In this episode of China Money Podcast, guest Paul Gillis, professor of accounting at the Guanghua School of Management at Peking University in Beijing, discusses Caterpillar's $580 million write-down in its acquisition of Zhengzhou Siwei. Prof. Gillis explains the three most common accounting tactics Chinese companies use to cheat and defraud foreign investors, and what can foreign investors do to prevent themselves from being duped.
Listen to the full interview in the audio podcast, or read an excerpt.
Q: Caterpillar is taking a $580 million write-down on its acquisition of Chinese mining company, Zhengzhou Siwei, after discovering a "deliberate, multi-year, coordinated accounting misconduct."
Key background: 1, What Caterpillar bought for roughly $700 million was Hong Kong-listed ERA Mining Machinery, which is a shell company that owns Zhengzhou Siwei, a Henan province-based mining equipment maker. 2, Zhengzhou Siwei was absorbed by ERA through a reverse merger in 2010 and never went through a formal IPO process.
So Paul, can you use your imagination and picture what you think happened when Caterpillar's CFO told the CEO about this massive loss in their C-suit?
A: I imagine that was a pretty awkward situation. It's very embarrassing for anyone at Caterpillar to be involved in a deal like this. I'm sure there is a search for the guilty parties on the way.
Q: Here is what Caterpillar disclosed about how they found out about the accounting misconduct:
"Caterpillar first became concerned about…discrepancies…in November 2012 between the inventory recorded in Siwei’s accounting records and the company's actual physical inventory…Caterpillar promptly launched a comprehensive review and investigation (that) identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."
From the above statement, what accounting fraud can you infer that Siwei has done?
A: The first thing they pointed to are problems with inventory. After counting the inventory in Siwei's factories, Caterpillar discovered Siwei didn't have as much inventory as recorded on their books. That means Siwei was capitalizing these costs and carrying it as inventory costs, as supposed to expensing it in the current period, which could lead to their profits significantly lower.
The more serious allegations in my mind are revenues being recognized too early or inappropriately. So some sales were recorded before they were actually completed. But this is a very common practice in China.
Western accounting standards are very detailed about when you can recognize revenue. For example, you must have signed contracts; you can't have rights of return; or obligations to do more things in the future. But in China, businesses are done more on relationships. The contracts are less important than the handshake. So I would not be surprised if management at Siwei didn't think they were involved in any kind of fraud relating to revenue recognition.
Q: But it does sound like that Caterpillar didn't check out Siwei's books and didn't examine physical inventories. Do you think it's likely?
A: It's hard to know. Caterpillar did say that they hired two Big Four accounting firms: Ernest & Young and Deloitte Touche Tohmatsu. It is unusual to hire two Big Four firms. But the due diligence is a customized process. Did the accounting firms miss what were right there in their face? Or did Caterpillar tell them not to look at certain things? We don't know.
The other thing is that you need to have access to get to the records and the people to conduct due diligence. But in some situations, you might not get as much as you'd like.
Q: One obvious red flag here seemed to be the fact that Siwei become part of ERA through a reverse merger. Wouldn't that already alarm auditors and buyers?
A: Everyone should have learned lessons on reverse mergers. The lack of scrutiny of reverse mergers deals is very dangerous. The number of accounting fraud associated with reverse mergers is huge. Most are U.S.-listed Chinese companies. Caterpillar is the first case involving a multinational strategic buyer and a Hong Kong-listed Chinese company through reverse merger.
The U.S. stock exchanges have effectively stopped reverse mergers by new rules that require reverse merger targets to be "seasoned" before listing. Hong Kong and other markets should probably look at potentially implementing the same rule.
Q: Who are legally liable relating to Caterpillar's massive losses?
A: Let me first give some clarifications about this goodwill write-down. Caterpillar paid significantly more than Siwei's book value. That excess was put into goodwill. Every year, a company has to determine whether it can continue to justify carrying that goodwill balance on the balance sheet. In this case, after learning all the accounting practices at Siwei, Caterpillar decided that Siwei will not be as profitable in the future as originally anticipated. What this means is essentially Caterpillar paid too much for Siwei.
When you pay too much for a company, who's at fault? Clearly, there will be a lot of focus on the management of Siwei. I understand that some of the purchase price is to be paid in notes. Surely Caterpillar's lawyers are looking at whether or not to pay those additional balances. The auditors of Caterpillar and the accounting firms that did the due diligence will also be looked at. Lastly, shareholders will also look at the management and board of Caterpillar. I think a lot of questions will be answered in the next couple of years.
Q: Do you expect anyone will be arrested and face criminal charges?
A: Not in China. I'm not aware of any criminal charges on an accounting fraud in China. Chinese government does not seem to consider accounting frauds as crimes in China.
Q: Looking at the broader Chinese accounting landscape, what are some of the most commonly used tactics by Chinese companies to cheat investors?
A: The most common is probably inappropriate revenue recognition or fake revenue. That's the simplest way to increase profits.
Relating to that are ways to fake cash balances. Once you record a sale, you need to find some place for it on the asset of the balance sheet. If you put it on receivables, the auditors will ask troublesome questions. So many companies record fake cash and convince banks to lie to auditors.
For example, a Chinese company created a fake online banking website to cheat auditors last year. The auditors found that an interest rate on the bank statement did not match Chinese Central Bank's official rates. The company promptly replied that it was a bank error and it was fixed in half an hour. The auditors became suspicious and clicked on some other buttons of the website, and found out the whole website is a fake.
Another example is putting deposits with contract manufacturers. If you use contract manufacturers, you usually have to give them some funds up front. That's a very hard number to audit. In some cases last year, auditors have decided to resign after determining that they can't verify those numbers.
A third tactic is the use of Variable Interest Entity (VIE) structure. It's been prone to accounting fraud (in a similar way like reverse merger).
Q: Lastly, what should overseas investors do to prevent a repeat of Caterpillar's sad fate?
A: If a foreign company is buying a Chinese company, it needs to go through a due diligence process that is significantly more vigorous than usual. It really needs to get access to all the records and people, and follow forensic auditing procedures that are intended to root out fraud. That means paying a lot more fees. Too often, these audits go to the lowest bidder, and that's just not appropriate.
Also too often, management of the company is trying to find ways to get the deal done. But when you do a deal in China, you really have to use another perspective. Look for reasons to not do the deal. Not for reasons to do the deal. Because China is an extremely high risk environment.
About Paul Gillis:
Paul Gillis is professor of accounting at the Guanghua School of Management, Peking University in Beijing, China. Gillis is a member of the Public Company Accounting Oversight Board (PCAOB)'s Standing Advisory Group. PCAOB is a nonprofit corporation established by the U.S. Congress to oversee the audits of public companies. Gillis also authors China Accounting Blog.