Ethical Culture of Chinese Businesses Raise Doubts about Financial Reports

Chinese-style western capitalism has been spreading to virtually every continent as China seeks to form joint ventures in Africa, South America, and elsewhere to ensure reliable access to needed natural resources to feed China’s hunger for economic growth and development. In recent years it has spread its “currency reserve wings” into the US through Chinese state-owned and private enterprises. The question for the investing public is whether Chinese financial statements can be relied on and, correspondingly, whether Chinese businesses can be trusted as they flex their economic muscle. A good example of the perils of outright trust is Sino-Forest Corp., a Chinese company that was 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.

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". I've also looked at regulation of Chinese companies doing business in the US. In this blog I look at a recent event where the Big-4 international accounting firm, KPMG, withdrew from the audit of a Chinese company because it couldn't trust the information provided for those reports.

Just last week it was announced that after issuing a “disclaimer of opinion” with respect to China Forestry Holdings’ financial statements for the year ended December 31, 2010, KPMG has opted not to stand for reappointment as the company’s auditor. KPMG resigned as auditors of the Company as of January 5, China Forestry disclosed to the Hong Kong Stock Exchange.

First, let me dispense with a disclaimer of opinion. According to generally accepted auditing standards, an auditor should not issue such an opinion unless the firm has been unable to gather a sufficient amount of credible evidence to support the numbers in the financial statements prepared by company management. KPMG’s disclaimer “was due to the irregularities we identified during our audit and limitation in the scope of our work,” KPMG told the company in a letter.

Scope restrictions are a valid reason for a disclaimer. I’m more concerned about the former – irregularities found during an audit. My concern is not so much from an audit opinion perspective but whether the ethical culture of Chinese companies is such that American investors should follow the old adage when contemplating investment in Chinese companies – “buyer beware”.

Returning to China Forestry, the company describes itself as “one of the three largest, privately-held, naturally regenerated and plantation forest operators in China”. On its website, it claims to own and operate more than 171,000 hectares of forest land in Yunan and Sichuan provinces. It reported a loss of RMB2.7 billion (US$429 million) in 2010, in the report that KPMG issued a disclaimer of opinion.

The company admitted that for the 2011 financial year, KPMG asked that “a number of other matters will need to be resolved”. These are verification of the ownership and valuation of plantation assets, valuation of lease prepayments, valuation and ownership of inventories of logs and related sales and purchase transactions, and estimation of payables for plantation assets and taxation matters. In other words, the accuracy and reliability of all company financial statements are in doubt. China Forestry had apparently not come through on these demands, resulting in KPMG’s decision to resign.

When I look at the way Chinese companies are run I am not surprised by the increasing level of disclosure of financial wrongdoing. I find that Chinese companies have not built a strong ethical base in their state-owned and private companies. Chinese companies are not used to being questioned about what they do and why they do it because they existed so long under the Chinese communist system where the government ran the businesses. Moreover, secrecy is an important value in Chinese society so their perspective is to disclose as little as possible about a company’s financial status. Contrast that with the full disclosure notion for US companies and you can see why there is what I call a “believability GAP” in Chinese financial reports.

In the US and all western-style capitalist nations, internal controls are the bedrock of accurate and reliable financial reports. In China, the notion of internal controls has yet to take hold as questions of management about their controls can meet with stares of mistrust about the motives of an auditor who questions the believability of the financial statements.

The next great financial scandal may be waiting in the wings with respect to financial statements by Chinese businesses. In a sense the expansion of capitalism and potential for greed is one step ahead of developing and enforcing rules to prevent such occurrences and creating the kind of ethical culture that helps to prevent fraudulent financial reporting.

Blog posted by Steve Mintz, aka Ethics Sage, on January 9, 2012