Chinese Accounting: Cooking the Books

by Crocker on June 18, 2012, 8:26 am

in Economics,Politics

Doing business in places like China and Russia can be an interesting experience. Going in you really must expect a certain ‘through the looking glass’ quality, particularly when you get down to nitty-gritty matters like financial accounting. With many others, I’ve wondered whether we can rely on any financials received from Chinese or Russian companies, particularly those that are state-run.

In Russia, for example, business people know enough to say, “US-UK GAAP” on demand, but generally don’t have a clue what this means in practice. Worse, they really don’t understand – or care – that western regulators take these numbers very seriously and businesses rely on them when making long and short-term decisions. In the business I’ve done in China – particularly with state-owned businesses – I’ve long suspected the same. And when you want to publicly trade your securities on U.S. exchanges, the accounting has to be fairly immaculate.

Now, Patrick Chovanec has described the simmering crisis in Chinese accounting that threatens Chinese companies’ ability to continue trading on U.S. exchanges. Chinese accounting is apparently quite as bad as we’ve suspected.

China and the U.S. appear to be an a collision course over accounting. That’s a lot more serious than it sounds. By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”: forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec,, China Life, and China Unicom. It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Last year, the US-listed stocks of more than a few Chinese companies took a beating following accusations by short sellers and research shops like Muddy Waters that SinoForest and other companies — many of which had avoided IPO scrutiny by arranging reverse mergers with already-listed entities — were grossly exaggerating their real assets and business performance in their official financial statements. These accusations prompted the Securities and Exchange Commission (SEC) to launch several fraud investigations into the Chinese companies in question.

Rather than assisting the SEC in its cross-border probes — as other countries regularly do — the China Securities Regulatory Commission (CSRC) has actively blocked the SEC’s information requests, insisting that audit materials on Chinese firms fall under China’s ambiguous yet draconian State Secrets Law. This April, when the SEC issued a subpoena to the Chinese arm of Deloitte, demanding the audit records of Longtop Financial (which collapsed last May after Deloitte resigned as its auditor), Deloitte refused, noting that the CSRC directly ordered them not to turn over such papers. The firm argued it could be dissolved and its partners jailed for life if they were to comply. In May, the SEC responded by initiating administrative proceedings to punish Deloitte China for violating its duties under the 2002 Sarbanes-Oxley Act. Penalties could include suspending the firm’s authority to perform audits for US-listed companies, which are required under U.S. securities laws. Apparently similar subpoenas have been issued to each of the other “Big Four” global audit firms (E&Y, KMPG, and PWC), and have met with similar replies.

But the Chinese are apparently doubling down, suppressing internal company filings that are ordinarily public. You see, outsiders can glean these filings and assemble a pretty accurate picture of what’s really going on.

In the meantime, Chinese regulators have been moving to exert even greater secrecy and control over companies’ financial information. Local bureaus of the State Administration for Industry and Commerce (SAIC) have started restricting public access to domestic corporate filings, after short sellers and analysts used information gleaned from those filings to call company financial statements into question. Of more immediate concern, the Ministry of Finance is following through on plans to force the “Big Four” global audit firms to surrender majority control of their Chinese operations over to local CPAs, and dramatically reduce the number of foreign-certified CPAs they employ.

Read it all.

While there may be some glimmers of hope that this very real crisis can be averted, it depends on whether the Chinese government can change a culture of secrecy in favor of financial regulation and transparency that the rest of the world expects.

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