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Auditing cash in China

A reader wrote to me a few weeks ago asking that I post an article about the auditing of cash in Chinese companies. †Cash has always been viewed as one of the easiest things to audit. My 800 page auditing textbook devotes only 15 pages to auditing cash. †Only one of those pages discusses the most critical step in the auditing process – the independent confirmation of bank balances. †Cash is the first section they let you work on as a new auditor. †Once you can find your way to the bathroom and back by yourself, you don’t usually ever have to work on it again. ††

But as easy as it is to audit, cash is the most important account for the integrity of the financial statements. †Business is all about deploying cash and bringing it back in, so cash is at the heart of any business, and any financial statement. † If you don’t have the accounting for cash right, it is pretty much impossible to have anything else right.†

The most important step in the auditing of cash is the independent verification of the balance with the bank. †Most audit work on cash is done working from the bank statement. Auditors generally (they are not required to do this if the risk is perceived to be low), will take the year end balance from the bank statement and put it on a separate standard confirmation form. † The confirmation form is then sent to the bank. †The bank signs the confirmation form and sends it back to the auditor. †The balance matches 99.999% of the time – after all the auditor picked the number off the bank statement. † But it is an important step, it verifies that the bank statement had the correct balance on it. † The actual cash that goes on the balance sheet is rarely the amount in the confirmation, since it needs to be reconciled with outstanding checks and deposits, but the confirmation gives a solid starting point. †

First VIE IPO after Buddha Steel

We may get a clue this week as to what China really thinks about VIE structures. On March 28, 2011,†Buddha Steel†pulled a $38 million offering that was to land the RTO company on Nasdaq and also advised investors not to rely on its financial statements after Hebei officials found its VIE agreements invalid. †

Internet data center operator 21Vianet is scheduled to debut on NASDAQ on Thursday, April 21, 2011. †The company hopes to raise $138 million. †The company uses the archetypal VIE structure for all of its operations - substantially the same structure that was used by Buddha Steel.

What we will learn on Thursday is whether the Buddha Steel case was a harbinger of the demise of VIE structures or just an aberration. †If the deal is allowed to go forward ( and assuming that Chinese officials are paying attention) it would appear that the Buddha Steel case may have been a local decision, or perhaps instead an initiative that was targeted at the scandal prone†reverse takeover companies.†

Statistics on VIE usage

I am pleased to turn the blog over to Fredrik ÷qvist for this post. †Fredrik was an exchange student from Sweden at Peking University last year and, like many exchange students (and more than a few readers I bet), he has stayed on in Beijing. Anyone who needs a good VIE analyst can drop Fredrik a note at:†

Paul Gillis

In this post I will present statistics about the usage of variable interest entities (VIEs) by US-listed Chinese companies. †In preparing this information, I have reviewed the annual SEC filings of 230 Chinese companies listed on the NYSE, NASDAQ and the ASE. †I have not included any OTCBB companies in this analysis, although many of these companies also use the VIE structure.†

Table 1 illustrates that 42% of U.S. listed Chinese companies use the VIE structure. †The VIE structure is used by more than half of NASDAQ listed companies, with fewer companies on the NYSE and ASE using this structure.

A separate analysis of 2010 listings indicates that the use of VIEs is increasing. †47% of 2010 NYSE listings (9 of 19) used VIEs, while 65% (10 of 16) of 2010 NASDAQ listings used VIEs.

Cleaning up the VIE sector

Buddha Steel, Inc. (OTCBB:AGVO) filed an 8k on March 28, 2011 reporting that it had terminated the agreements with its variable interest entities (VIE) because local government officials in Hebei Province had informed them that the agreements contravene current Chinese management processes related to foreign invested enterprises and, as a result, are against public policy. Buddha Steel was in the process of doing a $38 million underwritten public offering that was pulled. † The company announced that its financial statements should not be relied upon and announced it would not file its 10K on time.†

Buddha Steel was organized like many U.S. listed Chinese companies, particularly those that operate in markets (like steel, internet, and education), that are off limits to foreign investment. †Buddha Steel was a U.S. company that did a reverse merger with Gold Promise, a Hong Kong company. The actual operating assets of Buddha Steel, however, were in a Chinese company, Baosheng Steel. †Because Chinese law prohibits foreign ownership of Baosheng Steel, it remained owned primarly by Buddha Steel’s Chinese CEO and his family. † Similar to many other deals in industries restricted to foreign investment (and increasingly in unrestricted industries) Baoshen Steel and the CEO entered into a series of agreements to effectively transfer control of Baoshen Steel to Buddha Steel. † These agreements allowed Buddha Steel to consolidate Baosheng Steel in its financial statements as a VIE.†

PRC challenge to VIE structures

There is a significant development with respect to the use of variable interest entities in China. †Buddha Steel, Inc. (OTCBB:AGVO) filed an 8k on March 28, 2011 reporting that it had terminated the agreements with its VIEs because local government officials in Hebei Province had informed them that the agreements contravene current Chinese management processes related to foreign invested enterprises and, as a result, are against public policy. † Readers of this blog†will be aware that the government holding VIE agreements invalid was one of the two ways I saw VIE arrangements blowing up. †I was not aware of this case when I wrote that.†

The company also advised that their previously filed financial statements should not be relied upon. † The company was in the process of doing a $38 million underwritten public offering that has now been pulled. †Obviously, the company is no longer a going concern.

Thomas M. Shoesmith of Pillsbury Winthorp Shaw Pittman LLP has an analysis of this situation on the Pillsbury website. †He speculates this might be a one-off event driven by local facts and circumstances. †If not, investors in U.S. listed Chinese companies are in for quite a ride.†

The reverse merger problem

Anyone who follows the market for U.S. listed Chinese companies cannot have missed the growing number of accounting and auditing scandals, mostly with companies that have listed in the U.S. through reverse mergers. †Most of these scandals are still unwinding, but the rash of auditor resignations and delayed annual reports indicates we have not yet seen the end. † Clearly, the situation demands regulatory action, and I am encouraged by increasing numbers of SEC investigations. †I am hearing on the street that the SEC comment letter process has become more frequent and rigorous. †Comment letters are where the SEC staff send questions to the company and demand responses. †Often comment letters result in restatements of financial statements or amendment to annual reports. † All of this becomes public in time, but it will be a few more months before we understand the scope of what they are doing.†

There needs to be a robust debate in China and in the U.S. about the many scandals that have come to light in the past year. †From a public policy viewpoint, is it really appropriate for small Chinese companies to seek capital in the U.S., or should they be strongly encouraged to do it at home? †Should the U.S. raise its standards for listing at least as high as China’s to discourage the weaker companies from taking what they now perceive as the easier route to a public listing in the U.S.? †Should China be allowing companies to so easily circumvent their rules related to foreign investment in prohibited sectors and offshore listings? †How can U.S. and Chinese regulators work more closely together to police these markets? †This is an important debate that needs to be held, yet hopefully it does not become overly politicized in the run-up to elections in the U.S. †It will be tempting for politicians to turn this into a China bashing exercise, which will make it all the more difficult to find the cooperative solution between the U.S. and China that is needed.†

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