The SEC recently initiated stop order proceedings against China Intelligent Lighting and Electronics Inc. and China Century Dragon Media Inc. on suspicion of accounting fraud.  As reported by The New York Times, both companies failed to disclose that their independent auditors resigned after asking questions about the accuracy of the companies’ financial statements.

A number of Chinese companies have come under fire for accounting fraud stemming from corporate governance issues according to Forbes: “[i]n the past six months alone, more than 25 [NYSE and Nasdaq]-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign.”  In light of these discrepancies and departures, the need for increased transparency, strong risk management and broad financial oversight is greater than ever.  In particular, Chinese companies have been criticized for their relatively low number of independent directors (33% of the directors of Chinese-listed companies compared to 75% of the directors of U.S.-listed companies) and the lack of relevant industry experience these independent directors offer. 

In one recent case involving Chinese financial software company Longtop Financial Technologies Limited, auditor Deloitte Touche Tohmatsu handed Longtop a resignation letter, included as an exhibit to a Form 6-K filed by Longtop, that asserted financial statement fraud, bank corruption and threats against the auditors.  The New York Times explained the breakup as an investigation by Deloitte, after six years of clean audit opinions, into Longtop’s cash balances.  Longtop blocked Deloitte from following up with bank headquarters regarding cash balances (that bank branches had already confirmed) by telling the bank that Deloitte was not the company’s auditor and threatening to hold Deloitte staff captive unless Deloitte allowed Longtop to retain Deloitte’s audit files.  As described in the resignation letter, Longtop’s chairman Jia Xiao Gong, explained to a Deloitte partner why Deloitte could not find the cash:  “there were [sic] fake revenue in the past so there were [sic] fake cash recorded on the books.”  That is a disturbing clarification.

OUR TAKE:  Sound accounting practices and the independence and experience of directors are of paramount importance to sound corporate governance.  Foreign companies, which bring with them different regulatory, governance and financial backgrounds and standards, may pose unique risks for U.S. investors.  Investors should pay close attention to corporate governance and accounting issues generally, but especially with respect to less familiar foreign companies.  Reports identifying trends with respect to corporate governance deficiencies and/or accounting fraud especially raise investment red flags.