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.
Boshiwa and Daqing Dairy blow a gaping hole in this part of the argument. The HKEx has very strict listing requirements and tight regulations, the companies’ listings were IPOs and not reverse mergers, their operations are not on the other side of the world, and many investors and analysts based in Hong Kong have greater awareness of the local business culture, twinned with Mandarin language ability. This should enable them to be better informed, and in some cases even develop a close guanxi relationship with company management. That is proving not to be as reliable a way of protecting investors as initially thought. If I am wrong about this, then where were the “Sell” recommendations warning of these pending accounting problems prior to their announcement?
Hence these accounting problems may well be agnostic to the stock exchange the company is listed on (ie the US, Hong Kong, Singapore or Europe), its route to becoming listed (ie reverse merger or IPO), and the accounting standards used. This is because the heart of the problem is the auditing quality on the Mainland, and the willingness or ability of many analysts to blow the whistle if accounting irregularities are discovered. Auditors are starting to tighten up their act, and the banks who communicate to investors may follow, meaning further bad news announcements on the horizon.
There are some further realities to this:
1) Whilst accounting scandals for US listed Chinese companies may continue, their earlier arrival may be as much to do with the more aggressive and less tolerant approach by US investors when accounting irregularities are encountered. Moreover, it can be argued that the very strict rules based US GAAP accounting standards is more adept to uncovering potential cases of accounting fraud, compared to the principles (ie estimates) based IFRS or Chinese GAAP. In this respect, the cases in the US should be considered as a fore-runner of things to come elsewhere in the world, the tip of the iceberg to a much wider problem, rather than an isolated island.
2) Locality, mandarin language ability and guanxi work well when it comes to winning corporate mandates, they are good for gaining information from high quality companies, and these factors are especially suited for private/retail banking (a very large percentage of share turnover in the HKEx is retail investor related). However, Boshiwa and Daquin Dairy shows that this philosophy works less well when it comes to analytical ability for identifying potential fraud risk.
3) When I look at the potential accounting Red Flags in the report & accounts for Boshiwa and Daqing Dairy, I see very basic common issues from the numerous previous cases of accounting fraud for overseas listed Chinese companies that I have examined. A sharp eyed, experienced analyst responsible for the respective stock coverage who had read their filings should spotted them. Accounting fraud should have been spotted for famous US cases, but Enron and WorldCom were far more sophisticated and harder to uncover.
The alarm bells for Boshiwa and Daqing Dairy should have started to ring with their very substantial supplier prepayments and account receivables. In my research on accounting fraud in China, I have identified supplier prepayments as one of the highest risk and more common factors for potential accounting fraud. There are many other types of Red Flags that I have identified but I will focus on this one since it has been mentioned by the auditor for Boshiwa. There are a lot of credible business explanations for supplier pre-payments that make a great sense considering the unique business environment in China. However, the danger with supplier pre-payments is that they are unsecured, very hard for the auditor to verify, can be a way of disguising expenses, or lowering a false cash bank balance to a level closer to the real number by re-diverting these non-existent funds (thus escaping accusations of false cash bank balances), or as a disguised subsidized loan. At worst, it can be a siphoning of cash from the lending company to a non-existent entity. Further complications arise from supplier prepayments if they are used purely for tax avoidance (by the supplier), or between related parties (ie a real transaction of economic substance may not be deemed to have taken place).
In the cases of both Boshiwa and Daqing Dairy, the information given to date about the auditor resignations is incredibly sparse, and it is hard to conclude whether there is outright fraud or substantial financial misstatement; there is a fine line between the two. Thus one can only speculate at this stage about what is really going on. One reason why a supplier prepayment may have no “commercial substance” could be if it was effectively a subsidized loan that is not wholly economically beneficial to the lender, or that the monetary benefits from the transaction extend so far in to the future that is its value is hard to measure. In the latter situation, it is difficult to measure the value of Harry Potter goods to be supplied in one or two year’s time if there is risk that the franchise goes out of fashion. At present, it is still very hard for small to medium sized non-SOE to borrow from the banks. Hence it is not too much of a stretch to imagine a company, loaded with cheap investor cash from a recent IPO issue, wishes to strengthen its supplier relationship through financial assistance. This may seem reasonable but the problem is determining if it is a loan, or a prepayment for a business transaction, assuming that the transaction actually exists and is properly documented. Moreover, Boshiwa divested its manufacturing businesses prior to its IPO to give it a more efficient operational structure. This in itself does not create an unusual business model, but if those manufacturing businesses remained fully economically and managerially reliant on Boshiwa, and they received these supplier prepayments, then they may be considered as “quasi-subsidiaries” or related parties. In any event, there seems little point in divesting manufacturing operations to give a more efficient operational structure if huge chunks of capital are then recycled back in to those same divested businesses in the form of substantial prepayments.
If anyone has a professional interest in this, then please contact me.
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