UNIVERSITY OF NOTTINGHAM The Audit Risk Associated

UNIVERSITY OF NOTTINGHAM

The Audit Risk Associated with Fraudulent Accounting of Listed

Companies in China : A Case Study

By

Lei Lei

MA Finance and Investment

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Acknowledgement

Acknowledgement

Taking this opportunity, first of all, I would like to thank my supervisor Mark Billings,

for his invaluable comments and suggestions in guiding me finishing the dissertation.

Without his well-organized schedule, I would never finish the dissertation on time.

I am also appreciated with the help from my good friends, Luping Sun, Chunhui Lian,

Xiaoqi Zhu, Lerui Guo etc. Thanks for being with me for this wonderful year and

supports given during my gloomy days. Especially, I would like to thank my

boyfriend, Zhigang Zhao, who always supports and helps me whenever I am needed.

Lastly, I must express my sincere love to my parents, who encourage and support me

all the way. Without their faithful trust and enduring love, I would not finish my

degree and scholastic life in the University of Nottingham.




Abstract

Abstract

This dissertation studies the discipline of auditing and fraudulent accounting. The

investigation of literature review initially concerns about the basic concepts of

auditing and audit risk, and then followed by fraudulent accounting which has direct

impact on audit risk. The literature tries to discuss audit risk and fraudulent

accounting separately and then presents the relationship between the two.

Based upon this, firstly, backgrounds of Chinese auditing environment are analyzed to

have a preview of the conditions in the case, and then a case study is employed as the

methodology to find the gap between literature review and the truth in case study.

From the analysis, it can be concluded that literature can explain most of the truth in

the case except some particular points that are of Chinese characteristics.

Finally, conclusion is derived from comparisons and contrast between Guangxia and

Enron to stress the culture difference in terms of corporate scandals. Possible

suggestions are given from the inspiration of U.S. Sabanes-Oxley Act to solve

Chinese corporate scandal problems and improve business performance in stock

market. Limitations are also given to state the constraints to this dissertation and any

improvements that maybe needed.




Abbreviations

Abbreviations

APC: Auditing Practices Committee

CFO: Chief Financial Officer

CPA: Chartered Public Accountant

CICPA: Chinese Institute of Certified Public Accountants

CSRC: China Securities Regulatory Commission

EPS: Earnings per share

FASB: Financial Accounting Standards Board

GAAP: Generally Accepted Accounting Principles

IAS: International Accounting Standards

IASB: The International Accounting Standards Board

IASC: The International Accounting Standards Committee

IIA: Institute of Internal Auditors

IOD: The Institute of Directors

IFRS: International Financial Reporting Standards

MOF: The Ministry of Finance

OECD: Organization for Economic Cooperation and Development

PCAOB: Public Company Accounting Oversight Board

PRC: People’s Republic of China

SAS: Statement on Accounting Standards

SEC: Securities and Exchange Commission

SOE: State-owned Enterprises

SOX: Sarbanes-Oxley

SPE: Special Purpose Entities




CONTENTS

i

CONTENTS

Acknowledgement

Abstract

Abbreviations

Chapter 1 Introduction.............................................................................................1

1.1. Backgrounds and motivations…………………………………………………….1

1.2. Aims and objectives………………………………………………………………2

1.3. Methodology……………………………………………………………………...2

1.4. Structures of the dissertation……………………………………………………...3

Chapter 2 Literature Review....................................................................................4

2.1. Overview of Auditing……………………………………………………………..4

2.1.1. Introduction…………………………………………………………………4

2.1.2. The principles of true and fair view………………………………………...4

2.1.3. Accounting policy…………………………………………………………..6

2.1.4. Materiality…………………………………………………………………..7

2.1.5. Audit failure………………………………………………………………..9

2.2. Audit Risk………………………………………………………………………..11

2.2.1. Concept of audit risk………………………………………………………11

2.2.2. Identifying and assessing audit risk……………………………………….13

2.2.3. Relationship between materiality, audit risk and audit planning…………..14

2.2.4. Corporate governance……………………………………………………...15

2.2.5. Internal audit………………………………………………………………17

2.2.6. Auditor independence……………………………………………………..18

2.3. Fraudulent Accounting…………………………………………………………..20

2.3.1. Introduction………………………………………………………………..20




CONTENTS

ii

2.3.2. Concept of fraudulent accounting…………………………………………21

2.3.3. Causes of fraudulent accounting…………………………………………..24

2.3.4. Fraud techniques…………………………………………………………..26

2.3.4.1. Overstatement of revenues…………………………………………26

2.3.4.2. Cultivate current assets and concealment of losses or liabilities…...27

2.3.4.3. Tamper with taxation……………………………………………….27

2.3.5. Consequences of fraudulent accounting…………………………………..28

Chapter 3 Methodology…………………………………………………………..30

Chapter 4 Overview of Chinese Auditing Environment………………………..33

4.1. Inherent pitfalls of equity structure and company management………………...33

4.2. Auditor profession……………………………………………………………….34

4.2.1. Due-risks…………………………………………………………………..34

4.2.2. Agency problems…………………………………………………………..36

4.3. Traits of domestic audit environment……………………………………………37

Chapter 5 Case Study……………………………………………………………39

5.1. Introduction……………………………………………………………………..39

5.2. Backgrounds of Guangxia fabrication case……………………………………..40

5.3. Case analysis…………………………………………………………………….42

5.3.1. The true and fair view……………………………………………………..42

5.3.2. Materiality…………………………………………………………………43

5.3.3. Audit failure……………………………………………………………….46

5.3.4. Audit risk…………………………………………………………………..47

5.3.5. Internal control…………………………………………………………….52

5.3.6. Auditor independence……………………………………………………..53

5.3.7. Accounting fraud…………………………………………………………..54

5.3.7.1. Overview…………………………………………………………..54




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iii

5.3.7.2. Fraud techniques…………………………………………………..59

5.3.7.2.1. Overstatement of revenue………………………………...59

5.3.7.2.2. Cultivate account receivables and concealment of losses..60

5.3.7.2.3. Tax………………………………………………………..61

5.3.7.3. Consequences of accounting fraud…………………………………62

5.3.7. Implications……………………………………………………………….63

5.3.7.1. Generalize Accounting Standards……………………………….....63

5.3.7.2. Auditor independence………………………………………………64

5.3.7.3. Rationality of investment…………………………………………..65

5.3.7.4. Corporate governance………………………………………………66

5.3.7.5. Lacking of comprehensive statue…………………………………..67

Chapter 6 Conclusion…………………………………………………………….69

6.1. Problems…………………………………………………………………………69

6.2. Guangxia vs. Enron……………………………………………………………...70

6.2.1. Similarities………………………………………………………………...70

6.2.2. Differences………………………………………………………………..72

6.2.3. Summary…………………………………………………………………..73

6.3. Post-Guangxia thinking………………………………………………………….74

6.4. Solutions to fraudulent accounting………………………………………………75

6.4.1. Tenure of audit firm………………………………………………………..75

6.4.2. Non-audit services…………………………………………………………75

6.4.3. Supervision………………………………………………………………..76

6.4.4. Internal control……………………………………………………………77

6.5. Limitations………………………………………………………………………78

Bibliography………………………………………………………………………...79 Appendix……………………………………………………………………………86




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CHAPTER 1

Introduction

1.1. Backgrounds and Motivations

Financial statements, as the mirror of a company’s performance, require a

fundamental and appropriate financial analysis. The validity and accuracy of financial

statements is an issue extensively stressed due to its high significance. As companies

have grown in size, the management has passed from shareholder-owners to small

groups of professional managers. Thus, a need has arisen for company managers to

report to the organization’s owners and other providers of funds such as banks and

other lenders, on the financial aspects of their activities (Porter et al. 2003, p. 9).

Those receiving external financial reports wish to have the information “checked out”

or audited in the reports to assure reliability.

The external use of financial statements and high public importance are main driving

forces of creative actions. The gravity and credit given by the public for an

outstanding performance and the obsession for high profits and earnings, lead to

creativity (Griffiths, 1987). Nowadays more and more companies use fraudulent

accounting1 to make company economic performance attractive to investors, which

on the other hand provides more difficulties for external auditing and affects audit

quality.

The fraudulent accounting deliberately used by management may mislead

stakeholders and shareholders and result in investment loss ultimately. Therefore,

there is an increasing concern on the audit risk of fraudulent accounting used by listed

companies. The reason for choosing listed company is because the separation of 1 From 1994 to 2004, 117 out of about 1260 listed companies in China were exposed for fraudulent accounting by media (Han, 2005).




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ownership and management control in listed companies makes the independent

external audit especially important with respect to corporate governance and the

oversight of such companies (Nicholls, 2005).

1.2. Aims and Objectives

This dissertation is built up to review the literature in the field of audit risk associated

with fraudulent accounting. The most important task for this dissertation is to

compare the theories and the truth in case study of “Guangxia Ltd.” so as to interpret

whether those theories are good to explain the same evidences in the company.

The literature review generally focuses on following aspects:

1. Overview of auditing

2. Factors affect audit risk.

3. Causes of accounting scandals.

4. Techniques and consequences of fraudulent accounting.

5. The relationship between audit risk and fraudulent accounting.

With the literature review, a case study of “Guangxia Ltd.” will be provided to

examine whether those aspects have been consistent with the truth in the company.

From the comparison, an implication of possible solutions to fraudulent accounting

can be concluded.

1.3. Methodology

Qualitative research methodology will be adopted according to the nature of the

dissertation topic. Qualitative research is concerned with developing explanations of

social phenomenon, it is concerned with the questions about “how”, “why” but not

“how much” or “how often” (Bryman, 1993). In this dissertation, a case study named




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“Guangxia Ltd.” is concluded as an approach to the research. Case study is one of the

forms of qualitative research design, which offers a richness and depth of information

not usually offered by other methods. By attempting to capture as many variables as

possible, case studies can identify how a complex set of circumstances come together

to produce a particular manifestation.

Besides, both primary and secondary research will be carried out to obtain more

information. The primary data collection will be face-to-face and telephone interviews.

Unfortunately, the author failed to get in touch with the staff who had worked in

“Guangxia”, because it is difficult to get the truth from an old staff according to the

nature of accounting scandal. The secondary research will be conducted to collect and

organize data through an examination of an array of books, journals, articles,

newspapers, reports, professional bodies and government agencies.

1.4. Structures of the Dissertation

The dissertation is divided into six parts. The first part states the backgrounds,

motivations and objectives for doing this dissertation. At the second part, literature

review will be given to provide the theoretical basis for further research. The third

part will summarize the methodology used in the research. The forth part provides the

backgrounds of the Chinese auditing environment, which will offer a clear context for

better understanding in the future case study. As the most important segment of the

dissertation, the fifth part will focus on the audit risk associated with “Guangxia Ltd.”.

In this part, case and effects of fraudulent accounting will be introduced in order

based on the literature review. Further, the comparison between the theory and the

truth will be explained to support or argue against those literatures mentioned. The

conclusion in the last part will stress comparisons between “Guangxia” and another

well-known accounting scandal, “Enron” and then offer final opinions on possible

solutions to fraudulent accounting based on Sarbanes-Oxley Act.




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CHAPTER 2

Literature Review

This section is divided into three parts. In the first part will generally overview the

concept of auditing. In the second part, audit risk will be introduced from different

areas to aid understanding the audit risk in case study that discussed in chapter 5.

Then the relevant concept of fraudulent accounting which is another key element of

literature review will be addressed in part 3.

2.1. Overview of Auditing

2.1.1. Introduction

Financial statements are the primary source in discovering a company’s performance

and likewise companies are fully aware of the implications of this. There is a broad

range of parties use this financial information although their information needs vary,

such as investors, lenders, customers, employees, governments, the public, etc. The

audited financial statements may be perceived to be reliable by investors and the

public. However, when fraudulent accounting is used by companies, audit risk is

increased and consequently result in investment loss. By then, is accounting as Goethe

says the fairest invention of the human mind?

2.1.2. The Principle of True and Fair Financial Statements

The vision of promoting transparency, shareholder activism and finally, accountability,

is the purpose of a new co-regulatory regime (Dean and Clarke, 2004). Phrases such

as ‘a true and fair view’ and ‘presenting a fair view’ are expressions refer to the value

and validility of financial statements, which bring to the attention the issue of




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principle versus rules based accounting and the varying notions applied between

different countries. Dean and Clarke (2004) stated that the ‘true and fair’ criterion has

long been a cornerstone of British-based accounting whereas the U.S. standards in

contrast are categorized as the archetypal rules-based system of reporting.

The International Accounting Standards Board (IASB) and the newly formed

International Financial Reporting Standards (IFRS) used within the U.K. are

perceived to represent the closest thing to a principles-based regime (Vinten, 2003).

This can be defined as a ‘true and fair state of affairs and the need for current value

information to inform investors – reliable, relevant, understandable and comparable

data – proxied by fair value reporting’ (Dean and Clarke, 2004, p. 2)

The standards applied by the U.S. notably the Financial Accounting Standards Board

(FASB) and Securities and Exchange Commission (SEC) are significantly more

detailed and prescriptive than either the United Kingdoms IASB standards or IFRS

(Vinten, 2003). FASB standards are more prescriptive and rule based because the

litigious environment in the United States calls for this, and there is no such ‘true and

fair view’ concept in the U.S. with a comparable equivalent being ‘fairly presented in

conformity with generally accepted accounting principles (GAAP)’.

China has the continental law system and thus adopts the rule-based accounting,

which clearly identifies accounting policy, standards and regulations. It is difficult to

accurately define true and fair view as different people have different opinions toward

it. It is impractical to take true and fair view as the sole guideline in dealing with

financial reporting issues in China, there might be chaos and disorder in practice

(Wang, 2006). However, it is unreasonable to completely reject it; after all it is the

best representation of financial reporting objectives.

Wang (2006) suggests that the notion of true and fair view should be applied in




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enactions of regulations, standards and policies. Chinese accounting standards are

government-driven and concern more about governmental supervision and revenue

collection, whereas the true and fair view is information user-driven and focuses on

information credibility and preparation of financial reporting. Therefore, it is

necessary to put the emphasis on enaction of accounting standards and swift to

user-driven objectives.

2.1.3. Accounting Policy

China has long time been using its own accounting standards, which are different

from the well-known U.S. GAAP and European IAS (International Accounting

Standards: previous name of IFRS). On 15 February 2006, the Ministry of Finance

(MOF) issued a series of new and revised Accounting Standards for Business

Enterprises. Referring to the New Accounting Standards, David Sun, Chairman and

Country Managing Partner of Ernst & Young China says, ‘The issuance of the New

Accounting Standards marks the beginning of a new era for the alignment with

international accounting practices in China.’

The rapid development of China’s economy calls for more accurate and objective

accounting information to reflect the increasingly complex business environment. In

line with the globalization of the worldwide economy and international capital

markets, there is an increasingly strong need from the participants of capital markets

and users of accounting information for financial information that exhibits a greater

level of quality, transparency and comparability (Ernst & Young, 2006).

The New Accounting Standards represent convergence with IFRS. Most of them

make reference to the equivalent IFRS and adopt the principles and treatments similar

to its international counterpart. They have specified accounting treatments for

important accounting issues such as business combinations and consolidated financial




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statements, providing comprehensive and more authoritative provisions and

guidelines (Ernst & Young, 2006).

The IFRS provides the implicit framework used in accounting. As guideline to the

accounting practioners, they define the accepted accounting practices at a particular

time, concerning the accounting techniques and financial statements preparations

(Belkaoui, 1992; Lehman, 1995). The concepts of fairness, justice, equity and truth

are the basic core elements for the ethical validity of financial statements. There are

three concepts are needed for supporting accounting theory, concerning justice with

equitable treatment of all interested parties, fairness with fair, unbiased and impartial

presentation and truth with true and accurate accounting statements without

misrepresentation (Scott, 1941, in Belkaoui, 1992, p. 62).

2.1.4. Materiality

The auditors are required ‘to determine with reasonable confidence whether the

financial statements are free of material misstatement’ (Statement on Accounting

Standards: SAS 100, para 2,) and that a ‘matter is material if its omission… [or]

misstatement… would reasonably influence the decisions of an addressee of the

auditors’ report (SAS 220, para 3). Likewise, the International Accounting Standards

Committee (IASC) stresses the importance of materiality to financial statement users’

decisions. Therefore, auditors need to form a judgment with regard to what is

‘material’ in the context of a particular audit when planning their audits.

SAS 220 states that:

“The assessment of what is material is a matter of professional judgment and

includes consideration of both the amount (quantity) and nature (quality) of

misstatements” (para. 4).




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For instance, remuneration of an executive manager may be immaterial itself but may

be material as a whole to the financial statements. Thus, the sensitivity of an item

nature is important in deciding materiality, even a small inaccuracy can be material. A

user of the financial statements could be misled by inadequate or inaccurate

description of an accounting policy, this description can be perceived to be material

misstatement as well (Porter et al. 2003).

Moreover, different audit types have different understanding on materiality. For

example, a $10M fraud in General Motors was treated as an immaterial financial

event, because it was immaterial2. To some of the general public, and probably the

majority of GM stockholders would perceive such a fraud as a significant financial

event, but to fraud audit it is immaterial, since a fraud audit does not consider

materiality in the processes or in the analysis of the audit evidence (Singleton and

Singleton, 2007).

The overall materiality means the amount of error that the auditor is prepared to

accept as a whole but still concludes they provide a true and fair view of the affairs

and profit/loss of the reporting company. The auditor needs to estimate materiality

level before commencing an audit based on his understanding of the client, its

business and industry and on his assessment of the decision needs of users of the

auditee’s financial statements (Porter et al., 2003).

The lower the level of planning materiality, the greater the amount and/or the more

appropriate the evidence that needs to be collected to make sure that the combined

errors in the financial statements do not exceed it. However, “it must not be viewed as

a fixed monetary amount which, if exceeded even by a small margin, will necessarily

cause the auditor to conclude that the financial statements do not give a true and fair

view, but which, if not exceeded, will lead to the contrary conclusion” (Porter et al.,

2 In the early 1990s, General Motors suffered a lease fraud of over $10M by a Long Island dealer.




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2003).

2.1.5. Audit Failure

Audit quality can be viewed as a theoretical continuum ranging from low to high audit

quality, while audit failures occur on the lower end of the quality continuum (Porter et

al., 2003). It occurs when there is a serious distortion of the financial statements

which is not reflected in the audit report, and the auditor has made a serious error in

the conduct of the audit (Arens et al., 2002). A properly done audit does not guarantee

serious distortions have not occurred, but a properly done audit unlikely make serious

distortions. Thus, audit failure cannot occur unless there is serious auditor error or

misjudgment (Tackett et al., 2004).

The nature of this auditor error has only four systematic causes:

n “The auditor can blunder by misapplying or misinterpreting accounting

standards” (Tackett et al. 2004; Wang and Liu, 2004), and such a blunder is

unintentional that can be caused by fatigue or human error. n The auditor can be inappropriately influenced by having a direct or indirect

financial interest with the client (Tackett et al., 2004; Wang and Liu, 2004). For

instance, an auditor who is in consulting engagements for an audit client may be

reluctant to insist on accounting adjustments due to the fear of losing the client to

its competitors. In addition, when an auditor is not performing any consulting service in an audit

client, he is still reluctant to stand up to the client on accounting issues for fear of

being fired. Thus, the auditor perpetrate fraud by intentionally issuing a more

favorable report than is warranted (Tackett et al., 2004), especially at the time

when he accepts a bribe or bows to client pressure.




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n “The auditor can be unduly influenced because of having some personal

relationship with the client beyond what is expected in a normal audit between

independent parties” (Tackett et al., 2004). For example, it is common for a staff

member of a CPA firm to leave the firm if he was employed by a previously

audited client, because it is likely that personal relationships with his previous

employer may have some unfavorable impact on his audit opinions.

Further, Wang and Liu (2004) add that audit quality is influenced by two determinants:

the competency of collecting audit evidence and efforts made in achieving it; and

auditor independence, among which the latter is affected by pressures of litigation and

requirements of auditee company. Pressures of litigation derive from the potential

losses once audit fails, and requirements from auditee company may make auditors

conceal truth to financial statement users. Audit quality is inverse of audit failure, the

higher the failure rate, the lower the audit quality. Outright audit failures are difficult

to determine with certainty but can be obtained from some sources such as auditor

litigation and business failures, investigations by SEC, and earnings restatements

(Francis, 2004).

“Audit firms (especially large firms) have reviewed the causes of audit failure and

concluded that the failure does not generally come from auditor’s failure in detection

of accounting data recording or error processing” (Porter et al. 2003). On the contrary,

it tends to result from the matters associated with how the business is managed.

Lemon et al. (2000, p. 10) state that factors such as the business environment,

governance issues and the nature of managerial control will ultimately have

significance for the financial statements – their accuracy, issues of fraud and going

concern. They also add that effective auditing requires greater attention to be paid to

understanding the risks of the business (p. 12).




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A broader definition of auditor failure could be based on business failure rates. When

audited report has inappropriate presentation on financial statements, auditors may be

litigated by external users. Audit failure is inevitable as a result of Chartered

Accountants’ negligence or fraud. A recent study shows that nearly 50% audit

litigation is associated with business failure, and this is borne out by the fact of Enron

and other recent domestic fabrication cases of listed companies, but this does not

certainly mean all business failures are audit failures, rather, business failures are

more possible of audit problems.

2.2. Audit Risk

2.2.1. Concept of Audit Risk

Porter et al. (2003) define audit risk as:

“the risk that auditors may give an inappropriate opinion on financial

statements” (p. 56).

The audit risk has two forms, they are:

n “α risk: the risk that the auditor may express a qualified opinion (say something

is amiss) on financial statements that are not materially misstated; and

n β risk: the risk that the auditor may express an unqualified (‘clean’) opinion on

financial statements that are materially misstated” (p. 57).

In practice, α risk is very rare; therefore, the term “audit risk” is generally mean β risk.

Audit risk arises when auditors have legal liability due to an issue of a “clean” audit

report on financial statements which are materially misstated; therefore users of the




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financial statements are misled and suffer great loss as a consequence. Arens and

Loebbecke (1980) suggest that it is impossible to get absolute assurance of accuracy

of the financial statements, because auditors cannot guarantee the complete absence of

material errors and irregularities (Arens and Loebbecke, 1980). They only need to

express an opinion on financial statements rather than certifying the truth and fairness

on them.

Audit risk comprises two main components:

n “the risk that the unaudited financial statements are materially misstated in one

or more respects. (Inherent risk and internal control risk); and

n the risk that the auditor will fail to detect a material misstatement which is

present. (Detection risk)” (Porter et al., 2003, p. 58).

Audit Risk

Risk of material Risk of failing to error occurring detect material error

(Non-Controllable Risk) (Controllable risk)

Inherent risk Internal control Sampling risk Quality control risk risk

Management Account Business Failure to collect sufficient

Integrity Risk Risk appropriate audit evidence and/or evaluate it properly

Figure 1: The components of audit risk Source: Principle of External Auditing (Porter et al., 2003, p. 58)

The audit failure can be categorized as either non-controllable or controllable risk, or




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a combination of both. Corporate accounting fraudulence always has internal

fabrication which greatly increases the inherent risk and internal control risk. With the

existence of fraud, auditors fail to collect sufficient audit evidence or evaluate

properly, thus controllable risk is therein.

2.2.2. Identifying and Assessing Audit Risk

The existing audit risk model shows audit risk as following:

AR = IR× CR × DR

RMM

Inherent risk (IR) and control risk (CR) compose risk of material misstatements

(RMM). Inherent risk refers to the sensitivity of an account to misstatements before

applying controls, while the risk that the internal control system cannot prevent or

detect misstatements is control risk (Colbert, 2007). IR and CR are both owned by

entities, i.e. the entity influence them, but the external auditor cannot control the level

of either. Detection risk (DR) is defined as the probability that audit evidence and

auditor judgment will not detect a material error or irregularity when an error or

irregularity occurs and the internal control system does not detect it (Shibano, 1990).

The determinants of audit risk will vary by account, for example, assessment of

control risk will vary depending on the effectiveness of internal control for a specific

account, hence the AR model requires the auditor to assess audit risk for each account

and aggregate audit risk of each individual account to derive overall audit risk.

Besides the existing audit risk model, there are some other models incorporate more

factors in risk assessment. In recent years, more and more auditors have expanded

their focus to include client’s strategy and business processes and a number of recent

studies examine whether a business process focus affects auditor’s effectiveness when




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identifying risks. Bell et al. (1997) describe how this approach drives auditors from a

balance sheet orientation to a broader focus on the overall organization, environment,

and its key processes. Lemon et al. (2000) describe the extent to which firms are

adopting this focus in their audit methodology, and Eilifsen et al. (2001) describe how

this approach is applied to an individual audit.

Key performance indicators can be understood by understanding the client’s business

processes, meanwhile, it also aids in developing expectations for financial statement

accounts (Allen et al, 2006). By using this approach, auditors integrate assessments of

strategic business risks to some extent (O’Donnell et al. 2005). This approach helps

auditors to document more business risks of clients so that they can assess the strength

of control environment and inherent risk differently.

2.2.3. Relationship between Materiality, Audit risk and Audit planning

In order to reduce audit risk to desired level, auditors must plan the nature, timing and

extent of audit procedures carefully (Porter et al., 2003). When planning an audit,

“auditors consider the likelihood of error in the light of inherent risk and the system of

internal control in order to determine the extent of work required to satisfy themselves

that the risk of error in the financial statements is sufficiently low” (SAS 300, para 12).

The materiality limits (planning materiality and tolerable error) should be set at which

they affect the nature of audit procedures planning and the amount or appropriateness

of the evidence that the auditor must collect.

The lower the materiality limits, the greater the likelihood that errors or omissions

will occur in the financial statements that will exceed those limits and thus qualify as

material misstatements, therefore, the more (or more relevant and reliable) evidence

that auditors must collect to make sure they are not exceeded (Porter et al., 2003). In

addition, the lower the materiality limits, the more “careful” the auditor will be to




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determine whether those limits are exceeded. The inverse relationship between

materiality and the level of audit risk shows that the higher the materiality level, the

lower the audit risk and vice versa.

2.2.4. Corporate Governance

Davidson et al. (2005) comment that recent accounting scandals have focused

attention on the need for strong corporate governance mechanisms. The Institute of

Directors (IOD) defines corporate governance as:

“rigorous supervision of the management of a company…ensuring that business

is done competently, with integrity and with due regard for the interests of all

stakeholders (IOD, 2004)”

Balancing corporate performance with an appropriate level of monitoring can give

rise to strong governance (Cadbury, 1992). The board of directors plays a very

important role in corporate governance, which manages the strategic direction of the

company, evaluates the performance and determines the remuneration of management

(including executive directors). It also ensures the integrity of internal controls and

financial reporting. In U.S., only 9% of S&P 500 companies have a chairman

genuinely independent of chief executive, and in 70% of these companies the roles are

combined.

There are some other alternative board structures. The one-tier, also known as

Anglo-Saxon boards consist of a mix of executive and non-executive directors, while

the two-tier, known as German boards are separate executive and supervisory,

typically with employee representatives on the latter. However, neither system has

been entirely satisfactory, because scandals have arisen in both systems, and it is

difficult to ensure director independence in practice.




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The countries, including China, under continental law system employ the two-tier

board structure (Pi, 2006) and nowadays begin to construct the system of independent

director as the Anglo-American law system has (Ma and Cai, 2002). The number of

independent directors required by Company Law of China is one third of the total

number of directors to ensure independence.

From January 2002, Chinese corporations can constitute audit committees, thus there

are some corporations have a combination of both two. Since the functions of

supervisory board and audit committee overlap each other, some conflicts rise in

practice (Pi, 2006). Therefore, supervisory board should supervise the board of

directors on behalf of shareholders because it comes into being from general meetings,

whereas audit committee supervises managers on behalf of the board and is

supervised by supervisory board.

The preparation and disclosure of true and fair financial information is core of

corporate governance, because it enables stakeholders to exercise their rights so as to

protect their interests (OECD, 1999). However, audit committees in Chinese

companies fail to prevent various high profile corporate failures because the board is

controlled by a minority of directors (Pi, 2006).

Thus, the disclosure of financial frauds is difficult with the fact that they are typically

done by executive management. Auditors are normally constrained in detecting frauds,

because executives are in a good position to hide the fraud or misdirect auditors’

efforts (Singleton and Singleton, 2007). Similarly, an empirical study carried out in

the U.S. finds that the presence of audit committee does not affect the likelihood of

financial statement fraud significantly and no-fraud firms have higher percentages of

outside members in boards than fraud firms (Beasley, 1996).




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In addition, another study provides insight into financial statement fraud instances

investigated during late 1980s through 1990s within three volatile industries,

technology, health care, and financial services. It highlights corporate governance

differences between fraud companies and no-fraud companies on an

industry-by-industry basis. “The fraud techniques used vary substantially across

industries, with revenue frauds most common in technology companies and asset

frauds and misappropriations in financial-services firms” (Beasley et al., 2000).

From the research, fraud companies have very weak governance mechanisms

comparing with no-fraud industry companies. Consistent with prior research, fraud

companies in the technology and financial-services industries have fewer audit

committees, but fraud companies in all three industries have less independent audit

committees and boards (Beasley et al., 2000).

2.2.5. Internal Audit

The accounting system of an entity is designed to capture accounting data, convert

and output the data as useful financial information (Porter et al., 2003). It must be

reliable in order to ensure financial information is useful. Thus, the underlying

accounting data must be valid, complete and accurate. To ensure that the data meets

these criteria, internal controls are required to be built into the accounting system. The

internal control mechanisms within a system form the central point of an audit

(Hawks and Pitts, 1990), and the quality of internal control system usually has a

significant impact on audit.

Although internal audit function is internal to a company, it is not a part of the control

environment; “instead it is a mechanism for conducting an independent review of that

environment on behalf of the directors and senior executives” (Porter et al., 2003).

Ideally, the value of an internal control mechanism is its ability to prevent errors or




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frauds rather than to merely detect them (Hawks and Pitts, 1990). A fundamental

contributor to audit failure is a weak or ineffective internal audit function (Hamilton

and Micklethwait, 2006, because management always believe that it is expensive and

unnecessary.

If the internal control system is well designed and if it operates effectively to meet the

internal accounting control objectives, auditor will have a higher level of assurance

that any material errors or irregularities in the accounting data will be eliminated

when data passes through the accounting system (Porter et al., 2003). Thus, the

auditor will feel fairly confident when the financial statements are free of material

misstatement. In terms of audit risk, if an entity has a well designed and effective

internal control system, then the risk of material errors in the accounting data that not

being eliminated will be low.

However, if an entity’s internal control system is poor and /or is ineffective in meeting

the objectives of internal accounting control; the auditor will have less assurance that

the financial statements are free of material error. As a consequence, before issuing a

“clean” audit report, the auditor will need to conduct substantive tests in order to gain

sufficient assurance that the financial statements are free of material errors.

2.2.6. Auditor Independence

“Auditors being independent of their audit clients, their clients’ managements, and

any other influences which might impair their objectivity and impartiality, are of

critical importance to the audit function” (Porter et al., 2003). If auditors are not

perceived to be independent by those who use or rely on audited financial statements,

then their opinion on those the financial statements will lack of credibility and thus

the audit will have little use or no value.




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Auditors are hired, fired and paid by clients’ managements, they work closely with

them as they conduct their audits and, after a number of years of acting as auditor for

the client they become very familiar with them (Porter et al., 2003). Further, the long

and incestuous relationship between audit firms and their clients can weaken the

ability of audit firms to provide rigorous scrutiny of their client’s accounts, the

distorted incentives of providing non-audit services with their client companies can

also weaken the ability. Hence, if the auditors issue an audit report with a conclusion

that the financial statements do not show a true and fair view, they know that it is

possible to be fired or having their fee reduced (Moizer, 1997). In addition, a sense of

loyalty built up between an auditor and the managers will also threaten auditor

opinion, for example, an auditor may not want to jeopardize the career of a manager

who is a personal friend.

There are two types of ethical reasoning, consequentialism and deontology. In

consequentialism, actions are judged based on the consequences that it results,

whereas in deontology some acts are morally obligatory in spite of their consequences

(Moizer, 1997). The ethical position that an auditor has will influence his/her decision

in terms of auditor independence and honest reporting. Thus an auditor could adopt

the deonological stance because it is wrong to be dishonest. This sort of person

therefore would not give an audit opinion that he/she knows to be wrong, even though

the consequences of issuing an honest opinion are expected to be terrible for a number

of people.

Independent Auditors, like Chartered Public Accountants (CPAs) perform financial

statement audit to gain reasonable assurance that financial statements are free of

material errors or misstatements. Failed financial statement audits arise when auditor

fails to detect or detects but fails to report misstatements. Misstatements can be either

errors (unintentional) or frauds (intentional). The most dangerous fraud is

management fraud, intentional fraudulent financial reporting by management.




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Comparing with the incentives of deliberate fraudulent financial reporting by

management, ethical considerations relating to an auditor’s failure to report a

misstatement are obvious too.

Fellingham and Newman (1985) suggested that the auditor and client were competing

(playing a game) against each other in a way that “allow(s) the auditor to influence

the behavior of the auditee” (p. 635). This certainly implies the auditee (client) will

influence the behavior of the auditor too. In this game, the client chooses high or low

effort to eliminate the misstatements from financial statements; whereas the auditor

exerts high or low audit effort to detect misstatements and then issues an audit report

either qualified or unqualifited.

Shibano (1990) allows misstatements to be derived from both errors and irregularities

and tied his model to the three components of audit risk. Thus, he provides game

theory framework that distinguishes between test of controls and substantive testing.

This theory provides an insight into a client auditor relationship that may result in a

failure in audit. The literature stream of game theory was begun by DeAngelo (1981)

and resumed and extended by a number of authors, but a common characteristic of

these authors’ models is the creation of low-balling and potential loss of auditor

independence.

2.3. Fraudulent Accounting

2.3.1. Introduction

The late 1990s and early years of the 21st century, misreporting by public companies

had a relatively big scale. In the U.S. the number of companies that restate their

financial results more than doubled from 1998 to 2004, despite of a decline in total

number of public corporations. An increasing number of restatements were by large




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companies and a significant number were disastrous – they were accompanied by

losses in shareholder wealth of more than $1 billion and bankruptcy in some cases

(Grant and Visconti, 2006). Enron and WorldCom stood out as landmarks in recent

corporate scandal history. There are also some Chinese corporate scandals that stress

the issue of fraudulent accounting, for example, “Guangxia”, “Zhengzhou Baiwen”,

“Lantian” etc.

2.3.2. Concept of Fraudulent Accounting

Corporate accounting scandals are “political and business scandals which arise with

the disclosure of misdeeds by trusted executives of large public corporations”

(Wikipedia). They typically include complex methods for misusing or misdirecting

funds, overstating revenues, assets value, understating expenses or underreporting

liabilities, sometimes with the cooperation of officials in other corporations or

affiliates (Wikipedia).

The term corporate scandal lends itself to be a legal term and thus may be considered

as a form of corporate crime. Such example of corporate crime, defined as the

“deliberate steps by one or more individuals to deceive or mislead with the objective

of misappropriating assets of business, distorting an organization’s apparent financial

performance or strength, or otherwise obtaining an unjust or illegal financial

advantage” (Robarts, 1978, p. 46), as recognized by the APC (Auditing Practices

Committee), Guideline 418, and “encompasses white-collar crime, defalculation,

irregularities and embezzlement” (Hemraj, 2004, p. 268).

However, Levy (1985) asserts that in a corporate sense, fraud is “an intentional

deception, misappropriation of a company’s assets or the manipulation of its financial

data to the advantage of the prioritor” (p. 78). Therefore, it can be argued that a

corporate accounting scandal may have been the result of justifiable actions in view of




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period’s legislation rather than an intentional misrepresentation, concealment, or

omission of the truth, which always exist in fraud.

Fraudulent accounting is a major application of corporate scandals, which typically

involves various account manipulations. Fraudulent financial reporting is sometimes

called creative accounting, aggressive accounting, income smoothing, window

dressing and earnings management, etc. However, some literature states that creative

accounting is a broader term covering not only earnings management but other

practices such as deliberate misclassification in the balance sheet. Arthur Levitt

(1998), former chairman of U.S. SEC, defined fraudulent financial reporting as

practices by which “earnings reports reflect the desires of management rather than the

underlying financial performance of the company”. Recent reports of the demise of

high-profile giants such as Enron, WorldCom and Arthur Andersen have cast the

spotlight on this ‘numbers game’ (Levitt, 1998).

Dechow and Skinner (2000) state that appropriate accrual accounting may make

reported earnings smoother than underlying cash flows and the earnings can provide

better information about economic performance than cash flows to investors. But

when there is “too much” smoothing, it becomes earnings management. It occurs

when managers use judgment in financial reporting and in structuring transactions to

make changes on financial reports to mislead some stakeholders about company

economic performance or to influence contractual outcomes that rely on reported

accounting numbers (Healy and Wahlen, 1999).

The distinction between fraudulent accounting and earnings management, but

acceptable, that managers can exercise their accounting choices is illustrated in figure

2. There is a clear distinction between fraudulent accounting and the judgments and

estimates falling within GAAP that may comprise earnings management relying on

managerial intent (Dechow and Skinner, 2000).




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Accounting Choices Within GAAP ‘Conservative’ Overly aggressive recognition of provisions or reserves Accounting Overvaluation of acquired in-process R&D in purchase

acquisitions Overstatement of restructuring charges and asset write-offs ‘Neutral’ Earnings that result from a neutral operation of the process Earnings ‘Aggressive’ Understatement of the provision for bad debts Accounting Drawing down provisions or reserves in an overly aggressive

manner. Violates GAAP

Recording sales before they are ‘realizable’ ‘Fraudulent’ Recording fictitious sales Accounting Backdating sales invoices Overstating inventory by recording fictitious inventory

Figure 2: The distinction between fraud and earnings management

Source: Earnings Management: Reconciling the Views of Accounting Academics,

Practioners, and Regulators. (Dechow and Skinner, 2000, p. 239)

Sometimes accounting manipulation cannot be justified, therefore it can be perceived

to be a specific type of fraud. Afterwards, an important and much debated question is

raised about who is responsible for fraud detection. It is the auditor’s role to ensure

the credibility of financial statements and then different user groups of such

statements expect auditors to give early warning of the misdeeds and misstatements.

On the other hand, it can also be argued that the current examination conducted by the

auditors to express an opinion on the financial statements prepared by management is




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neither primarily nor specifically geared with regard to disclosing defalculations and

irregularities. Thus, although an auditor may discover a fraud by chance, an auditor’s

report cannot be completely relied on to reveal fraud.

2.3.3. Causes of Fraudulent Accounting

Smith (1992) states that much of the rapid growth of company profits in the 1980s

was because of exercise of accounting techniques rather than real boom in economy.

Levitt (2002) also comments that these kinds of scandals are symptomatic of a

breakdown of business ethical values over about 20 years. Academic analysis of the

systematic influences on accounting scandals has focused on three aspects: first,

inadequacies of oversight; second, weakness of accepted accounting principles; and

third, inappropriate incentives to executives. In terms of corporate oversight, the

boards have failed in representing shareholder interests and exerting scrutiny over

management. The structural weaknesses include: first, the chairman of board and

chief executive are a same person; and second, non-executive board members are lack

of independence, authority and autonomy.

However, when the ownership and management are isolated, agency problem arises.

Then business performance assessment is the key measurement assessing whether

company managers make decisions at shareholders’ interests. The assessment is

primarily based on company profit or share price, thus company management usually

window-dresses or falsifies financial statements to achieve individual interest

maximization (Li, 2003).

“In terms of accounting principles, the growing importance of intangibles, the

increased use of derivatives and off-balance sheet financing and the blurring of

current and capital items have undermined the ability of financial statements prepared

under accounting principles to reflect accurately past financial performance and future




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risks” (Grant and Visconti, 2006, p. 363). Lastly, since short-term performance is

closely related to financial incentives, such as bonuses and stock options, perverse

incentives are created to senior managers (Grant and Visconti, 2006). Jensen and

Murphy (2004) argue that between the 1990s and 2000s, overvalued share prices

encouraged managers to make more aggressive accounting and operation decisions.

When the issues are failed to be resolved, managers will turn to further manipulation

even fraud under the pressures.

In addition, Grant and Visconti (2006) find that the strategy executives are working in

matters as well. Particularly, the strategy pursued should be consistent with the

requirements of the company business and its resources and capabilities. Nowadays,

in many organizations, top management seeks ways to be competitive and maintain

market position or just to survive (Reider, 2007). When a company’s strategy does not

fit its external and internal environments, company performance is likely to decline

and management will be induced to fabricate accounting information.

Lastly, Kranacher (2006) states that the complexity of accounting standards provides a

breeding ground to various fraudulent activities. The more detailed the standards, the

more loopholes that companies seek opportunities to take advantage. Enron is an

example of how fraud can be perpetrated by misusing the standards and principles

that are expected to protect public interests. The complexity of the deals and contracts

Enron used to blur the truth of company transactions is a part of why Enron’s

management was able to keep the fraud under the radar for such a long time (Nicholls,

2005).

By ‘cooking the books’, ‘fiddling the accounts’ or ‘window-dressing’, businesses can

appear to be more attractive to investors by good business performance and stability

(O’connor, 2002). The increased pressure from investors, managers and competitors

becomes the main reason for companies to window-dress their accounts. Companies




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using fraudulent techniques are willing to pay a great deal of money to give a false

impression. Sen and Inanga (2003) state that financial fraudulence in a company may

arise under at least three conditions. First of all, companies float its shares and try to

develop a good price to attract investors. Secondly, listed companies try to make their

financial conditions more attractive. Thirdly, listed company try to pay dividend

through fabricated methods providing an image of good business performance to

investors.

Further, fabrication may arise when cost is less than the gains the actions generate and

punishments are not rigorous (Li, 2003). The inadequacy of relevant Chinese laws to

punishment of fraudulence encourages corporate fraudulence. According to a research

on accounting fabrication cases in the last decade, the number of punished listed

companies is less than 100 (Jing, 2002), and the responsibility is mainly

administrative rather than criminal and civil. Thus, listed companies are likely to

fabricate under this circumstances.

2.3.4. Fraud Techniques

The fraudulent techniques can be viewed as fabricating techniques that are executed

on financial statements and discovered by financial analysts. The followings are some

major applications of fraud techniques.

2.3.4.1. Overstatement of Revenue

The scope for turnover tampering is often determined by the nature of company

activities. It is impossible for a cornershop which is primarily in a cash business to

manipulate its sales than it is for a motor vehicle leasing company, where the

relationship between cash received and actual sale is more tenuous (Griffiths, 1987).

However, it is still possible for most companies to keep a substantial control over the




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figure of turnover.

Revenue overstatement includes the early recognition of sales income or the sales

transactions have no real substance. For example, a company is engaging with growth

performance may overstate operating revenues by early recognition. If an item issued

to a distributor on a ‘sale or return’ basis is recorded as sales, it will inflate sales and

profits even if the item is not returned. Another indicator that profits are being

overstated is when reported profits are higher than operating cash flow for the period.

This amount is not consistent with the real figure that the transaction should generate.

In other words, it might be fiction.

2.3.4.2. Understatement of Expenses

A company’s debtors and creditors are overshadowed by stock and cash or borrowings

in the balance-sheet under current assets. “The lack of attention which is paid to them

is misplaced if not misguided, since debtor and creditor management can be an

important influence in determining a company’s cash flow position” (Griffiths, 1987,

p. 23). A careful analysis of the relationship between creditors and debtors can give an

important indication of company’s performance and prospects. Business losses may

result in drop on share price; hence the company value will be reduced as well.

Concealment of losses is a technique to mask the effect of business losses. By

reducing losses or liabilities, this can have the effect of inflating profitability.

2.3.4.3. Tamper with Taxation

There is a close link between a company’s profits and the tax which will ultimately

pay for. Therefore, the creative accounting techniques used to influence those profits

should be seen in the context of the tax as well as the stock market implications

(Griffiths, 1987). The annual profits can even be determined completely by the




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amount of tax that it prepares to pay. In other words, “it decides on the cash it will

hand over to the government and then constructs its profit and loss account in order to

arrive at the desired result” (Griffiths, 1987, p. 63). It is clearly that tax planning and

creative accounting go hand in hand. The rate at which tax will be charged to a

company’s profits is crucial in determining the earnings per share (EPS) which will be

used in calculating the price earnings ratio. The lower the tax charge the more profits

there are available for shareholders.

2.3.5. Consequences of Fraudulent Accounting

External users of financial statements will be greatly affected by fraudulent

accounting. Investors will consequently suffer great loss once the audited financial

statements do not disclose the frauds. This will result in a decline of public trust in

accounting and reporting practices. External investors who rely on the audited

financial statements but with material errors and frauds will be misled and hence

make wrong investment decisions.

Stakeholders, such as employees, competitors, customers, and banks, as the group of

people and/or organizations holding mutual interest or having inter-related

relationship with the company can influence company performance and as such is

influenced by company. Stakeholders’ interest in company may not be expressed in

moneytary terms as it is in the case of shareholders. When a corporate scandal occurs,

government authority will be questioned leading to a decline on public trust. The

impact of corporate fraud on stakeholders can be either direct or indirect, for instance,

employee layoff due to bankruptcy will affect local well-being because of

unemployment.

Fraudulent accounting by management has been costly for shareholders (Kedia and

Philippon, 2006). During the periods when firms misreport, firms hire and invest




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more than comparable firms matched on age, industry and initial size (Kedia and

Philippon, 2006), and they grow at a significant higher rate. Once they are caught and

forced to restate, the firms shrink quickly.

From the auditor point of view, fraudulence may increase the difficulties in audit work.

Corporation’s intentional fabrication destroys the internal control mechanism at the

first place, and then increases the controllable risk when carrying out sampling audit

and audit control procedures, which directly influence the audit quality in the end.

Since the fraudulent techniques used today are sophisticated and state-of-the-art, it is

very likely that auditors may fail to detect the misstatements. The failure in audit will

then affect external users of audited financial statements.

This chapter brings a general idea of the concept of audit risk and fraudulent

accounting. Following the methodology in chapter 3, theories can be used to compare

with the truth in practice. Nexct chapter will stress the reasons for using case study

research methodology and choosing China and a Chinese company as research target.

Additionally, merits and limitations of case study methodology will be given to have a

clear view of this research method.




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CHAPTER 3

Methodology

This dissertation is going to use case study as the methodology, and mainly focuses on

qualitative method and secondary information. Case study is a non-experimental,

descriptive type of study and one of the forms of qualitative research design, which

offers a richness and depth of information not usually offered by other methods.

Robert K. Yin (1984, p. 23) defines the case study research method as “an empirical

inquiry that investigates a contemporary phenomenon within its real-life context,

when the boundaries between phenomenon and context are not clearly evident, and in

which multiple sources of evidence are used”. By attempting to capture as many

variables as possible, case study can identify how a complex set of circumstances

come together to produce a particular manifestation.

Yin (1993) identifies three types of case studies, exploratory, explanatory and

descriptive. Stake (1995) has his own three different from Yin’s, they are intrinsic,

instrumental and collective. When the researcher has an interest in a case, this is

intrinsic. When a case is used to understand more than what is obviously to be

observed, it is instrumental. When a group of cases is studied, it is collective (Tellis,

1997). Explanatory case studies may be used for doing causal investigations. This

dissertation is going to use explanatory case study to find the casual relationship

between audit risk and fraudulent accounting.

The author aims to examine the effectiveness of literature that developed in the west

in explaining a Chinese case. The objective of the dissertation lies in the likelihood

that the existence of gap between literature and the truth in case. China, after the start

of economic reform and opening up policy, has been speeding up its capital market

establishment. In terms of stock market development, China is new and less




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experienced comparing with western countries. Particularly, the nature of Chinese

political regime significantly affects the stock market development and company

performance in stock market. The author is interested in investigating whether or not

the fraudulent accounting used by listed companies in a typical socialism country can

be explained by western literatures. Since the nationality of the author is Chinese, it is

supposed that secondary data and information is easier to obtain.

The “Guangxia” case is one of the well-known corporate scandals in China and has

being widely discussed in literature. It is the first “blue chip” in China Stock

Exchanges, hence its collapse leads to a stock crisis that has never experienced in

Chinese stock history. Guangxia is the most significant accounting scandal comparing

with the preceding cases in terms of falsification amount and fraudulence scale.

Guangxia is quite alike Enron in terms of significance and similarities so that

observers nickname Guangxia the “Chinese Enron”. Subsequently, the audit failure in

Guangxia calls for great attention to be put in stock market mechanism and auditing

profession. Government and involved bodies and organizations take measures to

remedy the problems and improve the system. A number of regulations and acts are

enacted after the exposure of Guangxia fabrication case to prevent further accounting

scandals.

The data and information used in case study primarily stem from secondary Chinese

literature. Since it is a well-known case to both corporate business and auditing

profession, there are loads of information and discussion available on journals and

websites analysed from both views. However, this source of information is limited by

a fact that most of the Chinese journals are repetitive on one or more issues without

new information. It can easily find what frauds Guangxia has perpetrated but the

information about how Guangxia fabricates is little. It is presumed that this problem

can be resolved by using primary research methodology, but due to the nature of

corporate scandal, it is harder to know the fabrication truth by using it.




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The author tried to get in touch with Guangxia with the phone number got from its

website, but unfortunately, the author was refused by the employee who answered the

phone because it was unauthorized. In fact, it is reasonable to be refused as the author

is neither official nor journalist, Guangxia is not supposed to accept the interview.

Even if the interview can be conducted with insiders or former employees of

Guangxia, the credibility of research results can be questioned. It is very likely that

they may not tell truth due to various reasons, such as significant pressures from

management, personal career considerations, and fears of taking responsibility and so

on. After all it is a past event, thus people may not want to be in a trouble.

Case study can provide different views from what happens in practice, but it cannot

offer a comprehensive understanding. It is a single individual or just a few, thus may

not offer reliability or generality of findings. Some also believe that “intense exposure

to study of the case biases the findings”, and some believe that case study research

only useful as an exploratory tool (Soy, 1997). Therefore, based upon the arguments,

case study may not be the best methodology to this dissertation.

Before examining the case study, an overview of Chinese auditing environment is

given to obtain a preview of auditing under Chinese context in next chapter. The

auditing conditions in China provides some causal factors for corporate accounting

fraud, thus helps understand why fraud could happen in the case of Guangxia. Both

the intrinsic and extrinsic characteristics of current auditing environment can give rise

to corporate accounting scandal and auditing scandal, therefore they must be

investigated first.




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CHAPTER 4

Overview of Chinese Auditing Environment

4.1. Inherent Pitfalls of Equity Structure and Company Management

Most listed companies in China are whole state-owned enterprises (SOE) before

going public. Government owns an absolutely large stake of shares even after listing.

Institutional shareholders are the second large group shareholders except state

shareholders (Wan and Tian, 2003). They are non-circulating shares and make up a

large portion of the total shares. Thus, the inappropriate proportion of shares makes

non-circulating shareholders have an absolute say at board meetings. Non-circulating

shareholders make decisions from their own interests, so that the interest of small and

medium shareholders might be violated. Normally, the biggest shareholders are the

founder of company. They endlessly use company capital and pass the buck to

circulating shareholders who become innocent ‘scapegoat’ when financial crisis

arises.

The directors of board are normally administrative staff from management; most

importantly the chairman of board is also the manager which threatens the problem of

corporate governance (Wang and Liu, 2004). Hence, the appointment of audit firm

does not make any sense at the board meeting since it is decided by the administrative

management. Although annual board meeting, board of directors and supervisory

board are established according to ‘Company law’ and regulations of listed company,

they do not effectively function well. Non-executive directors are not qualified,

because lots of companies invite university or research institute professors and other

distinguished scholars to be non-executives (Wan and Tian, 2003). Further, since the

board is controlled by non-circulating shareholders, non-executives could not

investigate more and have a say on decision-makings.




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Investors in western countries make investment decisions highly rely on audited

reports. They more prefer trusting the audited financial statements from experienced

audit firms with good reputation to small and less-experienced ones, whereas the

Chinese investors in the environment of growing stock market less rely on audited

information due to the characteristics of gambling (Wang and Liu, 2004). This to

some extent may promote the development of unfavorable conditions in stock market.

Therefore, inappropriate company management, inefficient jurisprudence and

unreasoning investments lead to auditing market inefficiency and poor audit quality.

4.2. Auditor Profession

4.2.1. Due-risks

Audit firms or CPAs get engagements from auditee companies, carry out audit work

and issue audit report. During the course of audit work, auditors may be encountered

with audit risk when collecting audit evidence. Audit risk involves non-controllable

risk and controllable risk, among which quality control risk is more important to

auditors. It is always determined by auditor’s proficiency and competency. The audit

fee in China is priced by government and has two pricing approaches. The first

approach is based on the number of working hours of auditors and the second

approach is on the auditee company’s value (Zhou and Liu, 2006). Since the number

of working hours of auditors are difficult to be quantified, most audit firms adopt the

second approach. But this approach gets lots of critics from practitioners, who believe

that business complexity and risks should be considered when deciding audit fees.

One partner from a domestic audit firm added that audit fees charged by domestic

firms are much lower than Big 4 and other non-big 4 foreign firms, but the actual fee

got is only half of the price (Guo and Ma, 2004).




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YUAN

Figure 3: Average audit fee in 2001

Source: High audit fee charged by Big 4 dominates Chinese audit market (Guo and

Ma, 2004)

Domestic audit firms primarily focusing on the low-balling strategy which is different

from the high audit fee of Big 4 audit firms (Guo and Ma, 2004). It is two to five

times as domestic ones to a same audit project. The average audit fee charged by

domestic, Non-Big 4 and Big 4 audit firms in 2001 are shown respectively in the

above diagram, among which Big 4 charge apparently higher than domestic ones.

However, there are lots of big enterprises would like to be audited by the Big 4 due to

their reputation, expertise and credibility. The public trust has built by them is now the

most competitive advantage compared with domestic ones. In 2002, the corporate

equity that Big 4 audited made up 40% of the total out of 1,200 listed companies (Guo

and Ma, 2004).

Chen zhaowu from TsingHua University (China) said that the audit quality of Big 4

has got worldwide recognition; therefore poor audit performance is not likely to be

offered to ruin reputation. On the other hand, investors can get maximum

compensation for losses once they failed in audit work, so investors prefer those

financial statements audited by Big 4 and company management would like to pay

high audit fee to gain investor trust. On the contrary, domestic audit firms are small in




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business size; proficiency and internal management are inadequate, so that it is

difficult to acquire big audit projects (Guo and Ma, 2004). Competition among

domestic audit firms are so severe that a buyer’s market prevails, which results in

worries of being dismissed if requirements are not met. The excessive competition

subsequently leads to price war, therefore, to survive, they even take illegal actions to

attract customers and maximize business profits (Wang and Liu, 2004).

4.2.2. Agency Problems

The agency problem exists among financial statement users, auditee company and

audit firm. For example, first of all, shareholders (principal) and company

management (agent), secondly, shareholders (principal) and audit firm (agent). The

existence of second principal-agent relationship is based on the first one which is also

the most basic one exists in corporation management (Liu and Zhao, 2006; Wang,

2004). From this two-tier principal-agent relationship, it is obvious that both company

management and audit firm are the agents of company shareholders. It seems that they

have no conflict of interests and contractual relationship, which can be reasonably

believed that the audit can be reliable, but since the boards of listed company cannot

control company management, the three-party principal-agent relationship becomes to

be a one of two parties (Li, 2006).

The irrationality of Chinese stock market under the context of current mechanism of

auditing makes the audit work be a government conduct used to standardize stock

market rather than requirement from external users of financial statements (Zhou and

Liu, 2006). Because of this, external financial statement users benefit from the

costless information without effort. Although government or Chinese Stock

Regulatory Commission (CSRC) is the agent of the group of external financial

statement users and identify their needs on auditing, it is not the real constituent.

Certified accountants in fact face two different groups of people. One is the external




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financial statement users who use the audited information, the other is the client

company who pays for audit work. The existence of conflict interests determines

different audit needs they have; the former stresses more on audit quality, while the

latter cares more about audit price (Zhou and Liu, 2006).

The consequence of this special relationship always makes company management

choose audit firm based on audit price rather than audit quality, reputation, business

size and other intrinsic values (Zhou and Liu, 2006), since shareholders do not want to

have high audit cost. However, this case only exists among domestic audit firms. The

Big 4 and other Non-Big 4 international audit firms charges high but pursued by

numbers of big enterprises due to their worldwide reputation and proficiency. The

sensitiveness of company management to domestic audit firms leads to the

effectiveness of price competition is more apparent than quality competition.

4.3. Traits of Domestic Audit Environment

Chinese Certified Accountants are less professional and competent since auditing has

just emerged in the market for about 20 years. With regard to this fact, audit risk is

relatively higher and thus results in poor audit quality. In China, laws and legislations,

such as ‘Certified Accountants Law’, ‘Securities Law’ and ‘Company Law’ all present

the obligations and responsibilities of Certified Accountants, but they emphasize more

on audit firms than individual accountants. Even audit firm is dismissed due to

fabrication; the auditors are not influenced much by it and can still work in other audit

firms (Wang and Liu, 2004).

While in western countries, the nature of partnership of audit firms can lead to

individual auditor bankruptcy once audit failed. Since fabrication gains are far more

than its cost, Chinese auditors are more likely to fabricate to obtain excessive gains

(Wang and Liu, 2004). However, most auditors in recent corporate scandals had




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individual penalties due to the significance and consequences. Generally there is no

such legislation clearly defines penalty or sanctions to individual auditors.

Additionally, auditor independence in China is often questioned by public. A recent

survey, carried out among CFOs (Chief Financial Officer) in China received 378

responses and found that most CFOs in China think that their auditor would change

their opinion if offered more fees (Zhang, 2005). Although they are paid low, it does

not necessarily mean the audit quality is low. They can change their opinion from

unfavorable one to a favorable one if more fees are offered. A quarter of the

respondents said that the level of integrity in China’s auditing are unsatisfactory or

poor, and more than half ranked the auditing industry’s integrity as average. Some

saw the profession as rife with and open to corruption.

By understanding the current Chinese audit environment, a case study research

methodology will be employed to examine literature theories in next chapter. The case

study will examine the effectiveness of literature to see whether or not it can explain

the truth in reality. The case will be analyzed in accordance with literature review, and

implications from analysis will be stressed after case analysis.




CHAPTER 5

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CHAPTER 5

Case Study

5.1. Introduction

In 2001, ‘Yinguangxia’, the first ‘blue chip’ in Chinese Stock Exchanges was

suspended due to serious fabrication. It falsified profits for several years to present

itself as a fast-growing entity with sophisticated, state-of-the-art falsified sales

contracts and export figures and exaggerated its financial statements, reportedly

inflating net profits by 745 million YUAN in 1999 and 2000. With various accounting

manipulations, Guangxia successfully ‘pushed’ its EPS to 0.83 YUAN and thus

became the most valuable stock at that time in China.

There are a number of accounting scandals in China. Guangxia is neither the first one

nor the last one, but it is definitely one of the influential ones, leading observers to

nickname Guangxia the ‘Chinese Enron’. The main source of fabrication is the

creation of revenues by a number of fraudulent techniques. After Guangxia scandal,

stock market gets immediate ripple effect and the audit firm gets philippics on

negligence and malpractice. The recent corporate failures and frauds have deprived

confidence of investors on Chinese stock market and called into question the value of

the financial statement audit. Therefore, the preoccupation of auditor ethics relating to

audit failure needs to be overcome.




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5.2. Backgrounds of Guangxia Fabrication Case

Guangxia-Timeline of Events

Year Events

1992 Guangxia (Yinchuan) Magnetic Technology Ltd. was established.

1993 Shareholding reform was carried out in May with a capital of 44

million shares, among which a subtotal of 30 million ordinary

shares contains 3 million shares issued to employees and 27 million

shares to the public at 3.98 YUAN each.

1994 Guangxia (Yinchuan) Industry Co. Ltd. was established on 28

January.

Guangxia (Yinchuan) Industry Co. Ltd. was listed on Shenzhen

Stock Exchange bourse under the name of ‘YinGuangXia A’ (stock

code: 0557) on 17 June. The opening share price was 1.64 YUAN

and soon dropped below its face value to 0/98 YUAN.

Baojie Ltd., the biggest wholly-owned subsidiary of Guangxia was

established in Tianjin 1994.

1997 Baojie Ltd. changed its name to TianjinGuangxia on 31 December.

1998 TianjinGuangxia signed an agreement with Fidelity Trading GmbH

(Germany) on 19 October. According to the agreement, Guangxia

will annually export 50 tons of lecithin produced by the technology

of carbon dioxide extraction, 80 tons of cassia essential oil, cassia




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rosin, ginger oil, and ginger rosin, which amount to 50 million DM.

2000 Guangxia signed a contract worthy 110 million DM with Fidelity

Trading GmbH on 14 January.

2001 Guangxia signed another contract for further 3 years with Fidelity

Trading GmbH on 1 March. The contract value was 520 million

DM per year, which was 2 billion YUAN per annum according to

the exchange rate of 1 to 3.8471 on 28 February.

Guangxia released its annual financial report of 2000 which stated

that EPS was 0.827 YUAN and the margin was 60% under the

circumstance of doubled capital.

Media exposed the case Guangxia’s serious fabrication in 1999 and

2000, CSRC sent out an investigation team of 20 people to probe

into its fabrication and manipulation of secondary market price on

3 August.

Guangxia released the mid-year financial report of 2001 on 1

September.

CSRC finally concluded that the fabrication did exist on 6

September.

The company shares were temporarily suspended and again put up

its plate and resumed stock business on 10 September. And it sank

into the ranks of being a PT company for its suffering of loss for

two and a half years.




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It limited down for 15 trading days and stopped on 8 October. The

share price dropped from 30.79 YUAN before stopping trading to

6.59 YUAN.

2002 CRSC legally transferred 7 suspects involved in the case to public

security organs.

5.3. Case Analysis

5.3.1. The True and Fair View

China has an accounting framework that is in alignment with IFRS. It takes the

concept of true and fair view of financial statements because IFRS is the closest thing

to a principle-based regime where it holds the idea of true and fair view. Guangxia

violates the concepts of fairness, justice, equity and truth for the ethical validity of

financial statements. Thus the financial statements Guangxia management provides

are of little or no value to investors and external users, in other words, the financial

statements are not reliable.

It falsifies business income by way of counterfeiting purchasing and selling contracts,

export bill of entry, added value tax invoices, duty-free documents and financial notes.

Of the total sum of profits, 178 million YUAN went to 1999 and 567 million YUAN

to 2000. Fraudulence of Guangxia fundamentally alters the spirit of accounting

standards and misleads investors, even leads to government loss.

Given this, the myth about Guangxia's brilliant achievement has been

exploded and replaced by its deficit incurred in two and a half years. For

example, the notes of its financial statements state that the increased cash of




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227 million YUAN is attributed to increase on sales and receivables. But the

balance sheet and cash flow statement show that: firstly, the short-term loan of 2000 is

586 million YUAN more than 1999; secondly, the cash flow statement shows that

bank loans are the main source of net cash flow; thirdly, the balance sheet of 2000

shows company receivables increase 440 million YUAN, i.e. 96.5% more than 1999

means the sales of 2000 and collection of receivables are not good, thus the increase

in cash on balance sheet came from bank loans rather than operating sales.

Guangxia has more than 40 subsidiaries and associates, but the internal control and

Accounting regulations vary from one to another. There are 26 subsidiaries accounts

not consolidated, which definitely could not give a true and fair view of the

company’s financial status. Accountants even could not acquire the accounting

documents and other information of an overseas subsidiary company in Romania. In

addition, Guangxia conceals a lot of financial information, for example, it covers the

closing-down fact of one of its subsidiaries on financial statements. Therefore, the

published financial statements can impossibly represent the truth, fairness and equity

of financial information.

5.3.2. Materiality

The exposure of Guangxia fabrication results in a big financial crisis in stock market

and a decrease of public trust on auditor profession. The amount of overstated profits

reaches up to 745 million YUAN in two years which is reasonably influence the

decisions of financial statement users. It fabricates business income by way of

counterfeiting purchasing and selling contracts, export bill of entry, added value tax

invoices, duty-free documents and financial notes.

The amount of tax evasion is material to both company business and external

financial statement users, because the financial statements of Guangxia clearly




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identify the income tax rates for Guangxia and its subsidiaries as 15%, 24% and 33%,

among which ‘TianjinGuangxia’ and other three companies are currently tax free, but

the income tax of 2000 is only 7.39 million YUAN out of a consolidated profit of 423

million YUAN (Fu, 2005). In other words, the average tax rate is merely 1.75% which

does not match the actual tax paid.

Additionally, financial statements also show that the company has a VAT of 17% and

no entitlement on any reductions, but the annual financial report of 2000 states the

due VAT is negative, i.e. the company does not owe any VAT but has some amount

that has not been offset (Fu, 2005). The cash flow statement shows the actual VAT

paid is only 52,600 YUAN which is completely different from the productivity as it

announced, because the industrial sales of 2000 are 827 million YUAN and net profit

is 543 million YUAN, therefore the VAT should be more than it paid.

The external financial statement users are misled by the annual report of 1999 and

2000, which both state that 300 million YUAN capital funds raised by issuing new

shares in 1999 are all used in the predetermined investment projects, but the actual

amount invested in is only 178 million YUAN. The rest is used by the director board

of Guangxia and its subsidiaries and for lending, among which 12 million YUAN is

paid for the board operations (He and Han, 2002).

Actualinvestment(178 millionYUAN)

Other use(122 millionYUAN)

Figure 4: Total reported investment (million YUAN)




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Moreover, the annual report of 2000 discloses that 43.51 million YUAN is invested in

WuhuGangxia and established a new company named ‘Wuhu (Guangxia) biology Co.

Ltd.’ with a registered capital of 75.35 million YUAN. Guangxia (Yinchuan) and

Guangxia (Tianjin) owns 44.29% and 35% shares respectively, but the actual

registered capital is only 31.84 million YUAN, Guangxia (Yinchuan) holds 30%

shares but Guangxia (Tianjin) does not own any shares of the new company (He and

Han, 2002).

Wuhu(Guangxia) Guangxia(Yinchuan) Guangxia(Tianjin) Total

Registered 44.29% 35% 75.35 million

Actual 30% - 31.84 million

Table 1: Misstatement of shareholdings of Wuhu (Guangxia) Biology Co. Ltd.

The misstatements and non-transparency of financial information to investors could to

some extent influence investor economic decisions. The window-dressed financial

statements mislead investors to heavily invest in the stock market. With the

misstatements, they may believe that the adequate business competency of Guangxia

can certainly bring a good stock market performance. Day by day, investor trust is

built and more funds are raised from capital market by company management through

fabrications.

Prior to commencing the audit, estimated materiality should be based on the

knowledge of Guangxia’s business and industry. Lacking of profession and fieldwork,

the reasonable planning materiality is failed to be prepared. During the course of audit

work, the auditors want to carry out fieldwork in workshops but are refused because

the production is between April and October while the audit is being carried out

between February and March (Liu, 2006).




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Moreover, due to the good reputation and business performance Guangxia has,

auditors negligently investigate audit evidence. However, the lower the level of

planning materiality does not get the greater the amount and/or the more appropriate

the evidence that needs to be collected to ensure that the combined errors in the

financial statements do not exceed it.

5.3.3. Audit Failure

The audit quality of Guangxia is definitely at the lower end of theoretical continuum

and its failure is attributable to a number of reasons. There is a serious distortion of its

financial statements that is not reflected in the audit report, and the auditors have

made a serious error in the conduct of the audit. Guangxia fabricates business by way

of counterfeiting purchasing and selling contracts, export bill of entry, added value tax

invoices, duty-free documents and financial notes, and all of these fabrications greatly

distort financial statements and business performance.

The consolidated accounts of Guangxia do not cancel the inter-company transactions

and Guangxia fails to merge subsidiaries proportionally according to the shareholding

agreement, which result in an overstated equity and profit. The auditors fail to detect

this or report the abnormality and thus are against related regulations. For instance,

‘Special Considerations of Audit Planning’ Article 4 states that CPAs should know the

number of consolidated companies, shareholding of group companies, frequency of

inter-company transactions, substance, amount and other relevant information

associated with consolidated accounts. This blunder is unintentional and could be

caused by fatigue or human error, but the negligence could be avoided if auditors are

of due care to the conduct of the audit.

ZhongTianQin, helped Guangxia to make an IPO in 1993 and it automatically became

the designated audit firm after going public. The auditors or audit firm can be unduly




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influenced by having a direct financial interest. They may reluctant to stand up to the

client on accounting issues for fear of losing the client to its competitors.

ZhongTianQin has been audited Guangxia for three years and receives an annual audit

fee of about 1 million YUAN. This long-term financial relationship is closely tied to

audit quality which eventually influences auditor judgment and opinions.

Moreover, business management of Guangxia is another factor determines the audit

failure. Guangxia begins fabricating as soon as it made an IPO. The company

management cares more about how to sustain growth rate of business rather than

enhancing management or establishing an effective management mechanism. Since

the company is incapable of generating more profit, they have to overstate profit in

order to survive. Shareholders want share price to go up continuously, meanwhile, the

capital market did not have an effective supervision mechanism, then the management

pushed the share price to such a high price regardless of the reckless acts.

To sum up, lacking of effective and scientific management strategy and overlooking

the importance of management in business, Guangxia eventually has to employ

various fraudulent means to help Tianjing Guangxia regarding to going concern.

Guangxia is in a business of high technology which is unfamiliar to most ordinary

investors, therefore there is need to understand the risks of business. The cooperation

with German company on extraction technology does have some business risk, but it

is overlooked as the project is taken by two big enterprises. Hence, the negligence on

business risk audit is attributable to the overall audit failure.

5.3.4. Audit Risk

It is obvious to find that the audit risk of Guangxia is β risk, which means the risk that

auditor express an unqualified opinion on financial statements that are materially

misstated. The financial statements of Guangxia involve a great deal of fraud and




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fabrications that are not detected by auditors. The audit risk of Guangxia is mainly

composed of two elements, non-controllable risk and controllable risk, and both of

them are high in the audit work.

Guangxia had never established a set of effective management system, particularly the

accounting and internal control systems which automatically increase the inherent risk

and internal control risk of audit risk (Wan and Tian, 2003). If Guangxia has an

effective internal control system, fraudulence can be reduced to some extent.

Although internal control may not completely prevent fabrications, it can greatly

increase fraud cost to the management. With a number of fabrication means,

Guangxia overstates such a large amount indicating that audit independence is

nominal even if internal control exists. Internal auditors should be independent of

auditees and report to the board or audit committee, since the management of

Guangxia is lack of corporate governance and management supervision is poor,

internal audit is of no use to audit quality.

The accounting scandal of Guangxia is an intentional and systematic fabrication case,

thus the internal control risk is relatively higher because the company management

does not intend to have an efficient internal control and prevent, detect and correct

any misstatement (Fu, 2005). Likewise, the inherent risk is lower as the audit firm has

audited Guangxia for eight years and becomes less prudent on its risk assessment.

Further, the management of ZhongTianQian is so poor that auditors have

unprofessional attitude towards audit works. They believe that Guangxia can generate

high profit as it is a high technology company. Also, frequent high-tech information

disclosure induces auditors to believe that is true.

As a large enterprise Guangxia gains more recognition from government, many

government officers even visit the company, which misleads the audit firm to believe

that Guangxia is impossible to fabricate (Zhang, 2006). Thus, before conducting the




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audit, ZhongTianQin negligently fails to plan the nature, timing and extent of audit

procedures (Zhang, 2001). Since the nature of Guangxia business is high-tech

biological extraction, lots of investors including auditors have no knowledge about the

advanced production processes. The auditors do not take the company’s strategy and

business processes into consideration when assessing the overall audit risk. Lacking

of assessment of strategic business risks, auditors may fail to assess the strength of the

control environment and inherent risk (Zhang, 2006).

Guangxia is mainly in the business of production of 3.5 inch floppy disc before

making an IPO. When this business has no further prospects, Guangxia has to come

up with a new and innovative business strategy to generate profits and cash flow. The

strategy involves investing in various industries, such as toothpaste, cement, sea food,

alcohol, bezoar, active carbon, culture industry, real estate, wine and so on. However,

the switch in business does not make the company better off because there is no one

sustainable.

The number of irrational decisions abuse lots of capital funds and lead to shortage of

capital all the way. After making an IPO, Guangxia issues new shares three times and

collects 574 million YUAN from stock market to compensate losses and conceal the

investment decisions mistakes (Lin, 2006). However, it is all used by the ongoing

businesses while the day to day business operation and production funds are financed

by bank loans; therefore if this financial chain were unconnected, the bank loans will

be risky and probably become bad debt to the banks. Yet all of these do not raise

auditor attention on expectations for financial accounts, which increases the

probability of high detection risk.

The number of doubts on financial statements of Guangxia should have the auditors

placed sufficient attention, but the auditors conclude that the financial statements are

of ‘true and fair view’ in the three years. The auditors should focus on




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TianjinGuangxia which contributes 75% profit to the total profit of Guangxia group,

but they do not take it as the main auditee and check the credibility of its sales.

Therefore, it is obvious that the auditors are negligent and hence give unqualified

audit opinions. The following points are those that the auditors should have detected

misstatements on financial statements:

n Lacking of effective scrutiny. It is weird to find that the operating sales of

Guangxia increased dramatically in 2000, but the expense of power decreased.

Moreover, the productivity of lecithin in 2000 decreased unreasonably compared

with 1999, and the auditors believed what Guangxia’s management said that the

production was mature enough to reduce productivity without fieldwork and

consulting any professionals.

Moreover, an audit work should always be carried out by three groups of person:

an auditor, project managers and partners, sometimes another step of supervision

is added up to issue an audit report. However, ZhongTianQin only takes two steps

in the case of Guangxia. It is surprisingly to find that the audit work of

‘TianjinGuangxia’ is carried out by two CPA assistants rather than CPAs.

Therefore, non-professionals with inadequate relevant knowledge could not give

professional opinions.

n Invoices. Invoice is important document that identifies credibility and accuracy of

debt amount, it prevents mistakes and fraudulence that incur in auditee companies.

Invoices in nature show the existence of debtors and creditors and credibility of

financial records of auditee companies. During an audit auditors sign and post

enquiry letters to debtors and creditors who are provided by auditee companies to

identify accuracy of debt amount, debtors/creditors and other information.

However, in the case of Guangxia, if the auditors perform audit work in

accordance with statutory duties and are independent, objective, honest and




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diligent, they should have enquired the income source and relevant information

(Fu, 2005), for example,

ü Firstly, enquire Fidelity Trading GmBH. Although it might not respond, it at

least shows that auditors are of due care.

ü Secondly, enquire the banks involved in the transaction. Normally, banks

would like to respond to the enquiries, thus auditors may find any suspect

statements of the auditee company. ü Thirdly, enquire the Custom. It is better to enquire in person because of the

large amount. Since the extraction affects up to 95% profit of the company,

the auditors should be more prudent and careful. ü Lastly, enquire the Revenue Bureau to check the records of drawback.

Meanwhile, auditors can also enquire suppliers and relevant banks. However,

the auditors neglected all of these and even committed the company to post

enquiry letters, and the replied letters are given by the company when carried

out debtor auditing.

n Fieldwork. Since TianjingGuangxia is the major income source of Guangxia, the

auditors would better carry out fieldwork in Tianjing Guangxia Ltd. according to

the principles of auditing (Fu, 2005). During the course of audit work, the

auditors want to carry out fieldwork in workshops but are refused because the

production is between April and October while the audit is between February and

March. Therefore it is very likely that Guangxia tried to hide the fact and fool

auditors.

n The problem of drawback. If the export business of TianjinGuangxia is true, thus

there should be a number of millions of tariff returned according to tax law, but




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the accounting item of tax drawback does not show on the financial statements of

Guangxia. The auditors again did not have the common sense and thus did not

detect it.

Since the internal control system of Guangxia is very poor, there is a big probability

that the auditors may not detect a material error or irregularity. However, the auditors’

negligence and malpractice cannot plead to innocence in shaking off the

responsibilities. If the auditors carry out audit work with more care following the

regular procedures, the detection risk would be lower.

5.3.5. Internal Control

Like the most listed companies which reorganized from state-owned companies, the

internal controls of Guangxia do not function well, thus leading to weak corporate

governance. The supervisory function in Guangxia is meaningless because the board

of directors is controlled by a minority of directors and insiders. In Guangxia, some

members of supervisory board are subordinates of executives, thus the supervisory

board has no sufficient independence and can not supervise the board.

Guangxia is a high-tech company according to its business and TianjinGuangxia

generates a majority of profit of Guangxia group. But it has no audit committee in

terms of corporate structure at the time of fabrication, so it is clearly to know that the

internal audit will be ineffective due to inadequate supervision, which confirms that

technology industry has fewer audit committee and the fraud companies in technology

industry have less independent audit committees and boards.

The regulation of non-executive directors has problems too. The non-executive

directors should not be shareholders or staff and they are independent and objective in

decision-making. However, the non-executives in Guangxia even do not have any




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notice for board meetings and the number of non-executives is far more from the

stated number (Jiang, 2003). Therefore, it is obvious that fraud companies have weak

corporate governance and thus increases the audit risk.

5.3.6. Auditor Independence

ZhongTianQin, is one of the oldest accountant office in China, which has 35 Certified

Accountants and 17 partners. When Guangxia Fabrication Case is exposed, the

reputation of ZhongTianQin and auditor independence is questioned. ZhongTianQin

concludes that financial statements are of true and fair view for two years in the

presence of a number of obvious doubts. The auditors afterwards explained the reason

for audit failure as auditor’s negligence on bank and custom enquiries. However,

investigation of this fabrication case later shows that there are sufficient evidence

indicating that ZhongTianQin does not have auditor independence and substantially

connives Guangxia fabricate.

The importance of auditor independence is embodied by the extent that external

investors’ reliance on financial statements (Liu and Liu, 2002). Auditors should be

independent when carrying out audit work and issuing audit report. However, since

the ownership and management of Guangxia are not separate, the inappropriate

company management structure results in an abnormal client auditor relationship,

which means the management appoints audit firm to audit itself (Fu, 2005). Hence,

the management switches from an auditee to a client and determines the appointment,

contract extension of audit firm and audit fees.

ZhongTianQin provides other accounting services in addition to audit work during the

engagement, for example, consultancy on accounting policies, applications and tax. In

fact, when ZhongTianQin engages in the day-to-day business operations of Guangxia,

it in nature becomes an accounting department of Guangxia. Then its interest is firmly




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tied with the company’s. Therefore, ZhongTianQian certainly wants a win-win with

Guangxia to achieve its own interest regardless of reckless consequences,

responsibilities, ethics and interests of other investors (Liu and Liu, 2002). Further,

the eight-year client auditor relationship inevitably put auditor independence under

pressures. ZhongTianQin knows that if the financial statements do no show a true and

fair view and it does not qualify the audit opinion, there is a possibility either of

losing the audit or of having the audit fee reduced.

At present, it is very common to see more and more clients appoint audit firms to

audit themselves. This abnormal phenomenon eventually leads to clients build a

business partnership with audit firms, which greatly undermines auditor independence

(Liu and Liu, 2002). Thus, it can be reasonably believed that the ethical position

adopted by the auditors in Guangxia case is ignored. Under the sever pressures of

audit market competition, audit firms connive, even help listed companies to fabricate,

and seems to be a ‘rational’ choice to audit firms.

ZhongTianQin, after its reorganization in 1997, has a number of problems, among

which conflict of interest is the main reason for faction and finally leads to poor

management. In addition, ZhongTianQin is engaged in audit income rather than audit

quality after reorganization, everyone in the firm is instantly motivated to ‘do deals’,

thus it is reasonable to believe that consequences of malpractice are overlooked.

Although the auditors may feel that it is wrong to be dishonest, their profession ethics

are taken over by financial interests (Liu and Liu, 2002).

5.3.7. Accounting Fraud

5.3.7.1. Overview

According to the administrative sanctions of Guangxia given by CSRC, Guangxia




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overstates profits up to 77.1567 million YUAN from 1998 to 2001, among which

1.77610 million YUAN in 1998 (since the financial statements before 1998 of

TianjinGuangxia are missing, the credibility of profit is unknown), 17.78186 million

YUAN in 1999 and 56.70474 million YUAN in 2000. The first half year of 2001 has

an overstated profit of 0.894 million YUAN (See figure 5).

Million YUAN

Figure 5: overstated profit vs. actual loss

Million YUAN

-200

-100

0

100

200

300

400

500

1999 2000

reported net profit

restated netprofit/loss

Figure 6: Reported net profit vs. Restated net profit/loss




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Fiscal Year

1999

EPS (￥)

Net margin (%)

Operating sales

(￥/million)

Total equity (￥/million)

Net equity per share

(￥)

Reported 0.510 13.56 526.038 2429.896 3.73

Restated -0.20 -6.7 287.052 2218.959 2.96

Table 2: Key financial ratios and figures of 1999

Fiscal Year

2000

EPS (￥)

Net margin (%)

Operating sales

(￥/million)

Total equity (￥/million)

Net equity per share

(￥)

Reported 0.827 34.56 908.99 3151.295 2.39

Restated -0.30 -33.5 154.99 2401.586 0.88

Table 3: Key financial ratios and figures of 2000

Million YUAN

Figure 7: A comparison of operating sales and total equity between reported figure

and restated figure for year 1999




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YUAN

Figure 8: A comparison of EPS and Net equity per share between reported figure and

restated figure for year 1999

Million YUAN

Figure 9: A comparison of operating sales and total equity between reported figure

and restated figure for year 2000




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YUAN

-0.5

0

0.5

1

1.5

2

2.5

EPS Net equity pershare

ReportedRestated

Figure 10: A comparison of EPS and Net equity per share between reported figure and

restated figure for year 2000

With various accounting fabrications, Guangxia successfully pushes its share price

and becomes one of the most valuable securities in China. The opening price of

Guangxia is 1.64 YUAN, and it soon drops below the face value and reaches 0.98

YUAN (maybe this is the real value of Guangxia). Later on, the share price goes up

and drops from time to time but never exceeds 2.00 YUAN per share. It lasts for one

year and can be perceived to be one of the least valuable stocks in Chinese stock

market at that time. From 30th December 1999 to 19th April 2000, the share price of

Guangxia raised from 13.97 YUAN to 35.83 YUAN, ever reached 37.99 YUAN on

29th December 2000. Since the fabrications were disclosed by a Chinese finance

magazine ‘CaiJing’ in August 2001, the share prices dropped dramatically (see figure

5).




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Figure 11: Share price of Guangxia

Source: Shenzhen Stock Exchange

The overstatement of profit is achieved by a number of fabrication means. Guangxia

fabricates invoices from raw material purchase, production, sales and exports,

including falsification of sales contracts, fabrication of VAT invoices, export bill of

entry and tax-free documents (Lin, 2006). The fraud techniques are sophisticated and

state-of-the-art, and can generally be classified as the following ones.

5.3.7.2. Fraud Techniques

5.3.7.2.1. Overstatement of Revenue

The court trial record of Guangxia fabrication case shows that Ding Gongmin, the

CFO of Guangxia group made a call to Dong Bo, the CFO of TianjinGuangxia in

November 1999 and asked him to fabricate EPS to be 0.8 YUAN. Dong Bo calculates

the amount of profit that TianjinGuangxia needs to fabricate to arrive that figure and

afterwards he figures out the output, sales and raw material purchases to meet the

management requirement. In other words, the financial statements are all fictions and




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the transactions do not in substance.

The fabrication starts from raw material purchases. Dong Bo cooks up a number of

raw material suppliers and buys invoices, remittance receipts and bank transfer

receipts from blackmarket. He uses these invoices to fabricate a lot of raw material

purchases, such as ginger, cassia, product packing boxes, and the receipts to fabricate

the transactions like normal business. Further, he fabricates four custom declaration

forms amount to 56.10 million DM and three bank transfer receipts amount to 54

million YUAN paid by Cico co. ltd. (Germany).

Moreover, the general manager of TianjinGuangxia asks the staff to falsify records of

raw material purchases, production, shipping and so on, which results in a total

amount of fabricated export sales of 127.7866 million YUAN in 1999. The accounting

fabrication continues in 2000 and 2001 with fabricated export sales of 724 million

YUAN in 2000 and 290 fabricated VAT invoices in 2001.In May 2001, the CEO of

Guangxia group, Li Youqiang, borrowed 150 million YUAN from Shanghai Kinston

Investment Co. Ltd. with an excuse of purchasing equipments. Later Guangxia

transfers the amount to TianjinHeyuan Company (which is the chief agent of

extraction products) and again transfers it to TianjinGuangxia as product receivables,

among which 125 million YUAN is used as the profit of TianjinGuangxia.

In addition, the consolidated accounts of Guangxia do not cancel the inter-company

transactions which result in an overstated equity and profit. The cash flow statements

of 1998 and 1999 show negative figures, although it turns to be 120 million in 2000,

the net cash of each business activity is less than the gross profit and net profit. Thus

the inconsistency of reported profit and cash flow provides proof to accounting fraud.

5.3.7.2.2. Cultivate Account Receivables and Concealment of Losses




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Accountant receivables are a major accounting item in current assets. Since

receivables do not shown on cash flow statement, it is very likely that listed company

will falsify the amount of debtors. Account receivables mainly refer to product sales.

Since the export sales of TianjinGuangxia are fabricated by management, sales

income is difficult to be consistent with the amount in cash flow statement despite of

receivables (Sun, 2002).

Different from the other manipulations of receivables, such as early recognition of

sales and sales returns, Guangxia falsifies receivables by cooking up sales records

which do not exist in substance (Sun, 2002). Thus, the amount of receivables

increases as ‘sales’ increase. By boosting total debtors, the current assets increase and

enable ‘Guangxia’ to borrow a substantial amount of loans from banks and other

financial institutions easily.

Additionally, ‘Guangxia’ suffered losses every year since 1998, but it concealed losses

and continued fraud to show a bright prospect of company to external investors. Since

the financial statements are fabricated by management, external investors can not get

to know the truth. Due to the ‘excellent’ business performance of Guangxia, investors,

like banks do not hesitate to issue loans to it. Guangxia and its subsidiaries borrow

1.21 billion YUAN from 8 banks including 4 big national banks, but it minimizes the

liabilities to conceal its incompetency of debt payment in the financial statements to

window-dress its financial status and borrow more loans.

5.3.7.2.3. Tax

In early 2001, TianjinGuangxia fabricates 290 VAT invoices to TianjinHeyuan and the

tax payable amounts to 37.65 million YUAN, but it only pays 5 million YUAN with

an excuse of credit sales. Furthermore, the financial statements clearly identify the

income tax rates for Guangxia and its subsidiaries as 15%, 24% and 33%, among




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which ‘TianjinGuangxia’ and other three companies are currently tax free. However,

the income tax of 2000 is only 7.39 million YUAN out of a consolidated profit of 423

million YUAN. Hence, the average tax rate is only 1.75% which does not match the

actual tax paid.

Moreover, the company financial statements clearly show that the company has a VAT

of 17% and no entitlement on any reductions, but the annual financial report of 2000

states that, firstly, the due VAT was negative, i.e. the company did not owe any VAT

but had some amount that had not been offset (Fu, 2005). Secondly, the cash flow

statement shows that the actual VAT paid by the company is only 52,600 YUAN

which is completely different from the productivity as it announced. The industrial

sales of 2000 are 827 million YUAN and net profit is 543 million YUAN, therefore

the VAT should be more than the actual amount it paid (Fu, 2005).

5.3.7.3. Consequences of Accounting Fraud

Guangxia’s systematic accounting fabrication confirms the ineffectiveness of

company internal audit and greatly increases detection difficulties on material errors,

but the auditors’ negligence and malpractice on audit work consequently result in

audit failure. During the periods when Guangxia misreport, the fabrication cost to

Guangxia mainly stems from invoice purchase and some other paperwork, which is

rather little comparable to the gains it generates.

However, during the periods of misreport, Guangxia invests and hire more than

comparable firms matched on age, industry and initial size. For example, Guangxia

issues new shares three times after listing and collects 574 million YUAN from stock

market. However, it is all used by the ongoing businesses while the day to day

business operation and production are financed by bank loans.




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The fabricated financial statements do not reflect real financial status and thus are

lack of credibility and comparability. The overstated profits show investors a bright

prospect of company business and hence induce external investors to invest in the

capital market. The prosecuted losses of small and medium investors have

accumulated to 181 million YUAN, banks and other creditors to 500 million YUAN.

The exposure of Guangxia fabrication case diminishes investor and creditor

confidence on financial reporting and financial statement audit (Wan and Tian, 2003).

After the exposure of Guangxia scandal, stock market gets immediate ripple effect

and the audit firm gets philippics on its profession ethics.

The share price dropped from 30.79 YUAN before stopping trading to 6.59 YUAN,

nearly 6.8 billion YUAN floating capital sunk during 15 days. The company shrinks

quickly after it was caught and forced to restate. Both Shanghai and Shenzhen Stock

Exchange constantly drop during 4 months, Shanghai Stock Exchange even drops 700

indices. Small and medium investors suffer great losses in this fiasco, banks and other

financial institutions that issue loans to Guangxia are encountered with the risks of

inability of debt payment.

5.3.8. Implications

5.3.8.1. Generalize Accounting Standards

Generalized accounting standards can to some extent prevent companies from

fabricating, but it is impossible to prevent all company fabrication by one set of

accounting system, especially in today’s modern accounting affairs. Accounting

standards are just rules, but accounting practice varies from one to another. The

standards are even developed slower than practice, so the standards must be of

flexibility so as to meet the fast change in practice, and only flexible accounting

standards may be used in various companies.




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In the modern accounting environment, business complexity increases the difficulties

in accounting practice. Guangxia and other accounting scandals falsified profits with

sophisticated and state-of-the-art accounting manipulations that increase the audit risk

and challenge the existing accounting standards. The string of accounting fabrications

arouses the need of betterment of existing accounting policy. The standards should be

modified on a timely basis and prevent abuse and misinterpretation. Generalized

accounting standards can significantly decrease audit risk and other consequences that

the previous accounting policy may cause. Therefore, there is a great need of

enhancing the effectiveness of accounting standards to minimize the possibility of

fabrication.

5.3.8.2. Auditor Independence

Effective auditing can greatly help auditors to detect fraudulent manipulations of

listed companies and thus provide useful information to investors. However, the audit

work did not effectively prevent fabrication in recent corporate accounting scandals.

Auditor independence is the key factor that influences effectiveness of auditing and

hence fabrication prevention. Therefore, for those investors who highly rely on

audited financial information challenge the risks of auditor ethics and independence

of audit firms.

In China, auditors actually report to company management rather than shareholders

although the report is issued to all shareholders of the auditee company. Therefore the

problem is that management of company is very likely to appoint an audit firm based

on its self-interest. And the audit firm will be dismissed if it issues an audit report that

does not meet the requirements of auditee company (Lin, 2006). Under the increasing

competition among audit firms, they will probably hide the fact of corporate

fabrication and even help auditee company to deceive and finally conclude that the




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financial statements are qualified.

The law and legislations should clearly define auditee and consigner, and restrict the

management of auditee company to be a consigner. To ensure the independence of

auditors, it can be a third party who takes over the appointment of audit firm and

invites public bidding. Alternatively, audit fees can be paid to the local stock

regulatory authority and then transfer to each audit firm. It can prevent audit firm

from depending on auditee company and thus be independent, objective and fair (Liu

and Liu, 2002).

5.3.8.3. Rationality of Investment

Stock market is risky and changeable, so rational investors should always evaluate

risks of each individual stock carefully before making investment in order to

minimize losses. Although Chinese accounting system requires listed companies to

provide a full set of financial statements and auditors to carry out effective audit work,

to some big listed companies, auditors could not detect all the mistakes and faults due

to the nature of business complexity. That is to say, rational investors should get to

know more about company backgrounds, characteristics, prospects and so on to

analyze and identify any possible problems existing in the business.

However, the current stock market is less mature and investors are so irrational that

they overlook the importance of financial statements. Chinese investors typically

focus less on a company’s basic performance when making investment decisions than

on the names of the company’s key institutional investors (Shi and Meisert, 2002). As

long as the share price goes up, irrational investors will go and purchase it. Hence,

investors should care more about risk management to minimize risks which would be

helpful to establish an effective dynamic market mechanism to threaten defrauders.




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5.3.8.4. Corporate Governance

A string of corporate scandals prompt the widespread problem of ineffective and

corrupt management in Chinese public companies stressed. Government and company

efforts to build a corporate governance system during the 1990s thus existed largely

on paper and ultimately contributed little toward an effective system. In practice, key

managers sometimes gain control over the shareholders’ general meeting so it

functions mainly as a rubber stamp, giving green lights to decisions already made by

senior management (Shi and Weisert, 2002).

Few Chinese boards have influence over the selection of a chief executive officer,

partly because the CEO is often the founder and has packed the board with friends,

family and insiders (Directorship, 2007). Insiders have occasionally won dominant

positions on the boards of directors and supervisors and placed their cronies in board

positions. In such cases, the boards of directors and supervisors merely serve the

demands of controlling parties and their representatives. In some instances, managers

diverted money from state and company coffers into their own pockets—actions that

clearly ran counter to the goal of increasing the value of shareholders’ investments

(Shi and Weisert, 2002).

Poor corporate governance in China begins before a company is approved for listing.

Many analysts have highlighted the distortion caused by the government’s role in

selecting companies for listing. Companies such as Lantian and Zhengzhou Baiwen

Co. Ltd. and Guangxia as well were, in effect, phony entities even before their IPOs.

And government officials showered praise on them after the IPOs, thus obscure the

companies’ faults. The local regulators should crack down on corporate and securities

law violations, focusing on the relationship between subsidiary and parent companies,

the use of capital raised from markets, and the accuracy of financial data (Xu, 2003).




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5.3.8.5. Lacking of Comprehensive Statute

Although China at present has a set of laws, regulations that oversee and supervise

business operations and stock market, for instance ‘Company Law’ Article 212,

‘Securities Law’ Article 177 and ‘Criminal Law’ Article 181 all make provisions to

defrauders and purse pertaining crime responsibility towards breaching, this is not an

end of the problem but a starting point for those investors looking for protection,

because these laws do no sufficiently punish defrauders. The protection to investors

should not be limited at a policy level; instead it ought to be stressed on practicality.

The previous measures of investor protection emphasize political sanctions to

defrauders rather than overawing fabrication and compensating losses of investors.

For example, the ‘Securities Law’ states that the maximum fine to those who do not

disclose true accounting information is 300,000 YUAN and 3-year imprisonment to

criminals (including a maximum penalty of 200,000 YUAN). Hence, the punishment

to defrauders should be serious enough to prevent fraud, since the existence of ramrod

discipline does greatly improve prevention and stabilize the stock exchange market.

A well developed set of statute is a mechanism to market activities, preventing

fabrication and protecting investors. A lot of problems arise from Guangxia

fabrication case related to the imperfectness of current laws and regulations. For

example, there are no corresponding regulations to deal with the problem of

compensation of small and medium investors. The absence of this regulation greatly

encourages corporate fabrications and opportunistic activities. If the statute is

comprehensive enough to be enforced, the management would be under pressures

when deciding on fabrication.

Therefore, a set of regulations focusing on loss compensation will be more helpful to




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resolve the loss of law awe and build public trust of investors to the stock market. The

regulations will effectively warn those deceiving companies and reduce the risks in

stock market. Since lacking of a set of regulations to compensate investors, the court

at the very beginning refused to process the case, but later decided to accept it.

However, it has aroused attention of law and justice, the relevant regulations and

provisions must be enacted to meet the needs of investors and stock market

requirements. Additionally, enforcement and compliance are also crucial to the

prevention of fabrication, if they can be carried out simultaneously, prevention may be

achieved to some extent.

Next chapter will come to a conclusion of this dissertation. Based on corporate

accounting scandals, a comparison will be made between Guangxia and U.S. case,

Enron, as they are both representative and well-known scandals in China and the U.S.

It is worthy comparing these two cases because different business environment,

corporate management and auditing market may have different impacts on corporate

fraud. Following the comparison, some possible suggestions are given to improve the

efficiency of Chinese stock market and company performance in accounting and audit

profession. Due to limitations, the research may not be satisfactory in some areas, and

there is plenty of room for improvement if some primary research is done.




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CHAPTER 6

Conclusion

6.1. Problems

In today’s multifaceted and multidisciplinary economic environment, management of

organization places more and more emphasis on increasing results with fewer

resources through evaluation of the economy, efficiency, and effectiveness of the

organization’s operations (Reider, 2007). While the audit provides an after-the-fact

opinion that financial statements present a fair view of company affairs, no guarantee

is made to conclude that company operations are conducted in the most economical,

efficient, and effective manner.

Due to a number of external and internal factors, more and more listed companies

resort to falsification and fabrication on their financial statements for various purposes,

for instance, to be competitive, maintaining market position or merely surviving.

Normally, accounting fraud arises when entities begin to suffer loss but have to

maintain their market position in stock market, thus fraudulent accounting techniques

are employed by company management to achieve organizational or individual goals.

The recent corporate financial scandals like Enron, WorldCom and Chinese Guangxia

in the early part of this decade shocked financial markets and presented a lot of

problems existing in the capital market, such as auditor independence, corporate

governance, and legislation and so on. A corporate financial scandal always arises

with an aggregation of a number of factors which provide a breeding ground for fraud.

For example, the loopholes in auditing controls and corporate governance can to some

extent encourage companies to perpetrate fraud.




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External auditors in this context are obligated to collect audit evidence and take audit

trial to give an opinion that the financial statements of auditee company has a true and

fair view. But auditors may fail to detect fraud and material misstatements from the

financial statements, especially when the company internal control is weak and

company intentionally make frauds. However, that may not be the excuse for high

audit risk and hence audit failure.

Although the inherent risk is high due to business complexity and internal control is

weak, auditors should detect the apparent problems within financial statements if

regular procedures are followed. However, the auditors are negligent on audit work

and losing auditor independence, thus leading to audit failure. The audit failure results

in stock crisis and diminished public trust on stock market and hose small and

medium investors who rely on audited financial statements suffer great losses and

have no compensation due to unavailability of appropriate statute. Thus there is a

great need to improve both the external and internal audit environment to fight against

financial fraud.

6.2. Guangxia vs. Enron

Both Guangxia and Enron are representative and well-known corporate scandals in

China and the U.S. It would be interesting to have these two cases compared as they

are different in culture, social regime and corporate management, etc. The similarities

and differences may inspire stock market management and auditor profession

improvement in the future.

6.2.1. Similarities

n Impact on capital market. Guangxia overstates profit by 745 million YUAN in

two years and Enron exaggerates its profit by $ 586 million from 1997 to 2001.




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This amount of overstated profits is reasonably material and influence investor

decisions, because the overstated profits have impact upon share price on stock

market. During the years, both share prices continuingly increase and being one

of the most valuable stocks in the exchanges, but the exposure of accounting

fraudulence dramatically drives share price down within a short time horizon. For

instance, Enron’s share price drops by 75% in a day.

n External environment. Although the market economy in America tends to be

mature and has established a relatively better mechanism than China which is at

the stage of transferring from planned economy to market economy, the pitfalls

involved in its mechanism show that the U.S. need to remedy the existing

mechanism whereas China need learn to establish a better and effective

administrative mechanism from those scandals. However, the two remarkable

corporate financial scandals both stress the urgent need for a mechanism to

ensure credibility of financial statements of listed companies.

n Corporate governance. Both Guangxia and Enron’s board are not independent.

The audit committee of Enron is composed of 7 independent directors and the

board is composed of 17 directors, among which 15 are independent directors.

But about 10 out of 15 independent directors signed consultancy contracts with

Enron or work in non-profit entities of Enron, whereas Guangxia’s board of

directors is controlled by a minority of directors and insiders, most importantly,

Guangxia has no audit committee until the fabrication is exposed.

n Auditor independence. Both ZhongTianQin and Arthur Anderson provide

non-audit services in addition to audit work, whereas some senior accounting

officers in Enron are from Arthur Anderson. The close business relationship with

auditee company leads to a failure on audit independence. When audit firms are

paid for high audit fees, it is very likely that the audit opinion is lack of credibility




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and may mislead external users.

6.2.2. Differences

n Fabrication techniques. They both fabricate financial statements and exaggerate

profits, but by different means. For example, Enron is best known for its use of

Special Purpose Entities (SPEs) to manipulate accounting results and overstates

profit by selling equity between subsidiaries above market price, whereas

Guangxia falsifies business income mainly by counterfeiting purchasing and

selling contracts, export bill of entry, added value tax invoices, duty-free

documents and financial notes. However, the scandal influences of both are

significant on stock markets.

n Audit firms. Arthur Anderson knows the existence of financial frauds in Enron

but does not disclose the fabrication and falsification. When Enron scandal is

exposed to public, Arthur Anderson deletes all relevant documents and interferes

the course of investigation. Examining the audit failure from audit work point of

view, ZhongTianQin negligently carries out the audit and does not follow regular

procedures. The State Finance Administration revokes the license of the Zhong

TianQing Accountant Firm, and two CPAs are arrested because of negligence.

n Penalty. Both auditors in Guangxia and Enron cases are penalized and imprisoned,

but the audit firms are punished differently. The profession license of

ZhongTianQin is revoked, whereas Arthur Anderson does not get the same

punishment as ZhongTianQin. It is believed that the crucial point relating to

penalty is to investigate real reasons for audit failure, which is inadequacy of

audit independence in the case, and then takes appropriate actions toward those

reasons rather than stressing punishment on audit firms only (Du, 2002). If

profession license of audit firm is revoked once audit failure occurs, there will not




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be many left in the market3.

6.2.3. Summary

Although the two scandals occur in two countries, they have some similarities

regardless of the differences exist in culture, economy and legislation. As to the

differences, it is obviously to find that both cases show others the way toward audit

failure with their own characteristics. For example, the collapse of Enron has a

number of complicated reasons, among which corporate governance is one of the

important ones. The problems associated with U.S. corporate governance primarily

stem from the abuse of governance regulations rather than the inherent weaknesses of

regulations (Han and Zhai, 2006).

The shareholding of U.S. companies is extensively diversified and thus leading to an

inadequate control over management, whereas Chinese corporate governance

problems are from the intensiveness of shareholdings. However, the extensiveness of

shareholdings has same consequences as intensive corporate governance has i.e. the

board is controlled by a number of insiders (Song and Yang, 2003). Therefore, some

actions need to be taken to establish a better independent directorship system and

supervision mechanism on stock market.

Exposures of Guangxia and Enron corporate scandals highlight a listing of problems

existing in current stock markets, and most of them can be shared with some

accounting scandals in other countries. The increasing global trend on corporate

scandals calls for a need of establishment of a strong market supervision mechanism

and other corresponding systems. For example, establish a set of social credit system

and improve the existing regulations regarding to auditor ethics (Zhang, 2003), etc.

However, the improvement for enhancing corporate financial reporting will face a 3 An investigation carried out by National Audit Office of the People’s Republic of China in 2002 on 16 randomly

selected audit firms shows that 14 of them have serious profession problems.




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number of constraints due to the complexity of both domestic and American capital

market environment, such as inveteracy of corporate interpersonal relationships, and

the set of regulations may not be complied exactly the same way.

6.3. Post-Guangxia Thinking

China is new regards to auditing profession with a CPA history of about 20 years, thus

it still has a long way to get its maturity. The introduction of U.S. SOX ACT provides

a big room for Chinese CPA improvements and other disciplines’ thinking. After the

exposure of Guangxia fabrication case, investor confidence on security supervision

and audit profession is frustrated, therefore it seems a much-needed intervention

should be placed to prevent accounting scandals.

Following a range of scandals and collapses in the U.S., the Sarbanes-Oxley (SOX)

Act was passed by the congress in 2002. The purpose of the Act is to “protect

investors by improving the accuracy and reliability of corporate disclosure” (Pfefferle

III, 2004, p.1). From the publicized corporate failures, many listed companies have

not consistently complied with regulations, but changes brought about by the SOX

ACT including increased enforcement, more accountability, and tougher penalties,

have the primary aim of turning this around (McGowan & Brisendine, 2003).

The SOX ACT places responsibilities at the feet of corporate CEOs and CFOs to

certify quarterly and annual reports filed with the Securities and Exchange

Commission (SEC) (Kieckner & Jackon, 2004) and also sets serious criminal

penalties for intentional violation with fines of up to $ 5 million and up to 20-year

imprisonment. In addition, it places an emphasis on the auditors, by preventing the

audit company from providing certain non-audit work such as consultancy services

(O’Connor, 2002).




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There is no doubt that the SOX ACT is one of the most important pieces of legislation

in recent years in terms of its effect on the corporate world, and it has important

implications not only restoring investor confidence but also for accounting profession.

Under the context of Chinese accounting scandals, the SOX ACT would have some

revelations for practitioners and performance improvement.

6.4. Solutions to Fraudulent Accounting

6.4.1. Tenure of Audit Firm

Rule 404 of SOX ACT makes provision for the tenure of partners of accountancy

firms rather than audit firms. Ministry of Finance People’s Republic of China and

CSRC also enact a regulation named ‘Regulations regarding to the tenure of CPA in

audit work’ based on SOX Act. However, it is very likely that audit firm and its client

company will build up a good business relationship during the period of service.

Therefore, an appropriate tenure change on audit firms will be helpful to improve

audit quality. On the contrary, frequent change on audit firm will certainly result in an

abnormal competition among audit firms, which brings to poor audit quality (Zhou,

2003).

Hence, it is suggested that the appropriate tenure of accountancy firms should be 3 to

4 years and the contract can be extended only once (Sun et al., 2005). During the

extension period, the CPAs should be changed. With this new tenure policy, the

long-term business relationship between audit firm and client company is effectively

reduced and worries of unreasonable dismiss are eliminated.

6.4.2. Non-audit Services

The SOX ACT places an emphasis on the auditors, by preventing the audit company




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from providing certain non-audit work such as consultancy services. However, this

may not fit for Chinese accountancy firms, because China is on a different phase from

the international auditing with respect to audit business, it is currently at the stage of

business expansion, including non-audit services such as management consultancy

and so on. The non-audit services provided by Chinese audit firms are limited and

they are not the main factors affecting audit independence. However, the supervisory

body should necessarily intervene the non-audit services which significantly affect

audit independence or require audit firms to disclose the proportion of non-audit

income from a client company to its total service fees (Sun et al., 2005). When

non-audit services make up 25-30% of the total service fees, the audit firm should

give up the non-audit services.

6.4.3. Supervision

On November 15, 2002, Ministry of Finance of PRC promulgated No. 19 statute

which revoked the supervisory function on CPA profession from the Chinese Institute

of Certified Public Accountants (CICPA), the new supervision will be performed by

Accounting Department, Law Department and Supervision Department of PRC (Li

and Wan, 2007). Thus, the redistribution of supervision has more direct and powerful

influence on CPA performance.

Government places great emphasis on CPA profession supervision and introduces

more government officials to participate in enaction, implementation of profession

regulations so as to ensure rationality and standardization, which can to some extent,

reduces audit risk and strengthens supervisory mechanism (Li and Wan, 2007). On 3rd

November 2004, Ministry of Finance issued a statute about regulations of audit firms

which set restrictions to the establishment and partnership of audit firms,

qualifications of shareholders. This stresses governmental supervision and credibility,

efficiency of audit firms based on the existing supervision system.




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6.4.4. Internal Control

Although Chinese Accounting Law, Auditing Law and Auditor Independence

Standards have more or less involved the concept of internal control, they fail to

establish a set of frameworks relating internal control. Therefore, it is necessary to set

up an internal control evaluation mechanism to improve corporate internal

management and aid external audit and supervision.

The outstanding global internal control frameworks include American COSO,

Canadian CoCo, British Cadbury Report and Institute of Internal Auditors (IIA), etc.

Public Company Accounting Oversight Board (PCAOB) recommended COSO to be

used in 2004 and got authorization from SEC later. The three main aims of COSO are

business efficiency and performance, credibility of financial statements and relevant

regulations for compliance. They have much more influence on preparation of

financial statements and are the main components of internal control of financial

reporting. China may set up own internal control framework according to COSO and

integrate simple control activities with corporate environment, control objectives and

control risks, thus forming a self-corrective dynamic internal control mechanism (Han

and Zhai, 2006).

To establish an effective internal control evaluation mechanism, Chinese corporations

may establish a particular board with senior managers to recognize, evaluate, control,

supervise and improve weak and risky activities within corporations by enaction and

implementation of systematic policies and regulations (Han and Zhai, 2006).

Moreover, companies can appoint a financial intermediary or professionals to aid the

establishment of effective and efficient internal control evaluation system and

improve any control weakness to ensure preparation quality of financial statements.




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6.5. Limitations

This MA dissertation is a small-scale study and as such only has covered the tip of an

iceberg into the concept of audit risks associated with fraudulent accounting. This

piece of work primarily investigates a number of areas related to audit failure with the

analysis of Guangxia, therefore, the research did not illustrate the fraudulent

techniques in details, as they are extremely complex.

The Guangxia case is an extremely large area of investigation. Due to the limited

boundaries of this dissertation, the author generally focused on the audit environment,

i.e. both external and internal factors that give rise to audit failure. Although Guangxia

is the most representative case of Chinese corporate and auditing scandals, it may not

have the generality of all listed companies in China. Therefore, the analysis may

possibly exclude some exceptions. To improve this dissertation, more information can

be obtained to achieve a better work, such as opinions from the Big Four accountancy

firms, interviews with insiders in depth, and so on, and this would be carried out in

the form of qualitative research methods.




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Appendix

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Appendix

Correction of Annual Reports of Guangxia (Yinchuan) Industry Co., Ltd.

1. Annual Report of 1999 2. Annual Report of 2000 3. Chapter 2 of Annual Report of 2001

The Latest 3-Year Accounting and Financial Figures

Items 2001 (YUAN)

Restated Pre-restated

Operating Revenues 145,209,011.90 130,261,227.08

Net Profit -394,441,413.39 -135,823,810.33

Assets 1,390,560,083.26 1,429,597,831.23

Shareholders’ Equity

(excluding Minority Interest) -838,724,923.99 -340,353,948.53

Earnings Per Share(Diluted) -0.78 -0.27

Earnings Per Share(weighted) -0.78 -0.27

EPS(excluding Non-recurring Profit and Loss) -0.39 0.04

Net Asset Value per Share -1.66 -0.67

NAV per share (adjusted) -2.14 -1.28

Cash flow per share from Operating activities 0.27 0.25

Return On Net Assets -47.01 -39.9




Appendix

- 87 -

Items 2000 1999


Net Profit -149,401,045.14 -50,031,926.03

Assets 2,401,586,437.83 2,218,958,802.98

Shareholders’ Equity

(excluding Minority Interest) 445,901,823.33 746,881,282.46

Earnings Per Share(Diluted) -0.30 -0.20

Earnings Per Share(weighted) -0.30 -0.22

EPS(excluding Non-recurring Profit and Loss) -0.30 -0.17

Net Asset Value per Share 0.88 2.96

NAV per share (adjusted) 0.64 2.65

Cash flow per share from Operating activities -0.23 -0.02

Return On Net Assets -33.5 -6.7




Appendix

- 88 -

Balance Sheet

Current Assets 1999-12-31 1998-12-31

Cash and cash equivalents 315,294,402.44 24,633,236.64

Investments - Short term

Accounts receivable

Dividends receivable

Interests receivable

Net Receivables 339,172,464.96 408,963,481.93

Prepayment 160,674,222.52 63,449,913.40

Allowance receivable 2,600,000.00

Inventories 441,040,627.45 472,323,174.60

Prepaid expenses 2,976,440.92 1,656,023.74

Long term equity investment

due within one year

Other current assets

Total current assets 1,261,758,158.29 971,025,830.31

Long term investment

Long term investment on equity 98,659,143.03 101,165,072.16

Long term investment on credit 6,540.40 6,540.40

Total long term investment 98,660,183.43 101,171,612.56

Provision for long-term investment 22,839,011.21 22,839,011.21

Net long term investment 75,821,172.22 78,332,601.35




Appendix

- 89 -

Variance of investment 20,196,000.00 20,808,000.00

Fixed assets

Fixed assets-cost 678,528,636.48 255,506,824.41

Accumulated depreciation 102,823,014.25 62,031,612.13

Fixed assets-net value 575,705,622.23 193,475,212.28

Provision for fixed assets

Project goods and material 247,985.41

Construction in progress 238,184,818.20 193,042,707.52

Disposal of fixed assets 980,966.70

Total fixed assets 815,119,392.54 386,517,919.80

Intangible assets and other assets

Intangible assets 31,654,829.46 21,136,379.78

Long term deferred

and prepaid expenses 34,605,250.47 32,331,120.55

Other long term assets

Total Intangible assets

and other assets 66,260,079.93 53,467,500.33

Deferred taxes

Deferred taxes debit

Total assets 2,218,958,802.98 1,489,343,851.79

Liabilities and owner's equity

Current liabilities

Short term loans 410,282,931.23 410,007,178.60




Appendix

- 90 -

Notes payable 1,321,800.00 400,000.00

Accounts payable 60,877,011.76 89,536,935.47

Accounts advanced from customers 35,145,452.84 41,989,754.52

Accrued wages 759,182.10 1,290,236.60

Accrued welfares 5,953,905.52 4,678,346.82

Dividends payable

Tax payable 35,971,777.53 29,782,926.72

Other fund in conformity with paying 828,043.77 377,798.51

Other payables 147,609,798.54 79,187,985.94

Withholding expenses 7,588,125.56 14,176,271.80

Foreseeable liabilities

Long term liabilities

due within one year 74,814,882.50 58,777,526.76

Other current liabilities

Total current liabilities 781,152,911.35 730,204,961.74

Long-term liabilities

Long-term loans 403,975,686.00 53,166,666.70

Dividends payable 116,941,080.67 66,917,712.00

Payables due after one year 1,382,502.12 1,028,622.15

Government grants payable

Other long term liabilities

Total long term liabilities 522,299,268.79 121,113,000.85

Deferred taxes




Appendix

- 91 -

Deferred tax credits

Total liabilities 1,303,452,180.14 851,317,962.59

Minority interest 168,625,340.38 143,011,247.33

Shareholders Equity

Share capital 252,630,690.00 220,203,297.00

Capital reserve 467,329,282.63 197,858,109.01

Surplus reserves 75,954,897.34 50,397,577.16

Public welfare fund

Undistributed profit -49,033,587.51 26,555,658.70

Total shareholders equity 746,881,282.46 495,014,641.87

Total liabilities and shareholders equity 2,218,958,802.98 1,489,343,851.79




Appendix

- 92 -

Profit & Loss Account

Items 1999 1998


Less：Sales discounts and allowances 27,408.54 17,091,586.17

Net sales 287,024,660.01 532,553,008.41

Operating costs 226,874,637.72 310,897,451.16

Tax and associate charge 14,071,122.03 22,044,407.52

Operating income 46,078,900.26 199,611,149.73

Add: Income from other operations 771,107.54 845,480.56

Less: Selling & Distribution expense 23,728,125.74 20,611,879.65

Corporate administration expense 42,997,446.79 39,376,514.06

Financial expense 41,550,225.59 13,592,079.54

Operating income -61,425,790.32 126,876,157.04

Investment income -430,920.70 -18,896,246.64

Subsidy income 2,600,000.00 5,673,619.04

Non-operating income 7,564,119.69 2,261,458.58

Less：Non-operating expense 932,083.29 919,476.71

Income before tax -52,624,674.62 114,995,511.31

Less：Income tax 2,409,208.99 10,357,863.52

Minority interest income -5,001,957.58 63,926,110.64

Net income -50,031,926.03 40,711,537.15




Appendix

- 93 -

Add: retained profit 26,555,658.70 3,675,013.39

Other transfer-in - -

Profit available for distribution(-means loss) -23,476,267.33 44,386,550.54

Less: Appropriation of statutory surplus reserves 12,778,660.09 8,915,445.92

Appropriation of statutory welfare fund 12,778,660.09 8,915,445.92

Profit available for shareholders' distribution -49,033,587.51 26,555,658.70

Less: Appropriation of preference share's dividend - -

Appropriation of discretionary surplus reserve - -

Appropriation of ordinary share's dividend - -

Transfer from ordinary share's dividend to paid in capital - -

Retained profit after appropriation、 -49,033,587.51 26,555,658.70




Appendix

- 94 -

Balance Sheet

Current assets 2000-12-31 1999-12-31

Cash and cash equivalents 326,093,467.69 315,294,402.44

Investments - Short term

Accounts receivable

Dividends receivable

Interests receivable

Net Receivables 407,028,382.79 339,172,464.96

Prepayment 198,004,949.85 160,674,222.52

Allowance receivable 2,600,000.00

Inventories 399,121,753.08 441,040,627.45

Prepaid expenses 1,537,929.40 2,976,440.92

Long term equity investment

due within one year

Other current assets

Total current assets 1,331,786,482.81 1,261,758,158.29

Long term investment

Long term investment on equity 151,334,734.04 98,659,143.03

Long term investment on credit 1,040.40

Total long term investment 151,334,734.04 98,660,183.43

Provision for long-term investment 20,576,471.97 22,839,011.21

Net long term investment 130,758,262.07 75,821,172.22




Appendix

- 95 -

Variance of investment 19,584,000.00 20,196,000.00

Fixed assets

Fixed assets-cost 577,686,571.39 678,528,636.48

Accumulated depreciation 77,512,028.08 102,823,014.25

Fixed assets-net value 500,174,543.31 575,705,622.23

Provision for fixed assets

Project goods and material 181,448.68 247,985.41

Construction in progress 358,166,758.87 238,184,818.20

Disposal of fixed assets 980,966.70

Total fixed assets 858,522,750.86 815,119,392.54

Intangible assets and other assets

Intangible assets 42,378,169.96 31,654,829.46

Long term deferred

and prepaid expenses 38,140,772.13 34,605,250.47

Other long term asset

Total Intangible assets

and other assets 80,518,942.09 66,260,079.93

Deferred taxes

Deferred taxes debit

Total assets 2,401,586,437.83 2,218,958,802.98

Current liabilities

Short term loans 931,888,925.12 410,282,931.23

Notes payable 9,784,000.00 1,321,800.00




Appendix

- 96 -

Accounts payable 89,985,85806 60,877,011.76

Accounts advanced from customers 97,411,847.41 35,145,452.84

Accrued wages 566,386.48 759,182.10

Accrued welfares 4,376,755.25 5,953,905.52

Dividends payable 151,578,414.00

Tax payable 31,575,843.83 35,971,777.53

Other fund in conformity

with paying 154,677.36 828,043.77

Other payables 83,459,756.77 147,609,798.54

Withholding expenses 12,618,304.72 7,588,125.56

Foreseeable liabilities

Long term liabilities

due within one year 75,330,000.00 74,814,882.50

Other current liabilities 675,464.24

Total current liabilities ,489,406,233.24 781,152,911.35

Long-term liabilities

Long-term liabilities 247,572,686.00 403,975,686.00

Dividends payable 91,315,439.34 116,941,080.67

Payables due after one year 1,382,502.12

Payables due after one year

Other long term liabilities

Total long term liabilities 338,888,125.34 522,299,268.79

Total long term liabilities




Appendix

- 97 -

Deferred tax credits

Total liabilities 1,828,294,358.58 1,303,452,180.14

Minority interest 127,390,255.92 168,625,340.38

Shareholders Equity

Share capital 505,261,380.00 252,630,690.00

Capital reserve 214,698,592.63 467,329,282.63

Surplus reserves 159,484,183.56 75,954,897.34

welfare fund

Undistributed profit -433,542,332.86 -49,033,587.51

Total shareholders equit 445,901,823.33 746,881,282.46

Total liabilities and

shareholders equity 2,401,586,437.83 2,218,958,802.98




Appendix

- 98 -

Profit & Loss Account

Items 2000 1999


Less：Sales discounts and allowances 27,408.54

Net sales 154,988,746.19 287,024,660.01

Operating costs 124,521,861.80 226,874,637.72

Tax and associate charge 5,081,091.94 14,071,122.03

Operating income 25,385,792.45 46,078,900.26

Add: Income from other operations -121,896.71 771,107.54

Less: Provision for Inventory 7,094,359.78

Selling & Distribution expense 6,223,139.34 23,728,125.74

Corporate administration expense 74,175,402.36 42,997,446.79

Financial expense 59,957,774.82 41,550,225.59

Operating income -122,186,780.56 -61,425,790.32

Investment income -27,205,229.74 -430,920.70

Subsidy income 3,569,500.00 2,600,000.00

Non-operating income 879,755.35 7,564,119.69

Less：Non-operating expense 449,098.81 932,083.29

Income before tax -145,391,853.76 -52,624,674.62

Less：Income tax 7,389,721.67 2,409,208.99

Minority interest income -3,380,530.29 -5,001,957




Appendix

99

Net income -149,401,045.14 -50,031,926.03

Add: retained profit -49,033,587.50 26,555,658.70

Other transfer-in

Profit available for distribution (-means loss) -198,434,632.64 -23,476,267.33

Less: Appropriation of statutory surplus reserve 41,764,643.11 12,778,660.09

Appropriation of statutory welfare fund 41,764,643.11 12,778,660.09

Profit available for shareholders' distribution -281,963,918.86 -49,033,587.51

Less: Appropriation of preference share's dividend

Appropriation of discretionary surplus reserve

Appropriation of ordinary share's dividend 151,578,414.00

Transfer from ordinary share's dividend to paid in capital

Retained profit after appropriation -433,542,332.86 -49,033,587.51




Documents

UNIVERSITY OF NOTTINGHAM The Audit Risk Associated