Dubious Companies, Hapless Auditors

China Agritech. China MediaExpress Holdings. China Century Dragon Media. China Intelligent Lighting and Electronics. NIVS IntelliMedia Technology Group. Duoyan Printing. China Electric Motor. China Changjiang Mining & New Energy. Fuqi International. Heli Electronics. China Forestry Holdings. Longtop Financial Technologies. Real Gold Mining.

 
The roll of shame containing the names of mainland Chinese companies with a chequered past and present seems to be growing longer these days. The above enterprises listed in Hong Kong or the US have had their financial reports questioned in recent months. Trading in their shares has been suspended, and several have been delisted.
 
The latest disturbing case came to light just last week, when the Stock Exchange of Hong Kong suspended trading in the shares of Real Gold Mining, “pending the release of an announcement concerning price-sensitive information.” An investigation by local newspaper South China Morning Post had found contradictory financial reporting the company made in China and Hong Kong.
 
Days earlier, New York-listed software developer Longtop Financial Technologies was in the news after Deloitte (which coincidentally also audits Real Gold Mining) resigned as its auditor following threats by some Longtop executives against the auditors, their interference in the audit process, and Deloitte’s discovery of false financial records. Longtop CFO Derek Palaschuk also abruptly resigned.
 
In April, Hong Kong-listed China Forestry Holdings announced that its auditor, KPMG, will issue a disclaimer on its financial statements for the year ended 31 December 2010 due to incomplete books and records, among other shortcomings. Most of the company’s key accounting personnel “have left without notice,” and so the directors “were unable to ensure the genuineness and completeness of books and records.”
 
Too much, too soon
What’s going on? It seems to be a case of too much, too soon – a Gold Rush in which entrepreneurs and get-rich-quick schemers will do anything to raise capital. Perhaps they thought they could grow their way out of their fraudulent roots, given the Chinese economy’s continuing extraordinary growth spurt.
 
But if these companies are counting on hiding their tracks behind the complicated maze of Chinese regulations and procedures and the corruptibility of regulators and other parties, they are turning out to be mistaken. The transparency and speed made possible by the Internet, professionalising banks, increasingly sophisticated regulators, an assertive press and other trends are making it easier to unearth business shenanigans.
 
Sadly, auditors, accountants, investment banks, and other players are getting caught in the middle. It is possible that some of these professionals may be turning a blind eye to deficiencies for the sake of fat commissions and fees. But the seemingly substantial scale of the problem and the higher chances of damage to professional reputations and potential criminal and civil suits, should now give them pause.
 
Already, it seems that the negative backwash from these cases may be affecting in some way the credibility of the auditing profession in Hong Kong. In a survey of CFOs and Finance Directors across Asia conducted on behalf of the Institute of Chartered Accountants in Australia, only 34% of respondents strongly agreed with the statement that external auditors in Hong Kong demonstrate sufficient professional skepticism. A much higher proportion, 54% each, strongly agreed with the statement as it applies to auditors in Singapore and Australia.
 
Longtop’s tale
As Deloitte has found out, dealing with the problematic companies can be physically unsettling. As part of its audit of Longtop’s accounts for the year ended 31 March 2011, the Deloitte accountants examined the company’s bank confirmations. The process involved visits to certain banks.
 
In its resignation letter, Deloitte recounted that it identified “a number of very serious defects.” These included:
 
  • statements by bank staff that their bank had no record of certain transactions
  • assertions by bank staff that confirmation replies supposed to be from the bank were false
  • significant differences in deposit balances reported by bank staff and amounts identified in previously received confirmations (and recorded in Longtop’s books)
  • significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books of the group)
 
Because of these findings, Deloitte embarked on a second round of bank confirmations on 17 May 2011. According to the resignation letter, the process was stopped within hours “as a result of intervention by the Company’s officials, including the Chief Operating Officer.”
 
The “serious and troubling new developments” included Longtop officials calling the bank to assert that Deloitte was not the company’s auditor and therefore should not be allowed to do the confirmations. Its staff seized some second-round bank confirmation documents and audit working papers, and threatened Deloitte people from leaving company premises unless Longtop was allowed to retain audit files.
 
Three days later, Longtop Chairman Jia Xaio Gong phoned Paul Sin, Deloitte’s Eastern Region Managing Partner. As Deloitte tells it, Jia admitted that “there were fake revenue in the past so there were fake cash recorded on the books.” Jia did not answer when Sin asked the extent and duration of the discrepancies. Asked who were involved, the chairman said: “Senior management.”
 
Deloitte then washed its hands completely of Longtop. “We have reached the conclusion that we are no longer able to place reliance on management representations in relation to prior period financial reports,” the accounting firm declared.
 
“Accordingly, we request that the Company take immediate steps to make the necessary 8-K filing [to the US Securities and Exchange Commission] to state that continuing reliance should no longer be placed on our audit reports on the previous financial statements and moreover that we decline to be associated with any of the Company’s financial communications during 2010 and 2011.”
 
Tarnished gold, rotting trees
Unlike in Longtop, the issues are not yet as clear-cut at Real Gold. According to a South China Morning Post investigation, the Inner Mongolia miner’s three operating subsidiaries reported a loss of RMB7.5 million on RMB3.45 million in combined sales to the State Administration of Industry and Commerce (SAIC) in 2009. But in its annual report to shareholders in Hong Kong, Real Gold put its profits in 2009 at RMB543 million on sales of more than RMB1 billion.
 
Cui Jie, Real Gold’s CFO, told the newspaper on 24 May that the filings it obtained from SAIC were “inaccurate,” but did not provide the “accurate” reports despite repeated requests. The Post now says that the filings by the three subsidiaries – Chifeng Shirengou Mining, Chifeng Nantaizi Mining and Balinzuo Banner Guotao Trading Materials – were no longer being made available by SAIC. When asked why, Cui reportedly said: “I do not know.”
 
Deloitte has yet to comment on Real Gold. But over at China Forestry Holdings, KPMG has made its position clear. “We do not express an opinion on the consolidated financial statements as to whether they give a true and fair view of the state of affairs of the Company and of the Group as at 31 December 2010 and of the Group’s loss for the year then ended,”  it declared in its independent auditor’s report.
 
In the course of the audit, KPMG said it obtained evidence “irregularities” that centred around the financials of key subsidiary Kunming Ultra Big Forestry Resource Development, which accounts for all the Group’s reported turnover and inventory and a large part of its reported loss before tax and plantation assets.
 
Simply put, the holding company cannot locate all books and records of the subsidiary, and therefore the directors cannot represent that the financial statements comply with IFRS or the disclosure requirements of Hong Kong’s Companies Ordinance and the Rules Governing the Listing of Securities of the stock exchange.
 
Where’s the CFO?
As the directors tell it, joint CFO Wu Xiao Fen, Chief Resources Officer Zhang Hong Yu and certain members of the finance team kept more than one set of accounting records – allegedly under the direction of CEO Li Han Chun, who was arrested in February for supposedly embezzling RMB30 million in company funds.
 
The 36-year-old Li has been fired, though he still controls around 6% of the shares. He had admitted to the board that most sales at Kunming Ultra Big, which were conducted on a cash basis, had not been deposited into the company’s bank accounts. Instead, the money was supposedly used to buy forest assets from individual farmers and logs in northeast China, and to pay for operating expenses related to harvesting activities.
 
According to the board, CFO Wu and others in finance then concocted management accounts, harvesting records, bank statements and bank pay-in slips, among other false documents, to present to KPMG auditors. “Ms. Wu, Mr. Zhang and certain members of the accounting and finance team and resources management department have not reported for work since mid-February 2011 and they are now not contactable,” the board said in an April 29 filing with the Hong Kong stock exchange.
 
All this has cast doubt on the company’s viability. China Forestry had issued US$300 million in 7.75% Senior Notes last November, which are subject to the company fulfilling certain financial and non-financial covenants. (Trading in the notes in Singapore has been suspended since January; trading in the company's shares has also been suspended in Hong Kong.)
 
“We are not able to predict any action that may be taken by the Senior Notes holders and the consequential impact to the Group,” the board said in its filing. The uncertainty “may cast doubt on the Group’s ability to continue as a going concern.”
 
However, the directors hastened to add: “The Board believes that the Group has sufficient financial resources to pay off all existing loans and payables, expenses and carry on its operation for the foreseeable future.”
 
Extra vigilance
Of course, dodgy enterprises are not exclusive to China – Enron, WorldCom and Madoff’s Ponzi scheme all happened in the US, after all. It’s a worldwide phenomenon. But that is no excuse for finance professionals, including auditors, to take a resigned attitude.
 
Indeed, the recent scandals should embolden everyone to be extra vigilant. As forensic accountants often find, doctored bank records and different sets of books are not unknown in China. Knowing this, board directors, particularly independent directors in audit committees, should exert extra effort to make sure the CEO, CFO, finance and other departments are not keeping different sets of books.
 
Investment banks, underwriters, accountants, lawyers and other parties involved in initial public offerings, secondary listings and debt capital raising should take extra care on due diligence, too. The same goes to private equity players – the Carlyle Group owns nearly 11% of China Forestry and is represented by a non-executive director on the board. Carlyle is also a backer of China Agritech, whose financials have been questioned in the US.
 
Regulatory oversight should also be seen as robust as well. Bill Palmer, Director for Asia at the Institute of Chartered Accountants in Australia, notes that independent audit oversight inspections have been done in Singapore and Australia for some years, and in Malaysia in the last 12 months. “This is where the regulatory authorities go in and conduct inspections of the work that the audit firms do,” he explains. “I don’t think they’ve quite the same arrangement [in Hong Kong].” Or in China, for that matter.
 
Palmer points out that the institute’s survey does find that 86% of respondents agree or strongly agree that auditors in Hong Kong demonstrate sufficient professional scepticism (versus 94% in Singapore and 88% in Australia; China was not included in the study.). In that sense, Hong Kong’s auditors still commands respect, along with (presumably) the rest of the finance profession.
 
It remains to be seen whether that will remain the case if the spate of dubious companies continues to plague stock markets in Hong Kong and the US.
 
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation. 

 

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