What does PetroChina have in common with Exxon Mobil? Hutchison Whampoa with Wal-Mart? China Mobile or Cheung Kong with Cisco Systems, Intel, or Dell? The answer in all cases is most interesting: nothing -- not when it comes to accounting standards, anyway. And to put my conclusion first, thank goodness for this.
The thought arises from a superbly executed piece of research just published by CLSA Emerging Markets, the research side of Credit Lyonnais Securities Asia. CLSA consultant John May set out to compare the relative merits of Asian and American accounting standards -- an interesting exercise in the era of Enron, Arthur Andersen, and "pro forma" reporting of earnings. May's conclusions stand our generally accepted (if you will) assumptions about accounting practices East and West more or less squarely on their heads.
It turns out that the Asian companies in May's sampling have far NASDAQ-reliable reporting habits than companies atop the NASDAQ and the S&P 500. Who ought to be learning from whom, you have to ask?
That Asian companies suffer a stock-price penalty because of lower, sloppier, less stringently codified and regulated accounting practices has been a given for years. The quality of earnings reporting among US companies is so much higher, you see, and this justifies higher price-to-earnings ratios among US listings.
The idea doesn't come from nowhere. Asian markets are less developed than those of the US and the West in general. A scandal a season was the general rule when I first got to Asia 20 years ago, and a lot of them had to do with cooked books.
Investing in Asian markets consequently had a high-wire aspect to it.
The penalty is perfectly measurable today. Applying the US-backed Generally Accepted Accounting Principles (GAAP) as the yardstick, May's samples yielded the following: P/E's of leading NASDAQ-listed companies were 159 times earnings during the first three-quarters of last year; for S&P 500 companies, the figure was 37, and for the companies in his Asian sample, share prices were a mere 8.4 times earnings.
Measured according to the higher earnings the companies proclaimed in their press releases, the US ratios were less out of line: a ratio of 52 for NASDAQ, 31 for the S&P 500.
May measured the distance between GAAP and the increasingly popular use of pro forma earnings -- profit excluding whatever expenses the companies say shouldn't really count. "For the top five NASDAQ companies, pro forma earnings were 206 percent better than GAAP earnings," May says in The Gap in GAAP, his CLSA report. ``For the top five S&P 500 companies, earnings were 17 percent better, while taking the S&P 500 as a whole, earnings improved by 57 percent."
What happened with his Asian sampling? When May applied GAAP standards to their earnings reports, the difference went the other way: Asian companies had understated their earnings by 3.2 percent. May's explanation is simple: "Analysis of Asia's top five companies by market cap [and a sample of others]," he writes, "indicates that reporting in Asia has not been infected by the pro forma virus that is running rampant in the US."
I love May's designation of his samples -- they sound like outlaw gangs. "The NASDAQ Five" are Microsoft Corp, Cisco Systems Inc, Intel Corp, Dell Computer Corp, and Oracle Corp.
"The S&P Five" are General Electric Co, Exxon Mobil Corp, Microsoft Corp, Wal-Mart Stores Inc and Intel Corp. The Asian companies he used are China Mobile Ltd, Taiwan Semiconductor Manufacturing Co (台積電), Hutchison Whampoa Ltd, PetroChina Co, and Cheung Kong (Holdings) Ltd.
May, who is the founder and president of smartstockinvestor.com, an online newsletter, draws an important lesson from his work -- further elaborations of which he expects to complete shortly. "Pro forma accounting is essentially fictional financial reporting," he tells me from his base in Albuquerque, New Mexico, "and with its proliferation you are seeing that the gap between Asians and Americans is closing."
That's significant in itself, but there are other lessons to be added to this, it seems to me. Asians still have many decisions to make about their financial institutions and the best way to regulate them. And they are confirmed in their decision not to adopt GAAP simply because the Americans urge it around the world.
Hong Kong and Singapore have already chosen the EU's alternative system, known as International Accounting Standards, and there's a strong case for these judgments. IAS is based on general principles; auditors are required to understand the law and follow it in spirit.
GAAP, by contrast, is simply a set of rules listed one atop the other. As we can now see plainly, an auditor can follow the letter of them and still create a lot of trouble and mess. As many European auditors now assert, Enron might not be a household word today had the IAS system been applied in the US.
As to the matter of pro forma reporting, one hopes it is understood for what it is: a bad advertisement for self-regulation. Even the name is misleading, given that there is no form to pro forma. May quotes Lynn Turner, former chief accountant at the Securities & Exchange Commission, to describe pro forma practices as "everything but the bad stuff." The argument over global accounting standards has been running for some time and will continue to run for some time to come. Asians should pay close attention to it -- indeed, they should participate in it. They should take the current calamities in American accounting as symptomatic of larger problems with the American model, and they should decide for themselves just what they need by way of a suitable system.
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