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Thursday, 17 July 2014

China GDP audit for sceptics

Are things what they appear?

I noted here the other day that China had recorded annual GDP growth of 7.5%. Of course, so it would, because that was the target.

China's economic data always hits the government target, or occasionally it churns out a slight beat just to mix things up and retain a slender sheen of believability.

If there's one thing I can remember from my accounting days it's that data recorded 16 days after a period end can be very rubbery, sometimes referred to as a 'soft close'.

And when it relates to the recording of transactions in an economy with a GDP of more than US$8 trillion, I think it would be being kind to say that the China results released to the market are as much an art as they are a science.

It's worth nothing here that for a country which is supposed to rebalancing away from dwelling construction and fixed asset investment and towards a consumption-driven economy, the data was somewhat contradictory.

Both urban fixed asset investment (+17.3% y/y) and industrial production (+9.2% y/y in June, after rising only +8.8% y/y in March) beat expectations, yet the rate of retail sales growth has been declining and missed, although +12.4% y/y growth is still obviously a big number.

Importantly, China's property markets are now slowing in many of its cities and this is a key area of scrutiny for China bears.

I'd classify myself as a China sceptic rather than bearish - aside from one visit to Macau I've barely seen  any of China and hardly know enough about to form an opinion worthy of the name...not that ever stops some people! Clearly there are genuine risks around the use or misuse of credit.

China GDP for sceptics

When I was training as CA - since today I'm an FCA, so alarmingly this must have been a dozen years ago now - we were taught that auditors should use professional scepticism and consider whether figures pass a "smell test".

In some of Australia's banks, for example, middle managers have on occasion been seen to be living a lifestyle beyond what appeared commensurate with their salary. 

This can be a key indicator of fraud, and in some cases, thus it proved.

Auditors are often tasked with considering alternative ways to substantiate revenues or account balances rather than merely blindly ticking invoices or underlying documentation.

During an audit of a manufacturing firm, for example, auditors might choose to take a spot count of the number of trucks departing through the factory gates each day and extrapolate those counts in order to make an assessment of the completeness of revenue recorded.

During my accountancy traineeship a team of us used to audit the largest chain of strip clubs in the UK (insert obligatory 'assets' quip here), with me in the audit junior role.

Such a cash business tends to come with an inherent risks of incompleteness of revenue and receipts due to misappropriation, so an audit firm should consider how it can gain comfort that revenues are materially complete through designing tests for completeness and understatement. 

One way to do that is to test the rigour of and form an opinion on the internal controls in place. Another might be to check the cut-off of funds recorded to the bank.


How about checking a company's receivable balance or what we used to call 'debtors'?

Rather than checking back to invoices and reconciling the sub-ledgers, an audit firm might choose to write letters to third party debtors asking them to confirm outstanding balances independently, known in the auditing practice as a debtors' circularisation.

The point here is that auditing is sometimes about thinking of other mechanisms to substantiate figures for completeness, accuracy or material misstatement rather than blindly ticking off documentation, and assessing whether accounts "feel right".

When auditors stop applyinh professional scepticism and accept accounts data at face value, the audit process breaks down and its value is immediately diminished.

Back to China...

We can't readily perform circularisations for a country, granted.

However, one thing that we can do is to compare bilateral trade data, such as, for example, checking off China's reported exports figures with Hong Kong's imports data to ensure that the two figures can be reconciled.

This particular "smell test" has repeatedly shown there to be quite a mismatch indicating that China has been indulging in the underhand practice of fake invoicing in order to meet trade and growth targets.

Of course trade data should reflect parity - in this instance an export recorded in China's current account should be matched by an equal and equivalent import entry in Hong Kong's current account.

Yet by Q1 2013 the ratio of China exports to Hong Kong imports had become ridiculously skewed, always in favour of overstating China's exports, with the high point an almost comically high ratio of 2.36 to 1.

The ratio has narrowed significantly of late, implying that China's attempts to crack down on fake invoicing have worked to some extent, but history suggests that scepticism should certainly be applied to China's data.

We know that fake invoicing has taken place in the past in China in order to meet targets with magical consistency, and it strikes me from the trade data reported to be a fair bet that it still is happening, albeit to a significantly lesser extent.

In this case a sceptic would be far more concerned with testing for existence, accuracy, cut-off and overstatement of results than for completeness and understatement.

Other proxies for China GDP?

So, back to China's reported growth rate of 7.5%.

You may not believe it is correct, but how can that ever be substantiated?

Obviously we can't go back and re-test every transaction which makes up China's economic growth, even if we wanted to.

One worthy idea is to look at the rate of electricity output growth as a proxy for China's economic growth.

In the event, China's electricity output has declined from nearly 8% per annum back in early 2012, to only 5.70% y/y as at June 2014.

That suggests that the headline economic growth of 7.5% may indeed be well overstated.

Perhaps the economy is only growing at closer to 6% and is slowing further? Maybe.

Another key indicator one might choose to look at is that of reported truck sales, which declined by nearly 25% in the last quarter to be tracking at a recent trough and levels only recently seen during the financial crisis in 2008/9, and very briefly during the US debt-ceiling crisis of 2013.

Add that to property market data showing slowing and there may be more stimulus in the pipeline for China.