Evergrande’s Accounting Gimmicks

April 13, 2015 Updated: April 24, 2016

Things must be really bad for Chinese property development group Evergrande Real Estate Ltd. or why else would it resort to accounting gimmicks to reduce the debt it carries on its books.

Late in March, rumors in Hong Kong had it that the company from Guangzhou defaulted on its obligations to one of its suppliers. Hours later, the company put out a press release that it had secured financing worth $16 billion from China’s largest state-owned banks, widely considered a bailout.

Whether it had to actually draw on these lines of credit is unclear. What is clear is that it had to resort to accounting gimmicks to reduce so-called leverage on its balance sheet, or the relationship between debt and equity.

Specifically, it classified some of its debt as equity to push down its debt to equity ratio from 292 percent to 85.9 percent in 2014, according to research by Barclays.

The debt to equity ratio shows how much equity capital there is to absorb losses (in Evergrande’s case, losses from falling real estate prices) before bondholders have to take a hit.

In Evergrande’s case, equity is spread pretty thin whichever way you look at it. “Evergrande is a monstrous organization. It had exposure to everything everywhere. The idea it would be taking significant hits during a fall in property was to be expected,” said China expert Leland Miller of China Beige Book.

Actually OK

However, in Evergrande’s case, the accounting move might actually work from a legal and investment perspective.

Normally, debt is different from equity because it requires repayment at a certain date (maturity) and a fixed interest payment every year (coupon). If either of these payments is missed, the issuer is in default and will get into all sorts of problems, often ending in bankruptcy.

However, in Evergrande’s case, the accounting move might actually be OK from a legal and investment perspective.

Most often, the debt is also secured with some of the company’s assets. If the company can’t pay back, the creditors will just seize the assets (real estate) and try to sell them on the market to recoup some of their losses.

Not so, however, in Evergrande’s case.

“The Perpetual Capital Instruments are jointly guaranteed by the Company and certain subsidiaries, secured by pledges of the shares of the subsidiaries. There is no maturity of the instruments and the payments of distribution can be deferred at the discretion of the issuers of the Perpetual Capital Instruments,” states the 2013 annual report.

This means that Evergrande’s perpetual bonds behave more like equity. They don’t have a maturity and therefore don’t need to be paid back. And, like the dividend on common or preferred shares, the actual interest payment (2.62 percent on the 2013 issue) can be deferred at the discretion of Evergrande, so it can be scrapped whenever necessary.

It also doen’t have real estate as collateral but rather shares of subsidiaries. So for all intents and purposes, they are shares of stock but without voting rights.

Only one question remains then: Who would ever want to invest in Evergrande’s perpetual debt?

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