Last month I wrote a post where I pointed out two cash confirmation plays – situations where I thought that the allegations of fraud would be disproven if the auditor was able to successfully confirm the recorded cash balances using the extended procedures that most firms are using today. Both situations have now failed. Longtop Financial Technologies failed first when Deloitte resigned after a series of incidents that are dramatic enough for a screenplay.
Yesterday China-Biotics failed its cash confirmation test when auditor BDO resigned. China-Biotics is alleged by BDO to have put a new spin on cash confirmation issues. Rather than get the complicity of the bank, China-Biotics is alleged to have set up a fake bank website. From BDO’s entertaining resignation letter, it appears that China-Biotics was tripped up when it gave BDO a fake bank statement on which it had miscalculated interest income. BDO must have known they were on to something when the client then produced a “corrected” version. NASDAQ has already commenced delisting procedures.
From recent discussions I have had with auditors I believe that most accounting firms have instituted enhanced cash confirmation procedures which will make it much more difficult for these types of frauds to remain undisclosed in the future. We may still see some more frauds disclosed in the coming week as calendar year end foreign private issuers rush to file Form 20F by the June 30 deadline. Companies with fiscal years ending after December 31 will likely be subject to the new expanded audit procedures and that may flush out a few more frauds. I think we are likely nearing the end of the cash fraud scandals and the fraudsters will have to come up with some new tricks.
We have few details about the extent of fraud at any of the long list of companies that have fallen to the cash confirmation scandals. It will take some time before this information is available, if ever. The shareholders have paid a huge price, with all of these companies being delisted or in the process of delisting from the exchanges.
I will go out on a limb here, and predict that most of these situations will not involve any embezzlement by management. The cash is not missing because management stole it; it is missing because it was never there. What I suspect has happened is that management has faced earnings that were not going to meet expectations, so they juiced them up a bit by recording some sales that did not exist. That made shareholders happy, but in several cases attracted the attention of short-sellers who thought the margins were too good to be true. They likely were, caused by the company recording sales without any corresponding cost of sales. As a result, some portion of sales is false, but the rest of the accounting could be accurate. While there may be a few complete frauds out there, many of these companies might have real, profitable businesses that have real value. Whether shareholders ever see any of that value is uncertain, since the process or working through these fraud allegations may well destroy what is left.
While I don’t think it is likely that management embezzled the cash, I also don’t see that they have benefited from the fraud on the market caused by inflated stock prices due to inflated earnings. I have not seen a situation where insiders have tried to cash out by selling shares into the inflated earnings. This may come out in time, but I think the problem here relates to a more fundamental risk with Chinese listings.
I think many Chinese companies have listed in the U.S. because the CEO wants the prestige of a U.S. listing. It has become quite prestigious in China to be a NASDAQ or NYSE listed company. Some communities in China will give awards to companies that succeed in doing so. In some listings, I have questioned the motives of the founders in taking the company public. Some may need to do an IPO to provide an exit for the venture capital investors, but many raise significant amounts of proceeds which simply sit in the bank accounts since the company generates sufficient internal cash flow to fund future growth. Some of these IPOs may have been done mainly to feed the ego of the CEO, and that sets up the perfect conditions for fraud.
I teach a concept in my auditing classes that fits perfectly here. While there are evil people who simply set out to commit frauds, few frauds of the nature we are seeing in China start out that way. Instead, they are caused by an alignment of three factors that create conditions where good people are willing to do bad things. These three factors, known as the fraud triangle, are pressure, opportunity and rationalization.
Pressure is why most frauds occur. Many frauds happen because someone is under great financial pressure – often because of financial needs due to problems with gambling, addiction, or an out of control lifestyle. I don’t think that kind of pressure is at work in most of the China frauds. In China, I think an even more powerful pressure is in play – the pressure to maintain face. Face is important in all cultures, but in China it often rises to an existential level. A Chinese CEO, faced with disappointing financial results, might feel unbearable pressure to improve them in order to maintain his public image as a successful executive.
It is not possible to commit a fraud unless one has the opportunity to so. A CEO who decides to commit a financial fraud has significant power to alter the financial records to make it happen. Of course, the CEO fraudster needs to worry about the CFO blowing the whistle on him, and that might explain why the CFO in several of the recent cases in China was a foreigner who could not read Chinese. The CFO’s limited language and cultural skills may have also given the CEO the opportunity to execute the fraud. Opportunity also includes the opportunity to cover up the fraud. In the recent China cases this meant being able to get bank branch officials to cooperate in supplying false documents. Building guanxi with the local bank officials might have enabled that opportunity. Guanxi is a system of exchanging favors that builds mutual obligations that are difficult to refuse. Through regular gifts and business assistance the CEO might build strong guanxi with a local bank manager that would give him the opportunity to ask for fake statements and confirmations.
Many people have pressure and many also have the opportunity to commit fraud, yet most do not. The missing factor is rationalization; the act of reconciling ones behavior with commonly accepted notions of decency and trust. I am sure that in all of the recent frauds in China the CEO was able to justify to himself that his actions were acceptable. “No one will be hurt by this – the shareholders, employees and customers will all be better off.” “It is just a temporary thing, we can fix it next quarter when the results get better.” The rationalization does not have to be valid, it just has to seem valid at the time to the fraudster. As frauds continue, fraudsters usually need less and less justification to keep the fraud going.
In China’s vanity listings, I think the fraud triangle helps to explain why the frauds happen and might help to predict the next one.