Hanjin: Bankruptcy or barograph?
Hanjin Shipping was South Korea’s largest container-ship company in terms of capacity, and ranked No. 7 in the world. And yet in August 2016, it filed for receivership. Should its auditor have anticipated that the company was cruising into impending bankruptcy and its ultimate demise?
At its height, Hanjin Shipping’s fleet consisted of some 150 owned and chartered containerships, dry bulk, and liquefied natural gas carriers. It likewise had subsidiaries dedicated to ocean transportation and terminal operations (including a 54 percent stake in a terminal at Long Beach, Calif.) with branch offices in over 60 different countries. In the years leading up to its bankruptcy, Hanjin, as well as other large carriers, gambled that global trade would continue to expand exponentially, even as diminishing global trade, saturated U.S. retail inventories, changing consumer spending patterns and the Chinese economic slowdown all contributed, instead, to a precipitous down cycle. There were additional non-economic factors that contributed to the demise of Hanjin, including a national culture that discourages questioning authority, an organizational structure that discouraged junior staff from speaking up, easy financing arrangements, and bloated capacity.
Recently, the Public Company Accounting Oversight Board approved an expansion of the auditor’s report that would require investors to be told of “areas … that were especially challenging or complex or forced them to make tough decisions in evaluating the company’s books.” In reviewing the circumstances leading to the Hanjin bankruptcy and the economic environment in existence in its aftermath, I propose that such “critical audit matters” should have included an evaluation of the non-economic factors, in addition to the economy within which Hanjin operated and could be expected to operate in the near-term as well as the future.
Like many of its fellow chaebols -- the family-owned conglomerates that dominate much of South Korean business -- Hanjin expanded into new business lines with cheap government financing.
Before the Korean economic crisis of 1997 that pushed the country to the brink of bankruptcy, Hanjin had accumulated a debt-equity ratio of 10 to one. The crisis led to a $57 billion bailout package for Korea by the International Monetary Fund with the condition that reforms would be initiated to eliminate the politically motivated lending decisions enjoyed by chaebols. The company again slipped into financial distress with the global financial crisis of 2008. Hanjin had difficulty getting concessions from costly long-term ship leases that its top managers agreed to when shipping was booming.
To avail itself of foreign investing, the company was required to adopt the amendment to K-IFRS No. 100, “Presentation of Financial Statements,” for the year ended Dec. 31, 2012. In the shift from K-GAAP (which was viewed as lacking transparency, leading to the “Korean Discount”) to K-IFRS, it’s questionable whether umbrella conglomerates such as Hanjin Group had the right structure and attitude to deal with adversity.
By late June 2016, debt ballooned to approximately $5.5 billion (6.1 trillion won). A ship-ordering binge began around 2011. Vessel costs were financed by German banks and retail investors, which owned almost 30 percent of the world’s container ship capacity. In some instances, public-sector regional wholesale banks in northern Germany would put up 70 percent of a vessel’s cost before any infusion of capital. Even when faced with its inevitable demise, Hanjin planned to issue perpetual bonds having no maturity date or scheduled principle redemption and which could be treated as equity.
The beginning of the end
The shipping industry had become too bullish and built capacity too fast. Ships being delivered in the second decade of the century had been ordered a decade earlier when global trade was accelerating. The South China Morning Post quantified the global container fleet at four times as large as it was in 2000, a problem exacerbated by the development of larger vessels that could carry twice as much cargo as their predecessors, somewhat precipitated by the widening of locks in the Panama Canal allowing greater capacity.
In the meantime, Hanjin’s current and quick ratios by December 31, 2015 were 80 percent lower than the industry, indicating that it was experiencing a negative financial trend with limited liquidity. Its debt-to-equity ratio was greater than eight, with significant debt coming due within the upcoming year, while its return on assets was nearly 80 percent lower than the industry as well. It seemed apparent that any cash flow forecasting would demonstrate that Hanjin would imminently run out of cash and available credit. Since 2011, its Z-score, a ratio that measures the overall health of a business and an early predictor of Hanjin’s probability of bankruptcy, became progressively worse.
In its managements’ messages and reviews of business performances, which accompanied the audited financial statements, the company cited oversupply (excess capacity), deteriorated freight rates, low-efficiency vessels, costly charters and severe competition on trade routes as contributing to its poor performance.
Aside from a weakening economy, Hanjin’s can-do culture, its muddy governance and seductive financing abetted its fall into untenable operations. The container shipping outlook in 2016 indicated persistent problems for 2016 and beyond. However, the opinion rendered on the 2015 financial statements by its external auditor may not have been foreboding enough. Consider the Emphasis of Matter paragraph:
“Without qualifying our (unmodified) opinion, we draw attention to Note 41 (which is not available) in the financial statements. With a general depression in the shipping industry, current liabilities significantly exceeded current assets. In overcoming these difficulties … [Hanjin] has implemented financial reorganization plans which include, but not limited to, refinancing of bonds, reduction of costs, disposal of assets and issuance of perpetual bonds … financial performance depend(s) on the recovery of the shipping industry and the result of the financial reorganization plan. These conditions indicate material uncertainty … .”
Alternatively, to express an adverse opinion the auditor would need to consider if it was highly improbable the entity would continue as a going concern. My opinion is that filing for bankruptcy within six months indicates as much. The question is whether an audit firm, while being a member of a global assurance provider, could shed its own cultural affinity and accept the risk and long-term consequence of rendering an adverse opinion.