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 govemance, 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 Inancial 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 fallor the case difficulty to their students' loaming moods. Keywords: Alibaba Group Holding Limited; initial public offering variable interest entities; equity investment; financial statement analysis. INTRODUCTION O n September 19, 2014, Alibaba Group Holding Limited (Alibaba Group), the Chinese e-commerce giant founded in 999, 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 (Bancto 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 Intemel-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 I shows important milestones in Alibaba Group's history (hup:/www.alibabagroup.com/en/about/history).TABLE 1 Important Milestones In Alibaba Group's Hbiory 1999 Alibaba.com is officially launched by its 18 founders, led by Jack Ma, working from Jack Ma's apartment in Hang zhou. The parent holding company of Alituba own, Alibaba Group Holding Limited (Alibaba Group), i established in the Cayman Islands. 2000 Alibaba Group mises US$20 million from SoftBlank and US$5 million from Goldman Sachs. 200 Alibaba Group becomes profitable. 2003 Alibaba Group founds online shopping website Taobao.com 200M4 Alibaba Group mises 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 hered in Albata Group. Alibaba com is listed on the Hong Kong Stock Exchange at a price of HK$1350, raising HK$13 billion (US$ 1.68 billica), Alibaba Group launches Alimama, a marketing technology platform that offers sellers online marketing services for both personal computers and mobile devices. Alibaba Group funds Tmall.com, a platform for hid-party brands and retailers, Alibaba Cloud Computing is established to handle increasing data management needs, The Alibaba Partnership structure is established. Alibaba Group launches AliExpress to euble 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 share (US$7 billion) from Yahoo! in a restructuring of the companies" relationship. 20113 Alibaba Group abandons its plan to list on the Hong Kong Stock Exchange due to disagreement over shareholder rights. 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 (ie. the total value of merchandise sold) as well as fees from the sale of memberships on their wholesale marketplaces.' It does not engage in direct sales, compete with marketplace merchants, or hold inventory." 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-view advertising services (a.ka. "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-view 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-view 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 advertiser to pay for these online marketing services in advance. Commissions based on gross merchandise volume and membership fees accounted for 243 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 Alituba 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 duePrimary 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: Yahool. 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 eBlay'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 34 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 SoftBark 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." 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 rexpired 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 otherFIGURE 1 Ownership Structure for Allbaba Group's Variable Interest Entitles (VIEs) Foreign shareholders Legal ownership Contractual agreements Alibaba Group Holding Limited Offshore China 100%% through offshore holding companies Onshore China me VIE equity holders" Contractual agreements to establish VIIF Wholly foreign- gward enterprises The VIE equity hoklers of Alibaba Group are Executive Chairman Jack Ma and Vice President Simon Kie, both of whom are Chinese citizens. Source: Alitata Group IPO Prospectus (Form 42484) dated September 18, 3014, adapted by the case-writers. 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 goverment 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 Comunission 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 148 percent of its ordinary shares during the IPO in September 2014. After the completion of the IPO, 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-1 1 in its IPO Prospectus (Form 42484) dated September 18, 2014 (available at: hip://www sec.gov/Archives/edgar/data/1577552/ 0001 193 12514347620/d70911 1d424b4.htm). These financial statements were prepared in accordance with U.S. GAAP." 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 US. dollars were made at RMB6.2036-to-USSI, the exchange rate set forth by the Federal Reserve Board on June 30, 2014. CASE QUESTIONS 1. 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-view advertising services, Apply the five steps in the revenue recognition model of ASC 606 to account for revenue from pay-per-view advertising services. Prepare the necessary joumal entries. (Ignore any transaction amounts in the journal entries.) *According to a mile issued by the SBC in 2007, the SEC accepts filings from U.S.-listed foreign companies containing financial statements prepared in accordance with U.S. GAAP, International Financial Accounting Standards (IFRS) without a reconciliation to U.S. GAAP, or home-country accounting standards with a reconciliation to U.S. GAAP (SEC 2007 ). Similar to U.S. GAAP. IFRS 10 and 12 (JASB 201 1a. 201 1b) have provisions that albre Chinese companies to consolidate their VIE for "structured entities" under IFRS 12)2. Non-U.S. companies, such as Alibaba Group. generally use American depository receipts to establish a trading presence on US. 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. 3. As a U.S.-listed foreign company, which must file financial reports with the SEC, Alibaba Group had the choice between US. 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? 4. 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, 5. 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 Net Profit Margin Ratio Margin Radio Amazon 27.23% 0.37% Bay 68.62% 17.80% JD.com 9.87% -007%% 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. h. 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. 6. 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? h 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. 7. 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 cash flows from operating, investing, and financing activities from its Consolidated Statements of Cash Flows presented in its IPO Prospectus. h Generally speaking, how would a company's IPO directly or indirectly impact its cash flows from operating. investing, and financing activities? 8. Research the FASB ASC Topic 810 regarding variable interest entities (VIEs) Under this standard, a primary beneficiary must consolidate its VIE8. Research the FASB ASC Topic 810 regarding variable interest entities (VIEs). Under this standard, a primary beneficiary must consolidate its VIE a. In accordance with ASC 810, what is a VIE? b. How does Alibaba Group apply ASC 810 to consolidate its VIEs? Cite the specific provisions in the ASC to support your argument. 9. What are the potential risks and benefits for U.S. shareholders when investing in Chinese companies with VIE structures? If the Chinese government liberalizes the rules for foreign investment and allows private companies to directly list on U.S. stock exchanges, then would VIEs still be necessary? 10. With regard to Alibaba Group's partnership structure: a. What are the possible reasons that Alibaba Group's management insisted on its partnership structure? b. From an outside shareholder's perspective, what are the potential benefits and risks regarding Alibaba Group's partnership structure? 11. Most IPOs feature share lockup agreements. a. What is the purpose of IPO lockup agreements? b. Why is it important for Alibaba Group's shareholders to know about the lockup agreement and when it expires? 12. Research FASB ASC Topic 323 (FASB 2014c) (and 320 [FASB 2014b]) in the accounting for investments to answer the following questions related to Yahool's investment (assume the fair value option is not elected ) a. How should Yahoo! recognize and measure its 46 percent ownership in Alibaba Group for the fiscal year ended December 31, 2005? b. How should Yahoo! recognize and measure its 24 percent ownership in Alibaba Group for the year ended December 31, 20127 c. How should Yahoo! recognize and measure its 15 percent ownership in Alibaba Group for the year ended December 31, 20147REFERENCES Alibaba Group Holding Limited, 2014. Form 42484. Available at: http://www.sec.gov/Archives/edgar/data/1577552/ 0001 193 125 14347620/d7091 1 184246-4.him Barron, E. 2014. Alibaba IPO ranks as world's biggest after additional shares sold. 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