China Environment: Auditor Emphasis of Matter in RMB127m unsecured and interest-free advances to sub-contractor raises more questions on potential accounting tunneling risk
Related post: (1) 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, (2) Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? “Emphasis of matter” language predicts restatements
We note the SGX announcement made by China Environment (SES: 50U, Bloomberg: CENV SP) 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.