In an invitation-only conference-call on Thursday, a recording of which was obtained by Greentech Media, LDK Chief Financial Officer Jack Lai said the company includes wire-saw slurry and so-called off-spec broken wafers in its silicon inventory.

But while he said wire-saw slurry - the sawdust produced when silicon is cut - is not booked in the inventory until it is processed into a usable form, Lai said that off-spec broken wafers - broken pieces of wafers that didn't meet performance specifications - are recorded as part of the inventory right away.

Analysts say these off-spec broken wafers can't yet be refined into usable silicon without great expense.

"When [wafers] are purchased, they will be booked as inventory and they will be processed to check the … receptivity and to prepare to be ready for production usage," Lai said.

Lai didn't say how much of the inventory is made up of off-spec broken wafers and the company didn't respond to calls asking for clarification by press time.

A Piper Jaffray report last week included allegations by Charley Situ, a former financial controller at LDK, of inconsistencies in the company's inventory of solar-grade silicon.

LDK said an internal investigation revealed no discrepancies (see LDK Says Inventory Discrepancy Allegations Have 'No Merit'). The company also told the Associated Press on Monday that an independent audit of the inventory would likely be published "in a matter of days."

Still, LDK's stock plummeted about 26.4 percent Monday to $37.50 per share. It traded as high as $69.39 per share Wednesday before the allegations came out.

Shareholders care about the company's silicon inventory because - with a worldwide shortage of solar-grade silicon - sales, margins and profits all directly relate to the amount of silicon a company is able to obtain and the price it must pay to get it.

LDK claims it pays less for silicon than some of its competitors because only 10 to 25 percent of its silicon is so-called "virgin" silicon, or the unused, high-grade silicon favored by most solar manufacturers. The company says it buys used silicon for less and recycles it, processing it into a usable form.

But the allegations raise questions about whether LDK's future margins will be as lucrative as expected.

During the conference call, Lai said he didn't know how Situ got his numbers and repeated that the inventory matches LDK's ledger.

"In my personal opinion, he has many, many misperceptions about the inventory," Lai said. "My understanding is that he does not understand the different grades of silicon material we have in the warehouse.

"And if you are not familiar yet, the LDK business model is to use mostly recyclable materials rather than virgin silicon. … I think he misunderstood the definition of polysilicon material in LDK."

Aside from the different types of silicon in LDK's warehouse, another potential misunderstanding by Situ might be related to silicon being transported to the warehouse, Lai said.

LDK books silicon in its inventory once it pays for the material, even though it isn't physically in the warehouse yet, Lai said.

He compared it to buying something from a department store and having left the store, but not having brought it home yet. Once the company assumes the title - and the liability - the silicon is LDK's property and can be included in the books appropriately, he said.

About one-fifth of the company's silicon is in transit, Lai said.

Do Off-Spec Wafers Count?

Analysts said the main question is whether LDK is justified in counting in its inventory silicon that it might not be able to use yet, but that it expects to be able to use one day.

Michael Rogol, managing director of Photon Consulting, said LDK - along with competitor ReneSola - have been particularly successful in removing impurities so far.

"This issue is complex because LDK is very good at using silicon that other companies often can't use," he said. "What one company would call waste silicon and write off, LDK is sometimes able to turn into solar wafers. … That makes it harder to account for the silicon."

But Paula Mints, principal solar analyst at Navigant Consulting, called the practice of including off-spec broken wafers "highly questionable."

She said it is "highly unlikely" off-spec broken wafers will be usable without undergoing a "very expensive purifying process that probably wouldn't be worth doing."

While Mints said she isn't familiar with inventory rules in China, she said it is typical for U.S. and European companies to write off any off-spec equipment, raw material or product right away.

Mark Cox, CEO of New Energy Fund, said it's clear the stock market doesn't believe the company is being disciplined enough in looking after its silicon.

The company should consider the amount of money it will cost to purify any lower-quality silicon and find a way to include that cost in its inventory accounting, he said.

Travis Bradford, president of the Prometheus Institute, which is a Greentech Media partner, said the real issue is whether LDK bought material it can't use.

"If so, they need to take the earnings hit and write down their inventory," he said. "The point is that they may have done that because they wanted to show they were more profitable than they were, or they might have done that because they believe the inventory is still usable."

His advice to LDK would be to err of the conservative side, removing any questionable inventory from its books until it becomes usable.

But he added the company has been "reasonably forthcoming" about the issue and most companies include "nonvirgin" silicon (read: used silicon) in their inventories.

The stock reaction has less to do with the quality of LDK's silicon inventory and more to do with general market perception that solar stocks and Chinese stocks are in a frenzy, Bradford said.

"At this point, it's commonly believed that the investment in these stocks is in a bubble mentality, but nobody knows when that bubble's going to burst, and so small anxieties become panics," he said.

Wider Implications

The company's troubles could have wider implications for the industry, including the potential for an even tighter silicon shortage than expected and the possibility of more detailed disclosures about silicon inventories in the future, analysts said.

Mints said the situation shows that people need to be "more suspicious" about companies' claims.

"There are a lot of issues of poor quality wafers and cells coming out of China," she said. "It isn't a surprise to anyone in the industry - although the scale [of this situation] is. … It's an indication that more research needs to be done on every company, but - unfortunately - especially on the companies in China."

A number of industry forecasts are based on the idea that there will be a "huge glut" of product coming from China, Mints said.

If the LDK situation is an indication that glut might not arrive, it means those forecasts will need to be revised, she said.

Cox said investors and analysts are definitely going to have more questions about other companies' silicon inventories now.

"This is going to go through the entire industry," he said. "People are going to want to find out how everybody manages their silicon inventories."

Even if LDK's accounting turns out to be common practice, it highlights a lack of clearly defined standards for accounting of all the different types of silicon used in the solar industry.

As in the oil industry, where companies have to figure out how much of their stockpiles are "recoverable reserves," silicon accounting isn't cut and dried, Bradford said.

"Accounting questions are never clear," he said. "It all comes down to perception and accountability, based on a valuation. The assumption is the inventory is worth at least what you paid for it. If you discover it's worth less than what you paid for it, you have to take a write-down."

If the issue proves to be more widespread than just LDK and relevant to the industry, Bradford said companies could well be asked to separate out different types of silicon in their reporting.

But if the silicon shortage ends and more virgin silicon becomes available, the issue might not be large enough to matter, he said.

Toward the end of the call, Lai said that after the independent audit is complete, the audit committee will review it along with the results from LDK's internal investigation and form a conclusion. Then, the company's lawyer will draft a report to file with the U.S. Securities and Exchange Commission.

With so much at stake, you can be sure investors - along with the industry as a whole - will await the independent audit with bated breath.

Tags: ldk, newenergyfund, photonconsulting, renesola