Audit scandals in China | China Accounting Blog | Paul Gillis

Audit scandals in China

Audit Scandals in China

by: Paul Gillis, November 21, 2010

In recent years, many privately owned Chinese companies have gone to US stock markets to raise capital.Until recently, with the development of the CHINEXT market in Shenzhen, private companies found it difficult to get regulatory approval to list on Chinese stock exchanges.Many of the US listings were accomplished using the “backdoor” method of a reverse merger, where the Chinese company merges into a publicly listed shell.According toBarron’s, there have been over 350 of these deals with a combined market capitalization of over $50 billion.Some of the better ones find there way onto the NYSE or NASDAQ, although85%end up trading on the over-the-counter bulletin boards.

China has had more than its share of accounting and auditing scandals, and two recent cases shed a little light on the possible causes.

Duoyuan Printing, Inc.

Duoyuan Printing, Inc(NYSE:DYP) is a leading offset printing equipment supplier in China that was created through a reverse merger in 2006 with a Wyoming incorporated shell.It was offered on the NYSE in late 2009 and raised approximately $42 million.From a corporate governance perspective things seemed to be going in the right direction.The companyupgraded their auditor to Deloitteon March 1, 2010 and on May 26, 2010added two prestigious independent directors, one a former American ambassador and the other a former Deloitte consulting partner.

But then the wheels fell off.In early August 2010, Deloitte audit partner Frank Li called James Zhang, audit committee chairman and informed him ofseveral financial irregularities and management control weaknesses”.The audit committee hired outside counsel and an investigation was launched.By early September, the investigation had made little progress.James Zhang reported in his resignation letter:“As our Chairman put it in the board meeting just now that maybe due to the cross culture differences between US style work and maybe because of the second tier management don’t fully understand the US listing requirements, the investigation has not progressed in the last month”. Management suggested that the company switch back to its former auditor, Frazer Frost.The Board decided to fire Deloitte even though they had not received a signed engagement letter from Frazer Frost.

According to James Zhang, the vote was 4-3. Immediately following thedecision to fire Deloitte,Mr.William Suhresigned as Duoyuan Printing's CFO (the fourth CFOin three years) and Mr.Christopher Holbertresigned as Duoyuan Printing's CEO.James Zhang resigned from the board, as did AmbassadorPaula J. Dobriansky and Ms.Naoko Hatakeyama, the former Deloitte Consulting partner.

If it was management’s intent to rehire Frazer Frost, they have not yet been successful.On November 16, 2010 the companyinformed the SECthat it was still investigating the allegations and was still in the process of hiring a new CPA firm.The stock closed at $2.78 on November 19, 2010, down 75% from its 2010 peak.

RINO International

RINO International Corporation (NASDAQ: RINO) is in the business of environmental protection and remediation in China.It merged into a Nevada incorporated shell in 2007 and raised $94 million in 2009 in an offering that landed the company on NASDAQ.In what should have been a major red flag to investors, the husband and wife Chairman and CEO of the company took $3.5 million from the proceeds in an undocumented, interest free loan.The annual report onForm 10Kreported this transaction, as well as saying that the loan might be violation of the Sarbanes-Oxley rule that prohibits loans to directors and officers and could result in civil or criminal sanctions or penalties.

On November 10, 2010, Muddy Waters Research issued a report asserting that RINO was a fraud, claiming that the company had significantly overstated revenue and that many reported customers were non-existent.Muddy Waters admitted to having shorted the stock.The stock price collapsed from $16.21 on November 9 to $6.07 when trading was suspended on November 17.

On November 16 Susan Woo, the partner at Frazer Frost responsible for the RINO account, had what appears to be anextraordinary conversationwith CEO Zou Dejun.Of the six contacts called into question by Muddy Waters, he said that the company did not enter into two of them, one was good, and there might be problems with 20% to 40% of the others.The next day, after conferring with lawyers and the board, Mr. Zou asserted that other than the two problematic contracts, all of the other contracts were legitimate and could be verified.Not surprisingly, Frazer Frost advised the company that the previously issued financial statements for 2008 and 2009 could no longer be relied upon.

As of November 19, 2010 trading in RINO shares was suspended and I expect it will be some time before this is sorted out.

Frazer Frost

Small, relatively unknown CPA firms from the United States audit many of the reverse mergers.Once they get to the NYSE or NASDAQ, however, most select larger firms.The Big Four have 85% of the audit fees of Chinese companies listed on the NYSE, NASDAQ and ASE.Eight firms, adding Moore Stephens (of which Frazer Frost is a member) BDO, Crowe Horwath and Grant Thornton, have 95% of the audit fees.

Frazer Frost was formed on January 1, 2010 through a merger of California based Moore Stephens Wirth Frazer and Tolbert (MSWFT) with Frost PLLC of Arkansas.Frazer Frost is a member firm of Moore Stephens, the 12thlargestglobal accounting network.The merger was done on a trial basis, and on November 17th,2010 it wasreportedthat Frost PLLC had called off the merger, the timing curiously close to the RINO announcements.How they will unwind the firm is unclear.

Led by Frazier Frost, Moore Stephens had climbed to fifth place among auditors of Chinese companies listed in the U.S., just behind the Big Four.Frazer Frost audited 15 Chinese companies, 1 on the NYSE, 12 on NASDAQ and 2 OTCBB, earning fees of $6.1 million.According to partner Susan Woo, she is the engagement partner on all of this work, a sizeable portfolio for a single partner.According to her firmresume,Woo has more than 13 years of accounting and auditing experience and specializes in providing financial and international tax consulting for multinational businesses.The tax work makes sense, since she has a Master of Science in International Taxation from Golden Gate University.She was licensed as a CPA in California in 1999.International tax practice is a pretty tough field by itself, so it is remarkable that she had the time to also develop the skills to audit public companies.

Frazer Frost does not have an office in China, and has no staff permanently based in China, although Woo informed me that they have staff working in China all year around.All of the staff are assigned from the California office, all are Chinese, speak, read and write Chinese, and have been educated in the US.

A 2007 PCAOB inspection of MSWFT found no issues, nor is there any indication of issues in similar 2007 inspection of Frost.Both firms were due for an inspection in 2010, which presumably would be of Frazer Frost. Woo advised me that no issues have ever been raised by the PCAOB with respect to their work in China.As Woo described the way they work, they would not appear to be among the small CPA firms the PCAOB istargetingfor not understanding Chinese and for outsourcing the audit work.

In the case of Duoyuan there is no present indication of any problems with Frazer Frost’s work.It will likely take some time to untangle the mess at RINO.Both cases, however, paint a picture of CEOs who don’t take the responsibility of running a public company very seriously. Many people complain of Chinese CEOs who want the prestige (and money) that comes from a US listing, but who intend to continue to manage the company as if they owned the whole thing.Some companies, likeHarbin Electric(NASDAQ: HRBN) (another Frazer Frost client) have announced they plan to go private.That could be a good thing.

It is difficult for auditors to uncover fraud. That is why the integrity of management is so important. Auditors must carefully assess the integrity of management, and be prepared to walk away from profitable work when they cannot trust management to be completely truthful and open with them.

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