Spot the companies most likely to cook their books

PUBLISHED : Thursday, 25 November, 2010, 12:00am
UPDATED : Thursday, 25 November, 2010, 12:00am

Whenever two or more battle-scarred investors in China are gathered together, one of them inevitably repeats the old joke about how mainland companies always keep three sets of accounts; one to show their investors, one to show the authorities, and one set that is kept securely locked up in a safe which gives the true picture of the company's finances.

Of course, that is supposed to have changed in recent years. Managers are supposed to have seen the light and realised the benefits of good corporate governance. Auditors are supposed to have raised their game. And regulators are supposed to have cracked down on corporate malpractice.

Yet, you could be forgiven for wondering how much has really changed. After all, there are endless incentives for senior executives to cook their company's books. Managers might simply be on the take. Or, if their compensation is linked to the company's reported earnings, they might want to massage profits upward in order to bump up their pay.

Similarly, if executives own shares in the company they might exaggerate earnings to boost market confidence, and so lift the value of their own stock holdings. Or maybe they want to pad the books in order to reassure their creditors.

If the firm is state-owned they might need to be seen to be meeting government targets. Perhaps, bosses might be anxious to avoid reporting three consecutive years of losses, which would result in an automatic delisting. Or maybe they want to make the company appear more attractive to potential investors ahead of a share offering.

All are possible, and in a market where accounting standards are patchy and enforcement often weak, and which lacks the institutional checks and balances of more developed economies, the temptation can often prove too great for managers to resist.

To get a clearer picture of who might be cooking the books and how much it might be costing, Michael Firth of Lingnan University, Oliver Rui of the Chinese University of Hong Kong and Wu Wenfeng of Shanghai Jiaotong University examined five years' worth of earnings restatements issued by mainland-listed companies.

They reasoned that retrospective corrections to either a company's income statement or balance sheet generally indicate accounting manipulation in the past, and may well be evidence of deliberate misrepresentation and fraud.

Disregarding technical violations of reporting standards, they found that on average 3.7 per cent of non-financial companies listed on the mainland restate their financial accounts each year. For example, they cite the case of Shenzhen-listed WeiDa Medical Applied Technology, which was found to have falsely accounted for a production shutdown, enabling it to report an annual profit when, in fact, it had made a loss.

In all the researchers examined 271 similar cases, and found some clear patterns emerging. Some industries were more prone to fiddling their numbers than others. As the first chart below shows, each year on average 8.5 per cent of companies in the agricultural sector restate their earnings. In contrast, construction companies appear to have clean hands.

There are also clear differences between different provinces. As the second chart shows, companies in poorer, less developed provinces are far more likely to restate their earnings than companies based in provinces with a relatively advanced legal and accounting infrastructure like Guangdong.

Other trends show up in their analysis, too. Perhaps not surprisingly, companies that are deep in debt are more likely to make false accounting statements, while companies that are planning to issue shares are liable to exaggerate their earnings in advance of the offering.

Worryingly, the researchers found no evidence that employing a major international auditor discourages fraud. But they did discover that ownership makes a difference. State-owned companies are far more likely to misstate their earnings than private enterprises, either because of poor oversight or because they have been pushed by their controlling government shareholders to pursue political rather than commercial objectives.

By now you are probably thinking that the old joke about Chinese companies keeping three different sets of accounts doesn't sound like a joke at all. But that's because we haven't got to the punchline: the joke is that the third set of books, the one that gives the true picture of the company's finances, isn't kept hidden away under lock and key. It simply doesn't exist.