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Forex controls and VIEs

I was very fortunate to have KPMG consulting partner David Frey talk to my MBA class on Multinationals in China last week about the rapidly changing landscape for MNCs. He has some great insights. One of his predictions is that China will make the Yuan freely convertible sooner than people think. I hope he is right; currency restrictions are increasingly causing problems for U.S. listed Chinese companies. 

Chukong Holdings Limited filed on last Friday with the SEC for a U.S. IPO. Chukong is an online game company so it uses the variable interest entity (VIE) structure despite a specific MIIT prohibition against using VIEs for game companies. The company also faces a lawsuit alleging they ripped off their game Fishing Joy from an arcade game, report that they have not been paying required employee benefits, never bothered to register their stock option plan, and have an auditor facing suspension by the SEC, but based on past history investors ignore such matters. 

Chukong is unprofitable. Its losses have increased over the past three years from 30 million RMB to 91 million RMB. It has burned 84 million RMB of cash in operations over the past three years. It stockpiled that cash by selling preferred stock in its Cayman Island parent company to Sequoia and other investors. 

Hey cheetah!

Cheetah Mobile Inc. (Cheetah) has filed for an IPO with the SEC, joining what is shaping up to be a long line of U.S. IPOs this year. Its main product is Clean Master, the number 6 application worldwide on Google Play. The company previously listed on the Hong Kong exchange as Kingsoft and they now seem to be listing a holding company further down the chain. Fredrik Oqvist has tweeted that Cheetah may be the best name for a Chinese company since FU listed on the NYSE.

By my calculations, Cheetah’s earnings for 2013 would have been 36% higher if it had selected a different accounting firm. That is because Cheetah uses Ernst & Young (EY), which appears to be taking the position that deferred taxes are required on the undistributed earnings of variable interest entities (VIE). In 2013, Cheetah booked RMB 34 million of deferred tax expense related to “outside basis difference” which I believe relates to the undistributed earnings of the VIE. 

This is the third EY client where I have seen this accounting treatment (the others are Autohome and Soufun). I have not seen this treatment on any other U.S. listed Chinese company. 

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