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Hong Kong rules that a rise in the possible future value of unborn pigs is not a profit

China is just starting to transition from state-controlled, peasant farming to modern agribusiness. That is a tantalizing prospect for venture capitalists, who like to back young Chinese companies that have a chance of introducing modern technology into China’s slow and inefficient agricultural supply chain.

But Hong Kong’s exchange has just ensured that VCs backing Chinese agricultural start-ups must wait much longer to exit these investments via an IPO.

The problem is the risk of fraud. Investing in the agriculture sector is always nail-biting. Auditors for large farming or forestry companies cannot practically count every hectare of land, every tree or every fish. And the risk of agricultural firms faking assets is very high in China, which has no centralized or even city-level registry for agricultural land.

Toronto-listed Chinese timber company Sino-Forest was last year accused of fraud by a short seller and then filed for bankruptcy protection. Meanwhile Chaoda Modern Agriculture, a Hong Kong-listed farmer whose shares are suspended, was accused by media and shortsellers last year of overstating its assets.  Chaoda denied some of the claims but its auditors resigned and it is yet to publish a full response to the accounting allegations.

Weary of such scandals, the Hong Kong Stock Exchange has just made it a lot more difficult for start-up or young agricultural companies to meet its requirement that a company must post three years of consistent profits before listing. (An HKEx spokesman declined to comment on the reasons behind the decision.)

What Hong Kong has done is to state that when a farmer enters an item into his accounts called “unrealized gains on biological assets,”—which would describe mark ups on the potential future selling price of just-planted cabbages, or litters of baby pigs—this is no longer going to be considered the same thing as “making a profit.”

This can only apply to IPO candidates because international accounting standards actually suport the “unrealized gains” version of profit for farmers. It can take years for a tree or an animal to produce income. And the Chinese territory’s stock exchange “is not disputing this is the correct way of accounting for biological assets,” explains Hong Kong shareholder activist David Webb, who raised awareness of the decision on his website.

But when it comes to IPO candidates, the exchange’s listing committee has a fairly broad choice in who it will allow to tap the territory’s incredibly deep pool of capital, and who shall be turned away. So the stock exchange operator has basically said, in a new guideline, that “unrealized gains on biological asssets” are hogwash. It now wants farming companies to serve up a really big stack of proven sales invoices before they can raise cash in the territory, where retail investors can buy up to 50% of an IPO.

This is a problem for young farming companies. “Pigs take 180 days to gestate and some apple trees take two years to bear fruit,” the HKEx acknowledges in its guideline statement.

Such difficulties notwithstanding, it continues:

“We consider that the risks in biological assets are higher as they are perishable and their valuation is usually subject to higher uncertainty due to the complex and not easily verifiable assumptions adopted.”

It adds that the exchange now:

“must be satisfied that, based on the facts and circumstances of a particular case, the income was actively derived from commercial transactions in the applicant’s ordinary business throughout the trading record period, rather than from unrealized fair value movements.”

Hong Kong may be cutting investors out of an exciting sector by seemingly turning away Chinese farming start-ups. The rule will particularly annoy agricultural investors because, only a couple of years ago, Hong Kong waived its three years of earnings requirement for miners. But Chinese agriculture has been too regular a source of scandals and losses for the exchange to be perceived by the public and politicians as doing nothing.

Last year China Forestry, a Hong Kong-listed logging company, admitted that 100,000 cubic meters worth of its logging permits had been faked (pdf p.6). China Forestry’s shares have long been halted from trading and its former CEO, Li Hanchun, was detained for embezzlement in China last March. Back in 2003, Chinese orchid tycoon Yang Bin got 18 years in prison for commercial crimes including false accounting in the run-up to his company’s Hong Kong listing.

With its new rule, then, Hong Kong has come up with a rather effective way of cutting agricultural frauds off at the roots. By discouraging the “unborn pigs are our profits,” theory at the listing stage, Chinese farmers could well end up being more conservative with their accounting going forward. And companies who try to raise IPO funds based on the future value of agricultural assets that do not exist will no longer have that route open to them. Fraudsters will instead have to fake a very big stack of sales invoices, which takes a lot longer than faking land records.

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