Tuesday, July 12, 2011

China frauds: In (partial) defense of the auditors

The most common question I get asked about Chinese frauds by journalists (and even more by class action lawyers) is where were the auditors?

The class action lawyers are particularly interested in that because it is going to be very hard for instance to collect from China Media Express or Longtop (both probably overwhelmingly fraudulent) but it will be relatively easy to collect from Deloitte who audited both. (That presumes that liability can be attached to the auditor...)

Deloitte audited Longtop for six years giving a clean bill each time before the amazing auditor resignation announcement. Surely - or so the journos and class action lawyers say - they were negligent in their previous (clean) audit statements?

Starr Asia (Hank Greenberg's vehicle) is suing Deloitte for their audit of China Media Express.

The class action lawyers (and presumably Hank Greenberg) will not like my answer. I have told the class action lawyers that they can put me on the stand as a witness if they want - but my testimony will be supportive of Deloitte. That answer surprises them. But here goes:

Imagine you were auditing China Media Express. This is a company that claimed to have video screens showing adverts on twenty thousand buses. Buses by their nature (they move) would be scattered all over China. You can't physically audit the buses.

They sell adverts to maybe 15 advertising agencies. The company gives you - the auditor - contacts at all of those agencies. You ring the contacts. They confirm the contracts, the receivables and the like.

None of this would have spotted the fraud. After all the buses are impossible to audit and the particular advertising agencies are say 15 out of 3000 in China.

The way that you would really conduct this audit is match the business against bank statements. The company claimed roughly 30 million dollars per quarter of profit. An auditor verifies a sample of transactions and verifies the total. Finally they verify the cash balance.

If the bank statements contained verification of all your sampled transactions and in aggregate showed 300 thousand flowing into the accounts per day and 170 million in accumulated cash then you would have verified the business.

To be thorough the auditor would normally get the bank statements from the bank and not from the company. After all the company could provide you fake statements - it is unlikely the bank would.

Audit is a process. If you (a) sample the requisite number of transactions and (b) verify the key totals with creditors and banks you have done your duty. Indeed provided you actually verified the bank statements with a major (and presumably reputable) bank then you have met the audit standard.

The shock of Longtop and China Media Express is that the banks appear to have been in on what appears to be fraud. In both cases Deloitte went to the bank head office (not the local branch) and double-checked the bank statements. And in both cases this caused the apparent fraud to come crashing down.

The critical revelation is that the bank was in on the scam. If the bank is in on the scam it is possible for the auditor to conduct all the standard tests and do all their duty and sign-off completely dodgy accounts in good faith.

And when a fraud is exposed it is possible that no liability accrues to the auditor.

I can point to (several) examples where I think auditors are culpable. I can think of several audit firms that should cease to exist when the China frauds are all exposed. But those individual cases are not the rule.




John

PS. If this level of corruption is pervasive in Chinese banks then we are all looking in the wrong place for the next crisis. The next crisis comes from China.

25 comments:

Anonymous said...

John,
we have known for some time now that the level of bad debts in Chinese banks is quite high. Having read your post, I'm now inclined to think that they're probably much higher than the already high numbers!

The big question is what kind of trigger could cause this house of cards to collapse. I think the high levels of economic growth have helped smooth over the cracks, but that's not sustainable. Considering comments, thoughts and actions of senior Chinese officials, it would suggest that complicity goes to a very high level.

John.

But What do I Know? said...

Good points, JH. People sometimes forget that auditors are not criminal investigators--they are not trying to find fraud or put anyone in jail. As long as all the paper matches they will give the company a clean bill of health, and never bother that the paper might be fraudulent.

John Short said...

There was this guy who went to Shanghai to buy for a million dollars this expensive crane.
He saw it, he bought it, he went that night to celebrate. The next day it was gone. The money was gone the crane was gone.
He went to the harbor police. Crane was stashed in a warehouse on the dock. Police wouldnt help. Police knew the suspect.
So what happened? It turns out the shanghai harbor police were accomplices of the crane theft.
Terrifying story. This guy was then in the hole for 1 million or so.

Interesting fact, this guy was a shrewd businessman. He went to dubai, made millions, made deals even in russia. All succeeded, but he had never been scammed so bad, as in China.

Anonymous said...

I guess it depends on how you define the auditors. Firstly, the auditors should work for the shareholders, not the company - and as such, I'd expect them to be very aggresive. The problem is, that it's the company that pays/retains the auditors (to me, board and company is pretty indistinguishable in most cases, shareholders usually not being able to exercise that much control over either).
So, maybe the way to change this, is to change how the auditors are expected to work, and make them to be much more aggresive. So for example, stuff like Muddy Waters report would be a basis for negligence charges (as a lot of it was in the statement, and if checked more than cursory would be found wrong).
Of course, aggressive auditors may put shorts out of business ;)

Tom said...

I'd argue that the standards for an acceptable audit are too low. The way audits are run now, they do not test the legitimacy of an audit's earnings, but merely the *consistency* of management's claims.

Every audit should be a partial forensic audit. Dedicate, say, 10% of the team to channel checks, competitive analysis, etc. to see whether the results are plausible (rather than consistent).

The Catholic Church had the right idea when they employed a devil's advocate during the canonization process. Now that there's no one to argue the other side, they're popping out saints like they were sausages.

WellRed said...

Maybe it's my xenophobia, but the more I read about China, the less I believe in the Chinese miracle.

Clearly when you have a country with negligible capital per capita, there is enormous room for growth over the long term - to deny that would be downright irresponsible.

However, I see two enormous structural headwinds to China's growth: 1) The centrally planned economic policy and the misallocation of resources which results; and 2) Case after case of blatant fraud that authorities are either actively involved in, or at best unwilling to punish.

Beginning with economies with very significant central planning. The sheer number and size of SOEs in China, and the government's influence over the credit allocation decision of "private banks" is all the evidence I need of a very large problem.
It is inevitable that in a centrally planned economic system, capital is too frequently misallocated as a reward to those in positions of power, rather than to enterprises where the capital would reap the highest returns. At best this lowers trend growth, at worst, a whole lot of (very) bad debt ends up on government books. This is already happening - Michael Pettis recently wrote about this.

However, the paragraph above oversimplifies China's situation. Clearly the Chinese economy is not a command economy, there is (very substantial) private investment. However, in order for private investment to be sustained, the rule of law is a prerequisite. A lot of big players are getting killed in China(Paulson, Greenberg, Yahoo!, Deloitte, the list goes on and on), at a seemingly accelerating pace. It is the accelerating pace that disturbs me. At what point does preservation of capital trump the lure of high returns in China? When does it no longer become worth the risk to deploy capital? Perhaps when returns on capital start picking up in developed nations (should that ever come to pass)? Perhaps a bunch more scandalous frauds emanating from China?

China is not the first country to embarass foreigner and enrich the local elite in the process. The practice used to be known as nationalization. We all know how that ended (I hear the Venezuelan economy is booming). If the rampant corruption and fraud continues to go unpunished, China will become a pariah to international investors. I don't see us as close to this tipping point yet, but China's leadership had better start paying attention because the combination of declining foreign investment and egregiously poorly allocated state resources and declining foreign investment would be cataclysmic for China's investment-fuelled growth.

Bottom line, these charlatans projecting 10% growth in China for the next 30 years are in for a pretty rude awakening.

Sorry for the how raw (and verbose) thoughts expressed above are, but I didn't have time to craftily word my argument.

Anonymous said...

The problem is that Chinese simply don't operate to western standards and don't understand why anyone would. They are corrupt by nature. Having sais that , it doesn't mean anything is going to come crashing down. Pining for the old days of American compitence in economics isn't going to change the fact that the wealth has been transferred to china. They have the cash and are not going away.

Dannish said...

In the auditor's letter, it specifically states that fraud is an issue auditors do not guarantee against. (Even in the US, it is very easy for companies to commit fraud.) The auditors liability does not extend to catching fraud unless it is blatant and they knew about it.

The question that DTT faces in court is over a 6 year period, should DTT have seen fraud? Was it blatant? Should they have known about it? Should their analytical audit tests told them something is wrong?

The lawyers say that the analytical tests should have raised a warning flag because after all, that's how shorters figured it out.

DT will simply say it isnt their responsibility (as stated in their letter) and they performed sufficient audit procedures. Interesting implications to this case if it goes the way of the lawyers.

Zimmer said...

As a former securities lawyer, I agree that in some cases, there can be fraud and the auditors won't be liable.

In general, the auditors will on the hook unless they can show they reasonably believed the financials were true, after reasonable investigation. The reasonable investigation part will hang many of the auditors.

Anonymous said...

John,

I understand if it is not possible for you to answer this queation directly, due to possible legal issues, but can you give any insight into which firms should be banned from the auditing profession?

Brooks said...

"PS. If this level of corruption is pervasive in Chinese banks then we are all looking in the wrong place for the next crisis. The next crisis comes from China."

So, what to make of Australia, as Oz is a significant raw materials exporter to China....

Anonymous said...

China is a massive Ponzi scheme. There is no doubt in my mind of that. Local govt authorities, banks, property developers... they all need to keep it going. John is correct to ask what the catalyst is, and when. But I think better to position early as when the sh1t really hits the fan, it will be the mother of all meltdowns. I think Hugh Hendry, Jim Chanos, etc will be proven right while Anthony Bolton will turn out to be very late to the party. I have puzzled as to why the China bulls have remained so adamant; the domestic A share market in my view clearly peaked in Oct 2007 and is still more than 50% below its highs despite massive money printing. I think the stock market has been telling us something. Rebase the performance of the Chinese (and HK) share indices in Gold and you can see that the stock market has gone nowhere.

-KC

Anonymous said...

China has no rule of law, it has rule of a group of people.


All conclusions should start from this very basic fact.


China is one big bubble ready to explode. Their system WILL NOT work in the long run. It is one big illusion.

They have the means to keep increasing the bubble but eventually it will be destructed.

I would not touch ANY Chinese companies, even the big ones, with a 10 feet pole.

This situation is systemic. Banks collaborate on fraud. Why would anyone think the big companies will be all clean when it is systemic like that?

Wake up.

Anonymous said...

John, in reality, every Big 4 auditors in China and in Hong Kong know about these frauds. Everyone of them knows that each Chinese companies has two books, one for the auditors and one for internal use. There were a scandal in 2009 that a KPMG fresh-grad auditor with "high ethics" smuggled the "real book" out from China and made public with it in Hong Kong. KPMG ended up settled on a class action lawsuit about deliberating ignore this "real book".

John, you may defend all you want on how's innocence these auditors are, but I heard more than enough of this frauds and practices from my Big 4 auditors friends in Hong Kong.

Anonymous said...

Consider the case of the failure of Alliance Bank, Kazakhstan's 3rd largest bank, in 2008. It carried on its books USD1 bn in Treasuries -- enough to carry it through its troubles; enough, that is, until that 1 bn of treasuries turned out not to have been there. Deloitte has never explained how they missed that one -- to my knowledge no one even asked them how they missed it. Any idea how one "misses" 1 bn of US treasuries?

In the case of the bus advert company, presumably the bank "who was in on the fraud" (i.e. provided fraudulent statemtns) would be liable?

Anonymous said...

re Alliance bank's missing 1bn treasuries:

from what is heard respective treasuries had been pledged to some CIS investment bank as collateral for loans the owners of Alliance had obtained to fund the frequent capital increases of alliance bank. when the owners could not pay, the guarantee was drawn and the mentioned treasuries were gone.

the pledge had not been disclosed to the auditor (they call that
"safe guarantee" or so in CIS, because it is not in the books, but in the safe only)

the good question to ask for the auditor but also the creditors would have been why the bank is holding such a high amount of low yielding bonds deposited abroad and funded by more expensive sources (e.g. higher yielding syndicated loans and bonds issued by the bank).

anyway, unless the auditor knew of the "safe guarantee" and was in on the scam, he probably cannot be made liable in such case

"safe guarantee" and the like is probably known in China as well, so be prepared

Caramba said...

Agree with you to a certain point. Still, one would expect auditors to adapt to the environment they operate in and look into persistent rumors and industry chatter about fraud and suspicious activity. Surely, if the auditor fails to do so early on – in an effort to keep getting paid and meet their aggressive growth targets in China – it can be argued the auditors are negligent and not doing enough to verify the companies representations. Don’t forget that the BIG4 have invested hundreds of millions into capturing growth in China.

Also, it is more prevalent in China that entrepreneurs own controlling stakes in several large private and publicly listed enterprises.

Recently, frauds have mostly been discovered by journalists and short sellers, rarely auditors. This could indicate the auditors are often complicit in participation in the fraud and therefore negligent.

In their drive to get more clients in China are auditors really doing enough? There is a case to be answered to in my opinion.

PS.
Agree with your PS.

TahoeJohn said...

There is clearly fraud in China. But strictly from a top-level cash situation they seem to be generating more cash than they are taking in. Most frauds (private and government) involve running on huge debt. Am I missing something on this front?
TahoeJohn

James Cai said...

Public companies in China have been regulated much better than them in North America, especailly regarding disclosure. For example, Sino-Forest, TSX listed, it has never disclose its ten largest customers list. In China, every public companies have to do it, no exception, no excuse.

Re Auditors' liabilities in case of fraud, I think it depends how the books were cooked. If there are big holes in the books, the auditor should be held accountable.

Re Sino-Forest, my opinion is E&Y will probably be in trouble. Please see my blog: http://jamesanalysis.blogspot.com/

Anonymous said...

John, China seems to be a bubble (or ponzi schemes, as KC put it) that originated from a convincing story (indeed, story of a very powerful demographic shift). But with the combination of (1)rampant corruption / bribery (at all levels) which has lead to (2)an accounting "sleight of hand", (3)misguided government policies, and (4)misallocation of bank credit. Mix that with complicit people and rising (real estate) prices, and you get a toxic situation. We'll see how this unfolds.
-CT

Scott said...

I agree with John in this case. The CPA firm is auditing the specific client; not it's complete network of business relationships. If the bank is in on the scam; under standard audit procedures there's no way for the auditor to detect that.

Anonymous said...

So did you tell the Class Action lawyers to go after the Chinese banks? After all they have the deepest pockets of all, and as they want to become global players and have New York branches etc. there must be a way to make them pay (or they withdraw from doing any US business). Sounds obvious.

Anonymous said...

CT... I think the demographic story has played out to a great degree. With the fall of the wall and the acceleration of globalisation, China was very well-placed to take advantage of its export-led model. However, as a consequence of the one child policy, the working age population is now falling. In fact, whereas India's population is estimated to reach 1.5bn by the end of the century, China's is forecast to FALL to below 1bn. (Note that the US population is set to exceed 400m by 2050.) There is debate as to whether it is true that 64m households in China are vacant (electricity meters never even switched on); I have no clue what the "real" number is but anyone who travels through the country will see the excess supply in housing. I could go on and on and on, but I would simply say that I believe the fundamentals are far shakier than the consensus believes, while structurally (as other posters have noted) the absence of rule of law means you have no recourse in any event. The place is the mother of all bubbles.
- KC

Anonymous said...

KC, I think we have the same conclusion. I don’t have great/reliable data on China (while on this point, I think a lack of trustworthy/reliable data will become very problematic when people start to lose “faith” in China/central government.), but I think the demographic story may have more legs.

Two points come to mind: While population is not growing, people are indeed wealthier today – and as (parts of) population crosses certain wealth thresholds, the demand for certain services/products increases exponentially (imagine a bell shaped curve shifting right). We are seeing this already (with automobile, luxury, etc.). Conversely, if the bell curve shifts to the left (potentially due to real estate or credit issues), this will have a very devastating impact. While I am nervous short term, the bell curve seems to be gradually shifting right long term. Second point to consider is where future productivity gains (which drives *real* economic GDP expansion, not your fixed asset investment type non-productive GDP growth) will come from. I agree that export-led model is over. China needs to find new productivity gains (and it is struggling) to drive its GDP. This is key – if China tries to continue to grow GDP through fixed asset investment (eg housing), this will simply fuel the next credit/bank crisis (and it is already happening) because it is unproductive; but if it can find the next way to drive productivity gains, then you get sustained economic growth and shift in wealth/bell curve which is very powerful.

Btw, take a look at a GaveKal presentation on China at John Mauldin’s investment conference posted at: http://www.mauldincircle.com/. You need to register, but I think it is interesting.

In any case, I think we agree on the conclusion. Just trying to see both sides…

-CT

Anonymous said...

Wellington and now, Richard Chandler, have boots on the ground in the region. I would say their due diligence process is more extensive than MW's.

Chandler just acquired a significant stake in SF.

He tends to invest narrow and deep and for the long term.

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