FTI: Financial Statement Frauds - Chinese-Style (Presentation)

Association of Certified Fraud Examiners

Catherine Williams, Senior Managing Director

Forensic Accounting and Advisory Services

June 20, 2012

Financial Statement Fraud – Chinese style

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What Do These Companies All Have In Common?

http://en.wikipedia.org/wiki/File:Worldcom-logo.png

http://en.wikipedia.org/wiki/File:AdelphiaLogo.png

http://en.wikipedia.org/wiki/File:Enron_Logo.svg

http://en.wikipedia.org/wiki/File:Global_Crossing_logo.png

http://en.wikipedia.org/wiki/File:Logo_akai.png

http://en.wikipedia.org/wiki/File:Parmalat_logo.svg

Heightened public concerns over corporate fraud

Recent wave of accounting scandals in China and Hong Kong

Increased media/research analyst/short-sellers’ scrutiny

Trading suspensions/halts/delisting of Chinese firms on the HKSE and

overseas stock exchanges

Securities class action lawsuits

Regulatory inquiries/prosecutions

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Recent Developments

Reverse Mergers (U.S. & Canada)



Reverse Mergers (U.S. and Canada)

Sino-forest Corp (TSE, listed in 1995)

Lost C$3.3 billion (US$3.3 billion) of its market value after the research firm Muddy Waters accused the

company of fraudulently overstating its revenue and timber holdings. Delisted by the Toronto stock

exchange in May 2012. The company filed for bankruptcy protection last March and announced its plan

to be sold or restructured. The OSC recently commenced fraud proceedings against former senior

executives.

ChinaCast Education Corp (NASDAQ, listed in Oct 2007)

Company halted trading for failure to file its annual report for the fiscal year ended December 31, 2011. In

March 2012, the former CEO was ousted in a battle for shareholder control and for allegedly preventing

Deloitte from auditing the company’s books. One month after the event, the new executive team

discovered that the company seals for the Chinese subsidiaries were missing. Under Chinese law, the

seals are necessary to enter into contracts, conduct banking businesses, and take official corporate

actions.

Longtop Financial Technologies (NYSE, listed in Oct 2007)

Company delisted in August 2011. SEC charged the company for failure to file the current and accurate

financial reports. The auditors Deloitte resigned in May 2011. citing concerns about the accuracy of the

company’s financial records and bank and loan balances. It was reported in the media that some Chinese

banks may be complicit in the fraud. The SEC subsequently filed a subpoena enforcement action against

the auditors in Shanghai for failing to produce the audit work papers.

Accounting Scandals

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Red Chips (Hong Kong)

Real Gold Mining (HKSE, Listed in Feb 2009)

Suspended from trading in May 2011 after the local newspaper reported that the miner had filed one set

of accounts with the stock exchange and a much different one with the Mainland authorities. The auditors

Deloitte resigned in October 2011 following alleged corporate-governance breaches including failure to

disclose material transactions in the financial statements.

Boshiwa International (HKSE, listed in Sep 2010)

Suspended from trading in March 2012 following resignation of the auditors Deloitte relating to concerns

as to the existence and commercial substance of various transactions such as prepayments to a supplier.

The auditors claimed that the information provided by management was insufficient and unsatisfactory.

China Forestry (HKSE, listed in Dec 2009)

Company in a trading halt since January 2011 after its auditors KPMG found possible irregularities in the

audit for the 2010 fiscal year. The former CEO was arrested one month later by Chinese authorities for

alleged embezzlement of RMB 30 million (US$4.6 million) from the company. In May 2012, the company

conceded that less than 1% of its reported revenue for the three years through 2010 can be validated.

Accounting Scandals

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Listing Fraud

Hontex (HKSE, listed in Dec 2009)

Suspended from trading three months after the IPO. The regulator alleged that its listing prospectus had

“materially overstated” the financial position. The Company assets were frozen by the court. A senior

manager at a Big 4 accounting firm was charged for allegedly accepting a HK$300,000 (US$38,601)

bribe for his work on the listing prospectus. The regulator imposed a fine of HK$42 million (US$5.38

million) on the sponsor and revoked its license to advise on corporate finance.

Sinotech Energy (NASDAQ, listed in Nov 2010)

Delisted in January 2012 and sued by the SEC along with two top executives for allegedly

misrepresenting the value of the assets and the use of the IPO proceeds. In August 2011, the company

came under the attack of the short sellers who alleged that its largest customers and suppliers were likely

shell companies.

Accounting Scandals

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COSO in the Fraudulent Financial Reporting 1987–1997

Generally involved multiple fiscal periods

Companies were generally smaller in size and 78% were not listed

72% of the cases involved the CEO and 40% of cases the CFO

Most were owned by the founders and/or board members

The audit committee appeared to be weak and rarely met

The boards were weak and dominated by insiders (shareholdings)

Family relationships among directors and/or officers were fairly common

Over 20% had officers with incompatible job functions

Changed auditors during the fraud period

Source: Committee of Sponsoring Organisations of the Treadway Commission

Financial Statement Fraud

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COSO Fraudulent Financial Reporting: 1998–2007

Average fraud period extended 31.4 months

The size of companies in this study was much larger

The CEO and/or CFO had some level of involvement in 89% of the fraud cases, up from 83% of

cases in 1987–1997

More related-party transactions than no-fraud firms

Improper revenue recognition and asset overstatements

All companies had audit committees but effectiveness still an issue

Changed auditors in the fraud period

Source: Committee of Sponsoring Organisations of the Treadway Commission


6.5

49.7

79.6

0 20 40 60 80 100


Corruption

Asset Misappropriation

Percentage of Cases

Typ

e o

f F

rau

d

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* The sum of percentages in this chart exceeds 100% because several cases involved schemes from more than one category.

Source: ACFE 2010 Report to the Nations (Asia Pacific Edition)

Occupational Frauds by Category – Frequency*

Financial Statement Fraud – Asia Pacific

200,000

460,000

4,300,000

0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000

Asset Misapproiation

Corruption


Median Loss (US$)

Typ

e o

f F

rau

d

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Occupational Frauds by Category – Median Loss


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Percentage of Total Reported Dollar Losses


Financial Statement

Fraud 51%

Asset Misappropriation

34%

Corruption 15%

Regulatory bodies in the PRC

Ministry of Finance (MOF)

Accounting Standards for Business Enterprises (ASBE)—38 standards

International Accounting Standards Board (IASB) regard the ASBE as substantially

reflective of IFRS

State Administration of Industry and Commerce (SAIC) is responsible for business

registration and business licenses

State Administration of Taxation (SAT)

http://www.asianlii.org/cn/legis/cen/laws/toc-A.html

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Regulatory bodies in the PRC - SAT

Input VAT is payable at the point of raising an

invoice

Output VAT is credited on obtaining SVI Receipt

VAT Payable = Output VAT - Input VAT

The input VAT is determined on a periodic basis,

rather than on the matching basis followed under

the accounting rules. Hence, there is a mismatch

in the cash flows for output VAT and input VAT.

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Example – Manipulating goods delivery

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Company A delivers goods to Company B

All documents are included except the VAT sales invoice

Company B accepts delivery but does not record any purchases

Issue of VAT invoices is deferred until the

settlement date / when Company B has sold

the goods

Company B has the benefit of inventory but defers cash and VAT

settlement

Company A records the sale but issues a VAT

sales invoice when Company B settles

Example – manipulating consignment goods

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Company A & B agree to issue sales invoices on a

“consumption” basis

Company A delivers products to Company B but does not issue sales

invoice

Invoicing is based upon a pre-determined schedule

that mimics the consumption pattern of

company B

The timing and amount of invoicing is therefore

manipulated

Company A is able to control the monthly sales performance and achieve

its sales targets

Chops

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Company Chop

Contract Chop

Financial Chop

HR Chop

Legal Representative Chop

Invoice Chop (New)

(“Fapiao”)

Case Study

Moulin Global Eyecare Holdings Limited (In Liquidation)

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Financial Statement Fraud – Moulin

“Police raids net five in Moulin fraud case;

company founder, son and three other people

arrested amid suspected $1.6b fraud at the

debt-hit spectacles maker”

South China Morning Post, July 6, 2005

“Fall of Hong Kong firm is a shock to investors”

The New York Times, July 7, 2005

“Moulin father and son face trial for fraud”

South China Morning Post, January 28, 2010

“Eight on trial over eyewear firm collapse;

Moulin ex boss admits fraud”

South China Morning Post, September 29,

2010

“Eyewear boss, guilty in fraud trial”

South China Morning Post, November 20,

2010

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Case references

Active Base Limited v Roderick John Sutton & Other HCCW 470 of 2005

Moulin Global Eyecare Holdings Limited (in Liquidation) v Ernst & Young HCCW 470

of 2005

Moulin Global Eyecare Holdings Limited (in Liquidation) & Ors v KPMG (a firm)

HCA118 of 2007

Moulin Global Eyecare Trading Limited (in Liquidation) v Commissioner of Inland

Revenue Department HCA471 of 2005

Moulin Global Eyecare Holdings Limited (in Liquidation) & Olivia Lee Sin Mei HCA167

of 2008


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Listed on the HKSE October 1993

Suspension from trading on April 18, 2005

for delay in filing financial results

Auditors resigned on April 18, 2005 (3rd

change of auditors in five years)

Accounting irregularities identified during

review as IFA

Appointed Provisional Liquidators on June

23, 2005; Liquidators on August 28, 2006

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Delivering Documents – Hong Kong style


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Document Recovery


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Document Storage – Hong Kong style

A secret room in the treasurer’s office…………….


Draft Balance Sheet as at December 31, 2004

Assets

Cash at Bank – HK$1.2 billion (US$154 million)

– Including HK$310 million in the PRC

Trade Receivables – HK$679 million

“Other” Receivables – HK$500 million

Prepaid Board Space – HK$54 million

Fixed Assets – HK$870 million

Inventory – HK$465 million

Due from Senior Mgmt – HK$93 million

Liabilities

Bank Creditors – HK$1.7 billion

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Actual cash at bank was about

HK$9 million (US$1.2 million)

Trust Agreement signed

supporting HK$310 million (US$40

million) in the PRC but didn’t exist

Window dressed bank account

balances at year-end

Group and “related” entities had

over 350 bank accounts


Moulin Balance Sheet

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Locating Assets – in China

The PRC Credit Union where funds of HK$80 million were said to be deposited.


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False Bank Documents


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False Bank Documents


Draft Balance Sheet as at 31 December 2004

Assets

Cash at Bank – HK$1.2 billion



(US$87 million)






Liabilities


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Four biggest customers were in

the US/Canada.

Accounted for more than 37% of

group sales per year.

Didn’t exist, customer addresses

are all residential addresses. One

was a Chinese Restaurant in

McCook, Nebraska, and another

the CEO’s mother’s residence in

Richmond, Canada.

Moulin received significant trade

finance against these debtors.



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Locating Overseas Assets – Trade debtors



Assets





(US$64 million)





Liabilities


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Subsidiary with Money Lending

Licence.

Supposedly lending funds to third

parties.

Executed loan agreements at 9%

pa.

Didn’t exist, questionable parties

signing loan agreements.

Used Money Lending Business to

explain significant fluctuations in

cash and support large number of

transactions going through bank

accounts.




Assets






(US$7 million)


(US$112 million)

Inventory – HK$465 million (US$60 million)

Due from Senior Mgmt – HK$93 million (US$12 million)

Liabilities


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Cash Prepaid Board Space –

HK$54 million – didn’t exist

Amount Due from Senior

Management – HK$93 million –

didn’t exist

Fixed Assets – HK$870 million –

Significantly overstated, some

factory equipment didn’t exist –

leasing scam

Inventories – HK$465 million –

Significantly overstated




Assets









Liabilities


(US$219 million)

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Approximately HK$1 billion in “off

balance” sheet borrowings

Simply didn’t report it

Highly irregular trade finance

arrangements

Business was burning cash



Easy to obtain – not a lot of credit checks

Competitive market for the banks – high volume, short term

Suppliers and customers controlled by management

Management creates purchase orders, invoices, shipping documents

Type of finance not self liquidating – company settles loans not the

customer / vendor

Not incumbent upon the bank to verify authenticity of the documents

Multiple loan applications submitted

Volume of trade finance undertaken by small entities – red flag


Trade Finance Fraud

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Trade Finance Fraud

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Trade Finance Fraud


Earnings that have been artificially inflated will not provide operating

cash flow for the company

Increase in assets – inventory, receivables, prepayments, property,

plant, and equipment

Rate of growth in earnings should be commensurate with rate of growth

in operating cash flow

Working capital per dollar of sales ratio – good proxy


Trade Finance Fraud

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Ratio Analysis

Net working capital ÷ Total sales

Moulin’s working capital to sales Dec 31, 2003


HK$ ‘000

Turnover 1,237,732

Current asset 2,388,036

Current liability 1,035,398

Net working capital 1,352,638

The ratio 109%

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Benford’s Law

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The law says that the number 1 will appear as the first digit about 30% of the time, the number 2

will appear as the first digit about 18% of the time, and moving down, the number 9 will appear in

the first spot only about 5% of the time.

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Data Analytics


Case Study - Moulin

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Leadkeen Beijing Trial Balance

Includes “fake” accounting ledgers for Custom tax and Packing

materials

Red Flags and Warning Signs

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Warning Signs

Corporate governance issues – family hold key positions, weak independence

Significant, unusual, or highly complex transactions at the end of accounting periods

Related-party transactions – assets held on trust

Why borrow when you have cash?

Massaging the balance sheet – acquisitions/capital raising

Resignation of auditors/independent directors


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Warning Signs

Working capital blowout – disparity between reported earnings and free cash flow

Gross profit margin higher than industry peers

Unusual growth in the number-of-days-sales-in receivables calculation

Overcomplicated structure – weak accounting systems and reporting controls


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Warning Signs

Warning Signs

Company Listing Date High Sales over

Assets

High Cash High

Working

Capital

Frequent

Corporate

Activity

Directors

Resigning

Recent

Change in

Auditor

1 China Agritech Sep 2009

2 China Intelligent Lighting Jun 2010

3 China Marine Food Aug 2009

4 China Media Express Jun 2010

5 Longtop Financial

Technologies

Oct 2007

6 Moulin Global Oct 1993

7 Ocean Grand Sep 1997

8 Orient Paper Jul 2010

9 Peace Mark Feb 1993

10 Rino International Jul 2009

11 Sino Forest 1995

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“if we paid all the royalties we are supposed to, we would never make any money.”

– Manager of factory in China

“Our business works like this: Materials 80%

Labour 20%

Profit 20%”

???%

– Senior Manager in a PRC factory

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QUESTIONS?

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FTI: Financial Statement Frauds - Chinese-Style (Presentation)

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