China Due Diligence - Red Flags to Avoid Some of the Pitfalls

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China Due Diligence – Red Flags to Avoid
Some of the Pitfalls
John Besant-Jones and Marcel Wiedenbrugge
Abstract
China is full of wonderful investment opportunities but as many predecessors
have found out, it is also full of fraud risks that could be avoided or at least
minimized if appropriate due diligence steps are taken with proper awareness of
the red flags. Frequently, these risks are not the same as those contained within
Western companies. Lots of clues can be found on the ground and in the
accounting financial statements of Chinese companies, providing useful leads
for further investigation or the conclusion that it is simpler to just walk away.
Spending just a small amount of resource on this critical process may itself be
one of the best investments you ever make, because it could save you losing
many millions at a later date. In this article, the authors give a whirlwind tour on
what to look out for and include a mini case study as an example to start you off.
Introduction
It’s almost an irresistible opportunity. Your company has the chance to invest in
a business located in a huge and fast growing economy. The target is an
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Biography
Marcel Wiedenbrugge is the principal and founder of WCMConsult (Netherlands). He
combines knowledge and experience in account management/sales, credit
management, service management and related software solutions. Marcel is an
entrepreneur, consultant and writer on business process improvement, and aims to
bring finance and commerce closer together by developing integrated business
models. He develops and conducts trainings and workshops and undertakes credit
management market research, with a focus on Asia Pacific, in particular China.
He is the author of ‘The Customer Profit Maxim’ www.customerprofitmaxim.com and
can be reached at: marcel.wiedenbrugge@wcmconsult.com or www.wcmconsult.com.
John Besant-Jones is a special situations research analyst for Asian companies and
owner of Red Flags Consulting LLC. He has worked for banks such as Credit Suisse,
ABN and Barclays. John also holds an MBA in Chinese Business from the Chinese
University of Hong Kong, an MA in Finance & Investment from the University of Exeter,
and a Bachelor degree in Engineering. John is also a member of the Continuing
Education Committee for the Hong Kong Society of Financial Analysts, which is the
Hong Kong branch of the CFA. See website www.redflagsconsulting.com or contact
John on jbesantjones@redflagsconsulting.com. John’s professional profile can be
found on LinkedIn https://www.linkedin.com/pub/john-besant-jones/1b/5aa/865
Marcel Wiedenbrugge
Founder
WCMConsult
Keywords Due diligence, Accounting, Fraud, China, Asia, Financial statements, Red flags
Paper type Research, Case study
John Besant-Jones
Founder
Red Flag Consulting

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operation similar to your own, so you have the familiarity for a successful
business model. There are numerous areas where efficiencies can be made
and growth stimulated. Better still, the price of entry looks great. Yet despite all
this, many foreign companies and investors have traveled down the same path
of thinking and run afoul. Why? The answer is lack of proper due diligence, or
to phrase it better, not being aware of what can go wrong and how to avoid it.
We address just a few essential issues to increase your chances of being one of
China’s more successful foreign investors.
Basic due diligence
It is much more than just visiting operations on the ground. Rigorous checks in
all areas are needed to make absolutely sure that you get what you are paying
for, and avoid what you don’t want. Chinese companies sometimes have
complicated ownership networks, and these need to be fully understood so you
know where the profits are really generated and what you are really buying.
Conducting business using personal relationships is very important in this
region, yet that does not mean the seller will always truly be your new best
friend. The due diligence process should be critical, but not so rude as to send
insulting signals. You are also investing in something for the future, not just
today, and the seller may have personal friends who are important suppliers and
customers that you want to keep. Most of all, you want to make sure the seller
and yourself have a common and continued interest to make the business
successful in years to come. Without this common interest, there is a greater
chance that something can go wrong. Very basic checks can be for:
Basic financial due diligence
Schemes that inflate revenues and profits, or make false claims to asset
ownership are among the most common hazards. Forensic accountants can
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The manufacturing and storage facilities for existence, ownership,
condition, capacity and activity, as well as staff numbers to ensure that
everything matches what is being portrayed on the books.
A reality check with the competitor environment.
If there are plans for expansion or radical changes, the relationship with
local authorities and central government can be especially important.
Inventory levels and product quality (preferably over a longer period of
time).
A sensible supply chain and verifiable customer/supplier relationships.
Newly posted signs that may cover up facilities that could be owned by
someone else.
The company chops, which is the official seal used in business
transactions.

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provide great value here, and their findings can be merged in with discoveries
elsewhere to create a better overall picture of what is actually going on. The
quality of record keeping can be variable, and may not match the standards of
your own company.
There can be two or even three sets of books – the books that you see, the
books with the real numbers, and the books used for taxes. Written contracts
can be less extensive and verbal agreements are common. Rural regions
require an even greater level of scrutiny because of lower quality documentation.
These factors may restrict the ability of forensic accountants, which is why other
aspects of due diligence are important. Features to look out for are numbers
that look unusual, and if there is an explanation for this, consider its veracity.
Search for:
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Excessive account receivables or account payables relative to the income
statement or balance sheet.
Unrealistic asset values compared to industry and local norms.
Mismatches between physical inventory and inventory valued on the
books.
Significant cash transactions that reduce the paper trail.
Dominant customers may present a credit risk, while dominant suppliers
may present a supply chain risk. In both cases, there is higher potential
for collusion.
Hidden liabilities, including the potential for much larger than expected
funding requirements in the future.
Fake bank statements and invoices. Bank statements should be verified
at the central branch level, not the local branch.
Falsified purchase orders, invoices, shipping documents and receipts.
Original documents for asset ownership.
An independent valuation report for property and buildings.
Undisclosed side agreements and transaction documents that do not have
genuine official seals.
Staff members that have two or more different names.
Weak internal controls. These are cited as a contributory factor in almost
every post analysis of fraudulent activity of a company.

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Also take in to account cultural differences. For example, bad debt is an issue
that some Chinese may not like to provide for because it is sometimes
associated with losing face. It may also not be tax deductible. Hence the bad
debt charge could be too low. In some instances, unwritten down bad debt can
be shifted in to “Other Receivables” to make it appear that trade receivables
from normal business activities have kept a good collection track record.
Awareness and detecting more sophisticated fraud strategies
Many fraud strategies are able to overcome basic due diligence checks for the
more obvious red flags, such as excessive account receivables and fake bank
cash balances. These are often assisted by third party networks that are close
friends, family members or relatives. Sometimes a third party relationship can
be hidden with the use of puppet nominees, such as low level staff members.
Round tripping is a good example of that; sales, bank cash balances, receipts,
operations and asset ownership can all appear real. The method typically
tunnels out cash from the business to provide hidden forms of financing to
customers, who in turn use these funds to purchase products from the company
with the intention of artificially inflating revenues, profits and ultimately its value.
Round trip financing to the customer can be achieved in a variety of ways, either
directly such as payments cloaked in apparently legitimate transactions, or
indirectly such as undisclosed loan guarantees.
Other examples include rerouting products made by another business through
the company’s own channels and claiming all the revenue as its own, or the
company states it owns certain key assets that are really owned by another
party. Participating third parties may ultimately be related via nominee
ownership structures disguised by secrecy laws in offshore jurisdictions such as
the Cayman or British Virgin Islands. These methods frequently adopt the
tunneling and propping concept, a well-known fraud strategy in China.
Tunneling is used to covertly get assets/cash out of the company or increase its
liabilities, for example to misappropriate or round trip, and propping is used to
inflate the sales, profits and asset values/ownership of the company –most often
as a way to increase its value or credit worthiness. The strategy relies heavily
on the abuse of guanxi, which are close business networks in China. More
detailed checks to uncover these techniques may include:
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• Differences between accounting policies in China and that of your own
organization.
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Extensive activity and ownership checks on the company, its customers,
and its suppliers should be made all the way up to the ultimate ownership
level.
If possible, check the company’s and its counter parties’ tax records – no
one wants to pay real tax on fake or round tripped transactions.

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Obey the law and use it as a great tool to find red flags
It is not ok to only selectively adhere to corporate law in China, even if you think
some domestic Chinese companies are getting away with it. PRC corporate law
is often vague, complex, and open to interpretation, and may be applied more
rigorously to foreign companies. Moreover, if a legal dispute arises, and there is
discovery that your company was in breach of any law, related or unrelated to
the dispute, the chances of a successful outcome in court may be drastically
reduced.
There is also the possibility of inadvertently violating laws in your home country,
such as the Foreign Corrupt Practices Act for US companies, or laws on
regulation and compliance if your company is a stock exchange listed
corporation. Always conduct your due diligence within the bounds of PRC law.
You are strongly advised to get a very good PRC corporate lawyer.
PRC law should at least be considered at the asset, operating, and entity levels.
Areas to watch out for include valid business licenses, restrictions on foreign
ownership, taxation, and foreign exchange. For example, make sure you do not
pay a deposit to buy a company operating in a foreign owned restricted sector –
the deal will not happen, you have wasted your time, and have the uncertainty of
getting your deposit back. There may be PRC law restrictions on the amount of
foreign loans a company can borrow relative to its registered capital; this needs
to be factored in to future financing requirements. Different types of foreign
investment may have different applicable laws, such as Wholly Foreign Owned
Entities, Equity Joint Ventures or Contractual/Co-operative Joint Ventures.
Variable Interest Entity (VIE) type of structures are sometimes used to get round
foreign ownership restrictions or to speed up Ministry of Finance and Commerce
(MOFCOMM) approvals. These VIEs are contractual arrangements that give
the recipient the right to future economic benefits of the business, but at best
have precarious enforceability in PRC courts, may have substantial offshore
cash flow repatriation limitations, and ultimately there is no direct equity
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Verification that there are no assets or cash used for loan guarantees of
any form, and if so, to who.
A comparison to see if the company is performing inexplicably well
compared to competitors is useful.
Applying commercial and financial common sense can reveal a great
many red flags. For example, a big red flag giveaway is the co-existence
of large amounts of cash and debt on the balance sheet – it usually
makes no sense to have both in sizable amounts, and could indicate that
either the cash may be fake or it cannot be spent because it is locked up
as security in an undisclosed financing deal-which also means there is a
hidden liability.

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ownership in the target company. Moreover, there is a high risk that in the future
such VIE arrangements may be outlawed if the ultimate contractual beneficiaries
are non-Chinese nationals.
Ownership documentation can be questionable, particularly for land use rights.
If the target company does not have the original title to land use rights because
there is an excuse such as it is waiting for them to be converted in to its own
name, be very wary, even if a deposit has been paid. If the target company
previously had the business practice of not fully paying all taxes, or making
inadequate provisions for mandatory employee social benefits, statutory
reserves, selling inferior goods, operating without licenses, paying “commission”
or “consultant fees” to certain customer employees to get business, etc, do not
assume that under foreign ownership the business can continue this, or that it
will be as profitable if these practices are discontinued; this effectively means the
acquisition target may be worth less than the historic books show. Beware of
tax avoidance strategies such as transfer pricing – the Chinese are well aware of
these schemes and they are deeply frowned upon.
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A Mini Case Study – Faking financials to gain bank acceptance notes
Litigation releases from the SEC against a US stock market listed company provide an
interesting case study on what to look out for. Fortunately, the company auditors were
diligent enough to spot what was happening. The company, we shall call it “the
purchasing company”, produced cellulose ether, primarily used in the PVC, cosmetics,
foods, and paints industries. Although it was based in China, it was incorporated in
Delaware, and was listed on the US OTC Bulletin Board.
The case is relatively complex, but this is the minimum level of understanding needed to
reach an appropriate level of due diligence awareness, and it incorporates many of the
points made in this article. This was for a fully audited company to US Generally
Accepted Auditing Standards (GAAS) by a relatively well-known auditor; many Chinese
companies are audited with arguably lower auditing standards using less well-known
local firms.
The contested activity centres on the obtaining, use and disclosure of bank acceptance
notes. A measure used to assess credit risk was faked. These bank acceptance notes
were gained by creating fake purchase orders in collusion with a related third party
supplier. In China, the scrutiny from banks issuing acceptance notes is often considered
a less rigorous process than that used for standard bank loans, hence it is a vulnerable
area. It should also be remembered that what may be considered as normal business
practice in China could be interpreted as an invalid activity from the perspective of
Western companies and regulators.
The SEC alleged that in 2011, the purchasing company indirectly obtained bank financing
by issuing fake purchase orders to one of its suppliers. This supplier was 100% owned
by the CEO and President of the purchasing company, and thus was a related party. The
fake purchase orders and accompanying invoices were presented by the supplier to
banks so that bank acceptance notes could be issued. The subsequent funding received

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by the supplier were either routed back to the purchasing company, or kept by the related
party supplier for operational needs. In the context of tunneling and propping, the
tunneling was the creation of a bank acceptance notes liability, whereas the propping was
the subsequent cash received by the company.
The SEC litigation release states it was the banks that paid respective cash to the
supplier, however the supplier could also receive cash by selling these bank acceptance
notes at a discount in to a secondary market. The SEC also infers that the bank
acceptance notes were mischaracterized as notes payable owed to third parties but this
may in fact be two transactions rolled in to one; the first being the undisclosed creation of
a bank notes payable for purchasing company, and the second being the passing of cash
from the supplier to the purchasing company, which was then classified as a inter-
company loan from the supplier to the purchasing company. The chart above illustrates
what happened:
In the balance sheet of the purchasing company, a liability disclosure was made in the
form of “Notes Payable – related party”, but there was no disclosure of the full amount of
all notes payable to banks. In the cash flow statement, the related party notes payable
were presented in the financing activity section as a cash inflow “Proceeds from loan from
a related party”. As security for the notes, the purchasing company apparently deposited
between 50% and 100% of its cash, which then became restricted cash.
In some respects, this is an indirect form of round tripping using falsified orders to a
supplier that was part of the purchasing company’s related party network, and is an
alternative scenario to more well-known and direct round tripping schemes that use fake
sales. In this particular situation, the purchasing company had an undisclosed liability to

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banks, but only described a loan from a third party as part of the transaction chain.
Moreover, financing had been obtained by means that may be considered illegal in
China, hence exposing the purchasing company to potentially immediate demands for the
funds to be returned to the bank.
There were a number of red flags for this type of activity, many of which could be found
by simply reviewing the purchasing company’s accounts, including:
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The related third party nature with its supplier increased the risk of
collusion to obtain mutual benefit – In this case, the related party nature was
disclosed, but in many cases it is undisclosed and investigation is needed to
discover its true status.
The size of the respective purchase order was disproportionately larger
than the company’s business activity – According to the SEC allegations,
the fake purchase orders totaled some US$40 million, which was over ten times
higher than the estimated actual delivered orders from that particular supplier,
and well over the company’s estimated annualized total cost of sales, for all
related goods produced and sold in that year.
There was an unusually large increase in restricted cash – During the period
under investigation, standard short and long term bank loans remained virtually
unchanged, and declared notes payable owed to banks fell substantially. But at
the same time, there was a substantial rise in restricted cash (typically used as
security for bank loans). This strong rise in restricted cash contradicts the
direction of the company’s overall declared bank debt obligations. In contrast,
there was a significant rise in notes payable to a third party. This leads to the
suspicion that there may have been company cash used as security for
undisclosed bank debt obligations, and that the money apparently borrowed
from a third party used cash sourced from these undisclosed obligations.
The purchasing company claimed it made restricted security deposit
between 50% and 100% of the face amount for its disclosed bank
acceptance notes. Using restricted cash as security for 100% of the face value
for bank acceptance notes makes the effort of obtaining these notes seem a bit
pointless. It is more likely that the restricted cash secured between 30% and
50% of the notes total face value, hence the total amount of notes were larger
than disclosed.
The purchasing company had serious underlying cash flow problems –
Operating cash flow was very negative, and as a result the purchasing company
had clear funding requirements from external sources. PRC banks tend to limit
the amount they lend to non-State Owned Entity (SOE) companies, and often
only accept certain types of assets as loan security. In the case of this
purchasing company, the amount of standard bank debt the company had
obtained already appeared high. It was a logical choice to use bank acceptance
notes as further means of financing.
Direct lending from one firm to another is illegal in the PRC – Unapproved
non-financial institutions are not permitted to extend any direct loans to each
other; an approved financial institution as an intermediary must be used. Yet the
purchasing company accounts make clear statements such as “Proceeds from

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Conclusion
It is often better to be safe than sorry. There is no doubt that China is a wonder-
ful place to do business but if you have unanswered concerns then walk away.
Legal recourse may be limited in a subsequent dispute, very expensive, and
could take years to resolve. You might have lost money by spending on the due
diligence, but by being cautious you prevent a much greater loss, and gain some
great experience about what to look for next time.
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loan from a related party”. While this suggests the potentially illegal activity of
direct lending between two companies took place, it is possible that the
management of the purchasing company directed their 100% owned supplier to
“give” the purchasing company the cash without recourse instead of lending it,
but chose to describe this event in its audited books as an intercompany
borrowing transaction for the purpose of explaining the cash inflow in its US SEC
filings. The footnotes in the purchasing company accounts curiously describe
this “loan” as non-interest bearing with no fixed terms of repayment, which could
create a gray enough area for the definition of an intercompany loan under PRC
law. Moreover, it is possible that indirect lending can be made using an
entrustment loan, which is legal in China.
Questions also need to be asked about whether the 100% owned supplier
should have been consolidated on to the purchasing company’s balance sheet.
Although there is no suggestion of this by the SEC, the bank acceptance notes
financing potentially gives the related third party supplier an extra ability to
provide goods at discounted prices, which may temporarily boost profit margins
and give a false impression of higher profitability for the purchaser. Moreover,
there is the potential for the funding recipient to misappropriate the cash, or
covertly pass it on to a customer of the company to enable round tripping in the
form of purchases. There are numerous scenarios to consider.