A further update to this here:

http://www.chinaaccountingblog.com/weblog/china-and-the-pcaob.html

Hello,

You can find this in the

10q under Item4 or item4T; Controls and Procedures. For LLEN this is on page 24 of the most recent 10Q: Based on such evaluation, the Company, its CEO, and its acting CFO, have concluded that the disclosure controls and procedures are ineffective as of July 31, 2010, covered by this report.  http://www.sec.gov/Archives/edgar/data/1137083/000116854210000050/llen10q7-312010v2.htm

10K under Item 9A or 9A-T; Controls and Procedures. For SKBI this on page 40  of the 2009 10K: Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were ineffective at the reasonable assurance level. http://www.sec.gov/Archives/edgar/data/1076939/000114420410017628/v179475_10k.htm

What is interesting for SKBI is that internal controls have not been effecitive, at least since 2008 10K.

Maj

This very helpful. How do I find the most recent internal control opinion?  I noticed a few were left blank.

 Thanks

Professor,

Great post.  Thanks

Maj

Hello Professor,

Thank you for your helpful insight.

to your first point.. Yes I am aware that the SAIC does not cover offshore entities. I did not mention this because as you pointed out this will not matter much.

to your second point.. I do agree with most of your points, but not one company has taken the lead to reconcile SAIC/SAT/SEC differences. Also, how do you explain the differences between provision for income taxes?  i do think that at the very least, tax fraud may be common.

to your third point.. i agree and should have mentioned this.  TPI filings do not match, maybe due to this reason.

to your fourth point.. I think i will not be welcomed in China!!!

We just need a few brave companies to come out and reconcile filings or have auditors say that they have pulled SAIC and SAT files independently.

Maj

Hello,

Yes, I have seen this (Ben Wey) article.  His rationale echoes that of many others who have defended the ChinaHybrid space. But I respectfully call into question many of Ben's points.  

1. I have interviewed a handful of  CEOs who say SAIC docs are meaningful and that huge differences from SEC filings should not be the norm.

2. I have obtained filings used for SAT docs that materially differ from SEC docs.

Ben says:

There are over 50 million registered businesses in China. China's State Administration for Industry and Commerce ("SAIC") has no authority in overseeing the financials of a business in China.

It is incorrect to refer to SAIC filings as a Chinese company's "tax authority" and make accompanying accusations regarding tax evasion or derive judgment on a company's financial status. The SAIC's function is like the "Office of the Secretary of State" at the state levels in the U.S., whose primary responsibilities include business registration, issuing permits, and maintaining corporate status of a business. Here is how it works: Chinese companies are required to file annual tax returns with local tax bureaus. The same filing document is copied to the local SAIC branch office within the jurisdiction where a business is physically located. What does the SAIC office do with the documentation? It gets filed away and there is nothing more beyond that. The process is a simple formality to show that a registered business has filed its annual tax returns, which is a requirement for a business to maintain good corporate standing. In addition, SAIC has tens of thousands of branch offices across China that each provides varying lengths of information solely related to a business's registration status. There are more than 50 million registered businesses in China and all of them must register with their SAIC local branch offices before they can start doing business.

State Administration of Taxation ("SAT") is the only Chinese government agency that has the legal authority to collect corporate taxes and receives annual financial reports of a business. SAT has tens of thousands of local branch offices across China. Corporate tax reporting in China is a local event, filed by a business within the jurisdiction of an SAT office where the business is physically located. Once a business makes its tax filings, the local SAT office issues a "Certificate of Tax Completion" to the business which provides evidence that its tax filings are complete and accepted, and that the business has satisfied all of its tax and financial reporting obligations. Then a copy of such filings is provided to the SAIC office which can certify that the business is in good corporate standing. That is the very extent of the SAIC's involvement in Chinese tax filings.

My response:

He actually admits that SAT filing is copied to SAIC!!!  This supports information from my original article. So what is Ben saying here? That it gets filed and lost or is incomplete? I do not buy this.  I do not think that anyone has ever contended that the SAIC is a tax collector, but they do have tax documentation.

Ben Says:

All of the U.S. listed China based companies are under holding company structures which own multiple subsidiaries in China. Unlike the SEC, the SAT or SAIC does not require a holding company to file consolidated financial statements.

If a company is a holding company that owns multiple subsidiaries or factories that are not all located in the same physical location, then each subsidiary has to file its own tax returns separately with a local tax bureau where the subsidiary is located. Each subsidiary makes its own tax filings independently from other sister businesses as well. There is no such a thing as a consolidated tax return filed with either the SAT or SAIC at the holding company level. Therefore, for a holding company that owns multiple subsidiaries, pulling a tax return on one subsidiary certainly does not represent the holding company's financials. In the case of U.S. listed China based companies; all of them have multiple subsidiaries located in China. Until all of a holding company's subsidiaries are consolidated into one financial statement, simply adding up the financials of each subsidiary does not equate to the financials filed by the holding company, represented as an entire organization through its SEC filings.

On the other hand, a holding company's auditor reconciles tax filings, sales receipts, and other public and nonpublic financial evidence to produce SEC and U.S. GAAP required financial statements. Experienced auditors in China are well aware of this issue. Further, adjustments are made for differences between U.S. and Chinese GAAP. Thus, SEC filings are indeed the most reliable proxy for a U.S. listed company's financial performance.  

As an example, for a vertically integrated manufacturing business, it is common for subsidiaries to transfer revenues and expenses within the same organization for allocating profits to entities that are legally subject to lower tax rates or for the purpose of simply following a manufacturing production process. To avoid double counting, professional auditors consolidate all of a holding company's subsidiary financials after inter-company transactions are eliminated.  A holding company's financials are filed with the SEC only after such inter-company related transactions are eliminated. Therefore, financial reports obtained from SAIC or SAT are absolutely not correct reflection of a publicly traded holding company's financial statements.

My response:

Yes, I agree that one has to be careful when multiple subsidiaries exist and when dealing with differences with U.S. GAAP. Where I have a problem is when the summation of individual statements are drastically different from SEC. Not one accused company has shown a side by side reconciled process.

Ben says:

A company's tax filings with a local tax authority cannot be obtained by non-related third parties through legal means. By law, business tax filings are not publicly accessible.  

It would be impossible for anyone outside a business itself to have legal access to its SAT tax filings since the data is not publicly available and confidentiality is strictly preserved by the Chinese government agency. It is certainly illegal and a criminal act to trade or disperse rumors based on such nonpublic information. Many so-called China "sources", often backed by stock short sellers, tout their abilities to get purported financial reports filed with the SAT on any U.S. listed China based company. These are illegal claims. Also as discussed earlier, no consolidated financial statements exist for a holding company in China. Even if an SAIC filing is illegally obtained on a subsidiary, it does not reflect the U.S. listed holding company's consolidated financials.

My response:

I think the SEC will rule that it is more criminal for Chinese firms to defraud U.S. investors. His statement is laughable.

SAIC filings can be legally obtained, so I do not know what Ben is talking about.

Ben says:

SAIC filings have no relevance to the credibility of a company's public filings filed with the SEC

As long as a holding company structure is involved, the SAIC and SEC numbers cannot possibly match except under an extreme circumstance in which a public company has only one wholly owned operating subsidiary and there are no inter-company transactions of any sort, including expenses, different revenue recognitions under Chinese and U.S. GAAP accounting etc. at the parent company level. Presently, no such China based company exists on any U.S. stock exchange.

Any concern over SAIC filings is just one example of the many areas that investors are just beginning to learn about Chinese business practices. Be wary of less professional advice from amateur or anonymous sources that often have untold self-interest behind some seemingly legitimate arguments. There are often stock short sellers behind many "sudden discoveries of fraud" at a legitimate publicly traded China based company. Avoiding fraud involves much more than comparing apples to oranges. Understanding China, learning to speak the Chinese language, gaining

My response:

No relevance?? we shall see. But I have interviewed a handful of  CEOs who say SAIC docs  are meaningful and that huge differences from SEC filings should not be the norm.  I agree that uncovering fraud is a bigger task then just pulling SAIC and SAT files. SAIC/SAT differences can be tax fraud and not business fraud, but still a problem.  See the link on QING. http://geoinvesting.com/companies/qing_qingdao_footwear_inc/research/research/0026964

The VIE structures have received insufficient attention.

 As you observe, the public company does not actually own the VIE, which usually has most of the operations.

 VIE's came about in the internet industry, where China prohibits foreign investment. The early internet companies that listed in the US - Sina and Sohu, developed the VIE structure as a way around those rules. The ICP license is held by a Chinese company owned by Chinese members of management.  This company, and the management members, sign agreements giving management rights to the public company, and agreeing to pay any dividends they receive to the public company, and to sell the shares to the public company as soon as it is legally possible.  The public company loans the money needed to management, who contribute it to the VIE.  

The question has always been whether these agreements could be enforced in a Chinese court.  One requirement under Chinese law is that the indemnity agreement (where the shareholders pledge the stock to the public company) has to be filed with the government.   Baidu reports in its annual report that it did this on one VIE, but then the government would not record any further pledges.  

VIEs soon spread to many other areas that have restricted investment.  Education companies mostly use the VIE structure.  Now we see some companies using VIEs when there is no restriction on foreign ownership (See RCON).  In these situations it appears that management did not really want to give up ownership of the companies, but was willing to sign an agreement that a foreign company might have difficulty enforcing in a Chinese court.  A company recently tried to list in Hong Kong using a VIE structure.  Regulators rejected the listing, saying there was no need for a VIE.   The SEC, however, can't stop VIEs, they can only insist that the risks be fully disclosed.  They are, but most investors don't understand them.

The VIEs are incredibly tax inefficient, but the companies have managed that by keeping the profits of the VIE low - a situation that might be challenged under China's increasing transfer pricing enforcement.  

 The real risk with these deal is that the owner of the VIE (typically the CEO) has a falling out with the company and decides to take his VIE and go home.  There might also be some interesting times if the CEO of one of these companies dies and his kids inherit the VIE.   It will be an scary day for investors while the company tries to enforce an agreement in a Chinese court that was specifically designed to get around Chinese law. As long as the CEO is around and happy, it is not likely any problems will arise.

The SAIC reports are used principally to support the tax return.

 The reconcilation you are looking for is already in the US financial statements.  It is the calculation of deferred taxes, explained in the tax footnotes.

A couple of issues you are overlooking.

1. As you observe, the SAIC reports only cover Chinese subsidiaries and VIEs.  That means any activity in the offshore companies is not included.  There usually is not much offshore anyway, except in some of the bigger companies.

2. SAIC reports are prepared using Chinese accounting principles, while SEC reports are typically prepared using US GAAP.   Chinese GAAP is evolving, and most companies currently use a fairly primitive form that will migrate to CAS in the next few years.  CAS is comparable to IFRS.    What is important here is that revenue recognition is often considerably different under Chinese standards than US GAAP.  Companies tend to defer recognizing sales for Chinese purposes because the act of formal invoicing triggers the tax liability.  US GAAP has more complex rules for recognizing revenue, and it is not uncommon to see big legitimate differences in revenue between the US accounts and the Chinese accounts.  If this has been properly handled, you can find the differences reconciled in the tax footnotes related to deferred taxes.  This is a complicated area, but a good CPA can figure it out.   Remember, the main reason for the SAIC filings is to support the tax return, and nobody wants to pay more taxes than they have to. 

3. Many Chinese companies listed in the US use a fiscal year end.  They are all required to use a calendar year end for tax purposes.  This causes further differences.

 4.  It appears you are not aware that SAIC filings are not publicly available.  That is not to say they cannot be found - obviously your advisor found them.  However, they likely got them through the back door.  Read up on what happened to the guy from IHS who did this before you make a trip to China. It is very dangerous to be in possession of government documents you do not have the right to see.

 I am not trying to discourage you.  I think Chinese companies need more sunshine. 

Foreign Invested Enterprise (FIE): Foreign company has a direct ownership in a PRC company.  China's State Administration for Industry & Commerce (SAIC) requires audited financial documents.  An FIE can also be referred to as a wholly owned foreign enterprise (WOFE).

An example of an FIE is Zst Digital Networks (NASDAQ:ZSTN), where Zhengzhou Shenyang Technology, Ltd. conducts 100% of operations.

Domestic Owned Enterprise (DES): A company owned by Chinese individual(s) and/or entity(s). In many cases, the FIE will hold an equity interest in another PRC company.

SAIC does not require audited financial documents for a DES.

An example of a DES is Weikang Bio-Tech Group (OTC BB:WKBT) where the FIE is Weikang Bio-Engineering Co., Ltd. and the DES is Tianfang  Pharmaceutical Co., Ltd., which brought in 72% of total sales during 2009.

Variable Interest Entity (VIE):  Direct ownership in a PRC firm is not established. The flow of funds is set forth by a series of contractual agreements that establish control without direct ownership.  In this structure, an FIE is usually established first.  The FIE then procures a contractual arrangement with another PRC company as a VIE relationship . The net income of the VIE flows through the FIE to the foreign holding company (in the U.S.). SAIC does not require audited financial documents for VIE.

An example of a VIE is China Mediaexpress Holding (NASDAQ:CCME) where operations are conducted through Fujian Fenzhong.

A company can utilize a combination of  ownership structures.

An example of a combination structure is Vlov Inc (OTC BB:VLOV); The FIE is Dong Rong Company (in China) and the VIE is Jinjiang Yinglin Jinduren Fashion, which currently conducts all operations. The equity owners of Yinglin Jinduren intend to transfer all of the business operations currently conducted by Yinglin Jinduren to China Dong Rong sometime in 2010). No DES exists in this example.

Those who use SAIC documents to insinuate fraud must have a very good grip on company structure. They must be certain that the SAIC filings of the PRC companies are those of the FIE and represent the majority of business for the holding company. For example, in some cases the FIE has limited operations with most of the revenues derived from companies in which it holds ownership interests (DES) or contractual arrangements (VIE). 

Please note that Joint Venture relationships are also common in China.

Sino-Foreign Cooperative Joint Venture (CJV)

"A CJV is a joint venture between a Chinese and a foreign company within the territory of China. The Chinese company usually provides the labour, land use rights and factory buildings, while the foreign company brings in the necessary technology and key equipment, as well as the capital. This joint venture is based on a cooperative joint venture contract in which matters like the terms of cooperation, the division of earnings, the ownership of property upon the termination of the contract term of the CJV, the sharing of risks and losses, etc are laid down."

Sino-Foreign Equity Joint Venture (EJV)

"This type of foreign investment is currently still the most widely used in China, even though Wholly-Foreign Owned Enterprises (FIE) are developing strongly. It is a limited liability company (This means that the investor or partner is not personally liable for the debts that the company might make in the future) and it has the status of Chinese legal person. This is a crucial difference with a RO because unlike the latter, a Sino-Foreign Equity Joint Venture (EJV) is capable of buying land, hiring Chinese employees independently, constructing buildings, etc. An EJV is a joint venture between a Chinese and a foreign company within the territory of China. Both companies invest in the joint venture with the foreign company, in general, not investing less than 25% of the total investment."

The SAIC requires audited financial statements for both of these joint venture relationships.

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The following is a list of companies that have or had ties to auditing firms and associations whose quality of work has been challenged.

Notice that we have included firms with ties to the Moore Stephan network. However, the old MSWTF and its successor Frazer Frost have received most of the criticism within the Moore Stephens network.

By FAWN JOHNSON

WASHINGTON—The U.S. board overseeing company auditors has sent a draft bill to Congress to make its enforcement proceedings public.

The Public Company Accounting Oversight Board's proposal would repeal a requirement that its disciplinary actions remain secret, according to a copy of the document reviewed by Dow Jones.

The public now is denied access to information about accountants that have been sanctioned or charged by the PCAOB, acting Chairman Daniel Goelzer said in an Aug. 24 letter to several members of the Senate Banking Committee and House Financial Services Committee.

The private nature of the proceedings gives firms and auditors an incentive to drag out litigation, sometimes for years, while the public remains unaware, the letter said.

The cases also consume considerable board resources; three recent cases have used 17,000 hours of board staffers' time, the letter said. Two of those cases are still pending. One has settled.

The PCAOB's proposal comes as lawmakers are considering technical changes to the financial-overhaul law, changes that could be enacted in the next year. Lawmakers also are mulling legislation this year to give the public more access to enforcement documents from the Securities and Exchange Commission, which oversees the PCAOB, a nonprofit.

The draft bill from the PCAOB could be part of either measure.

The PCAOB's letter said public disciplinary hearings would conform to the longstanding practice at the SEC for public enforcement hearings.

"Virtually all other administrative proceedings brought by the SEC (including those against brokers, dealers, investment advisers, and public companies) and all SEC injunctive actions are public," the letter said.

The PCAOB was created under the Sarbanes-Oxley accounting law to inspect accounting firms for compliance, impose disciplinary sanctions, and set auditing standards.

The affected jurisdictions currently are the 30 European countries that are required to follow the European Union's Directive on Statutory Auditors, China, Hong Kong and Switzerland.

The new guidance appears in an addition to the staff answers to frequently asked questions relating to registration of non-U.S. firms. The guidance alerts applicants from the affected jurisdictions that the staff intends to recommend that the Board request certain additional information before acting on those applications, and it explains how an applicant can seek to avoid delay by including the information when it first submits the application.

The information includes identifying information about public company audits in which the applicant has recently played, or expects to play, any role, and identifying information about other PCAOB-registered firms in whose audits the applicant expects to play any role. The additional information will facilitate the Board’s understanding of the scope and nature of the applicant's activities related to SEC-reporting companies.

Under the Sarbanes-Oxley Act of 2002, auditors of financial statements that issuers file with the Securities and Exchange Commission must be registered with the PCAOB and must undergo regular PCAOB inspections to assess their compliance with U.S. law and professional standards in connection with those audits.

The PCAOB has conducted more than 1,300 inspections of registered firms in the United States and 33 non-U.S. jurisdictions but, due to positions taken by local authorities, has been prevented from conducting inspections in the European Union/European Economic Area, Switzerland, China and (to the extent an audit encompasses a company's operations in China) Hong Kong. Information on the Board's continuing efforts to conduct inspections in those jurisdictions is available on the PCAOB Web site, along with a list of issuers that have recently filed financial statements audited by registered firms in those jurisdictions.

The revised staff FAQs include a complete list of the affected jurisdictions, which will be updated as appropriate.

Xantu,

Thanks for the reply,

I need to think about your first question.  As for the second question.. Maybe the government just does not care. My DD is leading me to draw a conclusion that the government is part of the what we would call a "corruption" problem.

I don't have a time line on follow up yet, as i want to let this article digest for a bit.  My next article will be on ownership structures.

Maj

Hey Maj!

First I would like to congratulate you on the steps you have taken regarding to this subject.

I agree that it is unbelievable that no IRfirms or analysts seem to care. But of course the subject is complicated, and is more easy to just analyse the SEC-filings. 

By reading through your article, here are some questions that remain in my head: 

- how does the Chinese government calculate the spectacular growth numbers of the economy, if a lot of companies would forge their accounts (assuming solely) for tax purposes?

- why doesn't the Chinese government use the SEC-filings as "evidence" for trying to prove to the company that their SAIC-filings are wrong or at least ask for an explanation?

Surely to be continued...

Greetz.

Xantu.

P.S. When do you plan to release the results of your due diligence regarding this?

By Maj Soueidan
President, GeoInvesting

As I have begun to perform quality checks on the ChinaHybrid Space, I have received criticism from some investors who have questioned the relevance of some of the items on my check list. I had expected this, but blind ignorance is not the path I choose to follow, at least not yet. Such tact would be would be irresponsible to my readers. If I have to delay an opportunity to purchase a stock worth $20.00 at $5.00 as opposed to $8.00, the only harm done is damage to my ego.

One of the items on my check list that has received constructive criticism is the validation of whether SEC files match Chinese State Administration for Industry Commerce (SAIC) files. My critics hold the general belief that the SAIC financial statements have no relevance to those filed with SEC.

SAIC functions in maintaining market order and protecting the legitimate rights and interests of businesses and consumers by carrying out regulations in the fields of enterprise registration, competition, consumer protection, trademark protection and combating economic illegalities. Source: http://www.saic.gov.cn/english/aboutus/Mission/

My original motivation for this mission was not necessarily to find the truth, but arose from an understanding that the "perception" of risk can affect portfolios. Just like the majority of body building depends upon proper diet, psychology can play a large role in determining short-term stock valuations. By at least identifying mis-matches, I can be aware of the possibility that bad press may influence my investment until this issue may finally be put to rest. In the interim, I can buy put options, write calls against my long positions, establish larger positions in stocks where filings do match and adjust portfolio diversification.

Ultimately, I set out to gain an understanding of why filings don't match and determine if the fear created by the skeptics has led to unique opportunities to purchase insanely cheap stocks, especially those related to companies participating in an industrial revolution.

I almost published an article a couple weeks ago on the imbalance of SAIC filings versus SEC filings. My references for my original conclusions came from various blogs and matter of fact of opinions from investment professional; but what about auditors and lawyers? I paused for a second and thought if I continued upon this conjecture fueled by the "he said, she said" mentality, I would be just adding to the rumor mill. So I set out to analyze SAIC filings first hand and obtain a written legal opinion on this subject from an attorney with knowledge of Chinese law.

I am still perplexed that IR firms and analysts have not pursued this path. My opinion as to why they have not is because they know the truth. As luck would have at, one of my GeoTeam associates enrolled in a Mandarin class that is taught by an instructor who is friends with a Chinese lawyer (let's call him "Bob") who recently moved to the U.S. My luck did not end there as he also has an exceptional understanding of financial statement analysis. Initially, I asked Bob to get in touch with various SAIC and Local AIC agencies to learn more about them and any tax related issues. (See attorny letter. Comments are welcome).

Tax Issues:

There are two types of taxes relevant to this discussion. The value added tax (VAT) is levied as a percentage of revenue. (In the service industry there is a business tax; there is no VAT. The Business Tax is similar to VAT and the PRC government is transferring Business Tax into VAT) China has a sophisticated mechanism for collecting the VAT that involves a process of tracking invoiced transactions among all parties involved in a particular sale chain. Thus, the payment of this tax is difficult to circumvent. However, companies can underreport the top line through what is called white receipts, or transactions without invoices. On the other hand, underreporting income to lessen the burden of income tax appears possible. This arises from an inefficient income tax oversight process. Taxes are paid to the State Administration of Taxation (SAT).

I also learned that the SAIC is referred to as the "last stop", meaning that by the time financial statements reach the SAIC, a company has probably already filed reports with the SAT and disclosed its tax liability.

The most important factoid I received was that SAIC documents can be audited. Most supporters, including investment banks, have commented that SAIC filings are not audited or used in the tax system. This is generally true for companies that have a Variable Interest Entity (VIE) structure in which the U.S holding company does not have direct ownership in a PRC firm. The flow of funds is set forth by a series of contractual agreements that establishes control without direct ownership. On the other hand, for companies that have direct ownership (FIE, Foreign Invested Enterprises), the SAIC does police the PRC firm and requires AUDITED financial statements, which can be shared by several government authorities. Furthermore, this financial statement is also provided to the SAT. The audit is normally completed by a local auditor. (You will understand why after reading my lawyer's legal opinion).

The Investigation Begins

I asked Bob the following:

1. Verify that SAIC filings can be audited.
2. Retrieve the filings of seven ChinaHybrid firms, including two IPOs (one of which is an ADR) and five reverse merger firms. I also made sure that four of the companies did not have VIE structures.
3. If filings do not match, offer an explanation as to why.

Although my sampling is not large enough to draw a statistically reliable conclusion, I deemed it as a good start to my due diligence process that will eventually cover over 70 companies. Thus far, the results are unanimous. None of the filings come even close to matching on sales, net income and taxes paid. One company even showed revenue growth on the SEC filings from 2007 to 2008 to 2009, while the SAIC filing showed growth from 2007 to 2008, followed by a decline in 2009.

Are we to believe that all these companies and likely the majority of ChinaHybrids are a hoax? Fraud would be a much easier circumstance to phantom if it was related to just a few firms. If you accept the fraud argument, you are basically subscribing to a well orchestrated conspiracy theory.

The excuses as to why filings do not match may have some merit and include such things as varying accounting rules, complicated ownership structures, pawning off reporting duties to "agents" and the SAIC not being a tax agency. But I can't be convinced that possibly over 80% of companies (as some would have it) will fall into this "circumstance" by accident. This is more than just a random force of ineptness and bureaucratic mayhem. I challenge an auditor or investment bank to show me how diverging accounting rules can account for a company reporting revenue of $100 million and huge profits in an SEC filing compared with revenues of $1 million and substantial losses in the SAIC filings.

As for CFOs not having a good handle on audited financial statements at the time a filing is submitted to the SAIC - that is a troubling thought in and of itself. What some firms have listed as "filing agents" may be entities that the company has paid in order to purchase a generic financial report. Furthermore, what am I supposed to make of the certification signature conveying the accuracy and reliability of the SAIC document? As I indicated earlier, by the time a company files with the SAIC, taxes may have been paid and some SAIC reports even audited. So the excuse of not having a good handle on the financial statement seems illogical. The misrepresentation of SAIC filings appears deliberate.

Through information provided by my lawyer and other fact finding means I have come to the following conclusions.

Although I have found that SAIC filings do not match SEC filings, proving the fraud case is easier to conclude for FIE than for VIE structures. So far, I have pulled the SAIC filings of four FIE firms; one IPO and three reverse merger. In one case, sales, income and tax provisions matched at the SAIC and SAT level, but did not match at the SEC level. In two cases sales, net income and provision for taxes did not match the at the SEC level. In the last case sales matched at the SEC level, while net income and tax provision did not.  Most firms showed losses on the China filings and healthy profits with the SEC.

Worse yet, some of the SEC audits were performed by top tier firms. In a case like this, you can not help but surmise that a deeper level of misrepresentation and/or lack of auditor oversight has taken place. Is the company showing the auditor a different tax receipt? Did the auditor see the actual tax receipt and dismiss it? Are there existing tax documents that take precedence over SAT records? Finally, where did the reported taxes shown on the SEC flings go?

In the cases of VIE structures, I have only proven that SAIC files do not match SEC files. My attorney has commented that this can occur since SAIC filings are not usually required to be sent to the SAT. It is basically just a waste of time. Also, companies do not want to reveal information to competitors. The more accurate information will be in the SAT files which are unavailable to the public.

I still believe that VIE's are involved in some type of fraud. For example, in one of the companies I came across where sales in the SAIC and SEC did not match, the cash balance matched.

Drawing a Conclusion

Tax evasion may be prevalent across the ChinaHybrid space. However, what we call fraud could basically be common practice in China and possibly acceptable, as evidenced by my attorney's findings that the punishment for tax fraud does not seem harsh. As ChinaHybrid supporters have expressed, SEC filings are likely a better representation of a company's financial standing than SAIC filings, at least for VIE structures. Auditors, knowing that the income tax paid is unreliable, are likely looking at the VAT tax, white receipts and the "real" numbers contained in "secondary books" to verify sales numbers.

I also don't buy that auditors are in the dark on this issue. I am learning that it common knowledge that many Chinese firms have more than one "book". I am not sure what to make of a situation where, in the case of an FIE, we know that the SAT and SAIC documents are identical, yet diverge from SEC filings. In actuality, the SEC document is what the Chinese company should have filed in the PRC. (It makes more sense that the tax liability should be logged as taxes payable).

Another conclusion could be that some of these firms are real but smaller than they purport to be. This would involve a much more intense due diligence process.

Navigating These Findings

Even if we can come to the conclusion that SEC documents are more reliable than SAIC documents, should China Hybrids really expect to garner unconditional investor loyalty when a level of misrepresentation exists. The uncertainty surrounding this topic can still reduce the appetite and P/E expansion for the ChinaHybrid space, where many stocks have had muted reactions to spectacular 2010 second quarter financial results. The unfortunate circumstance is the collateral damage imparted on the quality companies.

In order to invest in this space you have to accept that what we may consider fraud is the norm in China. If all we have is tax fraud, it appears doubtful that China will levy punishment that would jeopardize the existence of so many companies. However, we cannot fully assume that serious monetary punishment will escape tax violators in the future. My lawyer's letter confirms this thought. It is more logical to assume that China will have to improve its tax system. Will monetary fines need to come from the company and necessitate capital raises to meet obligations? We also need to consider what interest the SEC may take in an issue where fraud and lax accounting oversight may abound. The Public Company Accounting Oversight Board (PCAOB) has already begun sniffing around the ChinaHybrid sector. (See more: http://pcaobus.org/News/Releases/Pages/07122010_SAPA.aspx and http://www.macpa.org/Content/25643.aspx)

Although SEC filings are likely more accurate, proving that they are 100% accurate would require firms to show why their filings don't match, or basically admit to some level of fraud and show us receipts. In the end, we have to trust auditors, a tough commitment now that we know of a few suspect FIE scenarios.

Our focus should be to use the available information in SEC documents, interviews and on site visits to validate a company's story.

1. Follow the cash. Cash in the bank is the easiest source of funds to verify. In order to fool an auditor, the majority of companies would have to be conspiring with bank tellers to forge bank accounts. Thus, we would prefer companies with healthy cash balances. When filings are off, attempt to identify clues that prove SAIC files are junk. The example of cash matching SAIC filings when everything else does not match is an example. Reference companies that use cash that is greater than balances outlined in SAIC filings to that pay regular dividends or large special dividends, enact stock buy backs and to complete acquisitions. Furthermore, we know that many of these firms completed offerings. It would be odd for them to have virtually no cash on the books as evidenced in many SAIC filings.

2. Look for clues in credit ratings, which ironically the SAIC administers. For example, when observing a company that has no debt, pristine financial ratios, healthy cash balances and steady operating cash flow in SEC filings, a low credit rating could indicate a red flag.

3. While I am not a fan of debt, companies that utilize debt as part of a growth strategy were likely scrutinized by the lender.

4. Look for companies that have canceled an existing financing transaction or given weak excuses for changing ownership structures from a FIE to a VIE.

5. Realize that companies who retain top U.S auditors with a strong presence in China will likely get more investor love.

6. Be aware of companies with internal control problems as defined in SEC filings.

7. Be aware of more than routine changes in CFOs.

8. Understand that SAIC filings for FIE structures should match SAT filings.

Please Prove Me Wrong

My intent for this article is not to cause abandonment, but to inspire debate and comments from regulatory bodies to eliminate conjecture on this topic, giving investors comfort to focus on fundamentals. I actually want to be proven wrong. In the end, my hope is that the current mayhem will make the sector stronger by increasing the pool of quality companies. The ChineseHybrid universe is evolving and will surely experience hurdles and pockets of fraud as it matures. Firms must become more familiar with the demands of U.S. investors, increase disclosure and eliminate uncertainty. The SEC needs to crack down on individuals who may be spreading "conceivable" lies to bring down companies. More importantly, these firms that we have helped make rich should just pay their fair share.

Please note that I am still probing into the Chinese tax system, especially to determine if SAT documents are actually representative of taxes paid. We will continue to highlight companies on the basis of fundamentals in SEC filings. Investors need to formulate their own opinion on the severity of the SAIC vs. SAT vs. SEC issue.

Disclosure: The GeoTeam continure to take a very tepid stance on the ChinaHybrid space as our due diligence process continues.  

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