China’s Shady Accounting Practices and Bad Apples

July 26, 2011Investingby Michele Lin

China’s Shady Accounting Practices and Bad Apples

In 2008, the National General Administration of Quality Supervision, Inspection and Quarantine raised the flags when a pediatric urologist noticed a rise in the number of children afflicted with kidney stones, a rare condition. Mounting fears and inquiries causally traced the source to then-popular Chinese infant milk powder, Sanlu, which was found laced with melamine.

Sanlu Group, a Chinese dairy produce company, based in Shijiazhuang in Hebei province, was found guilty and was ordered bankrupt after an estimated 300,000 infants fell ill - and at least 6 died from the tainted milk scandal.

This episode ignited what was perhaps the first wave of widespread international concern and skepticism over quality assurances in the “Made in China” label.

Headlines in the recent weeks have once again refocused the spotlight on bad practices in Chinese brands and companies.

Just last week, Chinese officials uncovered five fake Apple stores in the southwestern city of Kunming, and suspended two of the faux outfits as investigations are underway, a local government website reported on Monday.

The investigation follows a blog post by an American living in Kunming in Yunnan province who spotted the bogus Apple stores decorated, designed and modeled to the tee as the genuine Apple stores.

The proliferation of these sort of commercial fraud and lack of quality audits highlights the slow progress the Chinese government is making in countering a system of rampant piracy and shoddy management practices. Much to the dismay and frustration of its trading partners and investors.

Equity markets are not spared from allegations of false accounting practices at Chinese companies either. Sino-Forest Corporation is the latest company from China to characterize what is fast becoming a truism: for Chinese companies listed abroad through reverse takeovers, short selling can prove to be massively profitable.

Instead of attracting investors the conventional way, which is through initial public offerings, many Chinese companies listed on North American stock exchanges have opted for the backdoor route by buying over near-defunct shell companies.

Known as reverse takeovers, or RTO, this strategy provides Chinese companies a comparatively easier access to financial markets, without the strict scrutiny and filing requirements that initial public offerings are subjected to.  

In the case of Sino-Forest, analysts are split over whether Sino-Forest is a fraud. After a report by little known advisory firm Muddy Waters, sensational accusations were raised that Sino-Forest allegedly inflated its earnings and assets, and Sino-Forest saw its stock price fall by almost 75% from a high of $25.85 in March, wiping off more than $3 billion in paper value.

When it comes to reverse takeovers, it is difficult to gauge if companies are well-intentioned or unscrupulous businesses aiming for a quick shot at stock exchange listings.

According to a Bloomberg monitor, Chinese reverse takeovers more than tripled from March 2009 to January 2010. But the numbers do not reveal the list of Chinese companies suspended for securities fraud.

A study conducted by GovernanceMetrics International Inc. found that 60 per cent of North American listed Chinese companies had poor accounting practices. And the numbers simply do not add up.

“There has been a huge explosion of cases in the last quarter,” says Andrei Rado, plaintiff layer at Milberg LLP. Milberg suing Chinese companies Puda Coal and China Integrated Energy.

“The fraud that Enron and WorldCom committed in the 90s and early 2000s was more sophisticated. These guys are much bolder in what they do. Some of these companies are a complete sham,” Rado said.

Chinese authorities are also starting to get concerned. “I hate these scandals, everybody hates them … the scandals are very damaging for the reputation of all Chinese companies in the US,” said Liu Qingsong, deputy director of the research centre of the China Securities Regulatory Commission.

The key question then is whether investorsshould, or can, believe the numbers from Chinese companies.

As a major world economy today, Chinese regulators know fully well that haphazard and flippant accounting practices will no longer be tolerated as auditors move towards adopting internationally recognized accounting standards.

At the risk of coming across as a quasi Ponzi scheme, foul play and fraud committed by companies bearing the Chinese emblem potentially damages investor confidence.

But ultimately, the moral of the story is as Paul Dietrich, chairman of Foxhall Capital Management, aptly concludes;

“The account issue is not a new problem. I have been investing in China since the 80s and we would see five different sets of audits. You have to do your due diligence. If you think you can rely on audits, you’re fooling yourself.”

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