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Chinese Financial Statements Come Under Srutiny by U.S. SEC

Should American Investors Trust the Financial Statements Issued by Chinese Companies?

I have previously blogged about questions that have been raised by U.S. regulators about the reliability of the financial statements issued by Chinese companies. Recently it was announced that officials from China and the U.S. have committed to cross-border audit inspections in a deal that could end a long-running dispute between the two countries securities regulators. Jim Doty, head of the Public Company Accounting Oversight Board (PCAOB), said the U.S. audit watchdog expects to conduct its first inspection of a mainland Chinese audit firm by the end of the year. Protocols for the inspections are expected to be finalized in the coming months, Doty told Reuters.

U.S. and Chinese regulators have been in dispute over access to auditing documents of Chinese companies listed on the U.S. stock exchange. Back in January, a Securities and Exchange Commission (SEC) judge ruled that Chinese units of the Big Four accounting firms should be banned from conducting audits of U.S.-listed companies. The ruling has yet to come into effect and the firms said they intended to appeal the ruling. In 2012, the SEC accused the Big Four, and BDO's Chinese affiliate, of breaking securities laws by refusing to produce documents related to their audits of several China-based clients under investigation for fraud. The actions stemmed from a broader inquiry into Chinese companies listed on American exchanges.

Back in March the SEC charged an animal feed company and top executives with conducting a massive accounting fraud in which they repeatedly reported fake revenues from their China operations in order to meet financial targets and prop up the stock price.

The SEC alleges that four executives in China orchestrated the scheme at AgFeed Industries Inc., which was based in China and publicly traded in the U.S. before merging with a U.S. company in September 2010 and spreading its operations between the two countries.  With the bulk of its hog production operations in China, the executives used a variety of methods to inflate revenue from 2008 to mid-2011, including fake invoices for the sale of feed and purported sales of hogs that didn’t really exist.  They later tried to cover up their actions by saying the fake hogs died.  Because fatter hogs bring higher market prices, they also inflated the weights of actual hogs sold and correspondingly inflated the sales revenues for those hogs.  

Many questions exist about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises.  Questions continue to be raised about the value of those statements to investors looking to obtain a piece of the growing Chinese economic pie. For the most part, accounting rules are ignored; financial disclosures lacking; and transparency seems to be a word not in the dictionary of Chinese companies.

The (ethical) problem in all of this is that in the Chinese culture full disclosure is not a basic value. In China, historically, secrecy has been valued over transparency in all elements of society. Also, to accuse someone of fraud is a slap in the face – a loss of face -- especially when the allegation is based on another country’s set of values different from the Chinese. In China the group/family is paramount and any action that brings disgrace on them is a serious matter.

Cultural values notwithstanding, China must play by SEC rules if it is to audit affiliates of U.S. companies that are subject to inspection by the PCAOB and if Chinese companies are to list their stock on U.S. exchanges. All foreign companies that list stock in the U.S. are subject to such inspections. China should not be treated any differently. If China wants to be a key player and become a force in the international financial markets, then it must learn to play by the rules of regulators outside their own country even if it seems to run counter to cultural norms whereby such regulations and inspections might be interpreted as demonstrating a lack of trust in Chinese management.

Blog posted by Steven Mintz, aka Ethics Sage, on September 4, 2014. Dr. Mintz is a professor in the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.ethicssage.com.