Janus Henderson: China investing part 6 - external oversight

So far, the ‘Signals and Smokescreens’ series has focused on an analysis of internal governance; but as the proverb shrewdly observes, no one is infallible and mistakes can inevitably occur. While this risk is addressed in the West through the appointment of independent auditors and advisors, the practice of appointing an external auditor began only very recently in China. Moreover, the industry is heavily regulated by the state, which can compromise independence.

Certified Public Accounting firms (CPAs) have only existed in China since the 1980s; until 1998, the Chinese government required all CPA firms to be formed by government bodies or government- controlled institutions such as universities. Currently, CPA firms are regulated by the Chinese Institute of Certified Public Accountants, which is controlled by the Ministry of Finance. When they were first allowed into China in the 1990s, it was compulsory for the international ‘Big-Four’ accounting firms to operate through joint ventures with local accounting outfits. Foreign auditors are still required to be managed and controlled by local Chinese nationals and there are limits on the numbers of foreign partners. Additionally, Chinese regulations strictly prohibit auditors from surrendering their audit papers to foreign regulators, such as the US Securities and Exchange Commission (SEC) or the Public Company Accounting Oversight Board, even in cases involving a Chinese business listed on an overseas stock market.

These two factors – namely, the relatively recent practise of using an external auditor at all, and the heavy restrictions on the ability for foreign auditors to operate in China – can both lead to a potential dilution in the rigour of oversight by company auditors and also risk compromising their independence.

Competence and independence

When considering the audit of the financial statements of Chinese-quoted companies, we need to assess the reliability of the auditor by looking more closely at certain indicators. In our analysis of more than 50 companies through the course of this study, just under half exhibited warning signals related to the external audit function.

We will present some factors related to the capacity and independence of external auditors that investors should consider when reviewing published financial statements. Through our analysis, we observed some clear patterns between defects in external oversight and Chinese stock failure.

External oversight risk in practise

Here are some of the warning signs of problems relating to aspects of a company’s external oversight that we encountered:

• Rotating auditors – high turnover in auditors in a short space of time is an indicator of potential problems. For example, we encountered one Alternative Investment Market (AIM) listed company that had four different auditors in the same number of years. This is a clear signal that the audit cannot be completed to satisfactory standards. The change in auditor could be due to dismissal or voluntary resignation. In both cases the reasons should be evaluated carefully, as can be shown in the following examples:

• Resignation – we noticed one case where the auditor resigned because ‘management prevented [them] from performing adequate audit procedures on the cash at bank.’ Contrary to the situation in the West, where bank statements are taken as reliable third party audit evidence, the manipulation of bank statements, in concert with bank staff, is a notorious method of falsifying accounts in China. Consequently, auditors often undertake enhanced procedures. In this case, the management refused to allow the auditors to visit the bank and they therefore resigned. This type of event should be taken very seriously by investors but, in this case, an investor noticed that the market capitalisation of the company was lower than the net cash balances and bought $12m of the stock, losing all of it shortly afterwards. This was presumably due to not having reviewed the public disclosure of the reasons for the auditor’s resignation or ignoring it. It is of the utmost importance to satisfy oneself that the reasons for any resignations of auditing firms do not indicate problems and to assess the impact on the reliability of the financial statements.

• Dismissal – in another case, we noticed that the auditor of a NASDAQ quoted Chinese company had been summarily sacked after it asked to review the company’s bank statements. This absurd position taken by the Chinese Chief Executive Officer (CEO), with the excuse that the audit procedure was ‘too broad,’ led to several resignations from the board of directors and the collapse of the stock price. This might have been difficult to predict in advance, but more alert investors would have noticed that the same inpidual was the CEO of another NASDAQ company with the same brand name and, if they had promptly pested from that company as well, they would have avoided heavy losses that occurred when similar problems emerged in the second company.

• Unreasonably low fee – external auditors are often considered an unnecessary bureaucratic nuisance by Chinese businesses because there has never been a perception that an audit can add value to the investment process. We have seen cases where the fee is so low that there is no possibility of performing adequate fieldwork. For example, one internationally recognised firm of auditors was paid £16,500 to audit a multi-site New York Stock Exchange (NYSE) listed company with revenues of over US$130 million. The only possible way that they could complete the audit would be to rely on outsourcing to a local Chinese CPA firm, which would probably have compromised quality.

• Capacity and competence – we have seen cases where quoted companies have appointed very small auditors, which have a history of scandal or a very obvious lack of any experience in China. One US-listed Chinese company hired an auditor whose website boasted that they were the ‘audit alternative for listed companies’ but had no other listed clients on their website. In another case, a NASDAQ-quoted company appointed a firm of accountants based in Florida that had two audit partners and no presence at all in China.

• Outsourcing – foreign audit firms sometimes outsource the audit fieldwork in China to a local firm. For instance, the notes to the financial statements in one quoted company stated that ‘more than 50% of the audit staff are employees of the auditor,’ thus implying that a significant number were not, even though this was a well-known international firm of accountants. This raises the risk that audit staff have not been trained to international standards. Another listed company’s audit partners had not signed off on a single annual audit from China, implying that their work was  outsourced to unknown firms.

Valuations

A secondary area of external oversight that we considered was the use of external experts in assessing the carry value of material assets. Although the examples above include rather blatant attempts to avoid proper scrutiny of financial statements, we have also found some publically-listed Chinese companies with significant problems caused by expert valuations. In one example, a foreign-listed Chinese company had been involved in the development of forestry assets for harvesting and sale in China. The company’s shares were suspended from trading on the Hong Kong Stock Exchange and their auditor, one of the ‘Big Four’, later resigned over concerns about accounting irregularities in the group’s records. The company was subsequently delisted.

The company’s annual reports from the reporting periods prior to the delisting displayed warning signals prior to the share suspension. The financial statements revealed that almost all of the previous three years’ profits had resulted from large revaluations of forestry assets rather than revenue derived from the sale of timber. Further investigation showed that these valuations had been prepared by a small forestry consultant based in New Zealand. This firm was paid the equivalent of £3m, which was highly material to the consultancy, to conduct specialist valuations of forestry assets in China, a task for which the firm lacked any previous experience and did not have the capacity to conduct adequate on-the-ground surveys. This should have raised questions about the capability and independence of the consultant, since the entire three years’ profits derived from their valuation work.

Caveat

In summary, while it is an oversimplification to say that the appointment of a top auditing or valuation firm implies a clean bill of corporate health, nevertheless, the willingness of a management team to appoint competent auditors exhibits the mindset that should reassure investors that the financial statements have been prepared conscientiously.

Key considerations

How can it be determined whether a company is taking every reasonable step necessary to ensure that the information disclosed in the audited financial statements reflects a true and fair view of its state of affairs?

The table below illustrates some key flags that we found most instructive in our analysis of Chinese companies.

Investment team perspective

Charlie Awdry, China equities investment manager at Janus Henderson:

“In addition to the global issue of managing potential conflicts of interest, the domestic auditing profession in China is fragmented and suffers from overcapacity. Foreign joint ventures are highly regulated therefore monitoring the action of auditors and how management interacts with them is an important consideration in the due diligence process when it comes to investing in Chinese companies."

Part 1: Janus Henderson: China investing - China-specific risk
Part 2: Janus Henderson: Risk, with Chinese characteristics
Part 3: Janus Henderson - China investing - financial ratios
Part 4: Janus Henderson - China investing - board oversight
Part 5: Janus Henderson - China investing - material and related-party transactions