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Accounting fraud in China

Written by Paul Adkins

The phantom collateral that rocked Qingdao has left the metals market worried and uncertain, and raised serious questions about accountability and transparency in Chinese firms.  What some observers haven’t acknowledged is that the methods used to secure the multiple loans are neither particularly new nor innovative. Whereas corporate malfeasance in the West can take the form of labyrinthine arrays of special purpose entities and porous contracts, Chinese accounting fraud tends to be relatively straightforward deception. Thanks to loose and opaque accounting practices, there’s little need for multifaceted networks of half-truths; simply inventing an entry in the books usually suffices.

It wouldn’t, however, if the companies took more a proactive management attitude.

The Qingdao scandal came to light when a corruption probe in Qinghai’s capital, Xining, came across questionable dealings at Dezheng Resources’s subsidiary, Decheng Mining. The central government happened to be investigating a business partner of Xining’s Party secretary. As is common knowledge by now, the allegations are that Decheng took out multiple loans on the same collateral. To outside observers, this seems like something that should have been avoided with a fairly routine warehouse check, but it’s not an uncommon trick. Real Gold Mining suffered in a similarly reckless way in 2011, as the company’s mines were used as collateral for the owner’s private loans, a fact that went unnoticed by their third-party auditor despite it having being a matter of public record for over a year.

Another example is the pig and animal feed company AgFeed Industries Inc., where it was discovered senior management had simply been keeping an outside book for years, falsifying numbers to manipulate their stock price and reported nearly $239 million in fake revenue. In the absence of adequate oversight, the deception wasn’t discovered until this year, despite having been going on since 2008. Their US-based executives, having already overcommitted to their Chinese partners without checking if the numbers matched reality, compounded the issue further by trying to perpetuate the cover-up.

Multinational companies are facing the consequences of having little representative or physical presence in China to keep an eye and report on obvious discrepancies. Many have relied on independent teams from the big auditing firms to conduct their reviews for them, but they’re often left to the mainland member firms, with the final audit sign-off coming from Hong Kong. When ordered to look at a foreign-traded company, these auditors run into a legal grey zone; the central government may or may not have classified Chinese company accounts as state secrets. When the SEC ordered the Big Four to turn over working papers, they refused for fear of angering Beijing, which resulted in the Chinese member firms’ six-month ban back in January. The third-party auditors can’t make up for strict internal overview on the mainland.

Companies operating in China could take a more aggressive stance from the get-go to avoid accounting nightmares and alleviate fraud risk. In the case of companies trading in physical goods, stocks should be checked thoroughly; warehouses have been known to rent supplies for the day to convince visiting auditors that the numbers are correct. China’s informal network of unofficial suppliers can also create nightmares for auditors; documentation and a serious vetting process should occur before any business dealings take place. Strict regulations in place for revenue recognition are imperative, and they should be crystal clear to everyone. After this latest scandal, double-check and verify receipts to make sure they haven’t been falsified.

Most importantly, companies should foster a corporate environment where employees are willing to blow the whistle, knowing they will have the full support of the management. Internal audits should occur regularly, but it’s important to have a plan in place for the minute a red flag is raised internally or externally.
Accounting fraud in China is pervasive, but it’s not particularly insidious. Clear and concrete accounting rules and management policies can nip the majority of scams in the bud. Those who fall afoul are usually the ones who were overeager and rushed in too quickly, only to find out the warehouses had been standing empty for months.

 

Editor’s note: this is a guest post by Michael Laridan, from accounting firm DX Consulting]

 

Sources:

http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370541102314#.U9HxSICSy_0

http://www.forbes.com/sites/ninaxiang/2014/04/16/accounting-fraud-is-still-widespread-among-chinese-companies/

http://www.sjgrand.cn/alleviating-fraud-risks-china
http://uk.reuters.com/article/2014/06/13/china-qingdao-idUKL4N0OS1XO20140613

Qing Dao – ripple effect

Written by Paul Adkins

The scandal at Qing Dao port is having a ripple effect way outside its initial sphere of activity in alumina and aluminium.

It now emerges that at least 18 domestic China banks were allegedly hoodwinked by the perpetrators, with an unknown number of foreign banks and international traders.   As well, the whole process of using Letters of Credit for commodity trading is now under attack.

It is alleged that the company at the centre of the scandal, Dezheng Resources, allowed one of its subsidiaries to forge the company seal and other documents used by the Qing Dao Port Authority.   Those items were then used to create documents showing “ownership” of commodities, such documents being sufficient to convince these banks and traders to issue credit.

Essentially, anyone holding one (or more) of those fake documents is now out of pocket.

There’s a whole line of argument as to whether the banks and traders who got conned deserved what has happened to them.   Did they get greedy?   Did they have proper due diligence processes in place, and were those processes used?

Whatever one’s view on that, there’s no doubt that those banks and others who avoided getting caught will now retightening their systems to avoid a future occurrence.

It has been reported that 300,000t of alumina, 80,000t of aluminium and 20,000t of copper were involved.   Although the actual material has a value of roughly $300 million, the losses are likely to be 10 times that amount.   With at least 18 banks involved, it suggests these parcels of material were presented as collateral multiple times.

The ripple effect extends even further.    The Industrial and Commercial Bank of China (ICBC) has now applied to a court for the right to not honour a Letter of Credit (LC).   LC’s are at the heart of commodity trading.   They are relatively safe, not too expensive (usually about 1% of the transaction), and readily convertible. But it seems that trading of LC’s has also been part of the Qing Dao story, where the LC’s value can be recycled several times within the life of the LC.   The effect of being caught is that banks are now also slowing the LC issuance process, and now also (legally) defaulting on payment of the LC.

This will impact all commodities, from metals to maize.   It will also have some impact on the availability of credit within China.   Credit remains the single most important “asset” that companies can attain, and credit has fuelled China’s economic growth for years.   Perhaps players will find new means of obtaining credit and playing the system, but meantime, the screws just got turned a little more on China’s economy, thanks to one or two rogue players in a small city.

 

Where’s Heisenberg when you need him?

Written by Paul Adkins

Today China announced that Q2 economic growth came in at 7.5% year-on-year.

There are two possible responses to this announcement.   Some will look forward to increasing demand for iron ore, coal, copper – generally speaking a return to the paradigm that has been in place for so long.   Others will look back and cast a more critical view of this number.   In a sense, both positions are right.

Those who care to look more closely will find it hard to verify such a strong result.   The pillars of GDP growth are simply not there.   Property sales and construction growth have slowed. International trade is still not back to full health. Domestic consumption is not at the levels that the government hoped for.   But the Communist Party says it is achieving what it set out to achieve, so who are we to question the result.

And that is just the point. While Beijing has pinned its flag on the pinnacle of 7.5% growth, most likely before it arrived there, meantime, credit supply and money growth are quietly being primed for the sprint to the finish line. M2 money supply rose to  14.7% y-o-y from 13.4%, while new total social financing (TSF) also rose strongly to RMB1.97trn in June from RMB1.40trn.

In other words, we probably will see increased activity in infrastructure and housing and other investment-led economic activity in the second half of this year, and we almost certainly will see that China achieves its target of 7.5% growth in 2014.   Iron ore, coal, copper and aluminium will all gain from the renewed optimism outside and inside China as a result of announcing this Q2 score.

But it was Heisenberg that said that the more you measure a phenomenon, the less you can measure its velocity.   In other words, you can measure one but not the other at any given observation.   Which leads me to suggest to Beijing that they stop talking about 7.5%, and stop predicting it, because it’s more important to be travelling at that speed than to chalk up the correct score.

 

Goodbye Alcoa Aluminum, hello Alcoa

Written by Paul Adkins

Alcoa’s announcement last week that it is paying almost $3 billion for a aerospace parts manufacturer is a sure sign of a longer-term strategy to take the company away from aluminium.

Firth Rixson, the company at the centre of the takeover, uses little aluminium in its products.   But it is at the core of the aerospace parts market, producing jet engine blades. “We are really material-agnostic,” Klaus Kleinfeld said in an interview on Thursday.

According to press reports, Alcoa changed its company description – the piece that goes at the bottom of press releases.

Instead of “the world’s leading producer of primary and fabricated aluminum,” Alcoa now calls itself “a global leader in lightweight metals engineering and manufacturing.”

Interesting that this new self portrait does not contain the word aluminium, and more interesting that it does not mention extraction, refining or smelting.   By its own description Alcoa now seems happy to talk about its downstream activities.

There’s been speculation around the industry for almost a year now, that Alcoa would eventually syphon off the primary metal part of the business.   That step may still be a long time away, but these moves by Alcoa do suggest that it’s not impossible.

Still, investor seem happy with the result, with the share price now at new yearly highs.

Weekly report review: weak market behind stable prices?

Written by June Wang

Dear readers, here is our latest “Weekly Report Review” . If you have any questions or requirements please tell us, thanks!

weekly report

 

Energy

With Iraq tensions increasing, crude oil prices climbed to a new level and stood at $107.26/t last week. Focussing on the domestic market, the coal price fell further due to high inventory. A situation that leads traders with a negative outlook to think the price will go down.

Alumina and aluminium

Import prices remained stable last week, however imported material is uncompetitive when compared with domestic alumina. For aluminum, there is no positive change in the downstream market. On-demand procurement volumes were limited to sustain price increase. Last week, aluminum price went down slightly.

 Raw material of AL

Although downstream demand continued be weak, refineries controlled their output to a relatively low level which helped petcoke prices stabilize. With oversupply and tighter cash-flow within the industry, they can’t push the prices up easily. Additionally, as demand for aluminum in the main market has shown no sign of a rebound, the  price might drop again.

ALF3 price continued to rise due to the low inventory levels, increasing by ¥50/t WoW. For good news, fluorspar prices started to rise slightly.

Aluminium output suffers as World Cup begins…

Written by Paul Adkins

Talk about priorities – the “Beautiful Game” is causing aluminium output to suffer!

A newspaper report today says that in Ghana, the local aluminium company, Volta, has been asked to cut back on its electricity consumption, because more power is needed to satisfy the huge demand for electricity during games in which Ghana is taking part. Neighbouring Ivory Coast will supply electricity to cope with the peak times, as its games are not scheduled at the same time.

Okay, so I grant you that Ghana’s aluminium supply is not a global game changer, but such is the pulling power of FIFA and football.  Here we have national economies experiencing a small shock thanks to a sport.   In a similar display of pragmatic priorities, the coup leaders in Thailand have announced that the curfew has been lifted for the World Cup.   And no wonder – games will be televised at awful times, 11pm, 2am and 5am, thanks to the time zone differences.

AZ China has an excellent reputation for its forecasts and outlooks, so here are our tips for the carnival -

  1. Australia to go through the 3 initial games without scoring a single goal (sigh)
  2. Brazil to score much egg on face with venues not complete, transport links not working and too much Cachacha
  3. Germany to take home the silverware. Spain as the possible spoiler.

 

 

 

Important news – ban on petcoke

Written by Paul Adkins

We received word yesterday that it seems the Chinese government has placed a ban on the use of petroleum coke as a fuel for glass companies and power plants.   So far it is only occurring in Shandong province, but that just happens to be the landing port for much of the imported petcoke arriving in China.

We had treated this as just a rumour, but we have now received a second independent report of the same thing.  (That doesn’t make it a “fact”, but it’s now reliable enough to report on.)  Apparently petcoke is now piling up at Shandong ports as a result of the lost sales.

It’s now a question of how long before the ban spreads to other provinces, and other industries.   Petcoke can be used as a fuel in cement and in CFB boilers.

Putting a ban on petcoke makes no sense.   Considering the amount of ash present in coal  relative to petcoke, and the amount of coal burned compared to petcoke, why would anyone bother with such a small contributor to the pollution problem?   On the other hand, we have also heard that part of this pressure is coming from the natural gas/shale gas lobby, who want to lock in their customer base.   That also makes no sense, at least until each glass plant has its own gas pipeline, and has converted its burners to the vastly different fuel type.

This action, if it is proved true, soaks more about the blind approach to problems that the bureaucracy uses in China.   In the same way that the Government sent in tanks and machine guns to kill a student protest 25 years ago, a sledgehammer approach to fixing the pollution problem speaks more about desperation than any sort of thought-out plan.

We will keep watching this important development.   To date, there is nothing on the Department of Environment website, but that often means nothing in China, where words and actions often don’t match.

Farewell Jacynthe

Written by Paul Adkins

Jacynthe Cote, CEO of Rio Tinto Alcan, is leaving the company.    According to the RTA press release, Ms Cote is leaving at the end of September to pursue other interests.

Clearly this was not new news, as Rio has already announced the appointment of a former BP executive to fill the role.   There had been some speculation in industry circles about how much longer she would stay in the job, given the tough market conditions that have prevailed since she took over.

But such speculation was not based on any suggestion of poor performance.   Jacynthe held a reputation within the industry of being an excellent CEO, and there’s no doubt she will be missed, both within RTA and in the wider industry.

Jacynthe joined the former Alcan in 1988, and rose to the top position in 2009 after Rio took over Alcan.   it’s not widely known, but the present head of Rio, Sam Walsh, was Jacynthe’s mentor in her new job as RTA CEO.

But Jacynthe and Rio have been battling for more than 4 years with forces that are greater than them.   The Global Economic Crisis sent metal prices crashing, and even to this day aluminium is still under-performing.   RT and RTA looked at an expansion strategy at first, enunciating a plan to close old inefficient plants and build new low-cost capacity.    There was talk of a smelter in Paraguay, and another in Malaysia.   Soon enough however, both projects died, as the industry continued an over-supply scenario.   Eventually, RT sought to spin off some assets, creating Pacific Aluminium, and it was Jacynthe’s job to sell this new company.   But there were no buyers anywhere near RT’s asking price.

The one star in the RTA camp has been the AP60 plant in French Canada, which Jacynthe championed.   It must have been a difficult sell job, to convince the RT Board to stump up the funds for this plant, even as the world shunned aluminium as a commodity.

it is fair to say that the job description and objectives that the new CEO has been given are probably quite different to the set of documents that Jacynthe was given in 2009.

We at AZ China wish her success in her future career.

 

Keep your friends close, your enemies closer

Written by Paul Adkins

The Washington Examiner newspaper has named Chinalco as being one of the Chinese State Owned Enterprises involved in the cyber attacks on American corporations, specifically Alcoa.

According to the Examiner, the court documents identify a Chinese company, named only as “SOE-3″ as having entered a partnership with Alcoa in February 2008.   The Examiner points out that Alcoa’s website announced a partnership with Chinalco at that time, leading to the inescapable conclusion that Chinalco is “SOE-3″.

The Examiner goes on to quote the court documents, saying that Chinalco hired the secret army of hackers at around the same time as the partnership was announced.   The hackers then allegedly sent emails to Alcoa executives, with the emails loaded with “phishing” software that would allow the perpetrator to gain access to Alcoa’s internal documents. The “phishing” led to the hackers gaining access to at least 2900 emails, and 863 attachments.

One presumes Alcoa took extra precautions before it more recently entered into a Strategic Alliance with China Power Investment Corporation (CPIC), another Chinese SOE.   There is no allegation against CPIC in any of the court filings or charges.

Naturally, all corporations gather information on competitors and stakeholders, and indeed AZ China has been hired in the past to perform such duties.   But there is a clear distinction between the gathering of data using legitimate sources and the use of teams of hackers to illegally access sensitive information.   Of course the Chinese will throw allegations back at the Americans in this case, but the sheer numbers, the sophistication and the arrogance of the alleged Chinese attacks is over the top.   The thing is, most of us who have lived in China long enough have been warning for some time foreign companies entering China of just this threat.

 

AZ China Conference in Review

Written by Paul Adkins

We had a great turnout for our AZ China International Aluminium & Carbon conference last week in Beijing.  And there were even several prize winners! During the welcome reception on May 5, several people won a free wine tasting voucher for having attended all four AZ China conferences. Two people also won Bespoke Beijing vouchers.

It was interesting that the 3 economists that we had on stage all saw China’s economy growing at roughly 7% over the rest of this decade.    Even the most bearish outlook, from the Conference Board’s Andrew Polk, conceded that growth will continue at close to this level.

However, Andrew also warned that it is “wishful thinking” to rely on urbanisation as a driver of economic growth.   While there is no doubting that housing and construction will continue to be an important part of China’s economic future, Andrew warned that there are many problems attached to that sector.   Meantime, it is going to take a long while for domestic consumption to grow to high enough levels to have a major role in the economy, and much work is still to be done in China’s social security and personal savings network.

The aluminium panels were somewhat more pessimistic.   Both Mr Lang Dazhan and Mr Dong Chunming were concerned about growth in capacity, and the pressures on the financial health of China’s aluminium smelters.

What did become clear, when looking at the economic discussion in alignment with the aluminium discussion, is that as China moves from being a “blue collar” industrial economy to a “white collar” smart economy, the rest of the world will see increasing threats of jobs transferring to China’s millions of university graduates, and an increase in semi finished products being shipped.   China will move away from toys and clothes as an export staple into higher end products, and this will change the relationship between aluminium users in the rest of the world and Chinese producers.

In the petcoke discussion, despite the increased risks arising from shale oil in the USA, and potentially elsewhere, the conclusion seemed to be that there is no problem sourcing anode grade petcoke, provided one is prepared to pay the price.   Mr Gerry Sweeney put this succinctly – it’s a matter of price.   The problem of course is that consumers of petcoke are in no position to pay extra for their coke until the aluminium price improves, and that may still be some time off.   It wasn’t discussed in the panel session, but it seems that coke prices could start to rise faster than aluminium prices, over the next couple of years.

If you missed out on attending, here are a few pictures.

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