Opinion

Chinese accounting walls

MOHAN R. LAVI | Updated on July 29, 2011

Many Chinese companies went public in the US by the reverse-merger shell route that allows them to start trading without having the prospectus reviewed by the SEC.

A number of Chinese companies opted to get listed on the US-based exchanges went and earn their riches. Being mid-sized entities, they opted for the reverse merger route to take a short-cut to their listing ambitions. The definition of a reverse merger by the book is the acquisition of a public company by a private company, allowing the private company to bypass the usually lengthy and complex process of going public. A regular stream of accounting ambushes by these companies in the documents filed with the Securities and Exchange Commission ( SEC) have generated an altogether new definition of Chinese walls — Chinese accounting walls.

Longtop Financial

The accidents were simple yet bizarre. Hong Kong-listed Real Gold Mining Ltd, an Inner Mongolian company, halted trading in its shares in May after a newspaper report said the miner had filed one set of accounts with the Hong Kong stock exchange and a much different one with China's central government. A special investigator is looking into the double-filing mystery. The auditors of Shenzhen-based China Expert Technology are in a soup and could be investigated for camouflaging a $132-million fraud.

If the Satyam saga has taught auditors to be ultra-careful while confirming bank balances, the story of Longtop Financial Technologies — a software company that sells its wares to the banking and insurance sector — would probably teach them to visit the bank independently and get the bank balances confirmed in person. One of the top accounting firms in the world was the auditor for Longtop and had relied on the confirmation of balances from the bank branches for the past six years. For unrecorded reasons, they sought a confirmation of balance directly from the Head Office of the Bank in the seventh year which triggered cinematic drama.

Longtop stopped the process of confirmation stating that the audit firm was not “really” their auditor and also attempted to repossess the audit files by coercion. The Chairman of the company attempted to justify the non-existent bank balances to the mollified auditor by stating that there was fake cash recorded on the books because there had been fake revenue in the past. The audit firm gave up the audit and the company has since not filed its statements and is facing an investigation by the SEC.

Frauds in Chinese stocks are the in-thing in the United States. Many of the fraudulent companies went public in the US by the reverse-merger shell route. That route allowed companies to start trading without going through a formal underwriting process or having its prospectus reviewed by the SEC. In many instances, analysts who have gone short on the stock have been able to expose accounting weaknesses.

An analyst raised a red flag on the financial statements of Long-Top when he discovered that the company had cash balances equal to 250 quarters of capital expenditure but yet went to the market for funding; had amazing margins on its products but negligible incremental capital per staff member (which is to be expected in high-margin companies) and retaining its best-in-class accounting ratios despite doing some acquisitions. Adding doubly to the doubts about the financials was the tendency of the Chairman to keep giving away his stock in the company to employees and others.

Fiercely patriotic operating-in-China rules prevent the Public Company Accounting Oversight Board (PCAOB) from inspecting China-based audit firms for quality and documentation.

Auditors

The Longtop tales bring out the inherent risks in the profession of auditing. Regulations around them continue to be implemented. The PCAOB has issued a draft accounting standard on auditing of supplementary information that forms part of SEC filings. In the United Kingdom, the Office of Fair Trading (OFT) is considering including auditors under the Competition Commission Rules. The eternally-delayed Companies Bill in India introduces the concept of class-action suits against the auditor to the country. The idiom ‘better be safe than sorry' could well describe the stance that the auditors would take against the myriad regulations and ethical standards that surround them.

(The author is a Bangalore-based chartered accountant.)

Published on July 27, 2011

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