A short selling research group called Anonymous Analytics (AA) published a short report on Hong Kong listed Tianhe Chemicals Group Ltd (1619:HK) on September 2. Tianhe, listed only this past June, was the seventh company at-tacked by AA. While the people behind AA are not identified, I am told by a re-liable source that I know all of them, which suggests they are prominent shorts operating under a pen name. There is the usual menagerie of allegations, and AA published a letter to Tianhe’s auditor Deloitte pointing out some matters Deloitte should be looking into, a technique first used in Muddy Water’s attack on China Media Express in 2011. Deloitte has said nothing publicly, and they won’t unless they either prove the fraud or find that management has lied to them, in which case they will resign.
Tianhe asked the Hong Kong Stock Exchange to immediately suspend trading. That can be a smart strategy since it prevents the shorts from covering while they continue to pay for borrowed stock. Trading resumed a month later after the company responded to the 20 page AA allegations with a 55 page response alleging that AA had fabricated documents, forged signatures, and hacked email. Shares dropped 40% on resumed trading. The company and AA have since trad-ed insults but the stock remains down 54% from its high, suggesting investors believe AA over management.
One of the more interesting allegations (AA calls it the smoking gun) is that the company could not have paid the taxes they claim to have paid because they amount to more than the entire county in which the company is located collect-ed from all taxpayers. Tianhe has provided confirmation from the relevant tax bureaus that tax was paid, but AA has pointed out the statutory filings with the SAIC report a much smaller number. Now we are in the weeds of the cash flow statement and we will stay there for this post.
On the SAIC cash flow statement, there is a line for taxes paid. AA has pointed out that the amount of this line is significantly less than the company claims to have paid in the prospectus. The company has explained that most of the taxes paid are included in purchases.
Tianhe uses International Financial Reporting Standards (IFRS) for its Hong Kong listing, yet is required to use Chinese Accounting Standards for Business Enterprises (CAS) for statutory reports filed with the SAIC. There is a big differ-ence in the cash flow statements under the two standards. IFRS (and US GAAP) permit use of either the direct or indirect method for the cash flow statement, but most companies, including Tianhe, elect to use the indirect method. In the US, a 2007 study of 600 listed companies found 594 used the indirect method. CAS, however, requires that the cash flow statement be prepared using the dir-ect method, and following the belt and suspenders approach of Chinese financial reporting, CAS requires disclosure of the indirect method in the footnotes. So investors get it both ways, a modest plus for CAS.
Under the indirect method, operating cash flow is determined by starting with net income and then adjusting for non-cash items. The direct method reports all of the gross cash transactions, actual cash receipts, and actual payments.
The issue that was raised in the AA dispute with Tianhe is what goes on the taxes paid line. This line does not exist in the IFRS statements prepared under the indirect method, but is present in the SAIC filings that use CAS. To under-stand the dispute, we need to look at how VAT is accounted for.
If a company purchases inventory for $100.00 the purchase price typically in-cludes $17.00 of VAT and the company gets a tax invoice (fa piao) that sets these amounts out. The purchase is accounted for by putting $83.00 in inven-tory and $17.00 in creditable VAT, a current asset. That appears to be what Tianhe does on its IFRS statements. If the inventory is sold for $150.00 the company owes VAT of 17% or $25.50, but it is allowed a credit for the input VAT of $17.00 by supplying the tax invoices on purchases, so it actually pays the tax bureau $8.50. For IFRS purposes, the company records the sale net of VAT, or $124.50. It has cost of goods sold of $83.00 resulting in gross profit of $41.50. There is no VAT tax expense on the income statement – both costs and rev-enues are reported net of VAT.
The cash flow statement under CAS is prepared completely differently. Purchases are recorded at the full amount ($100.00) and sales are recorded at the full amount ($150.00). Taxes paid on the cash flow statement reflect the cash actually paid to the tax bureau for VAT ($8.50). There are specific rules under CAS that explain this, but they are poorly written, at least for this Western trained mind.
So, taxes paid on the cash flow statement should reflect actual taxes paid. The company’s claim that a significant portion of their taxes paid is in purchases is disingenuous. Those VAT taxes were paid by another company, and in another tax jurisdiction if the goods came from outside the county.
I have no position in Tianhe Chemical Group Ltd.