A Case Study of Financial Reporting Issues Qing L. Burke Tim V. Eaton Miami University Alibaba Group Initial Public Offering: A Case Study of Financial Reporting Issues ABSTRACT: In September 2014, the Chinese e-commerce giant Alibaba Group Holding Limited issued shares on the New York Stock Exchange, making it the world’s largest initial public offering. This case examines different aspects of the Alibaba Group’s initial public offering, including Alibaba Group’s business model, financial reporting and corporate governance, as well as the macroeconomic, political, and legal environment in which the company operates. In addition, this case will familiarize students with the risks and opportunities for Chinese companies and investors when a Chinese company lists in the U.S. This case is suitable for financial accounting and international accounting courses at the intermediate and advanced levels for undergraduates as well as graduate students. The case is scalable, and instructors can choose from multiple sections of the case and different case questions to tailor the case difficulty to their student’s learning needs. Keywords: Alibaba Group Holding Limited; initial public offering; variable interest entities; equity investment; financial statement analysis. 

INTRODUCTION 

On September 19, 2014, Alibaba Group Holding Limited (Alibaba Group), the Chinese e-commerce giant founded in 1999, had an initial public offering (IPO) of American depository shares at $68 per share on the New York Stock Exchange. Based on this offering price, this deal raised $25 billion for Alibaba Group, making it the world’s largest IPO (Barreto 2014) The scope of Alibaba Group’s IPO has drawn particular attention to the risks and opportunities of investing in this company as well as other U.S.-listed Chinese companies. This case will first provide a brief background on Alibaba Group, and then explore important aspects associated with its IPO in the U.S. Corporate Overview Since the launch of Alibaba.com in 1999 by Jack Ma in his apartment in Hangzhou, China, Alibaba Group has established a portfolio of companies operating in wholesale and retail online marketplaces as well as Internet-based businesses offering advertising and marketing services, electronic payments, cloud-based computing, and network services as well as mobile solutions. Alibaba Group has developed an ecosystem around its platform that consists of buyers, sellers, third-party service providers, strategic alliance partners, and investee companies. Table 1 shows important milestones in Alibaba Group’s history (http://www.alibabagroup.com/en/about/history). Important Milestones in Alibaba Group’s History 1999 Alibaba.com is officially launched by its 18 founders, led by Jack Ma, working from Jack Ma’s apartment in Hangzhou. The parent holding company of Alibaba.com, Alibaba Group Holding Limited (Alibaba Group), is established in the Cayman Islands. ? 2000 Alibaba Group raises US$20 million from SoftBank and US$5 million from Goldman Sachs. ? 2002 Alibaba Group becomes profitable. ? 2003 Alibaba Group founds online shopping website Taobao.com ? 2004 Alibaba Group raises US$82 million from a group of venture capital investors. ? 2005 Alibaba Group forms a strategic partnership with Yahoo! in which Yahoo! invests US$1 billion in exchange for 42 percent equity interest in Alibaba Group. ? 2007 Alibaba.com is listed on the Hong Kong Stock Exchange at a price of HK$13.50, raising HK$13 billion (US$1.68 billion). Alibaba Group launches Alimama, a marketing technology platform that offers sellers online marketing services for?both personal computers and mobile devices. ? 2008 Alibaba Group founds Tmall.com, a platform for third-party brands and retailers. ? 2009 Alibaba Cloud Computing is established to handle increasing data management needs. ? 2010 The Alibaba Partnership structure is established. ?Alibaba Group launches AliExpress to enable exporters in China to reach and directly transact with consumers around the world.?Alibaba Group launches the Mobile Taobao app. ? 2012 Alibaba Group privatizes Alibaba.com from the Hong Kong Stock Exchange at a delisting price of HK$13.50.?Alibaba Group repurchases approximately 20 percent of its shares (US$7 billion) from Yahoo! in a restructuring of the companies’ relationship. ? 2013 Alibaba Group abandons its plan to list on the Hong Kong Stock Exchange due to disagreement over shareholder rights. ? 2014 Alibaba Group lists on the New York Stock Exchange. ? Alibaba Group’s revenues are primarily derived from online marketing services, commissions based on gross merchandise volume (i.e., the total value of merchandise sold), as well as fees from the sale of memberships on their wholesale marketplaces.1 It does not engage in direct sales, compete with marketplace merchants, or hold inventory.2 Online marketing services constituted approximately two-thirds of Alibaba Group’s total revenue in fiscal year 2014. The two primary types of online marketing services are pay-per-click advertising services (a.k.a. ‘‘pay-for-performance marketing services’’) and display advertising services, which accounted for 45.3 percent and 7.7 percent of its total revenue in fiscal year 2014, respectively. Pay-per-click is an Internet advertising model in which advertisers pay the website a service fee when the advertisement is clicked. 

On Alibaba Group’s marketplace, the pay-per-click advertising service fee is determined through an online real-time auction system. Display marketing allows advertisers to place advertisements in particular areas of a web page at fixed prices or prices established by a real-time bidding system during particular periods of time. Alibaba Group’s marketplace requires advertisers to pay for these online marketing services in advance. Commissions based on gross merchandise volume and membership fees accounted for 24.3 percent of Alibaba Group’s total revenue in fiscal year 2014. Revenue arrangements with multiple deliverables (e.g., the sale of membership packages) currently constitute less than 1 percent of Alibaba Group’s revenue. Substantially all of Alibaba Group’s assets and business operations are in China and it derives substantially all of its revenue from China. Given China’s economic growth, political stability, increasing levels of Chinese consumer spending, and protection from foreign competition, Alibaba Group has grown rapidly. In the meantime, its costs have increased each year due to strategic investments and acquisitions to expand its user base and enhance its cloud computing business and other technology products designed to strengthen its ecosystem. Primary Investors—Yahoo! and SoftBank Alibaba Group’s success has already paid dividends to an investor with whom the company has had a long and tumultuous history: Yahoo!. In 2005, Yahoo! invested $1 billion in Alibaba Group in exchange for 46 percent of outstanding common stock. Yahoo! obtained the ability to exercise significant influence over the operating and financial policies of Alibaba Group. At the time the investment was strategically important for Alibaba Group as its subsidiary, Taobao.com, was competing directly with eBay’s Chinese subsidiary. However, after this investment, Alibaba Group and Yahoo! later developed a rocky relationship over issues including business operations, a spin-off of Alibaba’s payment business, Alipay, and board of director selections (Gough 2013). On September 18, 2012, Alibaba Group and Yahoo! entered into a share repurchase agreement pursuant to which Alibaba Group repurchased some of its shares from Yahoo!. Yahoo! received $13.54 per share, or $7.1 billion in total consideration. The sale of shares resulted in a pre-tax gain of $4.6 billion for Yahoo! in 2012. Yahoo!’s ownership interest was reduced to approximately 24 percent. Although Yahoo! retained some ability to exercise significant influence over Alibaba Group, the share repurchase agreement strengthened Alibaba Group’s management control and paved the way for its IPO. Another primary investor of Alibaba Group is SoftBank Group Corp, a Japanese telecommunications company and the controlling shareholder of Sprint. In 2000, SoftBank made its first investment of $20 million in Alibaba Group. In 2003, it made a series of further investments totaling $80 million. After Alibaba Group’s IPO in September 2014, during which the pre-IPO shareholders (e.g., SoftBank, Yahoo!, and Ma) sold a portion of their shares, SoftBank owned approximately 32 percent, Yahoo! owned approximately 15 percent, and Ma owned approximately 8 percent of shares.3 After the IPO, Yahoo! did not have the ability to exercise significant influence over Alibaba Group, nor could Yahoo! sell its equity stake in 2014 due to a lockup agreement. Variable Interest Entity (VIE) Structure Alibaba Group’s IPO carried a significant risk; it is essentially a Chinese company operating in China under Chinese law, which is very different from U.S. law. Private companies in China have difficulty accessing sufficient capital domestically and look to foreign investors that are keen to share in China’s economic growth for financing. However, foreign ownership of Chinese companies is regulated in China, and the Chinese government requires companies seeking to list overseas to obtain permission. State-owned enterprises, like PetroChina Company Limited listed on the New York Stock Exchange, have obtained this permission, but it is extremely difficult for a private company to obtain permission. In addition, the Chinese government regulates foreign investment through the Catalogue for the Guidance of Foreign Investment Industries (Ministry of Commerce 2011), which classifies industry sectors into encouraged, restricted, or prohibited categories. Certain essential Internet business activities, such as operating a website or providing Internet content, are in an industry sector for which foreign investment is restricted or prohibited. To bypass these restrictions, solutions were created to allow foreign investors to invest in Chinese private Internet companies. First, Chinese private Internet companies are split into an offshore holding company outside China, typically in the Cayman Islands or similar tax havens, and onshore entities in China. Foreign investors can then buy shares in the foreign-listed offshore holding company of the onshore entities. Onshore businesses in China hold licenses required to operate in China as well as other assets. In Alibaba Group’s case, Alibaba Group is a Cayman Islands holding company established in 1999, and it conducts business in China through onshore Chinese companies. Alibaba Group’s foreign shareholders own a piece of the Cayman Islands holding company. Next, Chinese private Internet companies’ onshore entities in China are further separated into two parts: (1) wholly foreign-owned enterprises and (2) variable interest entities (VIEs). With respect to the former, a wholly foreign-owned enterprise conducts business activities that are open to foreign investment and is 100 percent owned by its offshore holding company. A wholly foreign-owned enterprise is routinely used by multinational companies to operate in China, and also used by overseas-listed Chinese private companies that do not use VIEs. Alibaba Group holds 83 percent of its total assets in and generates 88 percent of its revenues from its wholly foreign-owned enterprises that provide technology solutions and other services to customers. Because Alibaba Group holds 100 percent ownership interest in its wholly foreign-owned enterprises, it consolidates these enterprises in its financial statements. With respect to VIEs, businesses that are restricted or prohibited from foreign investment are put into Chinese entities owned by Chinese citizens. The challenge then becomes how to include the restricted or prohibited part of the business in the offshore holding company. Solving this challenge was an essential requirement for an IPO in the U.S. Overcoming this challenge required the creative utilization of Financial Accounting Standards Board (FASB) Accounting Standard Codification (ASC) 810-10, Consolidation of Variable Interest Entities (FASB 2009b) (Interpretation No. 46 [FASB 2003a] and subsequent amendments including Interpretation No. 46(R) [FASB 2003b] and Statement No. 167 [FASB 2009a]). The FASB issued Interpretation No. 46 in 2003 to expand previous accounting guidance that addresses when a company should consolidate another entity in its financial statements. The previous standards focused solely on ownership: one company consolidated another entity in its financial statements if it controlled the entity through a majority ownership interest or voting rights. Many companies abused the previous standards by creating special-purpose entities to hold debt. Since these companies were structured to own less than 50 percent of the shares of the special purpose entity, they did not consolidate the entity, thus keeping the debt off their balance sheet. Enron Corporation made extensive use of this accounting loophole, and its collapse led to the establishment of Interpretation No. 46. Interpretation No. 46 expands the entities that are subject to consolidation by requiring a reporting entity to consolidate any entity in which it has a controlling financial interest, regardless of whether the controlling financial interest is through equity ownership, through contractual arrangements, etc. The FASB coined the term ‘‘variable interest entity’’ for entities to be consolidated under Interpretation No. 46. An unexpected consequence of Interpretation No. 46 is that it enabled Chinese private companies in restricted or prohibited industry sectors to list their shares in the U.S. (Gillis 2012, 2014). Alibaba Group’s VIEs, which are incorporated in China and 100 percent owned by Chinese citizens, hold the Internet content provider licenses required to operate websites in China. Alibaba Group’s onshore wholly foreign-owned enterprises enter into a series of contractual arrangements that provide these enterprises with controlling financial interests in VIEs. Specifically, these contracts (1) give wholly foreign-owned enterprises the power to direct the activities of VIEs that most significantly impact the entity’s economic performance, and (2) enable wholly foreign-owned enterprises to receive benefits or to absorb the losses from the VIEs that could potentially be significant to the VIEs. Ultimately, these complex contractual arrangements ensure that the economic benefits of the VIEs flow to Alibaba Group, which is the owner of the wholly foreign- owned enterprises. In accordance with ASC 810-10, Alibaba Group includes the financial results of its VIEs in its consolidated financial statements. Approximately 12 percent of Alibaba Group’s consolidated revenue and 17 percent of consolidated assets are attributable to its VIEs. Figure 1 is a simplified illustration of the ownership structure and contractual arrangements for Alibaba Group’s VIEs. Alibaba Group acknowledged that if the Chinese government deems that the contractual arrangements in relation to VIEs violate Chinese law, then the company could be forced to relinquish its interests in those operations. However, given the billions of dollars of foreign investment in dozens of Chinese companies through VIEs, Alibaba Group’s executives believe the Chinese government would not endanger these property rights. Further, as Alibaba Group’s IPO listing is the largest in the world, it would be a shock to global capital markets if China’s leaders undermine the VIE arrangement. U.S. legal experts also argue that if Alibaba Group were to ever declare bankruptcy, foreign investors might not be able to seize assets in the VIEs because the VIE contractual agreements may prove unenforceable in Chinese courts where the rule of law remains rudimentary. The U.S.-China Economic and Security Review Commission, set up by Congress, warned against these arrangements in a June 2014 report: ‘‘This intricate ruse is a way of making the business appear to be Chinese-owned to Chinese regulators while claiming to be a foreign-owned business to foreign investors. Neither claim is technically true, and the arrangement is highly risky and potentially illegal in China’’ (U.S.-China Economic and Security Review Commission 2014, 4). Partnership Structure Before seeking an IPO in the U.S., Alibaba Group initially approached the Hong Kong Stock Exchange despite the Exchange’s rules requiring equal shareholder rights. The Exchange’s rules were problematic because in 2013 Alibaba Group adopted an unusual partnership structure that allows the Alibaba Partnership team to nominate a simple majority of its board of directors. The partnership structure concentrates significant control within the 30-member partnership and limits outside shareholders’ ability to influence corporate matters. However, corporate governance structures with unequal shareholder rights are not uncommon in the U.S. Many U.S. technology companies, such as Alphabet Inc., Facebook, and LinkedIn, all have multiple share class structures that reject the one-share-one-vote principle (Moroney 2014). Thus, after the Hong Kong Stock Exchange refused to make an exception, Alibaba Group moved forward with a listing on the New York Stock Exchange. Lockup Agreement Alibaba Group sold approximately 14.8 percent of its ordinary shares during the IPO in September 2014. After the completion of the IPO, the remaining shares held by its early investors (including Yahoo!, SoftBank, and Alibaba Group’s directors, executives, and other employees) were subject to lockup agreements under which these shares could not be sold on the stock market for predetermined periods (e.g., 90 days, 180 days, or one year). Yahoo!, SoftBank, and Jack Ma agreed upon a one-year lockup on their holdings. After the lockup expiration in September 2015, the remaining Alibaba Group shares became available for sale in the public market. Financial Information Alibaba Group’s consolidated income statements, balance sheets, statements of cash flows, and statements of changes in shareholders’ equity for the years ended March 31, 2012, 2013, and 2014 are presented on pages F-3 through F-11 in its IPO Prospectus (Form 424B4) dated September 18, 2014 (available at: http://www.sec.gov/Archives/edgar/data/1577552/ 000119312514347620/d709111d424b4.htm). These financial statements were prepared in accordance with U.S. GAAP.4 The reporting currency of Alibaba Group is the Chinese currency renminbi (RMB). The financial statements for the year ended March 31, 2014 also contain translations of RMB into U.S. dollars. All translations of RMB into U.S. dollars were made at RMB6.2036-to-US$1, the exchange rate set forth by the Federal Reserve Board on June 30, 2014. CASE QUESTIONS

Q1. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, now part of ASC 606 (FASB 2014a). One of the most significant revenue sources for Alibaba Group is revenue from pay-per-click advertising services. Apply the five steps in the revenue recognition model of ASC 606 to account for revenue from pay-per-click advertising services. Prepare the necessary journal entries. (Ignore any transaction amounts in the journal entries.)

Q2. Non-U.S. companies, such as Alibaba Group, generally use American depository receipts to establish a trading presence on U.S. stock exchanges.?

a. The terms ‘‘American depository receipt (ADR)’’ and ‘‘American depository share (ADS)’’ are often used interchangeably. What is an ADR and what is an ADS??

b. Explain why U.S. stock exchanges have attracted non-U.S. companies’ share listings. Provide at least two reasons.

Q3.As a U.S.-listed foreign company, which must file financial reports with the SEC, Alibaba Group had the choice between U.S. GAAP and IFRS. Although its subsidiaries had once prepared financial statements under IFRS, Alibaba Group decided to prepare its financial statements under U.S. GAAP.?

a. What are the pros and cons for Alibaba Group preparing its financial statements in accordance with U.S. GAAP instead of IFRS??

b. Does the adoption of high-quality accounting standards such as U.S. GAAP or IFRS ensure high-quality financial reporting by companies on a global scale? Why or why not??

Q4. Using the information from Alibaba Group’s Consolidated Income Statements in its IPO Prospectus, calculate its gross profit margin ratio and net profit margin ratio for the year ended March 31, 2014.?

Q5. Compare Alibaba Group’s gross profit margin ratio and net profit margin ratio that you calculated in Question 4 with the following ratios from Amazon, eBay, and JD.com for the year ended December 31, 2013. Gross Profit Margin Ratio Net Profit Margin Ratio Amazon 27.23% 0.37% eBay 68.62% 17.80% JD.com 9.87% -0.07%

a. From the perspective of their business models, provide explanations for the differences in gross profit margin ratios among Alibaba Group, Amazon, eBay, and JD.com.

b. Based on the net profit margin ratios of Alibaba Group, Amazon, eBay, and JD.com, determine which company is the most profitable and which is the least profitable. Provide possible explanations for these differences in profitability.

Q6. Alibaba Group’s Consolidated Balance Sheets in its IPO Prospectus report that its retained earnings went from a positive balance in the year ended March 31, 2012, to a large negative balance in the year ended March 31, 2013. a. Generally speaking, what are the factors that impact a company’s retained earnings?? b. Using the information from Alibaba Group’s Consolidated Financial Statements in its IPO Prospectus, provide possible explanations for factors that contributed to the wild fluctuations in retained earnings and whether this should cause an investor concern.?

Q7. Answer the following questions related to the Statement of Cash Flows:

a. Interpret Alibaba Group’s performance and financial activities for the fiscal year ended March 31, 2014, using cashflows from operating, investing, and financing activities from its Consolidated Statements of Cash Flows presented in its IPO Prospectus.

b. Generally speaking, how would a company’s IPO directly or indirectly impact its cash flows from operating, investing, and financing activities?

Answer rating: 100% (QA)

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