A rash of Chinese accounting scandals has raised questions about whether audit firms are doing enough to detect fake money trails and confirm companies' cash, the most basic number auditors are supposed to check.
The risks in auditing bank balances came to the fore last week when Longtop Financial Technologies, a Chinese software company with shares listed in the United States, said its auditor had resigned amid questions about its cash.
In its resignation letter, auditor Deloitte Touche Tohmatsu CPA said it found falsified financial records and bank confirmations and that its audit opinions for Longtop should no longer be relied on.
Deloitte, which declined to comment for this story, has not been accused of wrongdoing and accounting experts said it did the right thing by insisting on more verification of Longtop's bank balances and resigning when it failed to get them.
Even so, questions have been raised about whether auditors need to beef up procedures for confirming bank statements. Cash is the lifeblood of any company, and bank balances have figured in a number of recent Chinese accounting scandals.
Many Chinese companies have found it easier to get a listing in the United States than on Chinese exchanges. Yet they have fallen through a regulatory loophole, partly because US audit inspectors have not been allowed inside China where the audits are done. Accounting problems often come to light only when short-sellers target these companies, posting negative research and profiting when a stock falls.
CASH CENTRAL IN MANY FRAUDS
Some veteran auditors who have worked in China said extra diligence can catch some of the kinds of trickery being alleged. Electronic confirmation of bank balances, used in many parts of the world, could also provide more safety, accounting experts said.
Most frauds eventually get reflected in misstated cash balances, said Paul Gillis, an accounting professor at Peking University in Beijing.
"If a company is reporting false revenues, the fraud is usually first covered up in accounts receivable," Gillis said. "But in time, that balance will become too large and the fraud becomes obvious, so the amount is moved to cash."
Another Chinese company whose bank balance was questioned was former Deloitte client China MediaExpress Holdings, which sells television advertising on buses.
Deloitte resigned as the company's auditor in March, citing suspicions about bank confirmations and authenticity of bank statements. Starr Investments, a firm run by former AIG chief Maurice Greenberg, has sued the company and Deloitte.
Longtop is among the largest of US-listed Chinese companies involved in recent accounting storms. According to fund tracker Morningstar, its shares were held by some of the largest US mutual funds, including Fidelity, Putnam and Janus. Goldman Sachs and Deutsche Bank led Longtop's US initial public offering in 2007.
In a stunning resignation letter, Deloitte said it uncovered problems at Longtop when it visited the company's bank and was told by staff there that previous bank confirmations were false. Among defects the bank identified were incorrect deposit numbers and omission of significant borrowings, Deloitte said.
When it tried to begin a second round of bank confirmations, Deloitte said Longtop's staff seized its confirmation documents and threatened to detain the auditors at the company unless they turned over audit files.
Longtop staff even called the bank and said Deloitte was not their auditor, Deloitte's resignation letter said.
Longtop said in a statement it will retain forensic accountants to investigate. It said the US Securities and Exchange Commission has opened an inquiry and it plans to cooperate.
CONFIRMATIONS SEEN AS ROOKIE CHORE
Since March, more than two dozen China-based companies have disclosed auditor resignations or accounting problems, according to the SEC.
Many of those cases involved difficulties in confirming cash or accounts receivable, according to an April 27 letter to a Congressional subcommittee from SEC Chairman Mary Schapiro. An SEC task force is probing accounting at US-listed foreign firms.
The Public Company Accounting Oversight Board, which polices US auditors, has been stepping up scrutiny of US audit firms that do work for Chinese or other foreign-based companies. It is also taking a closer look at how well global audit networks supervise far-flung affiliates and will look into changes in auditing standards if warranted, a spokeswoman said.
Auditors often confirm bank balances by sending a confirmation form to the bank, but they are supposed to go further if they see red flags. Given all of the accounting problems in China, some auditors routinely do much more.
"Often in the United States an auditor can mail a confirmation in and have some assurance the bank will fill it out correctly," said Michael Filkoski head of audit services at GHP Horwath, a member of Crowe Horwath International.
"What we generally do in China is hand deliver the confirmation and stand there while the bank officer fills it out," he said. GHP Horwath has been auditing Chinese companies for over 15 years.
In Longtop's case, the company reported USD 332 million in cash on its balance sheet, more than half of its USD 606 million in total assets.
"When you've got an item on the balance sheet that significantly impacts the net worth, you have to go through more than just your typical procedures to assure that you have confirmed the right balance," said Steven Levey, chief executive officer at GHP Horwath.
Bank confirmations are considered so routine they are often left to new auditors, according to Gillis.
"What is really needed in China is a centralized bank confirmation process where auditors can go to the headquarters of the banks and confirm balances," he said. "Electronic confirmations are catching on in the United States, and China should be adopting this practice immediately."