As previously covered on Pacific Money, accounting and reporting standards in mainland China have been under intense scrutiny in recent years following a string of scandals involving small Chinese firms listed overseas. The accounting issue raised its head again this week, this time sucking in a Fortune 500 Company in relation to its recent acquisition of a Chinese group.
Last year Caterpillar Inc. was ranked among the top 50 businesses in the Fortune 500. It operates directly and through numerous subsidiaries across North and South America, Japan and Europe, and has also made acquisitions in emerging markets – notably China and India – where construction booms have provided numerous opportunities for the company.
Caterpillar last June acquired ERA Mining Machinery Ltd, a HK-listed company that was in fact the result of a “backdoor listing” of Siwei, a Zhengzhou-based company which provides equipment for the mining industry. Siwei had undertaken a “reverse merger” with ERA Holdings Global Ltd (a “secretarial services” company listed on HK that had no relation to mining or construction) in 2010, and had thus been effectively trading on HK’s Growth Enterprise Market. Reverse mergers, which rose to infamy during recent short-seller provoked attacks on such firms trading in the United States and Canada, are a common way for companies to be listed without going through the more expensive (and revealing) regulatory and media scrutiny of an Initial Public Offering (IPO).
According to statements from the multi-national Caterpillar, in November 2012 “discrepancies” were discovered between Siwei’s physical inventory and its accounts. The investigation discovered what Caterpillar described as a “deliberate, multi-year, coordinated accounting misconduct” at Siwei. The “misconduct” (read “fraud”), involved deliberate miscounting of both costs and revenues. As a result, Caterpillar has taken an impairment charge (loss of value) of more than 80 percent the value of the deal, or nearly 10 percent of its expected 2012 earnings-per-share (EPS).
The Siwei debacle has probably taught Caterpillar a tough lesson about accounting standards in China which, as previously mentioned on this blog, can sometimes be lacking. Obviously questions are being asked about whether enough due diligence had been performed on Siwei before the acquisition. In Caterpillar’s defense, as the company has pointed out, “Siwei was a publicly traded company with audited financial statements.”
This last statement resonates particularly for those who have been following the events covered in the earlier Pacific Money posting. For the U.S. Securities and Exchange Commission (SEC), which is still involved in a stand-off with the China Securities Regulatory Commission (CSRC) about access to audit records, this latest incident will only bolster its case. It is significant that ERA Mining Machinery Ltd was listed in Hong Kong, not the United States, confirming that the issue is not just a U.S.-China problem, but a reverse-merger, and indeed, China-wide problem. Rather than obstructing the SEC and other foreign regulators, cooperation should be encouraged to allow Chinese firms to establish more solid reputations and higher standards, which will benefit not only foreign investors and companies, but also investors inside China.