Short Charade's  Instablog

As an investor, unless you’ve been living under a rock for the past two years it’s been pretty much impossible to avoid the cascading stampede of research outfits (many anonymous, some not) who have been staging a classic “Witch Hunt” against Chinese company’s screaming fraud, while shorting company stock. The evidence to support their claims is a fairly standardized formula:  finding discrepancies between SEC and SAIC (State Administration of Industry and Commerce) filings, looking for transactions that appear to funnel money out of the company, excessive secondary equity issuances – then of course typically the researchers scour the internet for any tenuous further evidence to support their claims. To be fair, some of the accused have warranted the attention and have been exposed as frauds, but many companies and their shareholders have simply become victims, losing substantial value due to the old “Guilty By Association” – if you are a Chinese company you must be crooked.

2012 is right around the corner and promises to be yet another interesting year for US listed Chinese companies, with many trading at just above 1x earnings, longs with an appetite for risk are sharpening their knives, or more specifically making sure their passports are up to date and downloading the online Chinese visa application. The relative risk reward of buying Chinese equities at these depressed prices while popping across the Pacific on due diligence is too tempting to ignore.

As a case in point, after China Agritech (CAGC.PK) took a beating earlier in the year from an outfit calling itself Lucas McGee Research, Jesse Glickenhaus from Glickenhaus and Co visited the company to conduct in person due diligence and confirm the existence of the company, it’s production and distribution channels. With recent coverage on Pimm Fox, the company recovered from its low of $0.50 and is now trading just below $2.00.

Gulf Resources (GURE) is another company that has struggled for credibility against an onslaught of negative articles. In September of 2011 a well written rebuttal was provided by Seeking Alpha author Marc Chang, which was followed up by verifications by local and provincial governments.

The most recent surprise has been the work of an independent investor who travelled to visit Advanced Battery Technologies (ABAT.PK) facilities throughout China during the opening ceremonies of the companies Dongguan property. The photos the investor posted on Flickr show a celebratory crowd in the hundreds. More telling however, were the photos of the interiors showing a bustling business.

The path to reclaiming good valuations is fraught with potholes and companies are obviously struggling to see what works best, the primary concern of course is investor confidence and when all else fails - the final option that seems the most welcome is simply to take the company private as in the cases of Harbin Electric (HRBN) and, well, soon to be, ChinaCast Education (CAST). The title of this article hinted at some sort of a prediction for the sector in 2012. Our crystal ball is pretty rusty and it would be foolish to say anything other than expect the unexpected. For those who have weathered the storm, remember that confidence and trust takes time to re-build. To everyone we wish a happy healthy holiday season and a prosperous new year.

Disclosure: I am long GURE, ABAT.PK.

If there were a Letterman Top Ten List for short claims of fraud against Chinese companies, the number one would have to be that the SAIC filings (State Administration of Industry and Commerce) do not match the companies SEC filings. Your average investor, institutions included, see discrepancies between the two filings and instantly flee from the company convinced that it must be a fraud or something is fishy in Fuzhou. While differences between the SAIC and the SEC filings might be a flag to signaling further investigation, as the article below discusses it is FAR from being a smoking gun:

Re-Printed From Trading China Website
The comparison of Chinese filings and U.S. SEC filings from U.S.-listed Chinese companies has become a hotly discussed topic over the past several weeks. A large number of articles, most notably from authors with short positions in the stocks discussed, focus on severe discrepancies between SAIC reported numbers and SEC filings, and conclude there must be fraud involved. Such an automatic conclusion is just plain wrong as there are many legitimate reasons for those numbers not to match.

With this article I am going to clarify some of the major aspects in this rather complicated system of multiple filings for one and the same U.S.-listed company. The article is based on a July 12 report from Roth Capital Partners (many thanks for supplying it for this purpose), several other reliable sources, and my own research.

Every U.S. listed Chinese company with actual business operations in China has to file financial statements with three agencies (there are more but those don’t matter here): The U.S. Securities and Exchange Commission (SEC), China’s State Administration of Industry and Commerce (SAIC), and the Chinese State Administration of Taxation (SAT). Let’s have a more detailed look at those Chinese agencies:

China’s State Administration of Industry and Commerce (SAIC)
The SAIC (www.saic.gov.cn) is primarily responsible for business registration, business licenses and acts as the government supervisor of corporations. The SAIC is the Chinese government registrar for official documents like articles of incorporation, legal persons, registered capital and company ownership. In order to renew their annual business licenses, all Chinese companies must file a so-called ‘Company Annual Inspection Report’ with the SAIC between March and June every year. This report includes financial statements such as balance sheet and income statement, but those numbers are not verified or audited by the SAIC. The agency is primarily concerned with legal compliance issues and not with operating data or taxes.

State Administration of Taxation (SAT)
Chinese companies pay a variety of taxes as VAT, Enterprise Income Tax (EIT), business tax and payroll taxes. The tax filings made with the SAT (www.chinatax.gov.cn) are much more similar to SEC filings than what has to be submitted to the SAIC for business licenses. The SAT requires audited financial data including balance sheet, income statement and cash flow statement and the tax bureaus audit those reports quite frequently themselves and fine offenders who under-report to the SAT. Tax collectors in China are not any less serious than those in Europe or the United States. Financial statements to the SAT are much more reliable than SAIC filings, however those are not publicly accessible and unavailable to investors or research analysts.

Reasons for non-matching SAIC/SEC Numbers
There are several legitimate reasons for SAIC reported financial statements not to match those numbers filed with the SEC. First of all, the SAIC is the business registrar and not the Chinese equivalent of the SEC. The SAIC does neither review nor audit financial statements submitted with the annual inspection report. Most companies see the sole purpose of an SAIC filing in getting their business license renewed, and some even hire a third party to do the filing for them. China Marine Food (CMFO) CFO Marco Ku explained that in a recent interview with Zack Buckley:

It is tedious to file with the government. They need to supply documents, ask for specific things, and it is very difficult. Most companies try to use an agent firm to file these with the government. I didn’t do it myself when I ran my personal business based in Beijing some years ago because it is too tedious to do all the filing. If you pay an agent it can be done without headache in a few days. CMFO used an agent, paid a fee and got the business license done. In the process, the agent doesn’t care whether you earn how much or whether you lose money. They just care whether your company is in operation. The agent firm doesn’t ask us for audited reports. We pay the fee and get the license back. When I realized that the public can somehow access SAIC documents, we immediately asked my team to do the filing on their own instead of agent firm.

Another reason is the difference in accounting principles. Chinese documents are audited under PRC GAAP, while SEC filings are based on U.S. GAAP standards for financial reporting. There are many differences between those standard, starting with how revenue is recognized. I can’t get into detail here but the bottom line is that certain key numbers don’t have to be the same in order to still both be correct.

Roth Capital points out several other possible reasons for divergent filings:

Business Consolidation: In China every legal entity has to file its own annual inspection report with the SAIC. This includes every individual division or subsidiary of the U.S.-listed company and a separate report from the parent company. Sometimes the parent report is consolidated while other times it is not. According to Roth, inter-company transactions might be treated differently than in the U.S.: “For U.S. GAAP purposes, inter-company transactions are treated carefully to avoid double counting. However, for PRC tax purposes, PRC tax professionals may seek to use inter-company transactions in ways to minimize tax. This includes using different consolidation approaches and/or using inter-company transactions to allocated profits to entities that are
subject to lower tax rates (including Hong Kong companies or PRC entities that have special tax benefits).”

Overseas Activities: SAIC filings only reflect business activities in the PRC while filed reports with the SEC have to reflect worldwide financial data for the consolidated U.S.-listed company. Revenue that is generated overseas or assets held outside of the PRC (even Hong Kong) will not be included in the SAIC filings. Another good example for the effects is that cash that a company keeps on U.S. bank accounts to pay for overseas expenses might not show up on the balance sheet submitted to the SAIC.

It can’t be denied that many Chinese companies try to under-report their net profits to the authorities. Roth Capital concludes that “companies often find ways to reduce PRC taxable net income through various means, including aggressive practices.” Another reason for understating financials with the SAIC is to avoid disclosing their real operating size to customers, suppliers and competitors. There, Chinese companies are not any different from those in America or Europe, why should they be?

Conclusion
Non-matching PRC and U.S. financial statements do not automatically point to errors, mis-statements or even fraud, as many of the circulating articles on this subject try to make you believe. In fact, in most cases they do not. The key here is the company’s independent public accounting firm, that is responsible for the SEC filings. The auditor is responsible for reconciling U.S. filings with the SAT tax filings in China. The amount of taxes paid in China are a U.S. GAAP expense and if the auditor has reviewed the Chinese filings and determines that there is an underpayment of tax, they will require the company to record a tax reserve on the balance sheet filed with the SEC.

I do fully agree with Roth’s conclusion that a high quality auditing firm with a great level of experience in China and with Chinese accounting should be one of the key criteria for making any investment decision in U.S.-listed China small caps. While I acknowledge that audit expenses for an early stage Chinese firm with limited business and profits should be contained at a reasonable level, I am convinced that with growing revenues and net profits every Chinese company should consider appointing a top tier auditor, and those who have not done this should be approached with more caution by investors. Roth Capital Partners:

“Severe discrepancies between U.S. GAAP reported income and PRC reported income and tax should be immediately apparent to the U.S. GAAP auditor, particularly those with extensive experience in China. We believe this experience is a critical consideration when evaluating companies as potential investments. We place most confidence in auditors with a high-level of experience in China, including a strong China-based team. While many U.S.-listed Chinese companies start out with less established auditors, we believe the highest quality companies migrate to more experienced auditors over time. We believe that retaining a small, inexperienced auditor year after year should be viewed as a risk factor and evaluated accordingly. “

Here at Trading China you will find the auditors of all companies we are tracking on their Score Cards. There is also a full list of auditors available. The list doesn’t mean to imply that all those auditors not ranked in the Top 10 (or Top 100) are bad or less trustworthy, many of them might do a fantastic job, however it can be safely assumed that all the top tier names have extensive experience in China and a large number of partners, a reputation to lose, a strong China team, to deal with all those questions in the best of interests for the company and investors worldwide.

Trading China Website