a few posts about what we found.
Many investors are rightly concerned about the proportion of assets held by the VIE and the proportion of income that is earned by the VIE. If most of the assets and income are in the VIE, a moral hazard is created for the VIE owner, since it might be in his economic interest to terminate the VIE contracts and take the VIE.
We found a wide range of results when we looked at Chinese companies listed on NASDAQ and NYSE that disclosed this information. Assets in the VIE ranged from 0% to 100% of consolidated assets, with a mean of 33%. Net income in the VIE ranged from 0% to 221% of consolidated net income, with a mean of 56%.
The net income findings are particularly troubling. Under the standard VIE arrangements all of the profits of the VIE are supposed to be extracted through the technical service agreements with the WFOE. Those technical service agreements are a critical component in establishing the right to receive the expected residual returns of the VIE that is required in order to consolidate a VIE (ASC 810-25-39). What that means is that the public company must have a right to get the profits of the VIE or it cannot be consolidated.
The technical service agreements establish that right, and they have been accepted by accountants as meeting the requirements for consolidation, even while lawyers have indicated there is substantial uncertainty about the enforceability of the contracts in Chinese courts. These data, however, suggest another problem. What if the WFOE has the contractual right to obtain the profits of the VIE through the technical service agreements, but never actually obtains them? It appears many companies have put the technical service agreements in place, but have never actually used them. All the profit is being retained in the VIE. Should the VIE be consolidated where there is a theoretical right to obtain the profits, but in practice the right is not exercised?
I have heard that some companies have resisted making the payments under the VIE arrangements because they do not want to pay the taxes that would be due on those payments. As a shareholder, I would not be impressed by that argument. I would rather have my income after taxes instead of not having my income at all. I suspect that in many of these cases there is no intent to ever pay the income over to the public entity, and that collapses the argument that the VIE should be consolidated.
If I were an auditor, I would be insisting that the technical service agreement payments be kept reasonably current. If they are not, I would be asking some very tough questions about whether the VIE should be consolidated.
Stan Abrams has a great legal analysis of this post at China Hearsay.