Two research reports came out recently against Vipshop Holdings (VIPS), a Chinese e-commerce company listed on NYSE. One report, from Beijing based J Capital, apparently focuses on differences between US regulatory filings and Chinese statutory filings. The J Capital report has not been made public, and my observations are based on the press reports. The company has pushed back on this report saying J Capital read the wrong statutory filings. I don’t put much faith in these types of analyses, since there are many reasons why those filings might be different that don’t point to fraud in the US filings.
The other report is from heretofore unknown research firm Mithra Forensic Research (Mithra). Mithra has taken the more traditional short selling research methodology so effectively used by the likes of Muddy Waters that involves throwing the kitchen sink at the company. At the heart of Mithra’s allegations is that VIPS is improperly recording revenue.
While it is disappointing to see another billion dollar plus market-cap Chinese company come under short attack, I am slightly encouraged because this attack may be different than many of the earlier attacks. Carson Block has said that frauds in the US typically are a result of overly aggressive application of ac-counting standards, but in China, frauds have typically been exposed as situations where large parts of the company simply do not exist.
I am encouraged that a big part of Mithra’s attack seems to fall in to the first category – overly aggressive application of accounting standards. Maybe that indicates that Chinese companies have moved on – from flat out making it up to just plain old ordinary cooking the books. Should we take small comfort in that?
The main issue at VIPS seems to be about how the company is recording con-signment sales. Mithra points out that the CFO has said that only 10% of the inventory in their warehouses was purchased from suppliers, suggesting that 90% is consigned. Of course, purchase agreements can make it difficult to de-cide whether an arrangement is a consignment, and careful examination of the terms of the agreement on issues like payment terms, risk of loss, right to return, etc. all factor into that decision. VIPS says Mithra does not understand their business model.
The accounting issue is how VIPS should record a sale when it sells inventory that has been consigned to it. If it considers the transaction to be a sale from inventory, the gross amount of the selling price (less VAT) is recorded as sales. The amount paid for the inventory is deducted as a cost of sale to yield the gross profit from the transaction. If the goods are treated as consigned, then only VIPS’s share of the sales price should be recorded as commission revenue, and no cost of goods sold should be entered for the cost of the inventory. Both approaches yield the same gross profit, so some analysts have called this a tempest in a teapot, since the net income of the company should be unchanged whether the revenues are reported gross or net. Revenue under the net ap-proach, however, would be a fraction of what is currently reported, and the SEC is unlikely to agree with the “no harm, no foul” argument.
It is not possible to discern from the public information whether VIPS has the accounting right. The SEC is likely to soon ask the company and its auditors Deloitte some pointed questions about how they are accounting for consigned inventory, and that might flush out a problem or determine that the company has done things right. That is hard to do from a half a planet away, and neither the SEC nor the PCAOB can look at the books on the ground in China. Account-ants, who seem to have a tough time getting the accounting right on this, call the issue “gross vs. net”. The Hong Kong Institute of CPAs even warned its members to be on the lookout:
It is not uncommon that some Mainland enterprises may fail to understand the importance of considering the economic substance of the consignment agree-ment and may simply recognise the gross amount collected on behalf of others as revenue.
The most notorious case of misapplying gross vs. net was Groupon. Prior to its IPO, Groupon recorded the cash received from its customers on the gross basis, picking up the full value of the coupon, not just the part left after Groupon sent most of the cash on to the supplier. EY signed off on the accounting, but the SEC balked and forced Groupon to restate its financial statements prior to the IPO, taking off half its revenue. Accountants who should know better often fall victim to client pressure to inflate revenues by allowing the gross treatment when it is not appropriate.
Accounting standard setters have attempted to clarify the accounting but have stumbled mightily. The Financial Accounting Standards Board (FASB) which sets US standards (as used by VIPS) and the International Accounting Standards Board (IASB) which sets IFRS, have been working on a joint project to come up with new revenue recognition standards, but the issue is so difficult the FASB has proposed to delay implementation until 2018. Mithra speculates that the new standard will make it tough for VIPS to keep doing what they are doing. It will be a long time before we find out.