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. 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 −

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 −

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

6.5
49.7
79.6
0 20 40 60 80 100
Corruption
Asset Misappropriation
Percentage of Cases
TypeofFraud
− 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
Median Loss (US$)
TypeofFraud
− 11 −
Occupational Frauds by Category – Median Loss

− 12 −
Percentage of Total Reported Dollar Losses
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

− 21 −
 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

− 23 −
Document Recovery

− 24 −
Document Storage – Hong Kong style
 A secret room in the treasurer’s office…………….

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
Moulin Balance Sheet

− 26 −
Locating Assets – in China
The PRC Credit Union where funds of HK$80 million were said to be deposited.

− 27 −
False Bank Documents

− 28 −
False Bank Documents

Draft Balance Sheet as at 31 December 2004
Assets
 Cash at Bank – HK$1.2 billion
(US$87 million)
Liabilities
− 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.

− 30 −
Locating Overseas Assets – Trade debtors

Assets
(US$64 million)
Liabilities
− 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.

Assets
(US$7 million)
(US$112 million)
 Inventory – HK$465 million (US$60 million)
 Due from Senior Mgmt – HK$93 million (US$12 million)
Liabilities
− 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

Assets
Liabilities
(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

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
Trade Finance Fraud
− 34 −

− 35 −
Trade Finance Fraud

− 36 −
Trade Finance Fraud

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
Trade Finance Fraud
− 37 −

Ratio Analysis
Net working capital ÷ Total sales
Moulin’s working capital to sales Dec 31, 2003
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 −

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

Case Study - Moulin
− 41 −
Leadkeen Beijing Trial Balance
Includes “fake” accounting ledgers for Custom tax and Packing
materials

− 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

− 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

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 −

“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 −

“Association of Certified Fraud Examiners,”
“Certified Fraud Examiner,” “CFE,” “ACFE,” and
the ACFE Logo are trademarks owned by the
Association of Certified Fraud Examiners, Inc.
The contents of this paper may not be
transmitted, re-published, modified, reproduced,
distributed, copied, or sold without the prior
consent of the author.

FTI: Financial Statement Frauds - Chinese-Style (Presentation)

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FTI: Financial Statement Frauds - Chinese-Style (Presentation)