Chinese Auditors Find Lies

Yesterday’s Wall Street Journal ran a story that only confirmed my worst fears about the quality of Chinese financial data.  In short, the piece, entitled “Auditors Sharpen Queries in China,” catalogs a series of lies found by auditors of Chinese businesses.

For example, one of the very easiest things for an auditor to confirm anywhere else in the world besides China is the cash that a business has.  The reason this is easy to confirm is that the auditors simply call the banks where the cash is on deposit and ask for an affidavit as to the amount of cash a business has.

But in China the banks lie on behalf of their clientele.  In one incident logged in the WSJ piece a Hong Kong-based auditor of the Chinese felt that the audit client was directing them to a faked website setup to provide false information!

Another technique used by auditors is to query multiple people at the bank and on multiple occasions to see how consistent the cash balances are that are reported.  Yet, when this is done, different cash totals are coming up even when quoted for the same day from the same bank!

Additionally, the Securities and Exchange Commission recently disclosed that such cash verification problems have arisen in over 10 cases between Chinese firms and their auditors.  So if something as simple as cash is difficult to audit in China, what about something super complex, like profitability?

The profit number is the last number on a company’s income statement (i.e. the bottom line).  That means that if any of the numbers above it are inaccurate, that the profit number is also inaccurate.

This wouldn’t be a big deal if no one cared about a business’s profitability, but that is the very reason to invest in a business.  Duh!

I have written at length about the difficulty of trusting Chinese company financial statements, and, by extension, China’s economic statistics.  The most important skill as an investor is to: understand information.  Yet, if that information is falsified, it is impossible to have an accurate understanding of the story that the information is supposed to tell.

Unfortunately, the oppressive and unforgiving nature of the Chinese Communist government has the unintended consequence of creating a culture of lying in China.  After all, business goals are not established by individual firms, but by the government of China.  The penalties for failing to achieve goals are often severe, including imprisonment.  So if a business falls short of mandated marks it lies to cover up the failure.

One of the benefits of failure is that it provides a sounding for decision makers as to how their choices have played out.  If failure is forgiven and then examined consciously then a path for improvement is often suggested.  This mechanism is broken in China due to unethical choices that start at the very top of the power structure there.

This is the primary reasons that I am certain that an economic bubble exists in China.  After all, the lying statisticians of China even acknowledge that their economy is in a bubble.  So ask yourself: are Chinese statistics likely to be erring on the side of the bubble being more severe than believed, or less severe than believed.

I think that you would have to argue that the culture of lying in China means that the bubble must be bigger than reported.  Ultimately, this means the reckoning will be more painful.  Without accurate economic information it is hard to know what to manage in order to lead an economic recovery.  Ouch!

As an investor I would steer very far away from China.  If you are nervous about a Chinese economic bubble bursting I encourage you to check out my piece entitled “Effect of a Chinese Bubble Burst” to quell your fears.

Jason