Caterpillar setback puts Chinese reverse mergers back
USINFO | 2013-11-15 12:00

 

Just when you thought you had heard the last of Chinese reverse mergers, along comes another accounting scandal that puts them back in the spotlight again.

The victim this time? Caterpillar, which on Friday stunned the market with news that it would have to take a $580m write down in the fourth quarter after it unearthed accounting irregularities at ERA Mining Machinery, a Chinese company that it acquired last June for $886m.

Caterpillar said it has uncovered “deliberate, multi-year, coordinated accounting misconduct” at Zhengzhou Siwei Mechanical & Electrical Manufacturing Co. (Siwei), a subsidiary that is wholly owned by ERA and through which it conducts most of its business.

Siwei had earlier gone public in Hong Kong through a reverse merger with ERA in Hong Kong. But more on that later.
From Caterpillar’s SEC filing (emphasis ours):

Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition. This review is ongoing.

The statement will likely bring up memories of Sino-Forest, the Chinese forestry group listed in Toronto that was accused by short-seller Carson Block of “stratospheric fraud” – including “massively” exaggerating its assets and creating non-existent “artificial intermediaries” to hide its real revenues.

In the wake of the allegations and subsequent trading ban in Toronto, Sino-Forest filed for bankruptcy protection last March and the court process is due to end sometime this month. But the fallout from Sino-Forest and other foreign-listed Chinese companies such as China Forestry, software maker Longtop and fertiliser producer Yongye, all of which have been accused of fraud, have prompted many investors to dump Chinese reverse merger stock and some companies to delist.

In its defense, Caterpillar said its due diligence process for ERA was “rigorous and robust”.

It is important to understand that Siwei was a publicly traded company with audited financial statements.

But hey, just because a company is listed and has its account audited doesn’t mean it’s trouble-free, right?

One immediate red flag is the fact that Siwei, a mine safety equipment maker, only became a public company after it engineered a “reverse merger” with ERA Holdings Global (a secretarial services company listed in HK that had nothing to do with mining or construction) in 2010.

Reverse mergers, in which a company acquires a shell company to gain a listing on a stock exchange, are a common way for companies to become listed and bypass the regulatory scrutiny involved in a traditional initial public offering.
But as Paul Gillis, author of the China Accounting Blog and a professor at Peking University’s Guanghua School of Management, noted:

We will undoubtedly hear much more about the due diligence process. I would be highly surprised if the customary due diligence procedures conducted by Big Four firms uncover these kinds of problems with any degree of reliability.Due diligence is viewed by many corporate executives not as a means to evaluate acquisitions but rather as a form of career insurance should anything go wrong. Fees are often beaten down to levels where the investigating firms are unlikely to find anything but the most obvious problems.

It is not clear who performed due diligence on behalf of Caterpillar on the ERA acquisition. PwC is Caterpillar’s auditor while RSM Nelson Wheeler in Hong Kong (the HK subsidiary of China’s fifth largest accounting firm) audited ERA.

Although sales from China accounted for just 3 per cent of the $60.1bn in sales made by Caterpillar in 2011, the US machinery maker made no secret that it believed its future growth was closely tied to that of the world’s second largest economy. Even before it splashed out on ERA, it was spending heavily to build up manufacturing capacity in China in recent years.

But judging by weaknesses reported by Caterpillar in its China business in recent earnings results, its bet is increasingly going sour. The ERA accounting scandal won’t help.

 

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