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Are VIEs a going concern?

One of the cornerstones of accounting is the concept that a business is a going concern.  Financial statements are premised on the assumption that a business will continue to operate for the foreseeable future.   That is important because the recovery of the value of the assets on the balance sheet usually is premised on their being used in the business and not sold at liquidation value. 

Auditors are required to assess whether there is substantial doubt about a companies ability to continue as a going concern.  Ordinarily this assessment centers around the issue of whether a company has sufficient resources to meet its obligations as they come due without a major restructuring.   Auditors are to look forward one year from the date of the financial statements in making this assessment. 

When auditors conclude that there is substantial doubt about a companies ability to continue as a going concern, they are required to include an explanatory comment in their opinion on the financial statements.  That opinion is commonly referred to as a going concern opinion, and the issuance of such an opinion usually sets off an alarm in the financial markets.  A bankruptcy filing often happens within days. 

Explaining VIE structures

This posting will explain the use of variable interest entities (VIEs) by U.S. listed Chinese companies.  I have selected E-Commerce Dangdang, Inc. (NYSE: DANG), which listed on the NYSE late in 2010, as an example of how the VIE structure is used.  I have selected Dangdang because it follows the archetypal model for VIE structures, not because it has any higher or lower risks than other companies using VIEs. 

Offshore holding companies. Like most U.S. listed Chinese companies, the actual listed company of DangDang is a Cayman Islands corporation.  After the IPO, founders Peggy Yu and Guoqing Li controlled 44.1% of the voting power of the company.   

Chinese companies that list in the U.S. mostly use a foreign incorporated company as the listed company. The exceptions are large former state-owned enterprises like PetroChina or China Life, which list the Chinese incorporated parent company. The foreign parent companies are usually incorporated in the Cayman Islands because it is a favored location for offshore companies due to its tax-free status and established legal system that is built on English law. Some companies have used corporations formed in the British Virgin Islands or the U.S. U.S. holding companies are usually a poor choice, since this brings the corporate group into the U.S. tax net. Such arrangements are usually an accident of history –  the founders having started the company in the U.S. or used a reverse merger with a U.S. shell company.

PCAOB reports on reverse mergers

On March 14, 2011, the PCAOB released a research note on reverse mergers in China.  The purpose of the note was to provide context for the concerns that were raised in Audit Practice Alert No. 6.   This alert indicated that some U.S. registered accounting firms may not be conducting audits of companies with operations outside of the U.S. in accordance with PCAOB standards.  

The note was prepared by the PCAOB’s Office of Research and Analysis (ORA) and identified 159 companies from China that came to market in the U.S. through reverse mergers.  It  found that U.S. based accounting firms audited 74% of the reverse mergers, while China based firms (including Hong Kong) audited 24%.  The research note makes no policy recommendations. 

The note is focused on the reverse merger market, and accordingly does not provide any information about the much larger (by market capitalization) market of companies that have come to market through traditional IPOs and which are typically listed on NASDAQ or the NYSE.   It also limits the data to companies that came to market between January 1, 2007 and March 31, 2010. 

A call to action: Plugging the regulatory holes

China MediaExpress Holdings, Inc. (NASDAQ: CCME) reported that its registered independent accounting firm, Deloitte Touche Tohmatsu (DTT) has formally resigned as of March 11, 2011.    CCME CFO Jacky Lam subsequently resigned.   CCME had been under attack since February 3, 2011 when Muddy Waters Research issued a report alleging that the company was a fraud.  Muddy Waters and other short sellers have created a cottage industry outing fraudulent Chinese companies listed on U.S. exchanges.  

According CCME’s press release, Deloitte advised the company that it was no longer able to rely on the representations of management – code words that suggest that management was less than truthful in statements made in the all important representation letter where management takes responsibility for the financial statements.  Auditors have limited responsibility for detecting fraud and rely heavily on management integrity when they conduct their audits.   If you cannot trust management, you cannot trust the financial statements. DTT also told the company that it recommended that certain issues encountered during the audit be addressed by an independent investigation. DTT's resignation letter also stated that these issues may have adverse implications for the prior periods' financial reports and that, in their view, further investigatory procedures would be required to determine whether the prior periods' financial reports are reliable.  The  company has launched the necessary investigation and says their annual report might be delayed a month or more while they work through that and find a new CFO and auditor.  Good luck with that. 

The emperor's new suit: VIEs in China

“But he has nothing on at all,” said a little child at last. “Good heavens! Listen to the voice of an innocent child,” said the father, and one whispered to the other what the child had said. “But he has nothing on at all,” cried at last the whole people. That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself, “Now I must bear up to the end.” And the chamberlains walked with still greater dignity, as if they carried the train, which did not exist.

Hans Christian Andersen, The Emperor’s New Suit, 1837.

Ever since China opened up to the world in 1978, investors have fallen into the trap of treating China like a fairy tale.  “China is different”, they say as they proceed to check their experience and logic at the border and accept claims that the normal rules that operate everywhere else in the world do not apply in China. Many have left China with their tail between their legs, having taken a terrible beating for making fundamental business mistakes. 

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