FTI: Financial Statement Frauds - Chinese-Style (Presentation)
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Transcript of FTI: Financial Statement Frauds - Chinese-Style (Presentation)
Association of Certified Fraud Examiners
Catherine Williams, Senior Managing Director
Forensic Accounting and Advisory Services
June 20, 2012
Financial Statement Fraud – Chinese style
− 3 −
What Do These Companies All Have In Common?
Heightened public concerns over corporate fraud
Recent wave of accounting scandals in China and Hong Kong
Increased media/research analyst/short-sellers’ scrutiny
Trading suspensions/halts/delisting of Chinese firms on the HKSE and
overseas stock exchanges
Securities class action lawsuits
Regulatory inquiries/prosecutions
− 4 −
Recent Developments
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. and Canada)
Sino-forest Corp (TSE, listed in 1995)
Lost C$3.3 billion (US$3.3 billion) of its market value after the research firm Muddy Waters accused the
company of fraudulently overstating its revenue and timber holdings. Delisted by the Toronto stock
exchange in May 2012. The company filed for bankruptcy protection last March and announced its plan
to be sold or restructured. The OSC recently commenced fraud proceedings against former senior
executives.
ChinaCast Education Corp (NASDAQ, listed in Oct 2007)
Company halted trading for failure to file its annual report for the fiscal year ended December 31, 2011. In
March 2012, the former CEO was ousted in a battle for shareholder control and for allegedly preventing
Deloitte from auditing the company’s books. One month after the event, the new executive team
discovered that the company seals for the Chinese subsidiaries were missing. Under Chinese law, the
seals are necessary to enter into contracts, conduct banking businesses, and take official corporate
actions.
Longtop Financial Technologies (NYSE, listed in Oct 2007)
Company delisted in August 2011. SEC charged the company for failure to file the current and accurate
financial reports. The auditors Deloitte resigned in May 2011. citing concerns about the accuracy of the
company’s financial records and bank and loan balances. It was reported in the media that some Chinese
banks may be complicit in the fraud. The SEC subsequently filed a subpoena enforcement action against
the auditors in Shanghai for failing to produce the audit work papers.
Accounting Scandals
− 5 −
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Red Chips (Hong Kong)
Real Gold Mining (HKSE, Listed in Feb 2009)
Suspended from trading in May 2011 after the local newspaper reported that the miner had filed one set
of accounts with the stock exchange and a much different one with the Mainland authorities. The auditors
Deloitte resigned in October 2011 following alleged corporate-governance breaches including failure to
disclose material transactions in the financial statements.
Boshiwa International (HKSE, listed in Sep 2010)
Suspended from trading in March 2012 following resignation of the auditors Deloitte relating to concerns
as to the existence and commercial substance of various transactions such as prepayments to a supplier.
The auditors claimed that the information provided by management was insufficient and unsatisfactory.
China Forestry (HKSE, listed in Dec 2009)
Company in a trading halt since January 2011 after its auditors KPMG found possible irregularities in the
audit for the 2010 fiscal year. The former CEO was arrested one month later by Chinese authorities for
alleged embezzlement of RMB 30 million (US$4.6 million) from the company. In May 2012, the company
conceded that less than 1% of its reported revenue for the three years through 2010 can be validated.
Accounting Scandals
− 6 −
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Reverse Mergers (U.S. & Canada)
Listing Fraud
Hontex (HKSE, listed in Dec 2009)
Suspended from trading three months after the IPO. The regulator alleged that its listing prospectus had
“materially overstated” the financial position. The Company assets were frozen by the court. A senior
manager at a Big 4 accounting firm was charged for allegedly accepting a HK$300,000 (US$38,601)
bribe for his work on the listing prospectus. The regulator imposed a fine of HK$42 million (US$5.38
million) on the sponsor and revoked its license to advise on corporate finance.
Sinotech Energy (NASDAQ, listed in Nov 2010)
Delisted in January 2012 and sued by the SEC along with two top executives for allegedly
misrepresenting the value of the assets and the use of the IPO proceeds. In August 2011, the company
came under the attack of the short sellers who alleged that its largest customers and suppliers were likely
shell companies.
Accounting Scandals
− 7 −
− 8 −
COSO in the Fraudulent Financial Reporting 1987–1997
Generally involved multiple fiscal periods
Companies were generally smaller in size and 78% were not listed
72% of the cases involved the CEO and 40% of cases the CFO
Most were owned by the founders and/or board members
The audit committee appeared to be weak and rarely met
The boards were weak and dominated by insiders (shareholdings)
Family relationships among directors and/or officers were fairly common
Over 20% had officers with incompatible job functions
Changed auditors during the fraud period
Source: Committee of Sponsoring Organisations of the Treadway Commission
Financial Statement Fraud
− 9 −
COSO Fraudulent Financial Reporting: 1998–2007
Average fraud period extended 31.4 months
The size of companies in this study was much larger
The CEO and/or CFO had some level of involvement in 89% of the fraud cases, up from 83% of
cases in 1987–1997
More related-party transactions than no-fraud firms
Improper revenue recognition and asset overstatements
All companies had audit committees but effectiveness still an issue
Changed auditors in the fraud period
Source: Committee of Sponsoring Organisations of the Treadway Commission
Financial Statement Fraud
6.5
49.7
79.6
0 20 40 60 80 100
Financial Statement Fraud
Corruption
Asset Misappropriation
Percentage of Cases
Typ
e o
f F
rau
d
− 10 −
* The sum of percentages in this chart exceeds 100% because several cases involved schemes from more than one category.
Source: ACFE 2010 Report to the Nations (Asia Pacific Edition)
Occupational Frauds by Category – Frequency*
Financial Statement Fraud – Asia Pacific
200,000
460,000
4,300,000
0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000
Asset Misapproiation
Corruption
Financial Statement Fraud
Median Loss (US$)
Typ
e o
f F
rau
d
− 11 −
Source: ACFE 2010 Report to the Nations (Asia Pacific Edition)
Occupational Frauds by Category – Median Loss
Financial Statement Fraud – Asia Pacific
− 12 −
Source: ACFE 2010 Report to the Nations (Asia Pacific Edition)
Percentage of Total Reported Dollar Losses
Financial Statement Fraud – Asia Pacific
Financial Statement
Fraud 51%
Asset Misappropriation
34%
Corruption 15%
Regulatory bodies in the PRC
Ministry of Finance (MOF)
Accounting Standards for Business Enterprises (ASBE)—38 standards
International Accounting Standards Board (IASB) regard the ASBE as substantially
reflective of IFRS
State Administration of Industry and Commerce (SAIC) is responsible for business
registration and business licenses
State Administration of Taxation (SAT)
http://www.asianlii.org/cn/legis/cen/laws/toc-A.html
− 13 −
Regulatory bodies in the PRC - SAT
Input VAT is payable at the point of raising an
invoice
Output VAT is credited on obtaining SVI Receipt
VAT Payable = Output VAT - Input VAT
The input VAT is determined on a periodic basis,
rather than on the matching basis followed under
the accounting rules. Hence, there is a mismatch
in the cash flows for output VAT and input VAT.
− 14 −
Example – Manipulating goods delivery
− 15 −
Company A delivers goods to Company B
All documents are included except the VAT sales invoice
Company B accepts delivery but does not record any purchases
Issue of VAT invoices is deferred until the
settlement date / when Company B has sold
the goods
Company B has the benefit of inventory but defers cash and VAT
settlement
Company A records the sale but issues a VAT
sales invoice when Company B settles
Example – manipulating consignment goods
− 16 −
Company A & B agree to issue sales invoices on a
“consumption” basis
Company A delivers products to Company B but does not issue sales
invoice
Invoicing is based upon a pre-determined schedule
that mimics the consumption pattern of
company B
The timing and amount of invoicing is therefore
manipulated
Company A is able to control the monthly sales performance and achieve
its sales targets
Chops
− 17 −
Company Chop
Contract Chop
Financial Chop
HR Chop
Legal Representative Chop
Invoice Chop (New)
(“Fapiao”)
Case Study
Moulin Global Eyecare Holdings Limited (In Liquidation)
− 19 −
Financial Statement Fraud – Moulin
“Police raids net five in Moulin fraud case;
company founder, son and three other people
arrested amid suspected $1.6b fraud at the
debt-hit spectacles maker”
South China Morning Post, July 6, 2005
“Fall of Hong Kong firm is a shock to investors”
The New York Times, July 7, 2005
“Moulin father and son face trial for fraud”
South China Morning Post, January 28, 2010
“Eight on trial over eyewear firm collapse;
Moulin ex boss admits fraud”
South China Morning Post, September 29,
2010
“Eyewear boss, guilty in fraud trial”
South China Morning Post, November 20,
2010
− 20 −
Case references
Active Base Limited v Roderick John Sutton & Other HCCW 470 of 2005
Moulin Global Eyecare Holdings Limited (in Liquidation) v Ernst & Young HCCW 470
of 2005
Moulin Global Eyecare Holdings Limited (in Liquidation) & Ors v KPMG (a firm)
HCA118 of 2007
Moulin Global Eyecare Trading Limited (in Liquidation) v Commissioner of Inland
Revenue Department HCA471 of 2005
Moulin Global Eyecare Holdings Limited (in Liquidation) & Olivia Lee Sin Mei HCA167
of 2008
Financial Statement Fraud – Moulin
− 21 −
Financial Statement Fraud – Moulin
Listed on the HKSE October 1993
Suspension from trading on April 18, 2005
for delay in filing financial results
Auditors resigned on April 18, 2005 (3rd
change of auditors in five years)
Accounting irregularities identified during
review as IFA
Appointed Provisional Liquidators on June
23, 2005; Liquidators on August 28, 2006
− 22 −
Delivering Documents – Hong Kong style
Financial Statement Fraud – Moulin
− 23 −
Document Recovery
Financial Statement Fraud – Moulin
− 24 −
Document Storage – Hong Kong style
A secret room in the treasurer’s office…………….
Financial Statement Fraud – Moulin
Draft Balance Sheet as at December 31, 2004
Assets
Cash at Bank – HK$1.2 billion (US$154 million)
– Including HK$310 million in the PRC
Trade Receivables – HK$679 million
“Other” Receivables – HK$500 million
Prepaid Board Space – HK$54 million
Fixed Assets – HK$870 million
Inventory – HK$465 million
Due from Senior Mgmt – HK$93 million
Liabilities
Bank Creditors – HK$1.7 billion
− 25 −
Actual cash at bank was about
HK$9 million (US$1.2 million)
Trust Agreement signed
supporting HK$310 million (US$40
million) in the PRC but didn’t exist
Window dressed bank account
balances at year-end
Group and “related” entities had
over 350 bank accounts
Financial Statement Fraud – Moulin
Moulin Balance Sheet
− 26 −
Locating Assets – in China
The PRC Credit Union where funds of HK$80 million were said to be deposited.
Financial Statement Fraud – Moulin
− 27 −
False Bank Documents
Financial Statement Fraud – Moulin
− 28 −
False Bank Documents
Financial Statement Fraud – Moulin
Draft Balance Sheet as at 31 December 2004
Assets
Cash at Bank – HK$1.2 billion
– Including HK$265 million in the PRC
Trade Receivables – HK$679 million
(US$87 million)
“Other” Receivables – HK$500 million
Prepaid Board Space – HK$54 million
Fixed Assets – HK$870 million
Inventory – HK$465 million
Due from Senior Mgmt – HK$93 million
Liabilities
Bank Creditors – HK$1.7 billion
− 29 −
Four biggest customers were in
the US/Canada.
Accounted for more than 37% of
group sales per year.
Didn’t exist, customer addresses
are all residential addresses. One
was a Chinese Restaurant in
McCook, Nebraska, and another
the CEO’s mother’s residence in
Richmond, Canada.
Moulin received significant trade
finance against these debtors.
Financial Statement Fraud – Moulin
Moulin Balance Sheet
− 30 −
Locating Overseas Assets – Trade debtors
Financial Statement Fraud – Moulin
Draft Balance Sheet as at December 31, 2004
Assets
Cash at Bank – HK$1.2 billion
– Including HK$265 million in the PRC
Trade Receivables – HK$679 million
“Other” Receivables – HK$500 million
(US$64 million)
Prepaid Board Space – HK$54 million
Fixed Assets – HK$870 million
Inventory – HK$465 million
Due from Senior Mgmt – HK$93 million
Liabilities
Bank Creditors – HK$1.7 billion
− 31 −
Subsidiary with Money Lending
Licence.
Supposedly lending funds to third
parties.
Executed loan agreements at 9%
pa.
Didn’t exist, questionable parties
signing loan agreements.
Used Money Lending Business to
explain significant fluctuations in
cash and support large number of
transactions going through bank
accounts.
Financial Statement Fraud – Moulin
Moulin Balance Sheet
Draft Balance Sheet as at December 31, 2004
Assets
Cash at Bank – HK$1.2 billion
– Including HK$265 million in the PRC
Trade Receivables – HK$679 million
“Other” Receivables – HK$500 million
Prepaid Board Space – HK$54 million
(US$7 million)
Fixed Assets – HK$870 million
(US$112 million)
Inventory – HK$465 million (US$60 million)
Due from Senior Mgmt – HK$93 million (US$12 million)
Liabilities
Bank Creditors – HK$1.7 billion
− 32 −
Cash Prepaid Board Space –
HK$54 million – didn’t exist
Amount Due from Senior
Management – HK$93 million –
didn’t exist
Fixed Assets – HK$870 million –
Significantly overstated, some
factory equipment didn’t exist –
leasing scam
Inventories – HK$465 million –
Significantly overstated
Financial Statement Fraud – Moulin
Moulin Balance Sheet
Draft Balance Sheet as at December 31, 2004
Assets
Cash at Bank – HK$1.2 billion
– Including HK$265 million in the PRC
Trade Receivables – HK$679 million
“Other” Receivables – HK$500 million
Prepaid Board Space – HK$54 million
Fixed Assets – HK$870 million
Inventory – HK$465 million
Due from Senior Mgmt – HK$93 million
Liabilities
Bank Creditors – HK$1.7 billion
(US$219 million)
− 33 −
Approximately HK$1 billion in “off
balance” sheet borrowings
Simply didn’t report it
Highly irregular trade finance
arrangements
Business was burning cash
Financial Statement Fraud – Moulin
Moulin Balance Sheet
Easy to obtain – not a lot of credit checks
Competitive market for the banks – high volume, short term
Suppliers and customers controlled by management
Management creates purchase orders, invoices, shipping documents
Type of finance not self liquidating – company settles loans not the
customer / vendor
Not incumbent upon the bank to verify authenticity of the documents
Multiple loan applications submitted
Volume of trade finance undertaken by small entities – red flag
Financial Statement Fraud – Moulin
Trade Finance Fraud
− 34 −
− 35 −
Financial Statement Fraud – Moulin
Trade Finance Fraud
− 36 −
Trade Finance Fraud
Financial Statement Fraud – Moulin
Earnings that have been artificially inflated will not provide operating
cash flow for the company
Increase in assets – inventory, receivables, prepayments, property,
plant, and equipment
Rate of growth in earnings should be commensurate with rate of growth
in operating cash flow
Working capital per dollar of sales ratio – good proxy
Financial Statement Fraud – Moulin
Trade Finance Fraud
− 37 −
Ratio Analysis
Net working capital ÷ Total sales
Moulin’s working capital to sales Dec 31, 2003
Financial Statement Fraud – Moulin
HK$ ‘000
Turnover 1,237,732
Current asset 2,388,036
Current liability 1,035,398
Net working capital 1,352,638
The ratio 109%
− 38 −
Financial Statement Fraud – Moulin
Benford’s Law
− 39 −
The law says that the number 1 will appear as the first digit about 30% of the time, the number 2
will appear as the first digit about 18% of the time, and moving down, the number 9 will appear in
the first spot only about 5% of the time.
− 40 −
Data Analytics
Financial Statement Fraud – Moulin
Case Study - Moulin
− 41 −
Leadkeen Beijing Trial Balance
Includes “fake” accounting ledgers for Custom tax and Packing
materials
Red Flags and Warning Signs
− 43 −
Warning Signs
Corporate governance issues – family hold key positions, weak independence
Significant, unusual, or highly complex transactions at the end of accounting periods
Related-party transactions – assets held on trust
Why borrow when you have cash?
Massaging the balance sheet – acquisitions/capital raising
Resignation of auditors/independent directors
Financial Statement Fraud
− 44 −
Warning Signs
Working capital blowout – disparity between reported earnings and free cash flow
Gross profit margin higher than industry peers
Unusual growth in the number-of-days-sales-in receivables calculation
Overcomplicated structure – weak accounting systems and reporting controls
Financial Statement Fraud
45
Warning Signs
Warning Signs
Company Listing Date High Sales over
Assets
High Cash High
Working
Capital
Frequent
Corporate
Activity
Directors
Resigning
Recent
Change in
Auditor
1 China Agritech Sep 2009
2 China Intelligent Lighting Jun 2010
3 China Marine Food Aug 2009
4 China Media Express Jun 2010
5 Longtop Financial
Technologies
Oct 2007
6 Moulin Global Oct 1993
7 Ocean Grand Sep 1997
8 Orient Paper Jul 2010
9 Peace Mark Feb 1993
10 Rino International Jul 2009
11 Sino Forest 1995
− 46 −
Financial Statement Fraud
“if we paid all the royalties we are supposed to, we would never make any money.”
– Manager of factory in China
“Our business works like this: Materials 80%
Labour 20%
Profit 20%”
???%
– Senior Manager in a PRC factory
− 47 −
QUESTIONS?
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