China’s Shady Accounting Practices and Bad Apples

In 2008, the National General Administration of Quality Supervision, Inspection and Quarantine raised the flags when a pediatric urologist noticed a boost in the number of children afflicted with renal system stones, a rare condition. Mounting fears and inquiries causally traced the source to then-popular Chinese infant milk powder, Sanlu, which was discovered laced with melamine.

Sanlu Group, a Chinese dairy produce company, based in Shijiazhuang in Hebei province, was found guilty and was ordered bankrupt after an estimated 300,000 infants fell ill – and at least 6 died from the tainted milk scandal.

This episode captivated what was perhaps the first wave of widespread international problem and skepticism over quality assurances in the “Made in China” label.

Headlines in the recent weeks have once again refocused the spotlight upon bad practices in Chinese brands and companies.

Just last week, Chinese officials uncovered five fake Apple stores in the north western city of Kunming, and suspended two faux outfits as research are underway, a local government website reported on Monday.

The investigation follows a blog publish by an American living in Kunming in Yunnan province who spotted the bogus Apple stores decorated, designed and modeled to the tee as the genuine Apple stores.

The proliferation of these kind of commercial fraud and insufficient quality audits highlights the sluggish progress the Chinese government is making in countering a system of rampant piracy and shoddy management practices. Much to the dismay and frustration of its trading partners and investors.

Equity markets are not spared from allegations of false accounting practices from Chinese companies either. Sino-Forest Corporation is the latest company from China to characterize what is quickly becoming a truism: for Chinese businesses listed abroad through change takeovers, short selling can prove to be enormously profitable.

Instead of attracting investors the conventional way, which is via initial public offerings, numerous Chinese companies listed on North American stock exchanges have opted for the backdoor route by buying over near-defunct shell companies.

Known as change takeovers, or RTO, this strategy provides Chinese language companies a comparatively easier use of financial markets, without the strict analysis and filing requirements which initial public offerings tend to be subjected to.  

In the case of Sino-Forest, experts are split over regardless of whether Sino-Forest is a fraud. After a statement by little known advisory firm Dull Waters, sensational accusations were raised that Sino-Forest allegedly higher its earnings and property, and Sino-Forest saw its stock price fall by almost 75% from a high of $25.85 in March, wiping off more than $3 billion in paper value.

When it comes to reverse takeovers, it is difficult to evaluate if companies are well-intentioned or unscrupulous businesses aiming for a quick shot at stock exchange listings.

According to a Bloomberg monitor, Chinese reverse takeovers more than tripled from March 2009 in order to January 2010. But the numbers do not reveal the list of Chinese companies suspended with regard to securities fraud.

A study carried out by GovernanceMetrics International Inc. discovered that 60 per cent of North American listed Chinese companies had poor accounting practices. And the numbers simply do not accumulate.

“There has been a huge explosion of cases in the last quarter,” says Andrei Rado, plaintiff layer at Milberg LLP. Milberg suing Chinese companies Puda Coal and The far east Integrated Energy.

“The scams that Enron and WorldCom committed in the 90s and early 2000s had been more sophisticated. These guys are much bolder in what they do. Some of these information mill a complete sham,” Rado said.

Chinese authorities are also starting to get concerned. “I hate these scandals, everybody hates them … the scandals are very damaging for the reputation of all Chinese companies in the US,” said Liu Qingsong, deputy director of the study centre of the China Securities Regulatory Commission.

The key query then is whether investorsshould, or can, believe the numbers from Chinese companies.

As a major globe economy today, Chinese regulators know fully well which haphazard and flippant accounting practices will no longer be tolerated as auditors move towards adopting worldwide recognized accounting standards.

At the risk of coming across as a quasi Ponzi scheme, bad play and fraud committed by companies bearing the Chinese emblem potentially damages investor confidence.

But ultimately, the ethical of the story is as Paul Dietrich, chairman of Foxhall Capital Management, aptly concludes;

“The account issue is not a new problem. I have been investing in China because the 80s and we would see five different sets of audits. You have to do your due diligence. If you think you can rely on audits, you’re fooling yourself.”