To help inform investors about risk in China, Janus Henderson presents this wide-ranging educational series – China investing: Signals and Smokescreens. This is based on an in-depth study of China stocks that underwent periods of intense financial stress in recent years.
05.09.2018 | 12:45 Uhr
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.
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.
Here are some of the warning signs of problems relating to aspects of a company’s external oversight that we encountered:
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.
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.
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.
|Red flags||Green flags|
|Appointment of an obscure auditor.||Appointment of a ‘Big-Four’ auditor.|
|Turnover in auditors within short time frame.||Retention of auditor or a credible reason for the change.|
|Audit fees that are incommensurate with the company’s scale; increases in revenue without proportionate increase in audit fee.||Audit fees that are commensurate with the company’s size and the work to be undertaken.|
|Outsourcing of audit work to onshore firms.||Audit opinion confirms that work was not outsourced and performed by well-trained employees.|
|Appointment of small valuation firms without presence in China/requisite experience; doubts can be raised regarding independence.||Appointment of experienced valuation firms with experience in China and preferably with global credibility.|
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