Editor's Note:
The scandal-ridden Kangmei Pharmaceutical released its 2020 annual report on the evening of April 27, 2021, and the huge loss of 27.747 billion yuan once again shocked the capital market, and the huge loss mainly came from the huge price reduction provision for inventory, especially Chinese herbal medicines. On April 30, 2019, Kangmei Pharmaceutical's substantial increase in the inventory of Chinese herbal medicines and other chinese medicinal materials was questioned, and this time it seemed that the huge price reduction of the Chinese medicinal materials that was increased at that time seemed to be suspected of "taking a big bath". In this regard, Professor Huang Shizhong wrote the article "Inventory Price Decline or Fraud Cover-up", and put forward five major doubts worth pondering about the 2020 annual report of Kangmei Pharmaceutical. This is the torture that Professor Huang Shizhong once again raised on the financial report of Kangmei Pharmaceutical after "Eight Questions of Kangmei Pharmaceutical".
Inventory price drops or fraud cover-ups?
——The five major doubts of Kangmei Pharmaceutical's 2020 annual report
Huang Shizhong
Xiamen National Accounting Institute
On the evening of April 27, Kangmei Pharmaceutical, which was involved in fraud scandals and deeply involved in litigation, disclosed its 2020 annual report, and a huge loss of up to 27.747 billion yuan once again attracted the attention of the capital market. Together with the annual report, the Announcement on the Provision for Impairment of Assets was disclosed, and the total asset impairment provision of Kangmei Pharmaceutical in 2020 was 23.006 billion yuan, of which the inventory price decline provision for inventory with book cost higher than the net realizable value was as high as 20.483 billion yuan, accounting for 89.03% of the asset impairment provision for the whole year and 86.79% of the net loss in 2020.
Kangmei Pharmaceutical's 2020 annual report is sprinkled with 340 pages, but the explanation of the inventory price decline preparation accounting for 86.79% of the net loss in the notes to the statement is only 4 pages, giving people a feeling of concealment, and it seems that there are many hidden secrets. In 2020, Kangmei Pharmaceutical made a provision for inventory price decline of 20.483 billion yuan, is it a real decline in the net realizable value of inventory, or a cover-up of the inflated inventory in the process of restatement of the previous annual statement? The author believes that whether kangmei pharmaceutical's huge inventory price decline reserve in 2020 is indeed a big question of right and wrong, which is worthy of in-depth investigation. Investors have the right to understand the real reasons behind the provision for the huge inventory price decline, and the regulatory authorities have the obligation to instruct the management of Kangmei Pharmaceutical to explain this issue clearly, and it is necessary for the intermediary to issue an audit opinion on this from a professional point of view.
Question 1: What is the basis for inventory increase?
After the financial fraud incident on April 30, 2019, Kangmei Pharmaceutical restated its financial statements, the balance of monetary funds at the end of 2017 was reduced by 18.343 billion yuan, the inventory balance at the end of 2017 was adjusted accordingly by 18.343 billion yuan, and the increased inventory (Chinese herbal medicines) accounted for 52.04% of the inventory balance of 35.246 billion yuan after the restatement of the statement, accounting for 72.52% of the balance of Chinese medicinal materials in the inventory of 25.292 billion yuan after restatement. Such a large-scale adjustment has aroused widespread doubts in the capital market. On August 17, 2019, the author published "Eight Questions about Kangmei Pharmaceutical" (later published in the monthly journal of Finance and Accounting) in Genting Caishu, and the third question in it directly refers to the authenticity of Kangmei Pharmaceutical's inventory, which is summarized as follows:
The special note shows that the items corresponding to the reduction of inflated deposits, inflated income and inflated income are mainly increased by 18.343 billion yuan in inventory (Chinese herbal medicine). The question is, is the increased inventory real in terms of quantity and value? Do I need to hire an independent third party to verify this? Is there a provision for loss of price declines? Is there any suspicion of whitewashing the fictitious sales business? ...... Kangmei Pharmaceutical's inventory accounts for a particularly high proportion of total assets, which has always been a concern for investors, and financial analysts continue to question the authenticity of its inventory. After restatement of the financial fraud to increase inventory, kangmei pharmaceutical's inventory balance at the end of 2018 reached 34.210 billion yuan, accounting for 45.84% of its total assets of 74.628 billion yuan. Kangmei Pharmaceutical's rigid debts such as bank borrowings, bonds payable, accounts payable and accounts receivable in advance at the end of 2018 totaled 43.107 billion yuan, and whether the company can repay these debts in full and on schedule depends largely on whether the inventory of 34.210 billion yuan is true. The authenticity and fairness of this inventory is related to the vital interests of existing investors and creditors, and whether the decisions of potential investors and creditors will not be misled... In the case that the financial fraud has been made public, it is expected that Kangmei Pharmaceutical will clarify the authenticity and accuracy of inventory and other assets at one time, so as to avoid continuing to harm investors and creditors in the future by accruing inventory price losses or carrying forward operating costs. ”
Judging from the information recently disclosed, Kangmei Pharmaceutical has not seriously taken the doubts of investors and regulators about whether the basis for increasing inventory is sufficient. Is the provision for the decline in the price of 20.483 billion yuan of inventory in 2020 suspected of "taking a big bath"? The management and governance of Kangmei Pharmaceutical have the obligation to make it clear, otherwise it constitutes another form of false information disclosure and is likely to face the risk of being punished again.
Question 2: What do the three signs mean?
In 2019 and 2020, when the author taught "Financial Fraud and Audit Failure Prevention" to the training course organized by the China Annotation Association and ACCA, he pointed out many times that judging whether Kangmei Pharmaceutical's financial statements are true can be judged by three signs: (1) whether the gross profit margin has dropped significantly after the financial fraud scandal has been exposed; (2) whether there has been a bond default; (3) whether a large amount of inventory price decline provision has been made. Among these three signs, as long as there is one sign, it can basically be judged that the inventory of Kangmei Pharmaceutical is untrue. So far, these three signs have appeared at the same time, indicating from an accounting point of view that there may be false ingredients in the inventory increased by Kangmei Pharmaceutical at that time.
1. What does an abnormal gross margin mean?
Figure 1 shows the gross profit margin before and after the disclosure of the financial fraud scandal of Kangmei Pharmaceutical, of which the gross profit margin of 2016-2017 is the data before the financial fraud scandal is exposed, and the data of the financial fraud scandal in 2018-2020 is the data after the financial fraud scandal is exposed. It can be seen from this that the gross profit margin in 2019-2020 has dropped significantly, which has both elements of fictitious operating performance by reducing operating costs in 2016-2018, nor does it rule out the possibility of trying to "digest" false inventory by over-transferring operating costs in 2019-2020. It must be noted that the restatement of Kangmei Pharmaceutical's statement occurred in April 2019, and there was no opportunity to "digest" the false inventory in 2018 by multi-turning operating costs, which may be the reason for the high gross profit margin in that year.
Figure 1 Gross profit margin before and after the financial fraud of Kangmei Pharmaceutical was exposed
2. What does bond default mean?
The "Risk Warning Announcement" issued by Kangmei Pharmaceutical on August 22, 2019 pointed out that as of March 31, 2019, the company's monetary fund balance was 1.048 billion yuan, short-term liquidity was tight, and debt repayment pressure was high. However, at the end of the first quarter of 2019, the inventory balance of Kangmei Pharmaceutical was as high as 31.408 billion yuan, if the inventory is genuine, why not sell a part of the inventory to alleviate the liquidity pressure? On January 18, January 23 and January 31, 2020, Kangmei Pharmaceutical warned for three consecutive times that there was a risk that the principal and interest of the "15 Kangmei Bonds" could not be paid in full and in a timely manner. On February 3, Kangmei Pharmaceutical issued an announcement that due to tight liquidity, it had failed to repay the principal and interest of 2.492 billion yuan. On February 4, Kangmei Pharmaceutical issued another announcement that it had raised 1.13 billion yuan of debt repayment funds through asset disposal, but there was still a risk of not being able to repay the principal and interest of 1.362 billion yuan. This is the first time that Kangmei Pharmaceutical has defaulted on its bonds. In sharp contrast to the failure to repay the principal and interest of the 2.492 billion yuan bond, the remaining inventory balance is the high inventory balance, and the inventory balance of Kangmei Pharmaceutical as of December 31, 2019 was as high as 31.408 billion yuan. If the inventory at this point in time is true, Kangmei Pharmaceutical only needs to sell 5% of the inventory to repay the principal and interest of the mature bond. Kangmei Pharmaceutical does not actually do this, which either shows that its inventory is backlogged and slow to sell, or that its inventory is not genuine, or both.
3. What does it mean to be prepared for a price drop?
The use of impairment of assets to wash away false assets formed by fictitious performance in previous years is called "big bath charge" in accounting. As early as September 28, 1998, former SEC Chairman Arthur Levitt's famous speech "The Numbers Game" referred to the fraud tactics of listed companies as the five "Accounting Hocus-Pocus" (the other five scams are: creative merger accounting, cookie can reserves, abuse of materiality principles, and revenue recognition). Kangmei Pharmaceutical's 20.483 billion yuan inventory price decline provision in 2020 belongs to the inventory commodities mainly composed of Chinese herbal medicines. Of the 20.147 billion yuan of inventory restated in the statement on April 30, 2019, only 1.804 billion yuan was real estate development costs, and the remaining 18.343 billion yuan of inventory was in inventory of Chinese medicinal materials, after which the balance of inventory commodities at the end of 2017 soared from 7.468 billion yuan to 25.811 billion yuan, an increase of 245.62%. At the end of 2019 and the end of 2020, the book balance of inventory commodities was 24.676 billion yuan and 23.099 billion yuan respectively, and the accumulated inventory price decline reserve was 467 million yuan and 20.897 billion yuan, respectively, and the inventory price decline reserve ratio soared from 1.89% in 2019 to 90.47% in 2020! What is particularly incredible is that of the 20.483 billion yuan of inventory price decline reserves in 2020, the price decline reserve of Chinese herbal medicines alone is as high as 19.650 billion yuan. Investors have legitimate reasons to question: whether the increase of 18.343 billion yuan of Chinese herbal medicines at the end of 2017 on April 30, 2019 is fake? Is there a suspicion of "taking a big bath" in 2020 to prepare for the huge inventory price decline? It is hoped that the regulatory authorities will instruct Kangmei Pharmaceutical to explain this and give investors a reasonable explanation. If the increase in Chinese herbal medicines at that time really existed, why did such a high proportion of price drops occur after two years? Is the net realizable value of Chinese herbal medicines calculated during account adjustment?
Question 3: What was missed in the 2019 annual report?
The 2019 annual report is the first annual report released after the financial fraud of Kangmei Pharmaceutical was exposed, and the authenticity of its inventory has attracted much attention. Kangmei Pharmaceutical should have had the opportunity to correct the false inventory in a timely manner, but unfortunately its management and governance did not seize this opportunity. This can be confirmed by the notes to the statements on page 206 of the 2020 Annual Report:
"Determination of the quantity. On November 26, 2020, the Company officially launched a special inventory of the Chinese herbal medicine inventory involved in the inventory on the books. At the same time, jieyang public security organs carried out relevant investigations and evidence collection. In the process of verification, with the support of Jieyang public security organs, professional institutions and agricultural experts, a comprehensive inventory was carried out, and the quantity was determined in a comprehensive manner this time, and the nameplate information was registered and improved. In view of the fact that inventory and other assets have been in flat management, there are very few relevant insiders, and there are many inventory storage points and a wide range, and the inventory work is difficult. As of now, the relevant investigation work of the Jieyang public security organs is still in progress, and the final judgment will be made after the relevant investigation conclusions are issued. ”
The above-mentioned information disclosure is shocking, and it is really strange that a listed company has no idea about the inventory of more than 20 billion yuan of Chinese herbal medicines on the books, and it must rely on the public security organs to verify it. Investors can't help but ask: Is the problem that the number of Chinese herbal medicines is difficult to determine until 2020 that Kangmei Pharmaceutical will not know? Why is there no mention in the 2019 annual report? Why is the 2019 audit report silent on this?
Question 4: Is the reason for the accrual sufficient?
Along with the 2020 annual report, Kangmei Pharmaceutical's Announcement on Provision for Impairment of Assets was disclosed, and its board of directors, supervisory board and independent directors all claimed that Kangmei Pharmaceutical made an asset impairment provision in accordance with the Accounting Standards for Business Enterprises and the actual situation of assets, which was based on sufficient and fair reflection of the asset status at the end of the reporting period. Since Kangmei Pharmaceutical has so far been difficult to verify the specific quantity of Chinese herbal medicines, how does its board of directors, supervisory board and independent directors determine that the basis for the provision for asset impairment is sufficient?
On the other hand, the board of directors of Kangmei Pharmaceutical disclosed in the "Special Explanation on the Internal Control Audit Report Issued by accounting firms with negative opinions": "Kangmei Pharmaceutical's management of some assets is not standardized, it fails to timely check the true status of assets, pays attention to signs of asset impairment, and it is difficult to ensure the accuracy and completeness of the provision for impairment losses of relevant assets". The Announcement and the Explanation contradict each other and punch themselves in the face, and investors will inevitably question whether the reasons for the provision for inventory price decline in 2020 are sufficient. It should be noted that the premise of the provision for inventory decline is that the inventory is real. According to the accounting standards for business enterprises, if the inventory does not exist, or the quantity is not true, it can only be included as an asset loss as an out-of-business loss, and no provision for the decline in the price of the inventory can be made.
At the end of 2019, Kangmei Pharmaceutical only made a provision for the price decline of 467 million yuan for inventory commodities with a book balance of 24.676 billion yuan and mainly composed of Chinese herbal medicines, but at the end of 2020, it made a provision for the inventory price decline of 19.650 billion yuan for inventory goods with a book balance of 23.399 billion yuan. Why is there such a big difference in price decline between the two fiscal years? The COVID-19 pandemic is raging in 2020, "Kangmei. The China Chinese Herbal Medicine Price Index "showed an upward trend (see Figure 2 for details), while Kangmei Pharmaceutical recorded a huge price loss on Chinese herbal medicines. Kangmei Pharmaceutical's preparation for a huge price decline in Chinese herbal medicines is contrary to the Price Index of Chinese Herbal Medicines released by itself, and it is hoped that the management and governance of Kangmei Pharmaceutical can give investors a reasonable explanation.
Figure 2 Kang Mei. China Chinese Herbal Medicines Price Index
Source: www.cnkmprice.com
Question 5: Is the inventory audit appropriate?
Some people believe that the audit risk of listed companies will be greatly reduced after the fraud is exposed. However, this view does not seem to apply to Kangmei Pharmaceutical's audit, especially the audit risk of inventory. After the financial fraud disclosure, Kangmei Pharmaceutical resigned from Zhengzhong Zhujiang Certified Public Accountants and rehired Lixin Accounting Firm to audit its financial reports for 2019 and 2020. Fong's certified public accountants issued qualified opinions and audit reports that could not express opinions on kangmei pharmaceutical's financial reports in 2019 and 2020 respectively, and the audit quality was generally remarkable, but further research seemed to be necessary on whether the inventory audit was appropriate and whether it could effectively avoid audit risks.
The 2019 audit report mainly put forward reservations about the capital occupation, construction in progress and inventory of Kangmei Pharmaceutical, but the reservation on inventory only related to medical devices, and did not touch on the key issue of whether Chinese herbal medicines were genuine. In 2019, Kangmei Pharmaceutical only made a price reduction provision of 467 million yuan for inventory commodities mainly composed of Chinese herbal medicines, but in 2020, it made a price reduction provision of 19.650 billion yuan. Does the contrast mean that the provision for inventory decline in 2019 is insufficient? In addition, the problem that the quantity of Chinese herbal medicines is difficult to verify cannot exist until 2020, is there an audit risk that the certified public accountant does not give a reservation?
In the 2020 audit report, Revenco's certified public accountant issued an audit report that could not express an opinion on matters such as material deficiencies in kangmei pharmaceutical's financial report internal control, uncertainty in going concern, non-operating capital occupation by related parties, and inability to obtain audit evidence of construction in progress projects and medical machinery inventory impairment and revenue recognition. There was also no objection to whether the quantity of Chinese herbal medicines was true and accurate and whether the provision for huge impairment was made, but the internal control audit report clearly pointed out that the internal control of Kangmei Pharmaceutical was difficult to ensure the accuracy and completeness of the impairment loss provision for relevant assets.
Based on the very limited information disclosed so far, it is difficult to judge whether there is a risk in the audit of Kangmei Pharmaceutical and how great the risk is. However, one thing is clear, the risk of auditing listed companies with a history of financial fraud is still not to be underestimated. In particular, it is unrealistic to expect listed companies to make a radical correction to the financial fraud that has occurred. Based on litigation or other factors, some listed companies tend to use one lie to cover up another after financial fraud. Psychology tells us that it is not easy to tell the truth, it is difficult to tell lies, it is even more difficult to tell false words that do not show flaws, and it is even more difficult to tell lies that are not discovered. When the truth comes out, CPAs who fail to maintain due professional skepticism can easily fall prey to collateral damage from financial fraud in listed companies. (End)
exegesis:
1. According to the data of Tianjian Financial Judgment Fraud Identification System, the gross profit margin of Kangmei Pharmaceutical in 2018 was as high as 31.91%, which was much higher than the industry average gross profit margin of 12.44%, and it was used as a major fraud signal.
bibliography:
1.Arthur Levitt. The Numbers Game. Remarks by Chairman Arthur Levitt. Securities and Exchange Commission. September 28, 1998. www.sec.gov/news/speech/speecharchive/1998/spch202.tex.
2. HUANG Shizhong. Extended Analysis of Financial Fraud Problem of Kangmei Pharmaceutical. Journal of Finance and Accounting.2019(17):3-6.
3. Kangmei Pharmaceutical 2016-2020 Annual Report. www.cninfo.com.cn.
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Editor: Jenny Wang, Huimin Zheng