Open Letter to SGX/MAS: Reply to CFO of SGX-Listed China Environment (CENV SP) on report “Potential Accounting Tunneling Fraud at China Environment?” – Address the accounting and governance concerns in an SGX/MAS announcement

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).

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3 thoughts on “Open Letter to SGX/MAS: Reply to CFO of SGX-Listed China Environment (CENV SP) on report “Potential Accounting Tunneling Fraud at China Environment?” – Address the accounting and governance concerns in an SGX/MAS announcement

  1. 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 (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 Investigation unit of CAD (Commercial Affairs Department).

    KB Kee

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  2. Thank you for your informative and useful analysis. Time and time again retail investors have been misled by the financial reports of S-chip companies, and have likely lost their life savings as well. Singaporeans must have lost billions on these companies, and yet such accounting frauds continue to this day as evidenced by the many examples that you have cited.
    The S-chip companies have become vehicles to scam retail investors and sadly the regulators are doing nothing about it! It was SGX that provided the highway for such vehicles in the first place without providing a means of preventing the accounting fraud that followed.

    Keep up the good work.

    Liked by 1 person

  3. Related post: Open Letter to SGX/MAS: Reply to CFO of SGX-Listed China Environment (CENV SP) on report “Potential Accounting Tunneling Fraud at China Environment?” – Address the accounting and governance concerns in an SGX/MAS announcement

    We note the SGX announcement made on 2 April 2015 with the auditor Baker Tilly making an “Emphasis of Matter” with regards to Footnote 18 in the RMB127m in unsecured and interest-free “Advances/Loan to a sub-contractor”. This is essentially short-term money that can be shifted around and “repaid” by the close of financial period and “taken” again without the guarantee of repayment or recoverability and there is no collateral at all to offset this non-repayment risk imposed on the minority shareholders. Importantly, this emphasis of matter begs several important additional questions that requires proper disclosure for accountability to the minority shareholders given the significance of the sum:

    (1) Who is this sub-contractor? Is this a related-party? If this is an “independent” party, it will be necessary for the auditor to ascertain and verify this material information, including the financial track record of this sub-contractor in the event of default. There should be – must be – proper bad debt provisions if these information are not disclosed and ascertained. Also, if the sub-contractor is incorporated in the offshore haven centers, it will be hard to recover back the amount and the ultimate identity can be easily hidden to escape any asset tracing in the event of non-repayment. What is to stop the non-repayment?? This is an obvious red flag in accounting fraud.

    (2) Why is this huge amount “lent out” in the first place? And interest-free and unsecured! What is the nature of the relationship to warrant such terms? Without this loans amount, will “revenue” wax and wane with such short-term financing schemes? So with the partial repayment of RMB82.2m after the 27 Feb 2015 announcement, investors and minority shareholders must be even more watchful and suspicious should 1Q 2015 revenue show a corresponding increase in revenue by around RMB82m.

    (3) Why does the 4Q14 revenue plunge by RMB122.5m correspond to this “advances to sub-contractor” amount of RMB127m? This is particularly worrying and a cause for accounting tunneling risk with these short-term financing routed to related party vehicles posing as fictitious customers to engage in artificial sales in prior periods – and the abrupt decline in the revenue that correspond to the non-repayment risk of this short-term loan highlights that this scheme may be unwound easily, leading to the missing cash and cash equivalents. This casts huge doubt on the revenue recognition policy and revenue reliability of the listco. Like most capital equipment companies, this should be treated as debt on the liability side since it is the same as the machinery companies incurring a debt and then selling the machines to customers on credit. The cashflow from operations that come from this purported vendor financing activity should be re-categorised as cashflow from financing, which would turn most of these companies to be running negative operating cashflow positions. In other words, if the RMB660m in trade and bill receivables is funded by this “vendor financing”, there should be a corresponding RMB127m in debt liabilities recorded in the balance sheet, or the NET trade and bill receivables to decreased by RMB127m.

    In addition, we think that the statement “In our opinion, the accounting and other records required by the Act to be kept by the Company and by those subsidiaries incorporated in Singapore of which we are the auditors, have been properly kept in accordance with the provisions of the Act” is misleading, given that this evades the non-Singapore-incorporated and PRC-incorporated key subsidiaries Fujian Duoyuan and Anhui Dongyuan which formed the substantial bulk of the audit risk.

    We urge the independent auditor Baker Tilly to assist the minority shareholders and the investing public with more transparent and clear disclosures. We note that Baker Tilly’s Hong Kong practice has been banned by the US Securities and Exchange Commission from taking on any new US-listed clients until its audit policies and procedures have been reviewed by an independent consultant – due to its audit failure for failure in disclosing the magnitude and impact of the related-party transactions in another Chinese company (China North East Petroleum Holdings) which was charged in accounting fraud. We urge the independent auditor Baker Tilly’s Singapore practice to uphold its critical gatekeeper role and help restore trust in the capital markets in Singapore.

    Thank you.

    Warm regards,
    KB Kee

    Like

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