Accountants under the spotlight as China accounting problems surface

October 2011

China, it’s widely agreed, is the engine of world growth, today and for the foreseeable future. But it’s an engine that might need some tuning. As one industry after another – banking, telecoms, resources – gains new global champions from mainland China, it seems that some less esteemed names and practices are being pulled into the international spotlight along with them.

So far this year, three of the big four accountancy groups have either been caught up in controversy about their overseas-listed clients’ accounts, or have stepped away from a client out of growing concern about their books.

The biggest incident involved Sino-Forest, a Chinese timber company that listed on the Toronto Stock Exchange in the 1990s and grew to become one of the largest forestry groups listed in Canada. It appeared a success story, raising more than C$3 billion in debt and equity over the years and reaching a market capitalization of C$6 billion by March this year, reporting almost C$400 million in profit for 2010 from a 780,000 hectare forestry portfolio in China. But following a damningly negative research report from a hedge fund, triggering a share price plunge, it was suspended from trading by the Ontario Securities Commission in August for acts intended to “perpetuate a fraud” – specifically, that it didn’t have the assets it said it did, nor the profitability. Ernst & Young has been named in two class action lawsuits around Sino-Forest.

Elsewhere, big four accountants have started to become wary of their own clients. In May Deloitte stepped aside as auditor of Longtop Financial Technologies, a financial software provider from Xiamen, citing concerns about its accounts. In what is surely one of the most self-abrasing press releases ever assembled, Longtop itself said Deloitte had quit after identifying false financial records on cash and loan balances, the deliberate interference by Longtop management in Deloitte’s audit process, and the unlawful detention of Deloitte files. In late August Longtop said it could face legal action from the US Securities and Exchange Commission for violating disclosure rules.

And in January KPMG said it had found possible irregularities in the books of China Forestry, which is listed in Hong Kong; China Forestry’s shares were then suspended. Other problematic examples include Nasdaq-listed RINO International, which makes pollution control equipment, but admitted in March that two previously reported contracts didn’t exist (it has since been delisted); and Duoyuan Global Water, listed in the US, which has been suspended after it borrowed money from related parties and booked it as sales.

It’s hard to say how widespread this problem is, but some estimates are troubling. A Moody’s report in July assigned red flags to the corporate governance of 61 rated Chinese companies, including some big names like Hong Kong-listed Winsway Coking Coal. It spoke of “the inherent challenges in assessing these Chinese companies: their short history of operations, their diverse industries with limited peers for comparison, their concentrated family ownership structures, and their high-growth environments.”

But however widespread, it is causing a major challenge for the big four accounting firms who have worked long and hard to build businesses in China. Auditing Chinese firms who are readying themselves for international listing is a lucrative source of revenue. But at what risk?

At the very top level, there’s no obvious problem; corporate governance at some Chinese blue chips is in line with international best practice. The problem comes in smaller companies, often private sector seeking to float on the rising tide of investor interest in the China story. Here, auditors face a challenge: stick with the big names they are comfortable with, and forsake other revenue? Or spread the net wider and run the risk of it catching unscrupulous companies?

“My personal view is that the big four may step away from some high risk Chinese clients for the sake of their own reputation,” says Helen Yang, lecturer in accounting at Victoria University, who is working on a CPA Global Research Perspectives project on China’s convergence with IFRS international accounting standards. “If you look at those cross-listing companies controlled by the central Chinese government, a majority of them have the Big Four as auditors. To protect themselves, perhaps in the future they should have their own niche targeting these big Chinese companies rather than focusing on revenue accumulation only.”

But that would be to abandon a vast source of revenue: the private sector constitutes an ever greater part of the potential revenue pool for accountants in China – and the majority, it should be stressed, are legitimate businesses. It’s a debate that is troubling accountancy groups. All four of the big four names declined to comment on this story; however, before they all stopped talking, Paul Winkelmann, the partner in charge of risk and compliance for PWC in Greater China, was quoted as saying “costs have gone up, fees have gone down, as competition for fees is enormous. You can easily see there is a real risk of an audit firm failing.” Another big four auditor in China, asking not to be named, says: “I wouldn’t say we have changed our procedures exactly. But people are being careful.”

The generous interpretation of recent malfeasance is that it represents teething problems in Chinese corporate engagement with the world. “The way we read what’s going on in China among these smaller companies is that clearly many of them are relatively new to being listed, and aren’t entirely sure what they should be doing,” says Jamie Allen, founder and secretary-general of the Asian Corporate Governance Association. “We see some companies listing in Hong Kong, private Chinese companies that have only been in operation for a few years. If you look at governance, track record and continuity, it often raises lots of questions. If these are to be allowed to list on overseas exchanges, then it is absolutely to be expected that some are going to run into problems.”

Allen says this is not new – several years ago many companies listed on Nasdaq were sued for disclosure problems. “There has been a certain history of Chinese companies listing in the US then not fully disclosing material events and issues, then being sued through class action law suits.” But one of the things that is new is the scale of institutions that are being caught up, and that is turning it into a matter of concern for international regulators. Fidelity, for example, held 14.5% of Longtop’s stock as of its last filings on March 31, with major hedge funds also well represented. John Paulson, famous for spotting the problems in mortgage- backed securities early and making a fortune from them, was a Sino-Forest investor – selling out before suspension but at a heavy loss.

It has been sufficiently alarming for the US audit watchdog, the Public Company Accounting Oversight Board (PCAOB), to send a team to Beijing in July, for what has since been billed the “Sino-US symposium on audit oversight”. This pledged closer cooperation; beyond that, PCAOB spokeswoman Colleen Brennan told IntheBlack: “The PCAOB does not talk about any open enforcement investigations. Our recent trip to China was to talk about opening China to PCAOB inspections of auditors that are registered with us.” She also says Chinese officials have agreed to come to the US in October. Elsewhere, the Ontario Securities Commission is to review all companies listed in Canada with significant business operations in emerging markets, focusing on roles played by auditors and underwriters.

One common pattern in all of this has been that companies have often listed through reverse takeover, or back-door listing, which have less onerous standards than a whole new listing; this was the case with Sino-Forest, for example (although not Longtop, which raised US$210 million in an IPO in New York). PCAOB published a study in March which identified 159 Chinese companies that had listed on US capital markets alone through reverse mergers between January 2007 and March 31 2010 – and that’s without looking at Toronto, which has many more. That’s almost three times as many as the 56 Chinese companies that launched US IPOs during the same period. Between them, the 159 back-door listed companies had a market capitalization of $12.8 billion as of March 31 2010.

While the US and Canada allows this approach, Hong Kong has banned any attempt to get around listing requirements through a reverse takeover. “The US allows back door listings, which effectively means you do get much riskier companies,” says Allen. “In Hong Kong we started controlling these back in 2004. If you do a back door listing the exchange is not simply going to let that through; it treats it as an IPO and holds you to the same standards.”

“In the US there is a whole cottage industry of investment banks, accountants, auditors and law firms who specialise in these back door listings,” he adds. “Our problem with that is, they effectively undermine the IPO process and investor protection.”

The problems have come at a time of dramatic evolution in China’s domestic accounting industry. China is in the process of entering a new accounting regime, called Chinese Accounting Standards for Business Enterprises, which are largely in line with IFRS. CASBE was announced by the Ministry of Finance in 2006, began implementation for listed companies in 2007, and has since grown to cover local state-owned enterprises, commercial banks and insurers. A roadmap for further convergence with international practice was released in 2010.

Are challenges in Chinese disclosure related to this evolution? Professor Colin Clark, also at Victoria University and co-author of the CPA study, says that the varied quality of reporting is “a consequence of the stage of development of the profession. There are issues in the adoption of IFRS, issues around translation into a foreign language, and the shift from a more prescriptive basis of standard setting to a more principle-based system.” This inevitably gradual process of on-the-ground transition is a bigger problem than the regulatory infrastructure above it. “I don’t think the problems we’re referring to are problems of an absence of professional framework. The standards are in place. The problems are around implementation and enforcement.”

Naturally, no transition to international best practice takes place immediately. Yang says: “Because Chinese convergence with IFRS only started in 2007, it takes time for Chinese accounting professionals to catch up with international practice, and it is a steep learning curve for them to get used to IFRS.” And on top of that, there are clear issues around staffing. “The challenge is enormous,” says Clark. “The industrialization of the country has meant there has been enormous demand for accounting professionals, and a real challenge in producing sufficient graduates.” Other issues may be cultural – less willingness to speak out in a hierarchical structure, for example. (The Chinese Institute of Certified Public Accountants refused to answer IntheBlack’s detailed written questions on the profession and what is to be done about disclosure issues.)

There’s an issue here for the big four, because the near-monopoly they have held in being able to audit companies listing overseas appears to be ending. With convergence, it is understood that Chinese local accounting firms will also be allowed to do the auditing services for internationally listed companies. They will become direct competitors, and with much lower auditing fees. “The challenge for the big four is rising market competition in accounting services from local Chinese firms, and the need to localize their practices to be aware of the social and political context of China. Accounting reform in China goes hand in hand with economic reform.”

Even if big four groups are expected to have world-class standards in their accounting, there is some sympathy even at this level for those who have been duped by dishonest companies. “Even among state enterprises there have been significant frauds where bank statements or invoices are fraudulent, where a whole web of fraudulent deals has been set up with suppliers, customers and banks,” says Allen. “If you’re auditing that, it can be extremely difficult. On a typical audit you assume the documents companies are giving you are legitimate, so you’re cross-checking the trading and transactions the company is doing with the bank statement. Most are not forensic audits; that would cost a lot more money and effort.”

It should be said, too, that big four accountants resigning from auditing their clients’ books is not really a bad reflection on the accountants themselves; indeed, it’s what they should do. But nevertheless they find themselves in a challenging position with some tough decisions to make around, expansion, revenue, reputational risk and strategy. The coming years will be interesting.

Sidebar: The muddy waters of disclosure

A central character in recent Chinese accounting issues is a man called Carson Block, who founded a research firm and investment manager called Muddy Waters. The name comes not from the blues singer but a Chinese expression: Muddy waters make it easy to catch fish. In other words, there are opportunities to make money when things are opaque.

Block’s strong sell recommendation on Sino-Forest on June 2 set in motion its share price collapse and subsequent investigations and law suits. He really doesn’t pull his punches: the report, at a time when the company’s stock was riding high, said:  the company “was aggressively committing fraud since its RTO [reverse takeover in 1995”, and was “a multi-million dollar ponzi scheme, accompanied by substantial theft.” More specifically, it claimed the company had dramatically overstated its forestry holdings and passed revenues through a host of intermediate companies in order to confuse auditors.

A look at the Muddy Waters research list shows only strong sell recommendations, in all cases on companies where fraud or at least mismanagement is alleged: Orient Paper, RINO, China MedicaExpress, Duoyuan Global Water. In Block’s view, fraud is widespread in China, and the big four firms face great challenges in detecting it. One of his central points is that a company can, in a sense, fake transparency, in that it provides a great deal of information but not the right sort. He argues that auditors might be looking for aggressive accounting, but not a situation where the underlying business doesn’t even exist.

There is another side to this coin though. Block is not just a good governance advocate in the mould of renowned Hong Kong gadfly David Webb, or Allen’s ACGA; he is there to make money, and in every instance has built a short position in the stocks he then hammers in his reports, profiting from their subsequent share decline. Block is open about this: whenever interviewed, he points out himself that he is conflicted.

But the power of raising a red flag can be very destructive. Raising doubts about accounts is all but guaranteed to knock a share price hard, providing gains to anyone shorting the stock. The latest name to appear is Silvercorp Metals, a Toronto-listed company, accused by an anonymous whistleblower in early September of a “potential accounting fraud” worth $1.3 billion. Silvercorp has strongly denied this, publishing many documents to support its accounts; it has retained analyst support, such as broker BMO, which maintains an outperform rating on the stock; and as yet the Ontario Securities Commission has taken no action. No matter, the share price fell 10% in a day anyway; its management said there had been a dramatic increase in short positions on its shares in the last two months.

And this is a central point: there’s actually nothing new in irregularity in accounts for overseas-listed stocks. What’s changed is scrutiny. “The difference is people like Muddy Waters and other hedge funds are realising there are problems, short selling, putting out reports and publicly criticising,” Allen says. “They are essentially taking advantage opportunistically of a problem that is real, but I don’t think you would necessarily find in every PRC company listed in the US.”