Machinery giant Caterpillar has stunned investors with an announcement it will write off $580 million of the value of an acquisition in China, after alleging the firm it purchased did not have much of the inventory that was listed on its books.
If Caterpillar’s allegations are true, it will be only the latest in a long series of foreign investors coming up against irregular accounting in China. US investors have lost billions of dollars after more than 100 Chinese companies trading on North American exchanges were delisted following allegations or findings of accounting issues. A few years ago, investors in Singapore suffered a similar spate of losses from Chinese companies which traded there.
Chinese society is not, as a rule, especially corrupt. Tourists visiting a store or restaurant in mainland China will find staff are scrupulously honest. In Indonesia, by contrast, graft is engraved into daily life. And while Chinese officials often solicit bribes, much the same thing happens in Greece.
Yet there are features of China’s political and financial system that may encourage false accounting, particularly when the victims are overseas investors.
First is the intense need China’s wealthy have to build up a nest egg of foreign currency offshore. This cannot often be achieved legally, because the government sets strict limits on how much yuan can be taken abroad. So entrepreneurs could sometimes be motivated to dress up their companies’ accounts to attract foreign investment so they have foreign currency to keep offshore.
“Often you can’t get your money out of China,” says Rod Sutton, the Asia Pacific chairman of FTI Consulting and an insolvency specialist who says he has worked on unraveling over 50 Chinese frauds in the 11 years he has been based in Hong Kong. “But an overseas listing gives you offshore money,” he says, adding, “So the inflation of assets and revenues is common in the run-up to an IPO.”
Creative accounting can sometimes also be motivated by “the race for entrepreneurs to get rich and to grow their companies quickly,” says Sutton.
Since Deng Xiaoping opened China up to capitalism in 1978, “the society has moved from agrarian to capitalist extremely rapidly,” Sutton explains. China’s sclerotic economic growth has created anxiety and a fear of being left behind, and so-called “affluenza” even affects young children.
China also regularly seems unwilling to cooperate with other countries’ law enforcers or regulators. This may give Chinese businessmen a message that accounting irregularities committed outside China may go uncovered or unpunished, says Julian Russell, the Hong Kong-based director of business risk consultant Pacific Risk.
The SEC has complained bitterly that the Beijing government will not allow it to see the books and records of delisted Chinese companies it is investigating. (China says its companies’ audit records are state secrets.) Hong Kong’s regulators and law enforcers also have no legal reach (paywall) into mainland China.
Sloppy or restricted due diligence by Western investors and their bankers, lawyers, and auditors may also encourage Chinese businessmen to indulge in creative accounting. Sometimes even the biggest names get caught. Sino-Forest, a Toronto listed Chinese company that is now bankrupt following serious allegations of accounting misconduct, was audited by Ernst & Young, and its shareholders included hedge fund supremo John Paulson.
Sutton says the “level of questioning” of Chinese companies by Western investors and their advisers is “not high enough.”
Russell is more sympathetic. He says the auditors, lawyers, and bankers who work on IPOs are “not trained as criminal investigators.” He adds that fraudulent Chinese companies will often keep two sets of books, one for the management and another for outside investors and advisors. But sometimes the Western advisers checking out Chinese companies before an overseas IPO or other foreign investment “are really outside their own jurisdiction. They don’t know the lie of the land, and they are possibly bringing in local [Chinese] advisers who may be cooperating with the subject of the investigation.”