Monday, June 27, 2011

Understanding Chinese Fraud

I run into an article written by Paul Gillis. Paul is a visiting professor of accounting at Peking University's Guanghua School of Management.

One of the best articles I read since a long time!
Article China Accounting Blog

Some highlights
Cash confirmation tests issues play an important role in recent frauds ( China-Biotics is alleged by BDO to have set up a fake bank website)

Most accounting firms have instituted enhanced cash confirmation procedures which will make it much more difficult for these types of frauds to remain undisclosed in the future.

The cash is not missing because management stole it; it is missing because it was never there.

While there may be a few complete frauds out there, many of these companies might have real, profitable businesses that have real value.

Whether shareholders ever see any of that value is uncertain, since the process or working through these fraud allegations may well destroy what is left.

Many Chinese companies have listed in the U.S. because the CEO wants the prestige of a U.S. listing. It has become quite prestigious in China to be a NASDAQ or NYSE listed company. Some communities in China will give awards to companies that succeed in doing so.

While there are evil people who simply set out to commit frauds, few frauds of the nature we are seeing in China start out that way. Instead, they are caused by an alignment of three factors that create conditions where good people are willing to do bad things. These three factors, known as the fraud triangle, are pressure, opportunity and rationalization.

Pressure is why most frauds occur. Many frauds happen because someone is under great financial pressure – often because of financial needs due to problems with gambling, addiction, or an out of control lifestyle.

In China, I think an even more powerful pressure is in play – the pressure to maintain face. Face is important in all cultures, but in China it often rises to an existential level. A Chinese CEO, faced with disappointing financial results, might feel unbearable pressure to improve them in order to maintain his public image as a successful executive.

It is not possible to commit a fraud unless one has the opportunity to so. A CEO who decides to commit a financial fraud has significant power to alter the financial records to make it happen. Of course, the CEO fraudster needs to worry about the CFO blowing the whistle on him, and that might explain why the CFO in several of the recent cases in China was a foreigner who could not read Chinese. The CFO’s limited language and cultural skills may have also given the CEO the opportunity to execute the fraud. Opportunity also includes the opportunity to cover up the fraud. In the recent China cases this meant being able to get bank branch officials to cooperate in supplying false documents. Building guanxi with the local bank officials might have enabled that opportunity. Guanxi is a system of exchanging favors that builds mutual obligations that are difficult to refuse. Through regular gifts and business assistance the CEO might build strong guanxi with a local bank manager that would give him the opportunity to ask for fake statements and confirmations.

Many people have pressure and many also have the opportunity to commit fraud, yet most do not. The missing factor is rationalization; the act of reconciling ones behavior with commonly accepted notions of decency and trust. I am sure that in all of the recent frauds in China the CEO was able to justify to himself that his actions were acceptable. “No one will be hurt by this – the shareholders, employees and customers will all be better off.” “It is just a temporary thing, we can fix it next quarter when the results get better.” The rationalization does not have to be valid, it just has to seem valid at the time to the fraudster. As frauds continue, fraudsters usually need less and less justification to keep the fraud going.

In China’s vanity listings, I think the fraud triangle helps to explain why the frauds happen and might help to predict the next one.

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