Harvard Case - Evergrande: Accounting for Embedded Derivatives
"Evergrande: Accounting for Embedded Derivatives" Harvard business case study is written by Xu Li, Tsun-kan Wan. It deals with the challenges in the field of Accounting. The case study is 23 page(s) long and it was first published on : Jun 7, 2022
At Fern Fort University, we recommend that Evergrande implement a comprehensive overhaul of its accounting procedures and policies to address the embedded derivatives issue, improve financial transparency, and restore investor confidence. This involves a multi-pronged approach encompassing changes to accounting standards, internal controls, and corporate governance practices.
2. Background
Evergrande, a Chinese real estate giant, faced a severe financial crisis in 2021, largely attributed to its complex financial structure and the misclassification of embedded derivatives. The case study highlights how Evergrande used off-balance sheet transactions and opaque accounting practices to mask its true financial position, leading to a loss of investor trust and a liquidity crisis.
The main protagonists of the case are:
- Evergrande: The company facing the accounting challenges and financial crisis.
- Investors: Those who lost confidence in Evergrande due to the lack of transparency and potential misrepresentation of financial health.
- Regulators: Authorities responsible for overseeing financial markets and ensuring compliance with accounting standards.
- Auditors: Firms tasked with examining and verifying Evergrande's financial statements.
3. Analysis of the Case Study
The case study reveals several critical issues:
Financial Reporting:
- Lack of Transparency: Evergrande's financial statements were opaque, making it difficult for investors to understand the true nature and extent of its financial risks.
- Misclassified Embedded Derivatives: The company failed to properly recognize and account for embedded derivatives within its complex financial instruments, leading to an underestimation of its liabilities and an overstatement of its assets.
- Off-Balance Sheet Transactions: Evergrande used off-balance sheet transactions to hide its true financial position, further obscuring its liabilities and potential risks.
Corporate Governance:
- Weak Internal Controls: The company lacked robust internal controls to monitor and manage its financial risks, leading to the misclassification of embedded derivatives and other accounting irregularities.
- Inadequate Risk Management: Evergrande failed to adequately assess and manage its financial risks, particularly those associated with its complex financial instruments and off-balance sheet transactions.
- Lack of Independent Oversight: The board of directors and audit committees lacked the necessary independence and expertise to effectively oversee the company's financial reporting and risk management practices.
Management Practices:
- Aggressive Growth Strategy: Evergrande pursued an aggressive growth strategy, relying heavily on debt financing and complex financial instruments. This strategy, coupled with weak internal controls, contributed to the company's financial crisis.
- Short-Term Focus: The company prioritized short-term financial gains over long-term sustainability, leading to a lack of attention to financial risks and the potential consequences of its accounting practices.
Strategic Framework:
The case study can be analyzed using the Porter's Five Forces framework to understand the competitive landscape and the factors contributing to Evergrande's financial woes. The high competition in the Chinese real estate market, the increasing leverage of developers, and the regulatory scrutiny of the industry all contributed to the company's vulnerabilities.
4. Recommendations
To address the embedded derivatives issue and restore investor confidence, Evergrande should implement the following recommendations:
Accounting Standards:
- Adopt IFRS: Evergrande should adopt International Financial Reporting Standards (IFRS) for its financial reporting. IFRS provides a more comprehensive framework for accounting for embedded derivatives and other complex financial instruments, leading to greater transparency and comparability with global standards.
- Develop Clear Accounting Policies: The company should develop clear and comprehensive accounting policies for recognizing, measuring, and disclosing embedded derivatives. These policies should be aligned with IFRS and ensure consistent application across all financial instruments.
- Implement Activity-Based Costing: Adopt activity-based costing (ABC) to accurately allocate costs to specific projects and activities, providing a more realistic view of profitability and risk.
Internal Controls:
- Strengthen Internal Controls: Implement robust internal controls to monitor and manage financial risks, particularly those associated with embedded derivatives and off-balance sheet transactions. This includes establishing clear segregation of duties, implementing regular audits, and enhancing internal reporting mechanisms.
- Develop Risk Management Framework: Establish a comprehensive risk management framework to identify, assess, and manage financial risks across all business operations. This framework should include risk identification, risk assessment, risk mitigation strategies, and ongoing monitoring.
- Enhance Financial Reporting Systems: Invest in advanced financial reporting systems to improve data accuracy, transparency, and real-time monitoring of financial performance.
Corporate Governance:
- Strengthen Board Independence: Ensure that the board of directors is composed of independent and qualified individuals with expertise in finance, accounting, and risk management.
- Establish Audit Committee: Create an independent audit committee with strong financial expertise to oversee the company's financial reporting and internal controls.
- Improve Transparency and Disclosure: Enhance transparency and disclosure practices by providing detailed information about embedded derivatives, off-balance sheet transactions, and other financial risks in the financial statements and related disclosures.
Management Practices:
- Shift to Long-Term Sustainability: Adopt a long-term sustainability strategy that prioritizes financial stability and risk management over short-term gains.
- Improve Financial Performance Measurement: Develop comprehensive financial performance metrics that go beyond traditional profitability measures to include risk-adjusted returns, capital adequacy, and other indicators of long-term sustainability.
- Implement Employee Incentives: Align employee incentives with long-term sustainability goals, encouraging responsible financial management and risk mitigation.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with Evergrande's core competencies in real estate development and its mission to provide quality housing solutions. By improving financial transparency and risk management, the company can enhance its long-term sustainability and achieve its mission more effectively.
- External Customers and Internal Clients: The recommendations benefit external customers (investors) by providing them with a clearer understanding of the company's financial position and risks. Internal clients (employees, managers) will also benefit from improved transparency and accountability, leading to better decision-making and a more stable work environment.
- Competitors: By adopting IFRS and implementing robust accounting practices, Evergrande can position itself favorably compared to its competitors in the Chinese real estate market, enhancing its credibility and attracting investors.
- Attractiveness ' Quantitative Measures: The recommendations are expected to improve Evergrande's financial performance by reducing financial risks, improving transparency, and restoring investor confidence. This will lead to a more stable financial position, lower borrowing costs, and increased access to capital.
Assumptions:
- The Chinese government will continue to support the real estate sector, providing necessary regulatory guidance and support to ensure stability.
- Evergrande's management team will be committed to implementing the recommended changes and fostering a culture of transparency and accountability.
- Investors will respond positively to the improved transparency and financial performance of Evergrande, leading to increased confidence and investment.
6. Conclusion
By addressing the embedded derivatives issue, enhancing financial transparency, and strengthening corporate governance, Evergrande can restore investor confidence, improve its financial performance, and achieve long-term sustainability. This requires a fundamental shift in the company's culture, a commitment to transparency, and a focus on long-term value creation.
7. Discussion
Alternatives:
- Ignoring the issue: This would likely lead to further erosion of investor confidence, increased regulatory scrutiny, and potential legal action.
- Selective disclosure: Providing limited information about embedded derivatives could be perceived as disingenuous and further damage investor trust.
Risks:
- Resistance to change: There may be resistance from management and employees to implement significant changes in accounting procedures and corporate governance.
- Implementation challenges: Implementing the recommended changes will require significant time, resources, and expertise.
- Unforeseen market conditions: Changes in the Chinese real estate market or global economic conditions could impact the effectiveness of the recommendations.
Key Assumptions:
- The Chinese government will continue to support the real estate sector.
- Evergrande's management team will be committed to implementing the recommended changes.
- Investors will respond positively to the improved transparency and financial performance.
8. Next Steps
- Develop a comprehensive implementation plan: This plan should outline the specific steps to be taken, the timeline for implementation, and the resources required.
- Engage external consultants: Engage external consultants with expertise in accounting, finance, and corporate governance to assist with the implementation of the recommendations.
- Communicate with investors: Regularly communicate with investors about the progress made in implementing the recommendations and the company's commitment to transparency and accountability.
- Monitor progress and make adjustments: Continuously monitor the effectiveness of the implemented changes and make adjustments as necessary to ensure ongoing improvement in financial transparency and risk management.
By taking these steps, Evergrande can overcome its current challenges, restore investor confidence, and position itself for long-term success.
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Case Description
This case explores the accounting treatment for embedded derivatives of China Evergrande Group (HKEx: 3333). It had been the second-largest property developer in China by property sales and largest by land reserves and borrowing size. On 24 September 2020, a suspicious "letter" was widely circulated on the Internet. The stock price plunged. The "letter" was purportedly sent by Evergrande to the Chinese government, urging the approval of a "listing plan" which was crucial in the "reorganization plan" of the Group. Back in December 2016, Evergrande used this plan to attract new "strategic investors" (SIs) to inject capital. To attract SIs, Evergrande and the SIs had agreed that if the reorganization could not be executed by 31 January 2021, the SIs could exercise either one of the two rights. One right was to demand Evergrande to repurchase their shares. Another right was to demand Evergrande to compensate 50% of their shares. Later the SIs invested RMB130,000mn in total, instantly enabling Evergrande to alleviate liquidity strains and continued to expand aggressively by leverage. Was the RMB130,000mn properly accounted for in financial statements, despite RMB2,500mn of "financial derivative liability" throughout 2017 to 2020? Should the two "rights" be treated as "options" in accounting?
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