Can We Trust the Financial Statements of Chinese Companies?

I have previously addressed the growing questions about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises. I called it “The Dark Side of Chinese Capitalism.” Questions continue to be raised about the value of those statements to investors looking to obtain a piece of the growing Chinese economic pie. In this blog I look at how Chinese companies look for ways to avoid U.S. regulators including the SEC.

China is dealing with charges of fraud in financial statements. I blogged about how U.S.-style capitalism may be infecting Chinese companies with the “fraud bug.” A good example is Sino-Forest Corp. that has been charged with allegations of accounting abuses and fraud, burning investors including John Paulson, the billionaire whose hedge fund said in June it lost $468 million on Sino-Forest.

Two reporters for Bloomberg on line, Dune Lawrence and Gary Putka, identify a common corporate structure that has allowed dozens of Chinese companies to get listed on U.S. exchanges but may run afoul of U.S. regulations. Chinese Internet companies such as Sina Corp. and Baidu Inc. have used so-called variable interest entities, or VIEs, to work around Chinese restrictions and seek foreign investors since 2000. In case you have forgotten, these are the same self-created off-balance sheet entities used by companies such as Enron to keep debt of the balance sheet and make a company look more liquid than it really is thereby misleading investors and other users of the financial statements.

The VIE structure, which allows firms to set up contractual relationships that mimic equity ownership, may carry its own risks, according to Joseph St. Denis, director of research and analysis at the Public Company Accounting Oversight Board. The PCAOB, which oversees auditors of U.S. public companies, has begun to look at VIEs’ audit implications.

“China has blocked our inspections of firms in their region, but we think VIEs are a risk area,” St. Denis said. “We can’t know, without going to inspect, how much risk they represent.” Last month, the Chinese government signaled it may create new rules for VIEs, which have helped enable the boom in overseas listings of Chinese stocks.

Reporter Tom Schoenberg points out that financial software maker Longtop Financial Technologies Ltd., disclosed that it may face SEC civil claims related to accounting abuses and whose U.S. shares have lost more than 99 percent of their value this year, used a VIE structure. The company is conducting an independent investigation into allegations made by its auditor, Deloitte Touche Tohmatsu CPA Ltd. The auditor resigned in May, saying Longtop’s chairman had admitted there was fake revenue and cash on the company’s books.

Deloitte has its own problems. Mark Lanpher, an SEC lawyer, believes the company should be ordered to appear in a U.S. Court for rejecting a SEC demand for documents related to an investigation of its former client Longtop Financial Technologies Ltd. Lanpher claims Longtop has refused to respond to a court filing seeking documents that the regulator claims are “critical” to its probe of possible fraud at the company.

The key take-away is that China must play by SEC rules if it is to audit affiliates of US companies that are subject to inspection by the Public Company Accounting Oversight Board and if Chinese companies are to list their stock on U.S. exchanges. All foreign c companies that list stock in the US are subject to such inspections. China should not be treated any differently. If China wants to be a key player and become a force in the international financial markets, then it must learn to play by the rules of regulators outside their own country even if it seems to run counter to cultural norms whereby such regulations and inspections might be interpreted as demonstrating a lack of trust in Chinese management.

Blog posted by Steven Mintz, aka Ethics Sage, on October 26, 2011