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A level 2 problem

Muddy Waters continued its assault on U.S. listed Chinese companies with an attack on NQ Mobile. As is typical of short seller attacks, Muddy Waters has made a number of allegations, but the one that has been filing up my inbox relates to a disclosure of cash and short-term investments. 

This is the table from NQ Mobile’s 20F that has everyone worked up. You will find a similar one in every financial statement.   


What got Muddy Waters worked up was a comparison of this table to the prior year’s table.

As you can see, NQ Mobile has moved its cash and cash equivalents from Level 1 to Level 2 in 2012 and did not tell us why. That is a self-inflicted wound since an explanation probably would have headed off this part of the Muddy Waters attack. Instead, Muddy Waters suggests that the change implies the cash might have been diverted and is not there. 

Financial assets like cash and short-term investments are reported at fair market value on the balance sheet, rather than at their original cost. This valuation is done at every balance sheet date, and the assets are “marked to market” to reflect the current valuation. Differing approaches to doing this led to great confusion during the financial crisis of 2008, and the FASB and IASB conformed US GAAP and IFRS in 2011 to get consistency. Included in those reforms were expanded disclosures about how investments were priced, and it is those expanded disclosures that are getting all the attention in China today. 

Four new IPOs and forex problems

We have had several Chinese companies file for IPOs in the US recently. 500.com is an online sports lottery company.58.com is China’s copy of Craigslist. Sungy Mobile is mobile internet, mostly games.Qunar Cayman Islands is similar to Kayak. 

Auditors of these companies are:

500.com           EY
58.com             PwC
Sungy Mobile    KPMG
Qunar               EY

Deloitte won none of these engagements although it previously had the largest market share by number of companies. Some private equity people have told me that they have been avoiding Deloitte for fear that their SEC problems might get in the way of a timely offering. The problems that the Big Four are having with the SEC get extensive coverage in the risk factors, with three of them saying that if the SEC acts against the China Big Four, they will not be able to file financial statements and may be delisted. I was pleased to see that KPMG signed Sungy’s report using its mainland affiliate, breaking from its former practice of signing these reports in Hong Kong. The mainland affiliate does the audits; it needs to sign the reports. 

SFC proposes audit regulatory reforms

The Securities and Futures Commission (SFC) in Hong Kong has released a report on independent audit oversight. I have been calling for reform of Hong Kong’s notoriously weak system of audit regulation and this is a welcome development. 

Hong Kong has retained a system of self-regulation of the profession by the Hong Kong Institute of CPAs. The rest of the world learned its lesson after the Enron scandals of the last decade and toughened the oversight of auditors by putting in place independent regulators. Hong Kong accountants succeeded in preserving control of the process by conceding only to symbolic reforms. With the rise of the importance of the Hong Kong Stock Exchange to world financial markets and the increasing number of accounting frauds in Hong Kong and China, reform of the oversight of the accounting profession is critical. 

SFC retained Deloitte to prepare the report. While I had concerns about the letting the fox guard the henhouse, Deloitte has done a commendable job. The report is fair, and calls for the reforms that I think are necessary. 

PCAOB deal with Hong Kong?

PCAOB Chairman James Doty told 21st Century Business Herald (China’s leading business paper) that the PCAOB is negotiating with Hong Kong for access to do inspections of Hong Kong accounting firms on work related to Chinese listings. A deal to allow inspections in Hong Kong could provide a way out of the impasse between U.S. and Chinese regulators. If the audits of U.S. listed Chinese companies are signed by the Hong Kong member firm a deal might allow the working papers to be inspected. The problem with this kind of deal is that it requires both the CSRC and the PCAOB to turn a blind eye towards what is actually happening. 

Mainland authorities have blocked the PCAOB from coming to Hong Kong to inspect audits of companies with mainland operations. Hong Kong regulators must have been given permission by the mainland to have these negotiations, and that signals that mainland regulators are searching for a way out of the problem.

In addition to the PCAOB standoff over audit inspections, Hong Kong’s Securities and Futures Commission is in a court battle with Ernst & Young over its refusal to turn over working papers in the Standard Water case. I am surprised that case has not already been resolved. In May, Chinese regulators reached a deal with the PCAOB for access to working papers in connection with investigations, and I have thought that deal would have led to a similar deal with SFC by now. Hong Kong's weak regulatory system for accountants does not include inspections. 

Are you serious?

China-Biotics has been one of my poster children for accounting frauds in China. It blew up in 2011 after it was attacked by Citron. At the time, I observed that with 54% of its assets in cash, the proof would be in whether the auditors were able to confirm the cash balances.  

A month later auditor BDO resigned after they discovered that the company had sent them to a fake bank website to confirm the cash balances. There have been a number of problems with bank confirmations for Chinese companies, but this was probably the most audacious. 

The SEC suspended trading in the stock and in February 2012 an administrative trial judge revoked the company’s securities registration for failing to file annual reports. The SEC has revoked the registration of many Chinese companies when they “go dark”.

What is unusual about China-Biotics is that unlike most other deregistered Chinese companies it did not just disappear. An appeal was filed against the SEC action. The company found a new auditor, Weinberg and Co., a small CPA firm based in Boca Raton, Florida. Weinberg audits a number of Chinese reverse mergers. Its most recent PCAOB review found deficiencies in four of five audits reviewed that were so serious that the PCAOB concluded that Weinberg had not obtained sufficient competent evidential material to support the opinion on the issuer’s financial statements. That is about as bad as it gets in a PCAOB report.  PCAOB disciplinary procedures are so slow it could be years before Weinberg faces accountablilty for those audits. In the meantime, investors in their clients are exposed.

SEC slays accounting firm

On September 30, 2013, the SEC threw the book at a small U.S. based accounting firm because of a deficient audit of a Chinese reverse merger that had found its way onto NASDAQ. The auditor, New Jersey based Patricio and Zhao (P&Z) and partner John Zhao, have been banned from auditing U.S. listed companies for three years.

The audit in question was for Keyuan Petrochemicals Inc. which had completed a reverse merger and later upgraded its listing to NASDAQ. It has since been kicked off of NASDAQ and is traded on the pink sheets. P&Z was its initial auditor. According to the 2010 PCAOB inspection report on the firm that was issued in 2012, P&Z audited 12 U.S. listed companies. 

On January 17, 2011, Keyuan fired P&Z and hired KPMG. After the accounting frauds began to appear in mid-2010, many U.S. listed Chinese companies tried to upgrade auditors to the Big Four to provide confidence to skittish investors. Many of those “upgrades” did not end well for anyone. More often than not, the Big Four firm was unable to complete an audit, leading to the delisting of the company. That appears to have been the case here. 

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