Caterpillar announced last Friday that it had uncovered accounting misconduct at a recent Chinese acquisition and that it would be taking a non-cash $580 million goodwill impairment.
In June 2012, Caterpillar had acquired ERA Mining Machinery Limited (ERA), a Cayman Islands company listed on Hong Kong’s GEM market. ERA’s operations were mostly conducted through Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. (Siwei). ERA had gone public in Hong Kong through a reverse merger.
Caterpillar says this about the scandal:
Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition. This review is ongoing.
Parsing that statement suggests three accounting problems:
1. Missing inventory. This can happen if inventory is not expensed as cost of goods sold when it is sold. That can result in a major distortion to financial statements if revenue is recorded without the associated costs.
2. Improper cost allocation. This might be capitalizing costs into inventory that should have been expensed as incurred. That can defer the costs until the inventory is sold, or indefinitely if the practices suggested above took place.
3. Improper revenue recognition. Early and unsupported revenue recognition is a persistent problem in China. Revenue recognition standards, developed in the West and based on Western business practices, fit like a square peg in a round hole when applied in China. Western standards usually require signed contracts, while Chinese practices are often based more on personal relationships. Often revenue that Chinese executives consider to be “in the bag” cannot be recorded under Western standards because all of the paperwork is not complete.
Caterpillar’s write-off of goodwill is a curious response to the problems.
I would expect to see a write-off of inventory. If it is missing or overvalued because of improper capitalization it should be written off. The improper revenue recognition should result in a write-off of receivables.
Goodwill is impaired when the value of the business is less than its carrying value. The value of the business is usually determined by forecasting future cash flows. Caterpillar’s huge write-off suggests that it has now concluded that the cash flow forecasts for Siwei have been reduced, probably because they were based on the bad revenue and profit numbers in Siwei’s historical financial statements.
Fingers are being pointed at Caterpillar’s due diligence processes and there is a report that Caterpillar’s board (Jon Huntsman joined the board during the acquisition) was preoccupied with other matters. Caterpillar says it has a rigorous and robust process that includes Caterpillar personnel and outside accounting, legal and financial advisors.
RSM Nelson Wheeler in Hong Kong audited ERA. While PwC is Caterpillar’s auditor, I have heard that another Big Four firm did the financial due diligence on ERA. I am not going to name that firm until I get confirmation.
We will undoubtedly hear much more about the due diligence process. I would be highly surprised if the customary due diligence procedures conducted by Big Four firms uncover these kinds of problems with any degree of reliability. Due diligence is viewed by many corporate executives not as a means to evaluate acquisitions but rather as a form of career insurance should anything go wrong. Fees are often beaten down to levels where the investigating firms are unlikely to find anything but the most obvious problems. Certainly this is not appropriate for any Chinese acquisition. Boards should demand a lot more from due diligence for Chinese acquisitions, particularly where the target was audited by a small firm and came to market through a reverse merger. Due diligence procedures need to be significantly expanded in these high risk situations, and should include forensic audit procedures that are rarely included in a typical due diligence engagement.