Luckin Coffee Fraud | China Accounting Blog | Paul Gillis

Luckin Coffee Fraud

Luckin Coffee (Luckin) has taken the spotlight as the largest and perhaps most audacious Chinese fraud yet. On April 2, Luckin said that Chief Operating Officer Jian Liu and some subordinates might have faked more than $300 million in revenue, more than a quarter’s worth of reported sales. Luckin’s NASDAQ traded stock collapsed from $50 per share to $3 per share and faces likely delisting. 

The company says the fraud was in three quarters of 2019. If the fraud extends to 2018 it could mean the original IPO was fraudulent with serious consequences for the company, auditors, and investment bankers.  

Luckin’s auditor is the Chinese member firm of Ernst & Young, Ernst & Young Hua Ming. Normally auditors are silent when their clients are accused of fraud.  EY issued an extraordinary statement regarding Luckin, essentially saying they found the fraud. PCAOB standards formerly included this statement, although it was removed in a later revision: The auditor has an ethical, and in some situations a legal, obligation to maintain the confidentiality of client information. 

In the United States, state laws generally require auditors to maintain confidentiality. EY Hua Ming is not a CPA firm under any state, and it is unknown whether audit partner Lei Yang is a U.S. CPA. EY Hua Ming is subject to Chinese auditing standards which have similar rules. 

It is understandable that EY Hua Ming wanted to deflect criticism of their audit and cast themselves as the hero for finding the fraud, but should they have breached client confidentiality by commenting? After the initial comment on the Luckin fraud, an EY insider disclosed to Yicai that the company came clean after EY brought in an anti-fraud team. I suggest that relevant authorities, including the PCAOB and CICPA, and potentially the Hong Kong Institute of CPAs and the jurisdiction where Lei Yang is licensed should examine the situation to determine if any standards have been violated. 

Today Bloomberg has a report on Luckin that Representative Brad Sherman, a Democrat, said when he introduced his version of the Holding Foreign Companies Accountable Act (HFCAA) in the House: “Had this legislation already been signed into law, U.S. investors in Luckin Coffee likely would have avoided billions of dollars in losses.”  I strongly disagree with Sherman. I don’t the HFCAA would have altered the result at all. If the HFCAA pushed China to allow inspections, the inspections would not have found the problem since they are done in arrears.  The apparent reality of EY finding the fraud during its 2019 audit indicates that the audit process was working.  Now, if it is found that the fraud extends to 2018 all bets are off. 

I believe, without proof, that the Big Four accounting firms in China are following PCAOB standards in their audits and the inspections will have a marginal benefit. Of course, the PCAOB finds faults in many audits and they will undoubtably find problems with some of the Chinese audits. I believe that the firms are tuned into this issue and have mitigated the risk to investors through intensive internal inspections of audits.  

Another interesting aspect to the Bloomberg article is the disclosure that Luckin’s CFO is a foreigner who is still onboard. Many investors have taken comfort in the presence of a foreign CFO, but some of the most audacious frauds have taken place under foreign CFOs (Longtop Financial Technologies, Douyuan). I theorize that these frauds were enabled by the weak language and cultural skills of the CFO which allow others to defeat internal control processes. 

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