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Killing a chicken to scare the monkeys

There is a well-worn Chinese proverb that you must kill a chicken to scare the monkeys (杀鸡猴). Regulators commonly follow this proverb with a highly publicized prosecution meant to send a message to others to reform.

This week the SEC threw the book at Moore Stephens Wirth Frazer and Torbett LLC (MSWFT) and managing partner K. Dean Yamagata. The SEC found that MSWFT’s engaged in improper professional conduct in connection with its audit of China Energy Savings Technology, Inc (China Energy) in 2004 and 2005. China Energy was delisted from NASDAQ in 2006 and has been the subject of SEC prosecutions through 2009. There were two main problems. The SEC found that MSWTF should have exercised heightened skepticism over revenue recognition. Significant portions of revenues were discovered to not exist. In addition, MSWFT was found to have impaired its independence by performing the calculation of earnings per share. It is the company’s responsibility to do these calculations for the auditors review. When the auditor performs the calculation, it ends up auditing its own work and that is considered a violation of independence rules. This is a common problem in China because companies often do not have the skills required to do complex calculations like earnings per share and income taxes.

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