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Fraud midseason report

My post on the opening of fraud season has received a lot of attention. As a child I used to look forward to hunting season for pheasants in Western Minnesota.  Before I was old enough to carry a shotgun I would tag along with my father, and take my slot in the line of hunters who would walk through the cornfields trying to flush out the pheasants. Sometimes the pheasants would take flight in the middle of the field, but most would run along the ground until we reached the end of the field. There they would face the hunters we had sent ahead to wait for their arrival. Not many survived.  

Auditing works the same way. While some frauds are found early in the audit hunt, most are flushed out when the annual report deadline approaches and the company faces the auditor. We have seen that at work in Hong Kong where the annual report deadline is rapidly approaching. Annual results must be announced for Hong Kong listed companies by March 31 and the annual reports filed by April 30. Two likely frauds have been outed – Boshiwa and Daqing Dairy. Today, three companies were suspended from trading in Hong Kong when they announced they would not be able to announce annual results on a timely basis.  Ports Design said its auditor KPMG would need more time to audit its accounts and that the annual results would not be announced on time and the annual report might not be filed by April 20. Shirble Department Store Holdings (China) Limited was suspended from trading pending an announcement. It had previously said it was delaying its board meeting to approve the annual results by eight days until tomorrow because auditor KPMG needed more time. A lot more time apparently.  Ausnutria Dairy Corporation Ltd announced that it would miss its previously scheduled results release date of March 30. There was no indication whether the delay was because auditor Ernst & Young in Changsha, Hunan Province needed more time. There is no evidence yet that any of these situations are frauds.

Boshiwa and Daqing Dairy

Here is a guest post by John Besant-Jones. John is a recent MBA graduate from the Chinese University of Hong Kong. He has been doing extensive research into Chinese frauds.

Boshiwa and Daqing Dairy: Gone in a puff of powder!

The resignation of auditor Deloitte and subsequent suspension from the Hong Kong Stock Exchange (HKEx) of Boshiwa (which has a license for brands such as Harry Potter and Bob the Builder in China) and Daqing Dairy (formerly known as Global Dairies and supplier of milk products, primarily milk powder), represents a significant step up in the issue of accounting misstatements-and possible accounting fraud-for Chinese companies listed overseas. In the US, the well publicized accounting debacles, primarily from US listed Chinese reverse merger companies, were in part supposed to be because investors on the other side of the world had little or no knowledge about the way business is done in China, had limited or no Mandarin language ability, and had limited or no access to Chinese company management. Moreover, the listing requirements for reverse merger stocks were much looser than the standard IPO route. Short sellers are also more active in the US. Consequently, as the thinking goes, these Chinese US listed reverse merger stocks are far more prone to actual or allegations of accounting fraud.

Audit quality of the Big Four in China

I am frequently asked for my opinion as to whether audits done by the Big Four in China are equivalent to audits done by the Big Four in the United States. It is a difficult question to answer. The firms work very hard to ensure consistent audit quality around the world, particularly with respect to companies with cross border listings. Each of the firms has American partners with expertise in U.S. accounting and auditing present in China. KPMG even has a former Associate Chief Accountant of the SEC in Beijing. Without independent verification, however, it is impossible to determine whether the firms are successful at ensuring audit quality. That is why PCAOB inspections of Chinese CPA firms, especially the Chinese member firms of the Big Four (which audit most U.S. listed Chinese companies), are so important.

There has been a fair amount of academic work that usually, but not always, concludes that the Big Four have higher audit quality than local Chinese firms. Those studies are sensitive to the research methodology used. Local firms have different types of clients, and from my experience local firms tend to be more detailed and less strategic in their audit approaches. I am not aware of any studies that have compared the quality of Big Four audits of Chinese companies with Big Four audits of U.S. companies. I have been thinking about how to do that.

Deloitte bags Boshiwa as fraud season opens

Boshiwa International Holdings, the Hong Kong listed Harry Potter licensee, announced that its auditor Deloitte Touche Tohmatsu had resigned because "certain information" that it requested is "outstanding or explanations provided by the company are not to their satisfaction". It added that this "precludes the completion of the audit". One issue raised was the "existence and commercial substance of recorded prepayments of RMB 392 million with a supplier" as well as the commercial substance of recorded transactions with distributors and suppliers. 

We have heard this story before. In the last fraud season, most frauds were disclosed when auditors resigned. Few recover once the auditor resigns. Boshiwa's stock plunged 42% before trading was suspended. I will be surprised if it ever trades again. 

We are at the stage of calendar year audits where confrontations with auditors are likely to surface. For U.S. listed Chinese companies, the annual report on Form 20F is due on April 30, two months earlier than last year.  

JOBS Act enables Chinese fraud

The U.S. House of Representatives passed a modest collection of legislation collectively called the JOBS (Jumpstart our Business Startups) Act. The House passed the JOBS Act yesterday by a vote of 390-23. It is headed to the Senate where it is expected to be quickly approved.

Included in the JOBS Act is H.R. 3606 Reopening American Capital Markets to Emerging Growth Companies. H.R. 3606 hopes to reduce the costs of going public by providing companies with a temporary reprieve from SEC regulations by phasing in certain regulations over a five-year period. The bill creates a new category of issuers called an “Emerging Growth Company”, which would retain its status for five years or until it exceeds $1 billion in annual gross revenue or becomes a large accelerated filer.  The bill applies to companies that sells shares under a registration statement after December 8, 2011, or in other words, new IPOs.

The bill relaxes the IPO rules by allowing companies to omit certain disclosures and ignore certain reporting rules. Among the rules:

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