Related posts: (1) China Environment: Auditor Emphasis of Matter raises more questions on potential accounting tunneling risk; (2) CFO reply: https://asianextractor.com/2015/02/10/potential-accounting-tunneling-fraud-at-china-environment/#comment-785 (3) Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? “Emphasis of matter” language predicts restatements

Dear Mr Chiar,

Thank you for your reply addressing part of the corporate governance and accounting issues that were raised in Part 1 of the three-part article series that was based on the financial statements audited by Baker Tilly TFW LLP. We note that Baker Tilly did not disclose the name of its local auditor partners in the subcontract work for the wholly-owned subsidiaries Fujian Dongyuan 福建东源环保 and Anhui Dongyuan (Footnote 13) with the carrying value of RMB673.5m in FY14 (FY13: RMB698.7m), which form a very substantial part of the asset value of the group. We also note that Baker Tilly was recently fined in Dec 2014 by the U.S. SEC over audit failures tied to a mainland company suspected of fraud involving undisclosed related-party transactions; the audit failure was a result of subcontracting the audit work to a local partner.Essentially there is keen interest to understand more about the propriety in the movement and classification of “cash and cash equivalent”, “other receivables, deposits and prepayments”, intercorporate/related-party loans and transactions amongst the different entities, as well as the nature of the revenue generated from the “customers”, stemming from the RMB159m cash inflow in external public funds that were raised in FY13. For instance, when the “loan to subsidiaries”, “amount due to director (non-trade)” and “cash and cash equivalent” at these (unaudited?) local subsidiaries plunged by a total of RMB124.8m in 4Q14, there is a puzzling near-equivalent plunge in 4Q14 revenue by RMB122.5m, which should not be the case; advances, prepayments and loans do not create revenue transactions (only the sale of products or performance of services do), unless these transactions are with undisclosed related-party entities/persons who used these short-term financing to create a trail of dubious/fictitious “customer” accounts that engage in artificial revenue transactions with the listed entity. Funds/cash raised was transferred to these local subsidiaries who in turn use them to arrange for short-term rollover debt at a puzzling discounted value, begging information transparency on the flow of funds and to the related entities; for instance, RMB62.4m in bank deposit in these wholly-owned local subsidiaries was used to secure a discounted RMB60.1m in short-term bank loan in FY13.

We have observed such similar patterns in a list of S-chips, HK-listed P-chips and Asian companies that were involved in actual accounting irregularities and fraud across industries. They include the environmental protection equipment industry that China Environment operates in (Sino-Environment), industrials (China Packaging; FerroChina, Fibrechem, China Sky, China Gaoxian, Hongwei, Sino Techfibre, Falmac, China Zaino, Sinopipe, China Printing; Fushi Copperweld, Rino International, Orient Paper etc), consumer (China Hongxing Sports, Peacemark, Moulin Global, First Natural Foods, Warderly, Zhongguo Jilong, New Lakeside; Deer Consumer, Fuqi International etc), Resources (China’s Sino-Forest, HK’s Chaoda Modern Agriculture, China Green, China XLX, Pan Sino, Asia Aluminium, China Metal Recycling; Le Gaga, Celestial NutriFoods, China Sun Bio-chem, China Milk, China Integrated Energy, China SinoTech Energy, China Natural Gas, China Energy, China Oilfield Technology, etc), tech (Longtop Financial Technologies, China New Century Media, China MediaExpress, China Intelligent Lighting, KXD Entertainment, etc).

The accounting transgression pattern is that the cash raised from IPOs or share placement exercises is shifted into “deposits/cash equivalent” in local subsidiaries and affiliates who would then “tunnel” or expropriate them out via short-term rollover loans to undisclosed related-party entities. These related-party entities would disguise as “customers” who engage in fictitious sales with the listed company. Such misclassified short-term financing is disguised in cash equivalent, prepayments & advances, other receivables. Hence there is the “missing cash” implosion when the fraud unravel, by which time is usually too late with the minority shareholders bearing the painful losses. In essence, the question to China Environment based on this similar pattern is this: Where is the “missing” RMB120+m in cash (money raised from the public that were shifted into such short-term cash equivalents and loans whose amount had plunged), based on the latest FY14 results announced on Feb 27, 2015, a Friday evening after market close? What is the integrity and reliability of the revenue recognition and underlying profits given that cash is turned into cash equivalents and short-term financing/loans to related parties (both disclosed and undisclosed) and moved around in circular transactions?

We urge the company’s management and independent directors to address the spirit and substance of the concerns in an official SGX/MAS announcement as part of the fiduciary duties and responsibilities in accounting to the public minority shareholders and in constructive engagement/communication with both existing and potential investors (and regulators). They might have similar concerns in understanding the details and footnotes about the company’s financial health beneath the headline firm-level aggregate numbers and industry news (especially when there is a precedent accounting fraud case in defunct S-chip Sino-Environment that operates in the same industry as China Environment) to aid their decision-making process and make an informed judgment when investing in the shares of the company.

Warm regards,
KB Kee

P.S.1: All information used are based on publicly available information, facts and financial numbers. No short positions are held by the author. The views expressed are attributable only to the author and not to any institution with which he is associated.

P.S.2: Brief notes for the general reader to understand more about accounting fraud via tunneling using intercorporate loans, other receivables, and short-term financing schemes (one of the four commonly-used methods used by actual insiders and syndicates to expropriate cash and assets out of the firm):

Step 1: Listco engages in “intercorporate loans”
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Cash (raised from IPO, SEO, bank etc)

Step 2: Generates artificial or fraudulent sales via undisclosed related-party transaction disguised as fictitious “customers” (this is not observable in the financial statement, but will show up in Step 3)
DR “Cash” (“cash” or short-term financing loans re-enters the listco)
CR Sales (artificial or fraudulent sales)

Step 3: Check for artificial or fraudulent sales
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Cash (raised from IPO, SEO, bank etc) – strikethrough
DR “Cash” (“cash” or short-term financing loans re-enters the listco) – strikethrough
CR Sales (artificial or fraudulent sales)

The accounting transgression thumbprint left behind:
DR “Other Receivables” (or prepayments, advances, cash equivalents, etc)
CR Sales (artificial or fraudulent sales)

Changes in “Other Receivables”, cash equivalents, prepayment, advances etc, or accounts that are short-term financing schemes should not lead to revenue generated. Only the sale of products or performance of service obligation leads to revenue transactions. If there is a “matching” debit or increase in other receivables and a credit in sales, Step 2 shows up, that is, sales was generated using fictitious customers disguised as undisclosed related party transactions. Th

When the insider decides not to maintain the scheme, as in the case of the “missing cash” syndrome in the S-Chips and HK-listed P-Chips, the transactions unwind and a plunge in sales correspond to a plunge in these “Other Receivables”, cash equivalents, prepayment, advances and short-term financing accounts.

Thus, traders and investors using aggregate financial accounting numbers to derive superficial financial ratios (e.g. profit margin, return-on-equity) and valuation metrics (e.g. low price-to-earnings, low price-to-book) without understanding the underlying business model, the related-party transactions artificially inflating the aggregate financial numbers and the data generation process in the financial footnotes can be misled.

We have observed this accounting transgression pattern in a comprehensive list of Asian companies that unravel in actual accounting fraud. We are happy to share our findings with the regulators, including the White Collar Crime Investigation unit of CAD (Commercial Affairs Department).