Chinese Reverse Mergers: Beware of Accounting Problems

Nov.23.10 | About: RINO International (RINO)

Bad news regarding accounting irregularities is frequently greeted by investors with some variation of Captian Renault’s famous line from the 1942 classic Casablanca: “I’m shocked, shocked to find gambling going on here”. It’s feigned shock at what is common knowledge. Like Casablanca, accounting issues are frequently out in the open long before they have full impact on the stock price. Yet, despite such problems, investors frequently stick around for more.

Take, for example, Tongzin International (OTCPK:TXIC). The last time TXIC produced a full set of financial statements was 3Q09. The company has not been able to complete its audited annual report (20-F) for 2009 due to a disputed series of related party transactions. The absolute dollar amount in question is not particularly large, so I suspect the auditors must feel pretty strongly for them not to sign off. To add to the problems, the company was threatened with and eventually delisted for the late-filer status.

Irrespective of who is right or wrong about the particular accounting issue under review, why would investors step into a situation where a company has not filed financials in nearly a year, cannot get their auditor to sign off on annual financials for a year that ended 9-months ago, and is being threatened with delisting? How does one determine if a company is over/under valued if there are no reliable financials?

It’s a mystery to me, I’ll tell you that. This is particularly surprising given that TXIC went public via a reverse merger with a SPAC. Given Barron’s recent warning I would have thought that investors would have been forewarned. After what happened to Rino International (OTC:RINO), I thought that investors would absolutely flee Chinese companies with questionable accounting. Yet, despite all this the company has its entourage of supporters.

Unfortunately for investors, the surprises have not ended. The company added to the audit issue by lowering revenue guidance for 2010 and firing senior management. Yes, now that the year is almost over they lowered guidance. They took guidance down from $150-$160 million to $100-$110 million. Down about 33% with 6-weeks to go in the year.

Is it possible that the company didn’t know they would miss guidance until mid November? I think not.

I think it is unlikely that the related party accounting issue and bogus guidance were the only issues previous management created. In my experience, red flags such as those above are harbingers of things to come. Unfortunately, with accounting issues that point to less than honest management, many times what you see initially is only a fraction of what you get by the time the story ends.

This particular story is nearing a sad and ugly end. I hope the moral of this story is clear: Steer clear of companies with unresolved accounting issues.

Disclosure: I have a long standing short position in TXIC and TXICW