Accounting scandals have not been something out of the ordinary. Many companies across the world have tried to delve into fraudulent financial reporting practices to maintain growth and their position in the stock markets but have ultimately failed due to exposure of their business practices sooner or later. Today a financial accounting professor cannot end the class without ever mentioning Enron once and its associated malpractices in accounting. Such is the impact that accounting frauds have not only on the target company’s performance but also in the global outlook about companies trading in the securities market. Every investor today is more aware of accounting frauds but still falls prey to these frauds. This article aims to understand such frauds with the story of Kangmei Pharmaceutical and then tie that up with investing lessons from both the famous Luckin Coffee scandal and Kangmei Pharmaceuticals.
The Kangmei Pharmaceutical Story:
The Chinese traditional medicine maker Kangmei Pharmaceutical is one of the big-ticket stories of accounting frauds that is responsible for overstatements in its financial statements to the tune of $12.6 billion over the years 2016-2018. It was found that the company was using fake bank deposit slips to inflate its cash reserves, forged documents for business activities that weren’t taking place in reality and transferring company funds to related parties to trade in its own stock.
The company has been under investigation since December 2019 when it first declared to its investors that it has overstated its revenues by $4.1billion and operating profits by $575 million. Ever since this reveal, the company’s shares have fallen over 70% and the company has been de-listed from the MSCI China Index and the list of China Connect Securities.
China Securities Regulatory Commission (CSMR) has ever since August 2019 blacklisted 6 executives from the company who were found to be in direct connection to this accounting fraud. This action comes post the body charging fines to 16 of the company’s employees for a total of 5.95 million yuan or $834,455.
The blacklist includes Kangmei’s chairman and 5 other executives who will no longer be able to take up any executive positions at boards of companies for the next 10 years and cannot participate in the securities market as well. The CSMR also asked the company to pay a $84,600 fine in addition to the fines charged earlier.
The company has now become the first listed entity to default on a puttable bond issue worth $343.14 million that had taken place on March 6, 2015 with a coupon rate of 5.33% and maturity of 7 years ending in 2022. It declared on 3rd February 2020 that it will be unable to make both the principal and interest payment for the bonds on schedule and has been directed by the Shanghai stock exchange to raise funds to pay the bondholders on schedule.
Investing Lessons to Be Learnt from The Luckin Coffee Scandal and Kangmei Pharmaceuticals:
- It is absolutely important to stay diversified in your portfolio holdings no matter how positively you or your fund manager estimate the growth of a certain stock. The ground reality is always the company’s fundamentals. If a company like Kangmei has to have related parties trade in its own stocks to keep the company afloat in the stock market, then that highlights the clear inefficiency in management of the company to keep the business operations stable.
- Be careful with emerging market stocks in your portfolio. Most companies in growing economies even ones like China (the second largest growing economy) have numerous fraud stories that one can use an anchor. This is not to say that one must avoid emerging market stocks altogether but understanding the company’s business potential and earnings history is essential before making an investment decision.
- Unreal growth is something one must understand and be curious about when flushed with success stories of numerous start-ups with extremely high valuations in their initial years of growth. In the case of Kangmei Pharmaceuticals which was an established company was reported a 10% and more growth rate which was tremendous when compared with the Chinese pharmaceutical industry growth rate.
- Another common point of caution which is generally given to investors is to be wary of unprofitable firms raising money to fund their business strategies. In the case of Luckin Coffee it was raising funds from the public to expand its presence across China and investors were actively trading in the stock under the garb of growth rate in revenue and financial potential of the company. However, the fact is that Luckin Coffee was not making profits during this time.
The case of Kangmei is a little different though, after deducting the inflated net profit margin from the company’s reported net profit, the actual profit of the company was still satisfactory but its performance declined significantly over the years since the scandal as people’s confidence in the company decreased which in the case of medicine purchases is directly proportional to sales of the product. People will buy medicines only if they trust the company selling them.
- Lastly, it is impossible to see it all. No investor can foresee every movement of the stock market simply because the stock market is unpredictable and that is where the beauty lies. One can however make informed fundamental investing decisions based on sound financial metrics and investment principles which do generally assure a favourable result if not guaranteed success.