Alibaba Group Holding Ltd. said it has reorganized its investment in money-losing local services platform business Koubei, combining it with recently acquired online food-delivery company Ele.me with some fancy accounting that turns a loss maker into earnings gold.
Read: Alibaba misses earnings estimates, even in preferred renminbi terms
Alibaba BABA, +2.71% teamed up with its subsidiary Ant Financial to create a joint venture in June 2015 under the brand name Koubei. Alibaba and Ant Financial each invested RMB 3 billion ($440.6 million) and Alibaba threw in some additional related businesses.
Read also: Can we trust Alibaba’s numbers? Auditor PwC has never faced U.S. regulatory scrutiny
At the time, Alibaba and Ant Financial each held a 49.6% equity interest in the venture, while an unrelated third party affiliated with a major Chinese establishment held the remaining minority equity interests. The organization of the company including all cash and other contributions was completed as of March 31, 2016, according to the company’s last annual report for the fiscal year ended March 31. Alibaba recognized a gain of RMB 128 million on the transfer of the other businesses to the joint venture it had been accounting for under the equity method. The gain was based on their fair value at the time of the transfer.
As of March 31, Alibaba only held a roughly 38% equity interest in Koubei, according to its annual report.
The report said Koubei is one of the leading local services platforms in the People’s Republic of China, “generating traffic to restaurants and other local service providers by offering consumers a ‘closed loop’ experience, from content discovery to finding the store to claiming discounts to payments.” However, Alibaba said it had recognized its share of the net loss of Koubei of RMB 990 million and RMB 1.340 billion in fiscal years 2017 and 2018, respectively. It also said it had stopped recognizing its share of losses of Koubei since its cumulative share had now exceeded its investment in Koubei.
Read also: China’s Tesla is going public: 5 things to know about the Nio IPO
In its earnings release for the second quarter published last Thursday, Alibaba said it had reorganized this joint venture.
“We have established a company to hold Ele.me and Koubei as our combined flagship local services vehicle, which we plan to separately capitalize with investments from Alibaba, Ant Financial and third-party investors,” the company said.
Alibaba has received over US$3 billion in new investment commitments for the new entity, including from Alibaba and Japan’s SoftBank Group Corp. 9984, +0.74% As a result of this reorganization, Alibaba would begin fully consolidating Koubei into its results, which would result in the company recording “a material one-off revaluation gain when the transaction closes,” it said.
It’s not clear from the earning release how Alibaba gained control of Koubei from only holding a 38% equity interest. But that is what is required to recognize this gain, according to Paul Chaney, an accounting professor at Vanderbilt University, who spoke to MarketWatch.
Don’t miss: The questions every investor should ask about Trump’s proposal to radically change how companies report earnings
Related: Investors who paid attention to GE’s accounting saw trouble coming
A spokesman for Alibaba did not respond to a request for comment on the transaction.
Prior to the reorganization Koubei was an equity investment, not consolidated into Alibaba’s financial statements. In the U.S. under Generally Accepted Accounting Principles, the standards most companies that list on U.S. stock exchanges are required to follow, that means Alibaba held between 20% and 50% of the shares before this new transaction.
“Since, they are forming a new holding company and stated that they are consolidating, the new investment allowed Alibaba to gain control,” said Chaney who explained to MarketWatch that the company then followed the accounting rules for a “step acquisition.”
“Since it will be a new company, which they now control, they must consolidate and revalue prior ownership interests,” said Chaney.
Alibaba takes a big gain, Chaney said, because the fair value of the investment went from approximately zero to something much more based on the new investment and combination with a more successful company, Ele.me.
“Gaining control of an investment that’s losing money by injecting new capital and combining this investment with another investment into a new company results in a revaluation gain when control is achieved. This seems to be a sneaky way to turn a loss company into a gain,” said Chaney.
Want news about Asia delivered to your inbox? Subscribe to MarketWatch’s free Asia Daily newsletter. Sign up here.