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.
If a company is intent on committing fraud, the bank confirmation process is a major threat to their activities. If you are stealing money from the company, you can’t very well disclose that. If you are inflating revenues, sooner or later you need to move the receivables into cash or people will start asking questions. Frauds often end up with overstated cash balances. To cover up those frauds, the fraudsters need to generate fake bank statements and corrupt the confirmation process. Generating a fake bank statement is easy enough – a few minutes on Adobe Acrobat and Photoshop will do it.
Corrupting the bank confirmation process can be done in several ways. The usual way has been for the client to “help” with preparing and sending out the confirmations. Satyam was found to have perpetrated a fraud that had overstated cash balances by $1 billion. PwC India just settled with the SEC and the PCAOB over its audit of Satyam and paid a fine of $6 million to the SEC and $1.5 million to the PCAOB. The PCAOB found that PW Bangalore and Lovelock relied on Satyam management to send confirmation requests to Satyam's banks, and relied on Satyam management to return purported confirmation responses from the banks to the auditors. The same kind of failure had happened a few years earlier at Grant Thornton client Parmelet, where $4.9 billion was missing after the CFO offered to fax out the confirmation for the auditor, and then signed it himself and went to another fax machine and faxed it back. These were rookie mistakes by the auditors, and it is likely the auditors involved were very junior, and rookies are supposed to make rookie mistakes. But the partners never caught them.
China confirmation fraud
In China we appear to have a new twist on the problem. You have to read between the lines a bit here, but the rash of scandals and auditor resignations related to the bank confirmation process indicate that some local bank branch personnel may have cooperated with the fraud.
China MediaExpress (CCME) lost its auditor Deloitte and its NASDAQ listing in March. Deloitte resigned after raising issues related to the reliability of the bank confirmation process, among other things. Deloitte had requested that the bank confirmation process be re-done at the bank's head office. The company apparently refused, leading to Deloitte's resignation. This appears to indicate that Deloitte could not trust the confirmations signed by branch offices of the bank, suggesting that the process was corrupted in some way. I would agree with Deloitte’s assessment that the bank headquarters would not participate in a perpetuating a fraud, and it appears management knew that too and that is why they refused to agree, even though it likely doomed the company.
Three other recent cases illustrate that the problem is not isolated. China Century Dragon Media, Inc.'s auditor, MaloneBailey, resigned shortly after its IPO because the company was unwilling to provide authorization to the bank so that the auditor could obtain official bank records directly from the bank’s record keeping system. MaloneBailey resigned from another China client, China Intelligent Lighting and Electronics, Inc. citing accounting fraud including forged bank statements. It has not been a good audit season for MaloneBailey, who resigned from yet another U.S. listed Chinese company, NIVS Intellimedia Technology Group, Inc. because of “massive accounting fraud involving forging (the) Company’s accounting records and forging bank statements”. George Qin, MaloneBailey partner told the audience at Dealflow Media’s IPO Conference: “When the bank statements are falsified, because bank employees are providing customers with false statements, there is not much an auditor can do.”
NYSE listed China Education Alliance, Inc. (CEU) has been tormented by shortsellers alleging that it is a fraud. The company took the extraordinary step of asking its auditor, Sherb & Co., to do a midyear confirmation of cash and then provided copies of the confirmations. Investors were unimpressed, and while the reportedly highly profitable company reports cash of $2.29 per share, the stock is trading at $1.55.
The way forward
Clearly the rash of recent scandals has Chinese auditors paying attention, and some frauds that may have been going on for a while are being uncovered. I have to disagree with George Qin’s statement that “there is not much an auditor can do”. I think there is quite a bit that auditors can do.
I expect auditors have learned their lesson about maintaining control of the confirmation and not letting the client participate in the process. That does not appear to have been at the root of any of the China problems anyway. The problem seems to be the relative ease in corrupting low level branch officials at Chinese banks. The evidence from the cases cited above indicates that auditors simply cannot rely upon local bank confirmations. This is a major problem for China’s entire auditing industry, not just the small portion that serves U.S. listed Chinese companies.
China’s banking industry is dominated by four large state-owned banks, known as China’s Big Four. They are assuming considerable risk from the illegal and unauthorized confirmations and false statements being provided by branches. These banks need to put in control systems and training to try to put a stop to these activities. It is in their own interest to do so.
But there may be a more effective way to deal with this. I call for the Big Four accounting firms, the Big Four banks and the CICPA to get together to work out a system for online confirmations. The Big Four has the expertise, and ought to also have a ton of self-interested motivation to get this fixed. An online confirmation system would allow auditors, after receiving client permission, to confirm bank balances online from the headquarters database of the banks. This process would add significant integrity to China’s financial system.
Online confirmation systems are growing in popularity elsewhere in the world. In the United States, electronic audit confirmations have been adopted by more than 8,000 accounting firms and all of the Top 10 banks. China should get its roughly 8,000 accounting firms and top banks on similar system as quickly as possible.
In the meantime, I think it has become necessary for the auditors to work with the banks to develop more reliable ways of confirming balances, likely by sending the confirmations to a central clearinghouse within each bank.
Read the resignation letter Deloitte sent to Longtop for evidence supporting the above.