The phantom collateral that rocked Qingdao has left the metals market worried and uncertain, and raised serious questions about accountability and transparency in Chinese firms. What some observers haven’t acknowledged is that the methods used to secure the multiple loans are neither particularly new nor innovative. Whereas corporate malfeasance in the West can take the form of labyrinthine arrays of special purpose entities and porous contracts, Chinese accounting fraud tends to be relatively straightforward deception. Thanks to loose and opaque accounting practices, there’s little need for multifaceted networks of half-truths; simply inventing an entry in the books usually suffices.
It wouldn’t, however, if the companies took more a proactive management attitude.
The Qingdao scandal came to light when a corruption probe in Qinghai’s capital, Xining, came across questionable dealings at Dezheng Resources’s subsidiary, Decheng Mining. The central government happened to be investigating a business partner of Xining’s Party secretary. As is common knowledge by now, the allegations are that Decheng took out multiple loans on the same collateral. To outside observers, this seems like something that should have been avoided with a fairly routine warehouse check, but it’s not an uncommon trick. Real Gold Mining suffered in a similarly reckless way in 2011, as the company’s mines were used as collateral for the owner’s private loans, a fact that went unnoticed by their third-party auditor despite it having being a matter of public record for over a year.
Another example is the pig and animal feed company AgFeed Industries Inc., where it was discovered senior management had simply been keeping an outside book for years, falsifying numbers to manipulate their stock price and reported nearly $239 million in fake revenue. In the absence of adequate oversight, the deception wasn’t discovered until this year, despite having been going on since 2008. Their US-based executives, having already overcommitted to their Chinese partners without checking if the numbers matched reality, compounded the issue further by trying to perpetuate the cover-up.
Multinational companies are facing the consequences of having little representative or physical presence in China to keep an eye and report on obvious discrepancies. Many have relied on independent teams from the big auditing firms to conduct their reviews for them, but they’re often left to the mainland member firms, with the final audit sign-off coming from Hong Kong. When ordered to look at a foreign-traded company, these auditors run into a legal grey zone; the central government may or may not have classified Chinese company accounts as state secrets. When the SEC ordered the Big Four to turn over working papers, they refused for fear of angering Beijing, which resulted in the Chinese member firms’ six-month ban back in January. The third-party auditors can’t make up for strict internal overview on the mainland.
Companies operating in China could take a more aggressive stance from the get-go to avoid accounting nightmares and alleviate fraud risk. In the case of companies trading in physical goods, stocks should be checked thoroughly; warehouses have been known to rent supplies for the day to convince visiting auditors that the numbers are correct. China’s informal network of unofficial suppliers can also create nightmares for auditors; documentation and a serious vetting process should occur before any business dealings take place. Strict regulations in place for revenue recognition are imperative, and they should be crystal clear to everyone. After this latest scandal, double-check and verify receipts to make sure they haven’t been falsified.
Most importantly, companies should foster a corporate environment where employees are willing to blow the whistle, knowing they will have the full support of the management. Internal audits should occur regularly, but it’s important to have a plan in place for the minute a red flag is raised internally or externally.
Accounting fraud in China is pervasive, but it’s not particularly insidious. Clear and concrete accounting rules and management policies can nip the majority of scams in the bud. Those who fall afoul are usually the ones who were overeager and rushed in too quickly, only to find out the warehouses had been standing empty for months.
Editor’s note: this is a guest post by Michael Laridan, from accounting firm DX Consulting]
Sources:
https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370541102314#.U9HxSICSy_0
https://www.sjgrand.cn/alleviating-fraud-risks-china
https://uk.reuters.com/article/2014/06/13/china-qingdao-idUKL4N0OS1XO20140613
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