Overstating revenue growth | China Accounting Blog | Paul Gillis

Overstating revenue growth

Foreign currency accounting can be confusing. I will try to simplify it and point out how some Chinese companies distort results. 

Every company has a functional currency. That is the currency in which most of the business is done. For Chinese companies, this is always the RMB. Sales are made in RMB and suppliers and employees are paid in RMB. Under China’s currency controls, there really is no alternative.  

Companies are not required to report their financial results in their functional currency; rather they can report in any currency they wish. Multinational companies usually report in their home country currency.  It would be impossible for these companies to report unless they converted everything into a single currency. Foreign currency accounting can be quite complicated, but for most Chinese companies it is fairly simple. For those who want to dig into the details, this article provides more information.

While some of the larger U.S. listed Chinese companies use the RMB as their reporting currency, many report in U.S. dollars. I have been looking into the reasons why these companies choose to do this. Reporting in a different currency is much more work and it can distort financial reporting. People tell me that U.S. investors are more comfortable looking at U.S. dollars, but that seems to be a silly answer. I think it is because reporting in dollars makes revenue growth look better in an environment with an appreciating currency.

When a Chinese company reports in U.S. dollars it has to do two translations. First the income statement is translated into U.S. dollars at the average exchange rate for the year. There is no gain or loss on this translation. If there are transactions in a currency other than RMB there may be exchange gains and losses reported. Then the company translates the balance sheet into U.S. dollars using the end of period exchange rate. If the exchange rate has changed from the prior period, there will be a translation gain or loss. This translation gain or loss is accounted for in other comprehensive income – after the company has calculated net income. Most analysts ignore this item on the theory that it is not real income or loss and is merely an accounting convention, and they are right. 

The RMB has appreciated steadily against the U.S. dollar since 2005, moving from 8.27 to 6.25 to a US dollar.   

The problem is that a strengthening RMB can overstate revenue growth rates if the company reports in a weaker currency. Revenue reported in U.S. dollars by a company that earns its revenue in RMB includes an amount related to currency appreciation. 

This example shows the effect. The example assumes revenue of RMB 827,000 in 2004, and this amount does not change in RMB terms in future years. In other words, sales are flat in RMB. For reporting purposes, however, the company converts that RMB into U.S. dollars every year at the average exchange rate that year. In 2004 sales of RMB 827,000 are reported as $100,000.  By 2012, the same RMB 827,000 of sales are reported as $131,041. No increase in sales in RMB, which is what really counts, but a sizeable increase in reported revenue in U.S. dollars. Expenses are also translated at the average exchange rate each year, so they would also increase; meaning net income is not significantly distorted. 

The RMB weakened for the first time in many years earlier this year, which would have led to the reversal of this effect – U.S. dollar growth rates would have trailed RMB growth rates. The RMB strengthened recently, and I predict that the average exchange rate will strengthen about 2% for 2012. There is pressure from the United States for China to further strengthen the RMB. 

Analysts need to be careful when evaluating reported growth rates – is the company really growing its sales when measured in RMB? I believe that all Chinese companies should be using the RMB as a reporting currency. When they don’t, the SEC ought to be asking for additional disclosures as to the effect of currency rate changes on revenue growth rates. 

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