Schooling the auditors | China Accounting Blog | Paul Gillis

Schooling the auditors


Recently, a number of Chinese companies listed in the US have come under attack by short sellers alleging fraud.  So far they have taken down one: RINO International, delisted from Nasdaq in 2010.  A great deal of pressure has come down on the auditors of these companies.


Anyone who follows the market for Chinese companies listed in the US has probably heard of Austin based investor John Bird.  Bird is credited for focusing the attention of short sellers on these stocks.  Convinced he could not effectively sue China Sky One Medical in the US because all of the companies assets were in China, Bird sued its U.S. based auditor MSPC. “I just got pissed off, and I’m a stubborn man,” he says.  Frazier Frost clients ended up on a list of short seller's  targets after RINO failed. Auditors are back in the limelight in two other cases.


CCME and Deloitte


China Media Express (Nasdaq CCME). CCME traded at $22.81 on January 27, but plunged to $11.09 on February 3 when Citron Research declared it  “Too good to be true”.    Muddy Waters, the firm that brought down RINO, announced on February 3 that it was initiating coverage on CCME with a strong sell recommendation.  The stock closed at $14.42 on February 18.  With a price earnings ratio of six to one, I think we can fairly state that the stock is mispriced.   If the allegations are true, it should be worth much less; if false, it should be worth much more.  Unlike most of the other firms that have been alleged to be frauds, CCME is audited by a Big Four firm: Deloitte.


In an unusual development, someone has taken a new approach: setting up a web site to tell the auditors how to audit.   Deloittewatch.com takes Deloitte to school on the workings of SAS 99: Consideration of Fraud in a Financial Statement Audit.  The authors do an excellent job – in fact I would give them an A in my advanced auditing class!


Deloitte should be currently engaged in the audit of the calendar year 2010 numbers for CCME which should be reported in the near future. After the cajoling by Deloittewatch.com,  I think we can expect that there will be few stones unturned in this audit. I am confident that Deloitte will not sign unless they are comfortable with all of the issues raised by investors.  


Some commentators are claiming it matters which Deloitte affiliate signs the audit report.  In my view this is not much of an issue.  Deloitte on the mainland and Deloitte in Hong Kong operate as a single firm under common management, even though they are separate legal entities and are subject to different regulators. (the audits of U.S. listings like CCME fall into a regulatory hole).  In my view, there is no meaningful difference between an audit signed by Hong Kong or China – the work is likely done by the same people in either case.   People ask me regularly whether I think the Big Four in China is any good.  I think they are actually quite good. Since all the IPO action has been in China the past few years, many of the partners and managers in China have more experience with IPOs then their U.S. based colleagues. 


Because the firms have a fairly short history in China, Big Four partners here tend to be younger and there is a shortage in China of “no hair – grey hair” partners who bring the judgment that only comes from years of experience.  The firms have compensated for that by bringing in some senior partners from the U.S. to help with U.S. filings.  Is the quality as good as in the U.S.?   That is hard to say.  As I mentioned, many of the engagement partners are fairly inexperienced.  But the quality is definitely higher than if the U.S. firm tried to do these same audits, since the teams have the language and cultural skills essential to understanding these businesses. 


Audits rely on the client’s representation that their financial statements are accurate.  Auditors test these assertions by verifying key numbers by seeking out supporting evidence.  While auditors are on the lookout for fraud, it is actually quite difficult to find.  However, the types of frauds some of these Chinese companies are accused of perpetrating, where most of the business is supposedly fabricated, are near impossible to do and keep going.   One of the all time notorious frauds was ZZZZ Best, where records were fabricated in a manner similar to that which is alleged here.  That fraud fell apart when a Big Four firm was appointed to replace a sole practitioner.   Bernie Madoff's companies were audited by a sole practitioner.  Be very careful with Chinese companies audited by tiny auditors. 


Where is the cash?


Chinese companies have raised enormous piles of cash in IPOs, yet they often have little use for it because the business generates all they need.  As a result, cash is often the biggest item on the balance sheet.  From an auditor’s perspective, cash is the easiest and scariest asset to test.  


Audit procedures for cash are built around the independent confirmation.  The auditor sends a confirmation to the bank, which responds verifying the balance. This work is often done by the most junior of staff, because it is easy, but it can result in spectacular audit failures if it is not done right.  Most importantly, the auditor must maintain control of the confirmation.  You cannot ask your client to send out the confirmation or receive it when it comes back.  That prevents the client from providing a false confirmation.

  

Recently a Chinese company under attack took the extraordinary step of releasing copies of the bank confirmations.  China Education Alliance (NYSE: CEU) filed an 8K with the SEC  on December 2, 2010 that included photocopies of bank confirmations.   The SEC filing claims that CEU's auditors, Sherb & Co., LLP performed the confirmation procedures. 


There are some issues with the confirmations:  


1. We have no way of knowing what procedures Sherb & Co. LLP used in obtaining the confirmations.  The company states that staff members from Sherb’s Beijing office performed the procedures.  

2. It is extraordinary for an accountant to allow its name to be used in this manner with the SEC without actually issuing an agreed upon procedures report.  If they issued such a report, why wasn’t it submitted?

3. According to the confirmation, Sherb’s Beijing office appears to be Sherb Consulting LLC Beijing Representative Office.   As a separate company, this entity should be registered with the PCAOB, and it is not listed as registered. 

4. Most of the confirmations are not signed.  They all have chops, the red rubber stamp that is ubiquitous in China, and which is easily forged. 


Unfortunately, confirmations are easily forged in China.  Even if the auditor keeps proper control of the confirmation, they are usually being sent to low level personnel at branch banks who might easily be corrupted.  I have spoken to some Big Four partners this week who are saying they plan to test large balances by actually sending someone to the bank to look at the balance on the computer screen. That helps, but it does not necessarily disclose whether the balance was pledged as collateral for a loan.


What really is needed is a reform of the confirmation process in China.  It needs to be centralized in the bank away from any of the people with customer relationships.  They audit firms should be able to do electronic confirmations directly with bank headquarters.  China loves paper based systems, but paper is not working to protect investors in this area. 


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