Foreign investors quickly learn that accounting in China can be a snakes’ pit. Unaccountability and below-international standards of financial reporting are poisonous to financial probity. Caterpillar, the world’s largest maker of construction and mining equipment, is only the latest to have been bitten badly.
The company says it will take a $580 million charge after discovering “deliberate multiyear coordinated accounting misconduct” at the Siwei subsidiary of ERA Mining Machinery, the Chinese company it bought last year for $886 million. That write down will wipe out 10% of Caterpillar’s expected earnings for this year.
The accounting fraud, by Caterpillar’s telling, had the effect of overstating Siwei’s profits ahead of the acquisition by recognizing revenue and allocation costs improperly. Caterpillar discovered the problem after it had taken over the company, which makes hydraulic props for coal mines. It found inventory discrepancies between what the books said should be there and what actually was.
The questions raised are not so much why did this not show up when Caterpillar was doing its due diligence ahead of closing the deal, but why investors and auditors weren’t on to it long before. ERA was a publicly traded company, in Hong Kong, with audited financial statements, and Caterpillar says the senior Siwei managers responsible for the fraud had for years been cooking the books, books on which auditors would have signed off.
It is not as if listed Chinese companies have an unsullied record in this regard. There has been a string of accounting scandals in the past couple of years, including those involving China-based companies listed on U.S. stock exchanges that have resulted in more than 30 U.S. securities class actions suits since 2010.
A second reason for caution was that Siwei was not a state-owned company. The state keeps a close eye on the bookkeeping of any state-owned business that is going to list a subsidiary for fear of the embarrassment to the country should an accounting scandal erupt. Not so with private companies, where accounting standards may be more cavalier to start with.
Similarly, legal redress for financial crimes where the state is the victim of fraud can be extreme, including the death penalty. On the other hand, prosecutions over accounting fraud where private investors or acquirers are the victims remain few and far between. This appears to be the case with Siwei; Caterpillar says it has fired the executives involved but is not aware of any legal action against them.
