[Flashback] Accounting Fraud Is Still Widespread Among Chinese Companies



Posted by Amy CHAN Wen Yi, Year 4 undergrad at the School of Accountancy, Singapore Management University

Accounting Fraud Is Still Widespread Among Chinese Companies

With the renewed enthusiasm shown by the market for new listings from China, one would assume that investors had turned the page on all the claims of accounting fraud over the past few years.

But do so only at one’s own risk.

There are still many U.S.-listed Chinese companies with the potential to be hit with accounting fraud that investors do not yet know about, at least according to one China-focused hedge fund manager.

Bing Lin, portfolio manager at Hong Kong-based $1.4 billion Keywise Capital Management, warns that the cases of accounting fraud among Chinese companies made famous by Muddy Waters’ Carson Block might just be the tip of the iceberg.

“Based on my experience and observation, I think there is still widespread accounting abuse among listed [Chinese] companies, even some large ones,” Lin told me during an interview in Hong Kong.

Lin wouldn’t reveal their names, but says there are a number of common practices of misconduct. The first is revenue recognition. Lin says he sees some companies booking sales on a gross revenue basis, and therefore massively inflating their revenue.

Unfair related party transactions, such as acquisitions, are also common. Management may be paying inflated prices to a small business that’s related to a relative or friend.

That’s why Lin thinks this year will be good for long-short hedge funds like Keywise, unlike last year when almost all short trades were facing losses.

Aside from shorting those companies with abusive accounting practices, Lin is also targeting other companies to short. What kind of companies? Those whose business models are becoming obsolete, such as in the education sector, where online businesses are taking market share and profit from the offline business.

Another type of ideal short is companies that are engaged in other business beneath the surface. Some companies may say that they are in the technology business, but in reality, they are channeling money into real estate.

“The key is to read the small print in their securities filings. Not a lot of investors are paying attention to this, so this could be very good short opportunities too,” Lin says

Chinese companies head for US listings

Chinese firms are flocking to the initial public offering market in the United States in their biggest numbers since 2010, drawn by soaring valuations for technology startups and undeterred by a flareup
in an accounting row between Washington and Beijing.

About 30 Chinese companies could list in the US this year, investment bankers said. That includes JD.com (http://JD.com) China’s No2 ecommerce firm after Alibaba. It said last month that it was seeking to raise US$1.5 billion in what might be the secondbiggest listing in the US by a Chinese company.
The return to US shores comes on the back of renewed investor enthusiasm for China plays, particularly for internet stocks.

Transaction volume in the country’s online retail market jumped 42 per cent last year to 1.85 trillion yuan (HK$2.35 trillion) and was expected to almost double by 2016, figures from iResearch showed.
That has trumped lingering concerns about accounting irregularities and corporate governance issues that have forced many US listed Chinese firms to be delisted since 2011.

The delistings have prompted US investors to be more discerning about share offers from China this time round. The bar for Chinese companies seeking US deals is higher, improving the quality of recent offerings, ankers say.But John Hempton, the chief investment officer of Sydney based Bronte Capital, said a lack of penalties for Chinese firms’ past misdeeds in the 2011 scandals meant the potential to find accounting fraud was always there.

While only eight Chinese firms listed in the US last year, raising a combined US$1.1 billion, the returns have been spectacular. Semiconductor solution provider Montage Technology and 58.com (http://58.com) billed as China’s Craigslist, have jumped at least 70 per cent since their debuts. Online sports lottery operator 500.com (http://500.com) has nearly tripled in value since listing in November.

Newly US listed Chinese firms rocketed an average 53 per cent on their debuts last year, consulting firm EY said. The Nasdaq Composite Index has rallied 28 per cent over the past year.

The US market affords mainland Chinese companies options not available in Hong Kong, such as dual class
share structures and the ability to list without having turned a profit. It also offers far more liquidity than the newly reopened listing market in mainland China.


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