Saturday, August 20, 2011

Stock Pick: Dissecting Fuqi's Annual Report for Scams

Annual reports are the single most valuable source of information on any company. Annual reports, also known as 10-K reports for public corporations, are issued annually and submitted to SEC's Edgar site. We briefly went over a bit about annual reports in my article on Where to Find Information on Stocks. In this post, we will pull apart Fuqi's annual report, go through some major components, and along the way, look at some of the treasures that are hidden only by the average investor's unwillingness to look.


Overview of Fuqi's accounting fraud
Fuqi's 2008 annual report from EDGAR

I love picking on Fuqi. In my previous post, I've done a quick overview of Fuqi's accounting fraud, which lead to the investors' demise. As I mentioned, it only took me about 30 seconds of scanning the statements to see the fraud. I was curious to see how easily you could make this conclusion from the annual report. I considered it a learning experience and forced myself to read through the whole annual report, every word.

In this post I will walk through the Annual Report with you. In a brief moment, we will see how easily a poor company will discredit itself if you know where to look. I recommend that you read through a few annual reports in full. You will quickly realize that most parts of an annual report or disclaimers which are common to many companies. Annual reports look big and heavy, but you can usually skip over sections talking about foreign exchange risk, natural disaster risk, and legislation risk, just to name a few. The best way to get started is just to dive right in.

In Part I Business overview,
We have historically sold our products directly to distributors, retailers and wholesalers, who then sell our products to consumers through both retail counters located in department stores and in traditional stand-alone jewelry stores. We sell our products to our customers at price points that reflect the market price of the base material, plus a mark-up reflecting our design fees and processing fees. Typically this markup ranges from 8% to 14%. Our customers then further mark up our products to the consumers up to an additional 30%.  Our target price points for our traditional line of gold jewelry that we wholesale are primarily designed to appeal to China’s growing middle class, with an emphasis on young women consumers.
This little paragraph probably told you more about the company that any new article that you can find. Fuqi's customers are not the general public. Their customers are the retailers. We see that their markup is about 8% to 14%. The 30% is not a piece that Fuqi gets to keep. Their target audience are young, middle class women.
Our finished gemstone jewelry products are primarily designed to appeal to China’s younger, urban customers, who are generally better educated and influenced more by Western culture than older consumers.
A few lines down, I saw something that raised a bit of a red flag. They are stating that young women who are better educated? The probably meant to say that young women were more educated about Western culture. Instead, they implied that they were targeting educated customers. This exact wording appears multiple times in the report. I suspect cut and paste was a big factor their eleventh hour rush.

In the Credit Terms section on the end of page 4, there is a very big red flag. They said they used to have standards for granting credit. But recently, they grant credit to anyone.
We have traditionally granted credit to a customer if the customer has been in existence for at least five years and/or has been doing business with us for at least three years. More recently, we have increased credit decisions to new customers on credit checks from various sources, including department store operators and industry participants.
We see some more stuff about their aggressive attempt to expand, some statements about the Jewelry industry in China, minimum wage, marketing, some products they sell, nothing too special here. We reach a section with some juicy information on page 36.

Prior to the Reverse Merger in November 2006, our then-sole stockholder, Mr. Yu Kwai Chong, who is also our President, Chief Executive Officer and Chairman of the Board, made loans to us on a regular basis to meet short term financing needs of our company. Typically, these advances were in amounts ranging from $30,000 to $5.5 million, with no more than $10.0 million outstanding at any time. We did not pay interest on any of these advances. During the same period, Mr. Chong borrowed from our company primarily to fund personal liquidity needs. Since the closing of the Reverse Merger, at which time Mr. Chong ceased to be our sole stockholder, we have not engaged in any cash advance transactions with Mr. Chong and will not engage in these transactions in the future. Prior to the Reverse Merger, effective in November 2006, we paid dividends to our then sole stockholder, Mr. Chong. During the years ended December 31, 2008, 2007, and 2006, we paid cash dividends of $0, $0, and $2.7 million, respectively, to Mr. Chong. We currently have no intention to declare further dividends in the foreseeable future. Payment of dividends is further restricted under the provisions of our existing loan agreements.
This section should come as alarming as we see Mr. Chong basically commingling personal money with Fuqi. Then we see that he has paid himself a $2.7 million. Since he was the only shareholder, he is the only one who gets money. This was conveniently right before an enormous issuance of stock in 2007. (Refer to my previous post about Fuqi's accounting scam for more details) Let's put this into simple terms. He pulls the excess money out of his company for himself. Then, tells investors that he needs to raise money for his company, and sells $69.54 mil of stock. Sounds like $2.7mil of the investors' money went straight into his pocket. This information is repeated in multiple places in the report.

We'll see some more cookie cutter stuff, like warnings about interest rate risk, legislation risk, etc. On page 42, we see this:


1. 
We did not maintain effective control over the period-end closing process.  Due to the insufficient number of qualified resources, we were unable to timely and accurately complete our work needed to close our books and prepare financial statements in accordance with accounting principles generally accepted in the United States of America. This control deficiency resulted in significant amounts of audit adjustments to our 2008 financial statements.  In addition, this control deficiency could result in a material misstatement to annual or interim financial statements that would not be prevented or detected.   Accordingly, management determined that this control deficiency constitutes a material weakness.

2. 
We did not maintain effective control over the revenue cycle with revenue recognition.  We did not properly perform and follow the control procedures set forth in the revenue cycle.  This control deficiency resulted in  significant amounts of sales not being recorded in the proper periods.  Accordingly, management determined that this control deficiency constitutes a material weakness.

In so many words, they have openly admitted to doing a bad job on their accounting. They admit that  this error will be big enough to make a large impact on the statements, and cause significant amounts of sales to be recorded in the wrong period. This is an open admission of their statements will be misleading, without saying that they've intended to mislead the investor. There it is, hidden in plain sight. Slightly further down, we have one of the most important pieces of an annual report. It's the Report of Independent Registered Public Accounting Firm. This shows up in every annual report and basically tells you if the Accounting Firm has found any fraud or attempts of fraud. They have a few paragraphs explaining their purpose, which you can skip over. Then, they give you their conclusion.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.  The following material weaknesses have been identified and included in management’s assessment:
·
The Company did not maintain effective control over the period-end closing process. Specifically, due to the insufficient number of qualified resources, the Company was unable to timely and accurately complete its work needed to close its books and prepare financial statements in accordance with accounting principles generally accepted in the United States of America. This control deficiency resulted in significant amounts of audit adjustments to the Company's 2008 financial statements.  In addition, this control deficiency could result in a material misstatement to annual or interim financial statements that would not be prevented or detected.   Accordingly, management determined that this control deficiency constitutes a material weakness.


·
The Company did not maintain effective control over the revenue cycle with revenue recognition.  The Company did not properly perform and follow the control procedures set forth in the revenue cycle.  This control deficiency resulted in significant amounts of revenues not being recorded in the proper periods.

Now, sometimes, accounting firms can get a bit friendly and pass a company when it shouldn't deserve to pass. Usually, accounting firms will look the other way on marginal situations. However, when the accounting firm tells you that the is a reasonable possibility of a misstatement of financials, this is an incredibly loud caution sign for you to stay away. A few pages further down, we see that they have redone their statements properly and gotten an approval. This gives you an idea how easily it was to obtain an approval in the first place.


On page F-9, we reach the meat of the report. Most companies are not as bad as Fuqi and you won't find gems littered everywhere. For the companies that are a bit smarter about their fraud, you'll likely have to look in the Notes to Consolidated Financials Statements, or the Notes. This section explains accounting methods used, as well as numbers on the statements.


One of the most important sections here is the Revenue Recognition section. This section tells you at what point the company believes that they should report revenue. 

Revenue Recognition

Wholesale revenue is recognized upon delivery and acceptance of jewelry products by the customers while retail revenue is recognized upon receipts and acceptance of jewelry products by the customers, provided that the other conditions of sales, as established by the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 104, are satisfied:

·
persuasive evidence of an arrangement exists;
·
delivery has occurred, upon shipment when title passes, or services have been rendered;
·
the seller’s price to the buyer is fixed or determinable; and
·
collectibitliy is reasonably assured.
Collectibility is clearly not reasonably assured when the accounts receivable are about 3 times the size of last year's income.

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