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Media-savvy smartphone maker Xiaomi was in the headlines for the wrong reasons last week, facing a fine and embarrassing negative publicity after being exposed for inflating its sales figures in Taiwan. The news marked the latest in a steady string of accounting scandals and other financial misreporting that have plagued overseas-listed Chinese companies for the last 3 years, undermining their credibility and casting a negative shadow on China's own stock markets.

China's recent move to a market economy is the larger factor behind these scandals, since many of the country's companies are new to the business of transparency and western accounting standards. But a broader problem lies in lack of accountability, since most Chinese firms freely inflate their gains and hide losses because they know no one authoritative will ever question them.

China's securities regulator needs to take a more aggressive approach to exposing companies that inflate their profits and other business metrics, and severely punish them to deter others from engaging in similar practices. It can do that by boosting its own compliance arm, and also through working with outside auditors that often provide independent accounting services to many listed companies.

Xiaomi isn't a publicly-traded company yet, but many observers believe it regularly inflates its frequent announcement of sales figures, especially after big promotions. While many question its figures, no independent party could ever authoritatively say the company was lying before the case last week in Taiwan.

In that case, the Taiwan Fair Trade Commission ruled that Xiaomi overstated its sales figures during 3 promotions last December. (Chinese article) In 2 of those, it boasted of selling 10,000 of its low-end Red Mi smartphones in less than 10 minutes of launching online promotions. In the third case, Xiaomi said it sold 8,000 phones within just 25 seconds of another online promotion.

The Taiwan FTC conducted its own investigation and determined the numbers didn't add up, and fined Xiaomi NT$600,000 ($18,000). Xiaomi admitted to selling 30 less phones than it claimed, and continued to protest its innocence after the fine was levied.

The Taiwan FTC joined the US securities regulator, the Securities and Exchange Commission (SEC), which has launched a number of its own investigations into New York-listed Chinese firms after suspecting them of inflating profits or other business metrics in their public filings. The SEC began its more aggressive stance towards Chinese firms 3 years ago, after a group of short sellers started uncovering fraud in some of the companies' accounting statements.

In one of the first and highest profile of those cases, a short seller uncovered accounting irregularities at financial services company Longtop Financial, sparking a share sell-off that wiped out billions of dollars in shareholder value and ultimately forced the company to de-list. The SEC aggressively pursued the case even after Longtop de-listed, seeking to determine whether the company's independent auditor, the China arm of global accounting giant Deloitte, knowingly allowed Longtop to engage in the fraudulent reporting.

The SEC's aggressive stance has resulted in many more de-listings of suspect Chinese companies over the last 3 years. By comparison, China's securities regulator, the China Securities Regulatory Commission (CSRC), has remained largely silent over the same period in pursuing accounting fraud, preferring instead to go after rogue brokerages and people suspected of insider trading. It rarely de-lists companies, often because such firms play accounting tricks to avoid violating listing rules.

Rather than chase the accounting fraudsters, the CSRC even blocked the SEC from getting Longtop accounting records during its investigation of Deloitte, citing territorial issues. The CSRC has changed its stance somewhat since then, signing a landmark agreement with the SEC last year for limited information sharing. But that agreement doesn't apply to companies whose fraud has yet to be exposed.

Rather than sit by and let foreign regulators chase Chinese firms that engage in accounting mischief, the CSRC and other Chinese regulators should take a more active role in ferreting out such fraud. The CSRC and other agencies like China's Commerce Ministry could do this by building up their own fraud investigation units. China could also follow a practice used in many overseas markets by holding outside accounting firms responsible for financial statements of companies they audit.

By becoming more aggressive against accounting fraud, the regulator could restore some confidence to the nation's stock markets, which are struggling in no small part due to a high degree of investor skepticism towards the many companies' financial statements.

Bottom line: China's securities regulator needs to follow the lead of the US and Taiwan and aggressively pursue local companies that exaggerate their financials and other business metrics.

Disclosure: None.

Source: Taiwan Fines Xiaomi, China Should Take Note