On May 23, 2011 Longtop Financial Technologies (NYSE:LFT) announced that Deloitte Touche Tohmatsu (DTT) had resigned in a letter dated on Sunday, May 22, 2011. LFT’s CFO had resigned the previous Friday. The company has been under attack by shortsellers and the stock has been suspended from trading for the past week. The company also announced that the SEC has begun an investigation. In its letter of resignation, DTT said it resigned as a result of, including other things (1) the recently identified falsity of the Company's financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of LFT management in DTT's audit process; and (3) the unlawful detention of DTT's audit files. DTT further stated that DTT was no longer able to rely on management's representations in relation to prior period financial reports, that continued reliance should no longer be placed on DTT's audit reports on the previous financial statements, and DTT declined to be associated with any of the Company's financial communications in 2010 and 2011. It does not get much uglier than that. It is amazing that we have yet another company with huge cash balances apparently falsifying bank confirmations.
The problem for DTT is that they have had three ugly situations in the past year. Duoyuan Printing (NYSE:DYP) fired DTT on September 13, 2010 after having hired DTT only a few months earlier in an attempt to upgrade auditors. DTT apparently asked too many tough questions that DYP did not want to answer. DYP has been unsuccessful at finding a new auditor and the NYSE has delisted them. DTT never signed a report on DYP. With three major frauds in a year, DTT clearly needs to take a hard look at its client acceptance processes.
Deloitte was also the auditor for China MediaExpress (NASDAQ:CCME), which is now looking remarkably similar to LFT. Shorts went after CCME on the same basis as LFT – the results were too good to be true. DTT had difficulty confirming cash balances at CCME as well, and resigned when management would not allow them to confirm the balances with bank headquarters. And, like the LFT situation, DTT had signed off on prior year accounts.
DTT may have some explaining to do. It is difficult for auditors to find fraud, yet their audit procedures this year seem to have done exactly that. There is no evidence yet that DTT is at fault, even though it signed off on previous accounts for both LFT and CCME. I am sure the SEC and the PCAOB would love to sink their teeth into DTT’s work papers for the prior years, but they likely will not be able to do so because China will not let them come and do it on grounds of national sovereignty. The PCAOB and China have been negotiating for a solution, and the Chairman of the PCAOB indicated he is hopeful that an agreement can be reached this year.
In my academic writing, I call this situation a regulatory hole. It is a consequence of the globalization of capital markets and the national nature of regulation. The audit work on CCME and LFT fell into a regulatory hole where neither Chinese nor U.S. regulators are effectively providing oversight. Investors have lost a lot of money, and it is uncertain whether justice will be seen. It is high time for regulators to find a solution.
Will greater regulatory effectiveness help prevent situations like CCME and LFT? Indirectly, I think it will. I think the firms have improved audit procedures and that is one of the reasons all these frauds are suddenly coming to light. But the active presence of regulators will encourage the firms to spend more on quality control and to bring in experienced partners who can zero in on the real risk. And, they can also bring some form of justice to investors who have been wronged.
Deloitte's resignation letterreads like a screenplay. The problem appears centered around the bank confirmations. There must have been considerable terror in the audit team that was held hostage. Such behavior is a felony under Sarbanes Oxley, but the U.S. will most likely be unable to prosecute.
It is reported here that Oppenheimer has downgraded VanceInfo (NYSE: VIT) and Camelot (NYSE:CIS) because it has limited confidence in financial statements for Chinese IT services companies that have been audited by Deloitte. Similarly, William Blair predicts fallout from Longtop to affect other Deloitte clients, including CIS, VIT and IsoftStone (ISS) and Hi-Soft Technology (HSFT).
I expect the other three members of the Big Four will be talking to each of Deloitte's clients in the next few days. I am not certain what IPOs Deloitte has in the pipeline right now, but I am sure they are seriously considering making a switch.