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Whom can a poor investor in Chinese stocks believe?

For years, investors in Chinese companies have used the reputations of outside auditors, institutional investors and global investment banks as a proxy for reliable financial reporting. Maybe the disclosed data wasn't always easily understood, transparent or accurate but if a Big Four international accounting firm like Deloitte Touche Tohmatsu signed off on the audit, a big institutional investor like JPMorgan Chase (JPM, news) owned a couple of million shares and an investment bank like Goldman Sachs Group (GS, news) had underwritten the company's initial public offering, the financials had to be OK, right?

Apparently not.

That's what's so depressing, disturbing and disorienting about the fraud recently uncovered at Longtop Financial Technologies (LFT, news). The company's books were audited by Deloitte, and Longtop still managed to lie about the $332 million in cash it claimed on its balance sheet.

This was no penny stock that duped only unsophisticated individual investors. JPMorgan Chase owned almost 2 million shares that were worth $62 million as of March 31. FMR, which owns the Fidelity mutual fund family, had $261 million invested. Maverick Capital, a hedge fund with $20 billion under management, owned $177 million of Longtop Financial Technologies shares. The lead underwriters on Longtop's 2007 IPO had been Goldman Sachs and Deutsche Bank (DB, news). In 2009, Morgan Stanley (MS, news) was the lead manager of a sale of more shares.

Image: Jim Jubak

Jim Jubak

Longtop, which had been valued at $2.4 billion at its high last November, was valued at $1.1 billion when trading in New York was halted in the stock on May 17.

And it gets worse. Since March, more than two dozen companies based in China have disclosed auditor resignations or accounting problems, according to the U.S. Securities and Exchange Commission. The SEC has launched a task force charged with examining accounting at overseas companies listed in the United States.

In other words, Longtop Financial Technologies isn't a bad apple in a barrel of otherwise sound fruit. Instead, it's symptomatic of a big problem that has tainted an entire sector. And because China is too big an economy and too promising a stock market to simply ignore, investors need to figure out how to deal with the problem.

What happened at Longtop

Longtop's finances started to unravel when its accountants decided to double-check the accuracy of the cash balances the company claimed to have in the bank. Deloitte had statements from the company's banks showing the accuracy of the cash balances that the company claimed. But it's a good accounting practice to at least spot-check paper claims. If a company claims $100 million in inventory, the accounting firm will look at the paper trail for that inventory. Can the company show that it bought what it now claims to own? The accounting firm will do spot checks to actually eyeball the inventory that the company claims to have purchased. This practice doesn't stop all fraud, but it does make it harder to execute.

In this case Deloitte decided to go to some of Longtop's banks to find a paper trail and records that validated management's cash balances. And what did the accountants find? Let me quote from Deloitte's letter of resignation as Longtop's accounting firm. They found:

"Statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by bank staff compared with the amounts identified in previously received confirmations;...and significant bank borrowing reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group."

In light of what looked like an effort to inflate cash on hand, Deloitte tried to conduct a second round of bank confirmations on May 17. "Tried" is the key word. Longtop intervened to stop the process. According to Deloitte's resignation letter, management's actions included calls to banks "asserting that Deloitte was not their auditor, seizure by the company's staff of second round bank confirmation documentation on bank premises; threats to stop our (Deloitte's) staff leaving the company premises unless they allowed the company to retain our audit files then on the premises; and then seizure by the company of certain of our working papers."