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China audit season opens

Chinese accountants are celebrating Chinese New Year this week, which is early this year, making it less disruptive to the year end closing and auditing process. That is good news, since U.S. listed Chinese companies have less time this year to publish their accounts. Recent SEC changes require Form 20F to be filed on April 30, instead of June 30, for calendar year companies.   

Auditing season will begin in earnest next week as the auditors and companies return to work. Last audit season saw a number of Chinese companies fall to fraud allegations as auditors tightened audit procedures, particularly those surrounding cash confirmations. I have talked with a number of audit partners about new procedures they are putting in place to uncover potential frauds. Most of them center on enhanced cash audit processes that do not rely on mailed in bank confirmations. Good auditors are putting unpredictable procedures into their audit routine that may trip up companies that are trying to conceal fraud.  

VIE disclosures are pathetic

Variable interest entity accounting came about as a response to the Enron scandal, where special purpose entities that were actually owned by Andy Fastow were not consolidated in Enron’s financial statements because Enron had no direct ownership, even though it was on the hook for the losses in these entities. VIE accounting was designed to force liabilities onto the balance sheet. Chinese companies use the VIE rules in a different way – to put assets (and related income) on the balance sheet (and income statement) for companies that they do not actually own. 

Companies and their advisors are clever, and over the years since Enron have found new ways to use VIEs, so the Financial Accounting Standards Boards modified VIE accounting rules in 2009 to tighten them up. The FASB observed:

Some reporting entities have entered into arrangements using VIEs that appear to be designed to avoid reporting assets and liabilities for which they are responsible, to delay reporting losses that have already been incurred, or to report gains that are illusory.

Follow the VIE agreements?

U.S. accounting standards with respect to VIEs were changed effective for years beginning after November 15, 2009 – for most Chinese companies that means calendar year 2010. The new standards require increased disclosures with respect to VIE arrangements. Fredrick Oqvist and I have been examining the 2010 disclosures on Chinese companies using the VIE structure. I will be doing a few posts about what we found. 

Many investors are rightly concerned about the proportion of assets held by the VIE and the proportion of income that is earned by the VIE. If most of the assets and income are in the VIE, a moral hazard is created for the VIE owner, since it might be in his economic interest to terminate the VIE contracts and take the VIE.   

We found a wide range of results when we looked at Chinese companies listed on NASDAQ and NYSE that disclosed this information. Assets in the VIE ranged from 0% to 100% of consolidated assets, with a mean of 33%. Net income in the VIE ranged from 0% to 221% of consolidated net income, with a mean of 56%.

Deloitte loses a round against the SEC

Deloitte lost a round in its battle with the SEC over Longtop yesterday. 

Judge Deborah Robinson of the U.S. District Court for the District of Columbia ordered Deloitte to "show cause" for not producing the Longtop working papers. The case has been tangled up in her court since October over the issue of whether Deloitte had to be served before she enforced the show cause order. She has concluded that service is not necessary.  

On May 27, 2011, the SEC staff served a subpoena on Deloitte's former U.S. counsel, who represented he had the authority to accept service of the subpoena. That appears to have been a misjudgment that resulted in Deloitte getting a new law firm. Deloitte did not appear in court in October when the SEC asked the judge for the "show cause" order. That might indicate that Deloitte now intends to avoid being served so it can try to avoid being hauled into court. That might be a good legal strategy, but it is going to hurt them in the court of public opinion. At any rate, the ball is now in Deloitte's court. Will they thumb their nose at the SEC and U.S. Courts? If they do, what will the SEC and the Courts do?  Deloitte China's right to audit U.S. listed companies, including subsidiaries of U.S. MNCs, is at stake. 

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