The underbelly of Chinese accounting

Since the fall of Chinese Communist Party prodigy Bo Xilai, global media has shone a spotlight in the widespread fraud that has become apparent in both mainland and US listed Chinese companies. At the same time, an extraordinary number of the Communist Party and the military cadre have massive unexplained wealth, with the Top 70 recording a net collective worth of over $80 billion.

Last week, Bloomberg was banned by the Chinese government for reporting the incoming presidents families assets at over $367 million. "As Xi [Xinping, next in line to become China's president], climbed the Communist Party ranks, his extended family expanded their business interests to include minerals, real estate and mobile-phone equipment, according to public documents compiled by Bloomberg," the site reported.

"Those interests include investments in companies with total assets of $376 million; an 18 per cent indirect stake in a rare earths company with $1.73 billion in assets; and a $20.2 million holding in a publicly traded technology company. The figures don't account for liabilities and thus don't reflect the family's net worth."

This kind of net worth originally came about by the implementation of the Cadre capitalist system by Deng Xiaoping in the early 90s its evolution into a kleptocracy.

But to this stoush, we can now add the stand-off between the China and the US over accounting standards. This issue has been going on for a few years and there looks to be no resolution in sight. In fact, Chinese firms could be cut off from US capital markets by the end of the year, according to Tsinghua University's School of Economics and Management professor Patrick Chovanec in Beijing, China.

"Unless a compromise can be reached, there is a very real chance that US securities regulators may end up employing the 'nuclear option': forcibly delisting every Chinese company currently listed on a US stock exchange – such as Sinopec, Sina.com, China Life, and China Unicom. It's a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to," Chovanec says.

There is a high probability that China simply cannot comply with US requirements because Chinese politicians and princelings would be implicated in these massive frauds, and with over 200 companies listed in the US this would result in a massive dislocation of capital when these companies are forced to relist in Hong Kong. If, as Peking University Guanghua School of Management professor Paul Gillis contends that if the US Public Accounting Oversight Board and the SEC make no progress, and the issue becomes political, company de-registration will be the only option. In that case, he says "it is the PCAOB that pulls the plug".

"That then forces the exchanges to decide how to enforce their rules that require companies to have auditors and audited financial statements in order to be listed. I expect in this scenario that the exchanges are forced to delist the companies, and the scramble to Hong Kong begins," Gillis says.

On the June 20, the SEC served formal requests on the Chinese arms of each of the 'big four' audit firms – Deloitte, Ernst & Young, PricewaterhouseCoopers and KPMG. In turn, the China Securities Regulatory Commission warned the accounting firms not to provide audit records to overseas regulators. Currently, mainland Chinese affiliates of the international audit firms have 130 clients listed on US stock exchanges, with Deloitte topping the list with 48 clients, followed by PricewaterhouseCoopers and KPMG, with 28 clients each.

The reality is that Hong Kong hasn't the capacity to re-register this amount of capital, so the issue is likely to become a powder keg in a US election run up. Will Barack Obama or Mitt Romney be willing to stare down China on accounting and audit standards?

An article by Bronte Capital chief investment officer John Hempton leads to only one conclusion, that China is refusing because it is protecting kleptocrat racketeers. As Hempton says:

"(A) The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US.

"(B) The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available, to make it harder to detect stock fraud.

"(C) When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big four audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably ... the big four) are co-opted for the benefit of Chinese kleptocrats."

The problem maybe that neither side has room to move, US regulators and the ‘get tough with China brigade' must move to protect the viability of US capital markets, while western style audits may expose far too many politically connected kleptocrats behind the Chinese audit curtain for them to give way. The Chinese reluctance to provide information may indicate that the frauds that have been uncovered to date are merely the tip of a big Red Iceberg of Chinese cadre fraud.

Craig Tindale is the Vice President of the Centre for Economic Stability, Professor Steve Keen's non-profit research initiative. This is an edited version of an article which first appeared on the blog Debtwatch.

Twitter @ctindale