SAMPLE. Chinese Accounting Errors: An Analysis of Restatements. CFRA ACADEMY: Educational Report. Introduction

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1 CFRA ACADEMY: Educational Report October 6, 2011 Chinese Accounting Errors: An Analysis of Restatements COMPANIES KEY TAKEAWAY The report analyzes the nature of accounting errors reported by US listed Chinese companies that resulted in material restatements to previously reported EPS or operating cash flows. Most of the restatements in our analysis had a material negative impact on these performance metrics. The most common errors are related to debt/equity instruments (mostly derivatives used in financing arrangements) and related party transactions. We raise concern that disclosure regarding restatements, especially reclassification of cash flows, is inconsistent among these companies and often not transparent. Introduction Characteristics of Restatement Companies Companies included in this analysis are US listed Chinese companies that 1) restated their financial statements as a result of accounting errors, and 2) the restatements resulted in material adjustments to previously reported EPS or operating cash flows. Accounting errors that did not impact EPS or operating cash flows are excluded (e.g., restatements that reclassified expenses from selling expense to cost of goods sold are excluded). Restatements not triggered by accounting errors, e.g., discontinued operations or application of new accounting standards, are excluded. We identified these restatement companies by comparing originally reported annual EPS and operating cash flow with the restated figures going back to If the difference exceeded 5% based on either EPS or CFFO, we read the companies filings (primarily annual) to exclude restatements not triggered by accounting errors. All of the companies included in this analysis prepared their financial statements in accordance with US GAAP, except Company K, which reports under IFRS. Most of the restated years were audited by non-big four accounting firms, the majority of which are based in the US. 1 For less 50% of the companies, the current auditor is the same as the auditor that audited the restated year. The median annual sales of the companies included in the analysis were $93 million, a little below the median sales of all US listed Chinese companies in FactSet (about $98 million). Classification of Accounting Errors Many restatements we identified reflect multiple accounting errors. In characterizing the nature of the accounting errors, we focused on the error(s) that had the most significant impact on either operating cash flow (CFFO) or EPS. 1 The PCAOB issued Staff Audit Practice Alert No. 6 in July 2010 regarding using the work of other auditors. This alert was triggered by the staff s observation that some US auditors used outside accounting firms or assistants (based in the China region) to complete part or most of their audit work without complying with PCAOB standards. RELATED REPORTS Conference Call: Avoiding Portfolio Killers in Asia CONTACTS Zhen Deng Phone: zhen.deng@cfraresearch.com 1

2 We classify the restatements based on whether they affected CFFO or EPS. In situations where both CFFO and EPS were restated, the classification is based on the primary impact. In addition, some companies restated multiple periods. We generally focused on the most recent period subject to the conditions for inclusion discussed above. October 14, 2009 Table 1: Restatement Companies Company Exchange Sector Current Auditor Auditor Restated Period Company A NYSE Consumer Staples Ernst & Young Hua Ming (PRC) Same 306 Company B OTC Materials Wong Lam Leung & Kwok (HK) Gruber & Co (Missouri) 0.4 Company C NASDAQ Information Technology Samuel H. Wong & Co. (California) Same 28 Company D NASDAQ Financials Bagell, Josephs & Company, L.L.C. Paritz & Co (New Jersey) 45 Company E NASDAQ Information Technology BDO (HK) Same 160 UHY Vocation HK CPA Company F OTC Consumer Parker Randall (HK) 49 (HK) Company G OTC Materials Bernstein & Pinchuk LLP (NY) Robert G. Jeffrey (NJ) 54 Company H OTC Consumer Malone Bailey, LLP (Texas) Same 66 Bagell Josephs, Levine Company I NASDAQ Consumer Discretionary Moore Stephens (HK) 250 &Co (NJ) Company J OTC Consumer Discretionary Mazars CPA Limited (HK) Same 244 Company K NYSE Energy Ernst & Young LLP (HK) Same 27,735 Hansen, Barnett & Company L NASDAQ Information Technology Grant Thornton 23 Maxwell (Utah) Company M NASDAQ Industrials KPMG Peat Marwick LLP Frazer Frost (CA) 265 Company N NYSE Materials Frazer Frost LLP Company O OTC Consumer Staples Friedman LLP (NJ) Moore Stephens Wurth Frazer and Torbet (CA) Bagell Josephs, Levine & Co (NJ) (acquired by Friedman) Company P NASDAQ Industrials Albert Wong (HK) BDO China Li Xin Da Hua 93 Company Q OTC Consumer Discretionary Friedman LLP Bagell Josephs, Levine & Co (NJ) (acquired by Friedman) Company R NASDAQ Consumer Staples Sherb & Co., LLP (New York) Same 21 Company S NASDAQ Information Technology BDO China Li Xin Da Hua Kempisty & Co (New York) Annual Sales ($M) 1,

3 Misstatement of Earnings or EPS Table 2 presents accounting errors that misstated earnings or EPS. Restatements had a material negative impact on EPS in 10 of the 12 cases (EPS was overstated by a range of 11%-986%). Half of the errors are related to debt/equity instruments, including convertible debt, convertible preferred, warrants and swaps. Share-based related party transactions accounted for a quarter of the restatements. The remaining errors are related to land use rights/government grants, share exchange, and interest expense. In cases where multiple errors were identified, we highlight the error(s) that had the biggest impact on EPS. Table 2: Impact of Accounting Errors on EPS ($ ex. Company L) Company EPS-Original EPS-Restated Over (Under) Statement Restated Period* Error Code Company C (0.11) (0.14) 21% 2008 Interest Company F % 2008 Related party Company G % 2008 Land use rights/government Grant Company H 0.01 (0.05) - 3/10Q Warrants Company I % 2008 Related party Company J % 2009 Share exchange Company L (10.23)^ (8.01)^ -28% 2007 Converts Company M % 2009 Currency swap Company O % 2008 Converts Company P 0.35 (2.67) - 9M3/10 Warrants & converts Company Q % 2008 Related party Company S % 2009 Warrants & converts *Restatements may cover multiple periods and the same period may have been restated more than once. ^RMB. Debt/Equity Instruments Failure to apply derivative accounting rules (or misapplication) accounted for many of the accounting errors that misstated earnings. These derivative instruments were often associated with financing transactions. Warrants issued by Company H in connection with its private placement in 2/10 contain certain reset features, which should be treated as derivatives and marked to market through earnings. The company initially failed to recognize the derivative liability and the changes in fair value over time. The loss on derivatives of $1.7 million more than offset the originally reported net income of $0.3 million. The company also understated both basic and diluted share count by over 10% due to a clerical error. 3

4 Company L initially did not recognize as derivatives the beneficial conversion feature and a make-whole provision contained in its convertible notes, and the separable warrants. Most of the adjustments to income statement line items totaling RMB5.9million appear to be related to this accounting error. The aggregate impact of the accounting errors overstated loss per share by about 28%. Company P failed to account for its warrants denominated in US dollar and certain features ( down-round provision) of its convertible preferred shares as derivatives. The restatement includes a loss on derivatives of $55.9 million for the 9- month period ended 3/31/10, accounting for over 75% of the total adjustment. The other adjustment was attributable to understated share-based compensation expense. Company M applied hedge accounting to its cross currency swaps when the hedging criteria were not met. The changes in the fair value of these swaps were mistakenly recognized in equity (other comprehensive income) instead of earnings. The mistake overstated diluted EPS by almost 11% in 2009, understated diluted EPS by 9% in 2008, and overstated diluted EPS by 23% in Company S understated its weighted average basic shares outstanding by over 1 million shares related to converted preferred stock and exercised warrants and overstated basic EPS by 14% (but understated diluted EPS by 2%), while Company O omitted 13 million shares of convertible preferred stock in its diluted share count (diluted EPS was the same as basic EPS in the original filing). The share count error overstated diluted EPS by over 9 times for Company O. Related Party Share-Based Transactions Company I failed to expense options granted to its Chairman and CEO to purchase the shares in a related party entity overstating EPS by 67%. The performance based options were granted by the sole owner of the related party, which was the principal shareholder of a subsidiary of the company. Certain shareholders of Company F transferred 804,000 common shares to a financial institution as compensation for services after the reverse merger. Company F initially did not include the fair value of these shares in general and administrative expenses, overstating EPS by 23%. Company Q s CEO acquired 2,575,000 of the company s common shares as part of its share exchange program. It appears that Company Q initially treated all of these shares as a buyback, but the restatement added 2,215,206 shares (or 19%) to the originally reported weighted average of number of shares outstanding. The company also understated compensation expense to its advisers, former director and principal shareholder. The previously reported EPS (already restated) was overstated by 33%, close to two-thirds of which was attributable to the share count error. The originally reported EPS had been $0.25, which was revised up to $0.44 due to incorrect revenue recognition for membership fees and misclassification of warrants. 4

5 Land Use Rights/Government Grants Company G initially recognized an $8 million payment from the government as a gain from involuntary conversion of land use rights (government ordered relocation). But the company had not obtained the land use right certificate. In addition, of the total amount from the government, $5 million should have been treated as a loan. Correction of this error reduced pretax income by $3.2 million (12% of originally reported pretax income). The company also understated its income tax expense by $4.7 million related to a gain on debt forgiveness and the involuntary conversion gain. These and a number of other errors of much smaller magnitude overstated EPS by 42%. Interest on Variable Rate Debt Company C overstated or understated interest expense on its variable rate bonds in multiple quarters during The accounting error did not materially impact 2009 EPS, understated loss per share in 2008 by 21%, and understated diluted EPS by 8% in Share Exchange Company J overstated its basic and diluted share count following a share exchange transaction. The accounting error understated EPS by 18% in the fiscal year ended March 2009, and understated EPS by 32% in

6 Misstatement of Operating Cash Flows (CFFO) Table 3 presents accounting errors that misstated cash flow from operations (CFFO). The originally reported CFFO was materially overstated for all of the companies except for Company N. The magnitude of the overstatement ranges between 7% and 41%. Related party transactions and payments for operating expenses misclassified as capital expenditures or vice versa account for 6 of the 7 restatements (or reclassifications). We note that disclosure surrounding the cash flow reclassifications is inconsistent among these companies. Some companies did not explicitly discuss the reclassification. For these companies, we identified the reclassified amount and nature by comparing line by line the originally filed cash flow statement with the restated statement provided for comparative purposes in a later filing. October 14, 2009 Table 3: Impact of Accounting Errors on Cash Flow from Operations (CFFO) ($000 ex. Company K) Company CFFO-Original CFFO-Restated Over (Under) Statement Restated Period* Error Code Company A 25,409 19,659 29% 2009 Interest Company B (1,264) (2,152) 41% 2008 Related party Company D 1, % 2006 Gov t grant & related Party Company E 3,454 (1,546) - 1H10 Related party Company K 52,858^ 49,624^ 7% 2009 PP&E Company N 8,524 9,970-15% 2005 PP&E Company R 5,677 4,911 16% 2009 PP&E *Restatements may cover multiple periods and the same period may have been restated more than once. ^RMB million. Related Party Transactions Misclassification of cash from and due to related parties misstated CFFO at Company B, Company D and Company E. Not all of them explicitly disclosed the reclassification. Company B originally classified payments to related parties in the amount of $888,525 as cash used in financing activities in the K. This amount was reclassified as cash used in operating activities when presented for comparison in the K filing. The originally reported cash used in operating activities was understated by 41%. We did not see a discussion of the reclassification in the K filing. Company E originally classified a $5 million loan from a related party as part of cash flows generated from operating activities, which totaled $3.5 million for the six month period ended 6/10. Reclassification of the related party loan to financing cash flow (disclosed in an amendment to the 6/10 10Q filing) resulted in negative CFFO of $1.5 million for the 6 month period. Company D overstated CFFO by 39% as a result of misclassifying payments to a related party and grants from the government. It appears that a $350,000 payment to a related party was initially included in operating cash flows, 6

7 but reclassified to financing cash flows. The impact on CFFO was more than offset by reclassification of government grants in the amount of $655,739 from cash flow generated in operating activities to partly investing cash flow and partly financing cash flow. A comparison of the original and restated financial statements along with the adjustments was provided in an amendment to the K filing. PP&E Payments for exploration costs at Company K in the amount of RMB3,234 million were classified as additions to PP&E in the 2009 annual report. The company reclassified the payment as part of operating cash flows in its F. We did not see a discussion of the reclassification other than a general statement that certain comparative amounts have been reclassified to conform to the current year s presentation, and those reclassifications are not significant. By our calculation, the original CFFO was overstated by 6.5%. Company R classified certain payments in 2009 as purchase of plant and equipment in its S1 filing. In the K, cash paid for purchase of plant and equipment in 2009 was revised down by $766,537, and CFFO was revised down by the same amount. In other words, the company overstated its 2009 CFFO by 16% in the original filing. There is no clear indication in the K filing that the 2009 cash flow statement has been adjusted. Company N originally classified $1 million advance on equipment purchases as operating cash outflows instead of investing cash outflows. This mistake accounted for over 70% of the total amount restated. This and a few other classification errors understated CFFO by 15%. Interest Company A misclassified interest payment on convertible notes as cash used in financing activities instead of operating activities in 2009 overstating CFFO by 29%. There is no clear indication in the cash flow statement or elsewhere in the K that the 2009 numbers have been revised. 7

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