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.
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.
The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.