In this episode of China Money Podcast, guest Paul Gillis, professor of accounting at the Guanghua School of Management at Peking University in Beijing, discusses Caterpillar's US$580 million write-down in its acquisition of Zhengzhou Siwei. Prof. Gillis explains the three most common accounting tactics Chinese companies use to cheat and defraud foreign investors, and what can foreign investors do to prevent themselves from being duped.
Listen to the full interview in the audio podcast, or read an excerpt.
Q: Caterpillar is taking a US$580 million write-down on its acquisition of Chinese mining company, Zhengzhou Siwei, after discovering a "deliberate, multi-year, coordinated accounting misconduct."
Key background: 1, What Caterpillar bought for roughly US$700 million was Hong Kong-listed ERA Mining Machinery, which is a shell company that owns Zhengzhou Siwei, a Henan province-based mining equipment maker. 2, Zhengzhou Siwei was absorbed by ERA through a reverse merger in 2010 and never went through a formal IPO process.
So Paul, can you use your imagination and picture what you think happened when Caterpillar's CFO told the CEO about this massive loss in their C-suit?
A: I imagine that was a pretty awkward situation. It's very embarrassing for anyone at Caterpillar to be involved in a deal like this. I'm sure there is a search for the guilty parties on the way.
Q: Here is what Caterpillar disclosed about how they found out about the accounting misconduct:
"Caterpillar first became concerned about…discrepancies…in November 2012 between the inventory recorded in Siwei’s accounting records and the company's actual physical inventory…Caterpillar promptly launched a comprehensive review and investigation (that) identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."
From the above statement, what accounting fraud can you infer that Siwei has done?
A: The first thing they pointed to are problems with inventory. After counting the inventory in Siwei's factories, Caterpillar discovered Siwei didn't have as much inventory as recorded on their books. That means Siwei was capitalizing these costs and carrying it as inventory costs, as supposed to expensing it in the current period, which could lead to their profits significantly lower.
The more serious allegations in my mind are revenues being recognized too early or inappropriately. So some sales were recorded before they were actually completed. But this is a very common practice in China.
Western accounting standards are very detailed about when you can recognize revenue. For example, you must have signed contracts; you can't have rights of return; or obligations to do more things in the future. But in China, businesses are done more on relationships. The contracts are less important than the handshake. So I would not be surprised if management at Siwei didn't think they were involved in any kind of fraud relating to revenue recognition.
Q: But it does sound like that Caterpillar didn't check out Siwei's books and didn't examine physical inventories. Do you think it's likely?
A: It's hard to know. Caterpillar did say that they hired two Big Four accounting firms: Ernest & Young and Deloitte Touche Tohmatsu. It is unusual to hire two Big Four firms. But the due diligence is a customized process....
In this episode of China Money Podcast, guest Paul Gillis, professor of accounting at the Guanghua School of Management at Peking University in Beijing, discusses Caterpillar's US$580 million write-down in its acquisition of Zhengzhou Siwei. Prof. Gillis explains the three most common accounting tactics Chinese companies use to cheat and defraud foreign investors, and what can foreign investors do to prevent themselves from being duped.
Listen to the full interview in the audio podcast, or read an excerpt.
Q: Caterpillar is taking a US$580 million write-down on its acquisition of Chinese mining company, Zhengzhou Siwei, after discovering a "deliberate, multi-year, coordinated accounting misconduct."
Key background: 1, What Caterpillar bought for roughly US$700 million was Hong Kong-listed ERA Mining Machinery, which is a shell company that owns Zhengzhou Siwei, a Henan province-based mining equipment maker. 2, Zhengzhou Siwei was absorbed by ERA through a reverse merger in 2010 and never went through a formal IPO process.
So Paul, can you use your imagination and picture what you think happened when Caterpillar's CFO told the CEO about this massive loss in their C-suit?
A: I imagine that was a pretty awkward situation. It's very embarrassing for anyone at Caterpillar to be involved in a deal like this. I'm sure there is a search for the guilty parties on the way.
Q: Here is what Caterpillar disclosed about how they found out about the accounting misconduct:
"Caterpillar first became concerned about…discrepancies…in November 2012 between the inventory recorded in Siwei’s accounting records and the company's actual physical inventory…Caterpillar promptly launched a comprehensive review and investigation (that) identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."
From the above statement, what accounting fraud can you infer that Siwei has done?
A: The first thing they pointed to are problems with inventory. After counting the inventory in Siwei's factories, Caterpillar discovered Siwei didn't have as much inventory as recorded on their books. That means Siwei was capitalizing these costs and carrying it as inventory costs, as supposed to expensing it in the current period, which could lead to their profits significantly lower.
The more serious allegations in my mind are revenues being recognized too early or inappropriately. So some sales were recorded before they were actually completed. But this is a very common practice in China.
Western accounting standards are very detailed about when you can recognize revenue. For example, you must have signed contracts; you can't have rights of return; or obligations to do more things in the future. But in China, businesses are done more on relationships. The contracts are less important than the handshake. So I would not be surprised if management at Siwei didn't think they were involved in any kind of fraud relating to revenue recognition.
Q: But it does sound like that Caterpillar didn't check out Siwei's books and didn't examine physical inventories. Do you think it's likely?
A: It's hard to know. Caterpillar did say that they hired two Big Four accounting firms: Ernest & Young and Deloitte Touche Tohmatsu. It is unusual to hire two Big Four firms. But the due diligence is a customized process....