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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.

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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."

But my favorite part of the interchange between auditor and client company was still to come. On May 20, the chairman of Longtop called Deloitte's Eastern region managing partner. In the course of that conversation, Deloitte's letter of resignation says, Longtop Chairman Jia Xaio Gong informed the Deloitte partner that, "there were fake revenue in the past so there were fake cash recorded on the books."

Not surprisingly, Jia didn't answer when Deloitte asked how long this had been going on and how large the discrepancies might be. Surprisingly, Jia did answer when asked who was involved. "Senior management," he said.

What we can learn from this debacle

The first lesson is that the rules governing Chinese companies that list on U.S. exchanges have a huge loophole. In many cases local accounting firms that are affiliated with the Big Four accounting companies do the actual audits in China. These inspections are required in the case of accounting companies that audit companies that trade on U.S. markets as part of the Sarbanes-Oxley Act. But China has refused to allow inspections of the audits conducted by these affiliated companies. Investors have no idea of how closely their work conforms to international audit standards.

Second, the Chinese companies intent on tricking investors understand the reliance of many overseas investors on big names. On April 28, when short-sellers were questioning why Longtop needed $332 million in cash and asking if it even existed, Derek Palaschuk, a former audit manager with PricewaterhouseCoopers (another Big Four accounting company) in Hong Kong and Beijing, assured Wall Street that the claims were unfounded. Short-sellers were "criticizing the integrity of one of the top accounting firms in the world," he said.

Third, we shouldn't forget one of the lessons of the mortgage crisis and the technology bust of 2000 -- Wall Street is awash in conflicts of interest that can potentially warp judgments. Wall Street companies make money when they take a company public or manage an offering of additional shares. As part of the process for winning that business, investment bankers make all kinds of promises to cover the stock after the offering. The implication is that this coverage will be positive and help support the company's share price.

On May 4, an analyst for Morgan Stanley, which managed Longtop's secondary offering, defended Longtop against allegations of fraud. "Our analysis of margins and cash flow give us confidence in its accounting methods. We believe market misconceptions provide a good entry point for long-term investors."

Fourth, China's banks should never, ever be thought of as a bulwark against misrepresentation or fraud. Investors are safer thinking of them as enablers -- at least at this stage. Longtop would not have been able to pull off its deception without the active participation of bank employees. In April, Deloitte resigned as the auditor for China Media Express over, in part, similar questions about bank confirmations. That same month, another Big Four accounting company, KPMG, resigned from ShengdaTech, a Chinese chemical company, over serious discrepancies in bank balances and false bank confirmation letters.

Fifth, let's give the bears their due in this case -- and on China's stocks in general, given China's current financial regulations. Right now, bears provide a critical check on the claims of China's companies. Investors shouldn't take the charges of investors who will profit if stock prices fall on face value any more than they should take the claims of investors who will profit if stock prices climb.

But it seems likely that if the bears hadn't gone after Longtop, Deloitte wouldn't have decided to double-check Longtop's cash balances. After all, the accountants had signed off on Longtop's financials for six years.

A safer way to invest in Chinese stocks

First, don't abandon the big-name theory. While they are far from perfect, Wall Street's big names -- accounting firms, institutional investors and investment banks -- do have a financial interest in getting it right. Yes, they have conflicts of interest and institutional blind spots, but at least investors have a sense of what those problems are. Do you really want to add another level of uncertainty to the uncertainties of investing in a Chinese company by, for example, going with an accounting firm that you've never heard of -- and that might not even exist?

Second, extend the big-name theory to include China bears. Some investors are in it for the short term and will pass around any rumor that might help their cause.

But some bears believe in making their money the old-fashioned way -- by finding real problems that make a stock worth less than most investors think. Get used to including an Internet search for bearish opinions on any Chinese company before you buy as part of your due diligence. (Check out Citron Research, for example.)

More useful than the generic bears predicting a China collapse are those contrarians who see problems in individual Chinese companies. If you do a lot of investing in emerging markets in general and China in particular, and can afford the $910 subscription, check out Grant's Interest Rate Observer. If the price is too high, I think you'll still find it valuable to read the free teasers on Grant's home page.

Third, don't let the big-name theory replace your own accounting due diligence. You won't catch all the bad stuff just by reading the financials filed by Chinese companies that trade in the United States. But sometimes the red flags will be obvious.

In the case of Longtop, what was a company with total assets of $606 million doing with $332 million in cash? Companies that cook their books typically start with "improving" their accounts receivables by either booking fictional sales or inflating the price and size of sales. But if that "improvement" escapes detection for a while it starts to become so large that it draws attention and a company may then start to manipulate its cash balances.

Try to double-check a company's financial claims with those of its competitors. If its growth rate, profit margin or market share is out of line with similar companies, make sure you understand why. And check a company's balance sheet, income statement and cash-flow statement. The combined movements of cash should make sense.

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Fourth, understand the basic story about the way a company makes its money. Where does growth come from? Why are profit margins what they are? China is an amazing growth story, but nobody has repealed the rules of business. A company's story should make sense to you.

Fifth, be willing to walk away. China is still in the early stages of its growth story. All the great success stories of China's stock market won't be snapped up by the end of next month. Remember, you would still have had a pretty good run in U.S. stocks if you'd missed all of 1896.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund's portfolio here.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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