National accounting systems are increasingly enmeshed with each other, as Chinese and non-Chinese firms battle for both sales and capital on each other’s territory. Chinese firms now frequently list on US stock exchanges, which often brings their Chinese auditors up against the US Sarbanes-Oxley laws. These laws require that auditors of all US-listed overseas companies be monitored by the Public Company Accounting Oversight Board (PCAOB).
Over the past two years, US-listed Chinese companies have created a wave of scandals over suspicious or outright fraudulent overstatement of revenue and profit. Investors in some of these firms suffered massive losses. Auditors of these firms were ordered by the US Securities and Exchange Commission (SEC) to hand over audit work papers to PCAOB investigators.
In the most public illustration of the problem, the SEC subpoenaed Deloitte China for the audit work papers of software firm Longtop Financial Technologies.
In 2011, Deloitte had gone to Longtop’s banks to get confirmation of the company’s cash balance – and found less cash and more borrowings than the company’s books recorded. It was soon clear that Longtop was not what it claimed to be.
John Hempton, chief investment officer of Sydney-based hedge fund Bronte Capital, was one of those who warned of problems with Longtop. (Hempton, an expert on accounting fraud, was profiled in Public Accountant’s February/March 2013 issue.) He says Longtop didn’t exist as a working business.
“There was a bunch of front rooms and if you visited them, the bank would take you around to some of their data centres,” says Hempton. “Longtop was a fiction from start to finish.”
Worse, Hempton argues, Longtop’s Chinese banks were in on the fraud.
Longtop is just one example of a wider problem. Hempton, whose investment firm makes money by short selling the stock of potential fraudsters, has himself identified a number of Chinese accounting frauds – Universal Travel Group, China Agritech, China Media Express – and helped expose several others.
In January 2013, Caterpillar said it had found “deliberate, multi-year, coordinated accounting misconduct” in a Chinese acquisition and would take a US$580 million write-down.
Another media report this year claimed allegations of accounting irregularities had affected more than 100 listings on the NASDAQ and New York stock exchanges.
Deloitte resigned as Longtop’s auditor on 22 May 2011, citing false statements about cash, borrowings and sales, as well as management interference and “unlawful detention of our audit files”.
But Deloitte refused to comply with the SEC subpoena. It claimed Chinese regulators had told auditors that handing over audit work papers would violate China’s state secrets law. It said the Chinese had threatened to dissolve the firm entirely and seek sentences up to life imprisonment for any partners and employees who participated in the violation.
In December 2012, the SEC formally charged the Chinese arms of the Big Four and BDO over their failure to hand over Longtop’s audit work papers. It has been raising the pressure on Deloitte China, in particular, ever since.
A different mindset
Paul Gillis, a professor of practice at Peking University’s Guanghua School of Management and an adviser to the PCAOB, notes the parallels between China’s current fraud issues and those of the US and Europe during recent growth phases. The 2001 Enron scandal, the biggest audit failure of all time, brought down accounting giant Arthur Andersen; the 2003 Parmalat collapse was Europe’s biggest bankruptcy. Both were the products of boom markets.
“That kind of market attracts a lot of fraudsters – because if you’re going to sell something that’s fraudulent, having a whole bunch of people who are keen to buy makes it a whole lot easier to sell,” says Gillis.
Meanwhile, he notes, western auditing and accounting standards designed for western business systems are being imposed on a nation used to different methods. “They weren’t particularly adapted to the way the Chinese do business and to the Chinese mindset,” says Gillis. “China’s business systems rely much more on trust and a lot less on rule of law.” For instance, revenue recognition is more complicated, because in China an agreement between companies relies more on “the meeting of minds of the executives” than on a formal contract.
Auditors have been learning and adapting to Chinese practices and traditions, says Gillis. “But modern accounting has only been taking place in China for the past 20 years, and that’s not a lot of time to develop really sound practices of accounting and corporate governance.”
Finally, as Gillis points out, the attempt to enforce new standards from outside revives memories of China’s ‘century of humiliation’, from the Opium Wars with Britain starting in 1839 to the Japanese occupation, which ended in 1945. Imposition of foreign standards onto Chinese accounting, he suggests, “is going to be really hard for China to swallow”.
Dr Alice de Jonge, an Asian business specialist at Monash University’s Department of Business Law and Taxation, believes economic necessity will drive the US and China to a short-term compromise on standards and enforcement. “Both will learn a bit and move forward a little bit.”
Likewise, Gillis is optimistic that Chinese anti-fraud measures will improve, albeit slowly.
His prediction: “China is going to need a few more decades before it gets up to what we might view as global standards.”
