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In my previous Seeking Alpha articles (here and here), I challenged that ZST Digital Networks (OTC:ZSTN) provided false representation of its business relations and reported substantially exaggerated revenue and income to the SEC. The management of ZSTN responded on April 29th to some of the issues raised.

The management's response claimed that the SAIC reports are not audited.

A number of you have asked why it is that our Chinese State Administration of Industry and Commerce (SAIC) and SEC reports do not match, and the answer is that the SAIC filings are a formality, for the purposes of business license renewal with the government, and are not audited.

This is an outright lie -- the SAIC filings of ZSTN for 2008 and 2009 are audited.

The auditing firm is Henan Tianyou Accounting Firm and the auditors are two China Certified Accountants, Yuan Fengming and Liu Xuebing.

Of the 26 pages of the 2009 AIC filings I obtained from China and provided to the investors (original version, an annotated version I provided with my previous article and a further annotated version to provide more translation to the audit report portion), 15 pages belong to the auditing report, starting from page 11. Page 11 and Page 12 are the auditor's opinion ended with a chop from the audit firm, Henan Tianyou, and the CPA chops of Yuan Fengming and Liu Xuebing. Pages 13 to 18 are footnotes. Pages 19 to 21 are balance sheet, income statement and cash flow statements. Pages 22 and 23 are business certificates for Henan Tianyou. Pages 24 and 25 are the auditors' business licenses for Yuan and Liu.

Of the 29 pages of the 2008 AIC filings I obtained from China and provided to the investors (original version and annotated version), 17 pages belong to the auditing report, starting from page 12. Pages 12 and Page 13 are the auditor's opinion ended with a chop from the audit firm, Henan Tianyou, and the CPA chops of Yuan Fengming and Liu Xuebing. Pages 14 to 16 are balance sheet, income statement and cash flow statements. Pages 17 to 24 are footnotes. Pages 25 and 26 are business certificates for Henan Tianyou. Pages 27 and 28 are the auditors' business licenses for Yuan and Liu.

The image below is part of the 2009 audit report showing the audit opinion and chops for the accounting firm and China CPAs.

(Click to enlarge)

As I pointed out in my previous article, because Zhengzhou Shenyang Technology Company Limited (“Zhengzhou ZST”) is considered a foreign invested enterprise under PRC laws, as a result, it is required to have an annual audit report sent to the local tax bureau and the local SAIC office (references here and here (.pdf)). And we indeed found audit reports in ZSTN's SAIC filings.

While it is not unusual that the AIC filings differ from the SEC filings due to certain governing rule differences, it is extremely unlikely for these two reports to differ by more than two orders of magnitude, as ZSTN numbers have shown to us, because the Chinese tax system is designed to prevent an understatement of revenues.

Unlike the American tax system, which relies more on taxing the cash net income than the revenue, the Chinese tax system charges heavily on the revenue side: 5% business tax on the service revenue and 17% VAT tax on the sales revenue. The Chinese government thus designed an invoice system that makes sure that the business finds it hard to under-report revenues. For a primer, I googled 'China invoice' and here is the first link I hit - "10 Things You Didn't Know About Invoices in China", which should give readers some ideas.

As the regulators, the SEC and the PCAOB have expressed worries over systematic concerns surrounding the quality of the financial reporting by foreign RTO companies, the existence for such accounting irregularities just may not last very long.

Source: ZST Digital Networks: Comments on Management's Response to My Allegations