Can We Trust Financial Reports of Chinese Companies?

It's déjà vu all over again as the famous philosopher Yogi Berra once said. The Securities and Exchange Commission in the U.S. has sued yet another China-based company and two of its executives, charging them with lying to investors about the value of the company's assets and how it used $120 million in proceeds from its initial public offering on the Nasdaq. In a complaint filed on April 23, the S.E.C. also charged that the chairman of the company, SinoTech Energy, secretly siphoned $40 million from the company's account at the Agricultural Bank of China last summer.

I have previously blogged about accounting and ethics problems at Chinese companies such as Longtop Financial. The legal action against SinoTech, an oil field services company de-listed by the Nasdaq in January, is the latest example of a continuing crackdown on accounting fraud and other financial crimes at Chinese companies listed in the United States. The S.E.C. also charged 11 investors in AutoChina International, including a senior executive and director, with market manipulation. The Commission also secured a court order freezing the assets of six Chinese citizens and an offshore holding company after accusing them of insider trading in the shares of Zhongin Inc, a pork processor based in China.

In its complaint against SinoTech, the S.E.C. charges that the company “grossly overstated the value of its primary operating assets,” including hydraulic drilling equipment. The company claimed in its listing document it would spend $120 million on such equipment, but the Commission found that it bought less equipment than it said it would, lied about the equipment it did buy and overstated the value of its purchases by nearly fivefold in its financial statements.

The S.E.C. alleged that the chief executive, Guoqiang Xin, 47, and the former chief financial officer, Boxun Zhang, 35, were behind the equipment purchasing fraud. In addition, the Commission accused the company’s chairman and controlling shareholder, Qingzeng Liu, 50, of stealing $40 million from a company bank account and lying about it to investors.

SinoTech Energy raised $167.8 million in an initial offering on the Nasdaq in November 2010. The company caught the attention of regulators after it was criticized last August in a negative report. The company’s auditor, Ernst & Young Hua Ming, resigned in September.

Many questions exist about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises.  Questions continue to be raised about the value of those statements to investors looking to obtain a piece of the growing Chinese economic pie. For the most part, accounting rules are ignored; financial disclosures lacking; and transparency seems to be a word not in the disctionary of Chinese companies.

An important point 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 April 27, 2012