Can any accounting out of China be trusted?  This is what prudent investors have to start asking themselves.  Since early this year a new report comes out nearly every week that reveals some alleged misbehavior on the part of yet another China-based firm. The first firm to earn the spotlight was a billboard company, but now some of China’s biggest state-owned firms are taking the stage.  If the state-owned firms are fudging on the books or ‘overlooking’ key data, how on earth do investors trust any company’s reports in China?

Aluminum Corporation of China, or Chinalco, is a holding company and the controlling shareholder in Aluminum Corporation of China Ltd. (NYSE: ACH), or Chalco. Along with China National Offshore Oil Corp. and China Unicom, which respectively control Cnooc Ltd. (NYSE: CEO) and China Unicom (Hong Kong) Ltd. (NYSE: CHU), Chalco has been named as one of 17 state-owned enterprises to have irregularities and other violations in their financial statements to the Chinese government in fiscal year 2009. China’s Xinhua news agency reports that by March of this year 735 irregularities had been corrected and “65 people responsible for the irregularities or violations have been punished.”

The accounting irregularities for the 17 companies included overstatement of assets, profits, and liabilities by $292.4 million, $405 million, and $528 million, respectively. Undercounted assets totaled $446 million, while undercounted profits totaled $185 million, and undercounted liabilities totaled $385 million.

In the case of Chinalco, the problems appear to be violations of Chinese rules more than accounting irregularities. Chinalco included 11 companies in its 2008 financial report that failed to meet profit targets by the end of 2009 and launched or acquired 10 projects for which Chinalco did not have permission from the state. The total investment in the 10 projects topped $1.4 billion in 2008. Chinalco also got slapped for some irregularities in its senior managers’ shareholdings.

The troubles at Chinalco are reasonably small, but they should be the final straw needed to kill speculation about the company’s rumored intention to buy Alcoa, Inc. (NYSE: AA). The truth could be that China just doesn’t want to be embarrassed by another rejection of a bid for a large US firm. And Chinalco probably doesn’t want more scrutiny from the SEC after getting raked over by Chinese regulators.

Running afoul of China’s regulations governing state-owned enterprises is not the only issue. The so-called “Facebook of China,” Renren Inc. (NYSE: RENN) had to correct its financial statements just before its IPO earlier this month. Shares officially opened at $19.50, climbed to $24, and closed the first day’s trading at $18.01. Shares are now trading at around $12. Busted IPO for sure.

Hong-Kong based financial software maker Longtop Financial Technologies Ltd. (NYSE: LFT) lost its CFO, saw its auditing firm resign, and watched the US SEC initiate an investigation of the company’s financial reports. Shares had fallen -25% since the beginning of May before trading was halted last week. Longtop’s CFO was also an independent director and chairman of Renren’s audit committee.

Advanced Battery Technologies, Inc. (NASDAQ: ABAT) and China MediaExpress (OTC: CCME) are both Chinese reverse merger companies. Advanced Battery’s chairman has been accused of selling a key subsidiary to himself without compensating the company. A report by a short-seller has led to a -33% drop in the share price and a bevy of shareholder lawsuits. Advanced Battery makes lithium-ion batteries for electric vehicles, including its own line of motorbikes and scooters. China MediaExpress, the billboard company, saw its share price fall from near $20 to around $1.50 following a short-seller’s report regarding reporting irregularities.

China Shen Zhou Mining & Resources, Inc. (AMEX: SHZ) is one of China’s leading miners of rare earth minerals and other metals. If any company should be making money, this is one. But the company’s auditing firm issued a “going concern” note to China Shen Zhou’s 2010 10-K. The auditors apparently don’t agree that a private placement of $20 million in common stock and another $7.2 million in warrants is enough to keep the company going for all of 2011. China Shen Zhou’s stock peaked at $10.84/share in January, and trades at about $4.10 today.

While each of these companies may exemplify a different aspect of what’s going on with Chinese firms, they all have one thing in common: they’re Chinese. That is, they must operate under the constraints of Chinese regulations, which are a little hard to pin down at times. The major problem that firms face is that the Chinese government has given inflation fighting a pre-eminent position in its policy making. Higher interest rates, lower lending limits, and reduced liquidity make profitability uncertain.

There are also, apparently, more than a few executives willing to cut corners in pursuit of riches. Accounting rules in China are different from US SEC GAAP accounting rules, and taking advantage of those differences leads to different numbers on both Chinese and US reports, which leads to reports from short-sellers who smell blood in the water, and eventually to government investigations on both sides of the Pacific.

Finally, it’s also worth noting that China faces a serious real estate bubble and that many well-known investors are counseling short positions on Chinese real estate. But real estate, like copper, can be used by China’s small- and medium-sized firms as collateral for low-cost loans while the country’s banks are prohibited from making more loans.

China wants to grow its economy by about 8% annually in an effort to keep up with population growth, rising wages, and large numbers of retirees. To date the country’s exports, wild lending, and government funding have pushed GDP growth above 10% for a number of years. Ratcheting back to 8% means cooling the economy, as the government has done.

The problem is that the constant accelerate/brake pattern is hard to control. China essentially has no choice but to keep the shell game going. If it stops, no one will know for sure where the pea is. 

We have a saying here at 24/7 Wall St.: KNOW WHAT YOU ARE INVESTING IN!  It is getting hard to trust anything out of China at the moment.  Maybe trusting Chinese accounting is becoming the same as trusting that Chinese vitamins are even half of what they are supposed to be.  Welcome to the World of Knock-Off Accounting.

Paul Ausick

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