Recent events have put the corporate governance of many mainland firms in the spotlight. But what can be done to expose them? And are there signs pointing to potential fraud that canny investors should be aware of? Joy Li investigates.

Chinese companies - mainly listed overseas - have been making headlines lately for all the wrong reasons. Red flags have been flying over the state of their corporate governance and some investors are of the opinion that the balance sheets don't quite add up. It has made investors nervous and has been a windfall for short sellers.

Things really heated up on the other side of the Pacific where short sellers such as Carson Block, the man behind Muddy Waters, threw himself into the fray by releasing accusatory reports on firms such as Sino-Forest and Longtop Financial Technologies.

Later on, the flares sailed across the ocean and frayed investors' nerves on the Hong Kong stock market, where mainland companies constitute half of its capitalization. The fuse was a report from rating agency Moody's, which assigned red flags on the corporate governance of 61 rated Chinese companies. The blast sunk the benchmark Hang Seng Index by 3.1 percent, or 684 points on July 12, the index's worst one-day drop in 14 months.

Investors clearly voted with their feet and walked away from what they consider to be shams. However, investment, or hunger for returns, will not come to a halt just because of some executive's window-dressing. Rather than being appalled by the sleaziness, investors can cast a wary eye and engage in a bit of whistle-blowing themselves.

At the height of the saga, Bank of America Merrill Lynch (BofA-ML) came up with some guidelines after reviewing 32 Chinese companies listed on US, Hong Kong and mainland exchanges. The samples were all of suspicious companies, that were publicly reported as engaged in fraudulent or manipulative behavior. BofA-ML said that there are "three common manipulations" which indicate areas that are often gilded, and "three common ways of detection" which help to shed light on numbers too good to be true.

The first is "sales to non-existing customers". For example, in RINO International Corp's case, the pollution control equipment maker admitted in March that two of its previously reported contracts didn't exist. The company has been delisted from the Nasdaq in New York and has since become a target of a regulatory probe.

The second is "inflated sales and cost of goods sold via related party transactions." Related parties often refer to companies owned by relatives or friends of top management or board member directors, according to BofA - ML. For example, it was found that US- listed Duoyuan Global Water company borrowed money from related parties but recorded it as sales. Stocks of the water treatment equipment supplier were suspended from trading by regulators in March this year.

The third is "inflating the valuation of total assets." A case in point is Hong Kong-listed China Forestry Holding, which was found to have overstated its timber holdings. While the company said they had 200k Mus of timber assets in the village of Luxi, Yunnan province, the village's total timber acreage was only 20K Mus.

But if these are areas where fraudulent claims commonly pop up, what are some of the ways to bring light to the dark corners?

First comes "checking bank statements." In BofA-ML's view, bank balances are often the "most difficult to dress up." Many of the suspicious companies need to spend in order to reassure outside parties, yet the spending doesn't bring in economic returns, such as keeping a big sales team to make big sales numbers more plausible. As a result, these companies have to seek loans from related parties or banks to meet their cash needs, which mean that a check of bank statements may effectively expose irregularities.

The second way is "cross-checking with the company's government filings." In China, accountants sometimes find their workload doubled, since they need to deliver two sets of books to both government authorities and stock exchanges. In this case, companies are more inclined to tell their true stories to government officials since they are more difficult to fool and decide how much to tax them, according to BofA-ML. For example, China Education Alliance was found to have inflated its 2008 revenue to the SEC (Securities and Exchange Commission) by 38 times the actual amount it reported to the local State Administration of Industry and Commerce (SAIC).

The third way is through "field checks." A visit to plants which claim to be at full capacity in corporate presentations can reveal exactly the opposite. A casual chat with suppliers and customers may challenge executives' confidence in their order books. Meanwhile, local branches of the SAIC are often a good source to find out the key personnel and owners of local companies, suggested BofA-ML.

In recent years, enthusiasm to tap capital by going public has also been running high among Chinese companies. According to the Public Company Accounting Oversight Board, more than 150 China based companies, with a market value of US$12.8 billion, have entered the US since 2007 through reverse mergers - the fastest and easiest way of listing.

Auditors, sometimes dubbed as the police of the financial market, feel that their task of checking the financial records of some mainland companies is becoming more nerve-racking and they need more input and vigilance to keep up.

Cheung Yuk-lam, a forensic and dispute services partner at Deloitte, one of the "big four" auditing firms, recently told of some "real-life experiences" at a recent seminar on corporate financial statement fraud organized by the Hong Kong General Chamber of Commerce.

Checking bank confirmations, which used to be assigned to junior auditors, "now requires more partner involvement," said Cheung.

He recalled that a colleague at Deloitte recently went to a bank on the mainland to check a confirmation document, when suddenly someone from the company being checked appeared out of nowhere and snatched the paper away.

"Compared to a few years ago, it is now a high-risk area," said Cheung.

Deceitfulness is another problem. Cheung cited a site visit at a company claimed as a customer. The office that Cheung's team were shown was neatly decorated, with the company name printed on a plastic board hanging on the wall. Three days later Cheung's team returned to the same place and found that the nice office no longer existed!

Cheung said that companies listed through reverse mergers are more likely to be involved in financial frauds since they usually do not need to go through comprehensive and time-consuming reviews by regulators such as the procedures found in a typical initial public offering.

As for Chinese regulation enforcement, Cheung's observation is that though it has improved, there has been not enough effort in slashing crime due to "fundamental cultural differences."

"What is deemed as crime in the West can turn out to be everyday life in China," said Cheung.

joyli@chinadailyhk.com

(HK Edition 08/12/2011 page2)