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Auditing China
Massive losses and possible fraud have been discovered in some of China�s state owned enterprises during a comprehensive investigation by the China National Audit Office, which examined the accounts of 130,000 SOEs under instruction from the Government. As much as $8bn (£4.2bn) of funds may have been improperly used or stolen, said the auditor.
Many of China�s leading state businesses have been victims, but the NAO�s biggest concern seems to relate to the running of the Industrial and Commercial Bank of China, one of the country�s four largest banks. Irregularities were discovered at ICBC, where it is alleged some loans were backed by false documentation and others to municipal government were awarded beyond authorities� ability to repay. CNAO reportedly found ICBC�s loans records to be in �a mess�.
There had been widespread rumours of bad lending practices at ICBC and other major banks, contributing to the high level of non-performing loans, estimated at $420bn (£221bn). It is thought that ICBC alone may have suffered losses from fraudulent loans running into hundreds of millions of dollars.
There was also serious criticism by the state auditor of the State Power Corporation, the former monopoly energy supplier which was dismantled last year. The company�s balance sheet was found to be inaccurate, hiding much larger than reported losses, with weak management and a serious loss of state assets.
A report on state-owned television stated that the recently privatised China Life Insurance had separately been discovered by the auditor to be involved in multi-million dollar frauds. However, in a statement, China Life denied that any irregularities had been found relating to the company since its recent privatisation. The company confirmed that CNAO had reviewed its pre-privatisation activities and suggested that any problems had been resolved prior to its IPO last year, the largest international stock market listing of 2003. The company is China�s largest life insurer and has just opened the country�s first ever asset management business, with $40bn (£21bn) of funds under management.
Investigations by the CNAO have had widespread repercussions. Defrauded funds of $2.9bn (£1.5bn) have been recovered, while it is reported that thousands of state and SOE officials have fled the country to avoid arrests flowing from the investigation. Some 749 officials have been referred for possible criminal prosecution.
One unnamed investment banker quoted in press reports in the United States said that the findings should come as no surprise. He said that audit and management standards in China were not yet of adequate standard and that shares in major Chinese companies carried a discount to reflect these concerns.
But Sonia Khao, head of technical services, ACCA Hong Kong, challenged the perception that accounting and auditing standards in China lag behind those of US and Europe. �This type of problem is not specific to a particular jurisdiction,� she said. �The issue is related to the general ethics and integrity of management and the accounting profession. It is not related to a particular region.
�When we looked at accounting standards development, we found that the process is continuing to meet international harmonisation. International standards are being met. The auditing standards are also international. The problem is not about accounting and auditing standards in China. The problems are like those of Enron.�
The Chinese state has been attempting for several years to raise the quality of its audits. In 2002 Deloitte Touche Tohmatsu was appointed by CNAO to formulate an audit manual for the country�s banks to introduce more effective corporate management systems and bring reporting practices up to international standards. This was in line with commitments made by China to the World Trade Organisation to facilitate its membership.
The CNAO is also overseeing a programme designed to eradicate corruption in the relationship between auditors and audit bodies. It is implementing six key measures to make auditing more objective, including standardising audit practice, imposing penalties on auditors who fail in their duties, limiting auditors� conduct of non-audit work and improving the quality of internal audit.
J�Accuse
Former French Prime Minister, Alain Juppe, has been convicted of
mis-using his previous position of finance director for Paris to allow the improper employment of members of the political party, the Rally for the Republic (RPR), of which he was at the time also secretary-general. The conviction is enormously damaging to the political reputation of President Jacques Chirac, because Chirac, as mayor of Paris, was Juppe�s employer and also the founder of the RPR. Juppe is a close ally of Chirac�s and had been assumed to be the President�s favoured successor. As part of the verdict on the case - which is being appealed - Juppe is banned from political office for 10 years and received a suspended
18-month prison term.
Juppe pleaded not guilty, not denying that the party officials had been employed in the mayor�s office, but saying that he was unaware of this. His conviction raises the possibility that Chirac himself could face trial after completing his presidency. He is legally protected from prosecution when President.
The damage to the body politic of France is enormous. This is not because the Juppe case is a one-off - rather it reinforces an impression of deep-seated corruption at the heart of the French state. Juppe�s was merely one more episode in a sequence of scandals affecting senior politicians.
Just days after Juppe�s judgement, two other senior French politicians were convicted in an unconnected prosecution. Renaud Donnedieu de Vabres - spokesman for President Chirac�s new party the UMP (Union for a Popular Majority) and a former minister for Europe - was found guilty of money laundering to fund illicitly the now disbanded Republican Party. In the same case, former defence minister and leader of the Republican Party, Francois Leotard, was convicted of related offences.
Five years ago, another former Prime Minister, Edith Cresson, was forced to resign as a European commissioner and played a major role in bringing down almost all her fellow commissioners. It was found that she had improperly employed her dentist - who, according to internal Commission records, lived at the same address - as a senior medical research adviser, despite an absence of qualifications and without using proper recruitment procedures. A Belgian judicial investigation into Cresson�s behaviour as commissioner is continuing, but a lawyer speaking on behalf of Cresson said that they expected no charges would follow.
Cresson had been appointed by former, and now discredited, President Francois Mitterand. Another of Mitterand�s senior ministers and close associates had been Roland Dumas, foreign minister and subsequently President of the Constitutional Council, one of France�s most important positions. Two years ago Dumas was acquitted on appeal - after initial conviction in 2001 - of mis-using the funds of the formerly state-owned Elf Aquitaine.
Co-defendants, also appointed by Mitterand to Elf�s board, were convicted. Former Elf President, Loik Le Floch-Prigent, was imprisoned for five years only last November for embezzling company funds, having previously been sentenced to three and a half years on similar charges. Fellow executive Andre Tarallo - in charge of Elf�s Africa operations - was jailed for five years, but was recently released on the grounds of ill health.
The court was told that there had been �a culture of bribery� at Elf, which involved paying hundreds of millions of dollars to senior officials and politicians to obtain access to markets and assets in emerging countries, particularly Africa. Other bribes were used to facilitate Elf�s purchase of a refinery in the former East Germany. It was also alleged that some funds from Elf went into France�s political parties.
Former interior minister Charles Pasqua was another politician connected with Elf, who was named in a judicial report on the Elf scandal as having used company planes for personal use. Pasqua faced no criminal charges and has denied recent unrelated allegations, made in the emerging independent Iraqi press, that he received gifts from Saddam Hussein in return for providing assistance to Iraq. Pasqua told French television: �Former Interior Minister Charles Pasqua is not involved, but maybe other former ministers are involved.�
Bizarrely, sections of the French press argue that the biggest political scandal of them all has been buried. Investigative judges have been unable to complete their criminal inquiry into allegations of the improper sale of frigates to Taiwan, which began in 1997. Neither the French nor Taiwanese Governments have
co-operated with the investigation, each claiming that to do so would damage national security.
It is alleged that state-owned Thomson-CSF paid commissions of 2.4bn euros (£1.6bn) to key Taiwanese Government officials, to assist with the procurement of frigates from France which failed to meet the Taiwanese navy�s specifications. Some of this money has been identified and recovered from Swiss bank accounts. As Thomson-CSF was named in court as providing bribes and gifts through Elf to some people also named as involved in the frigate deals, it is possible that the two scandals are connected. That, like many other things in French political life, we just do not know.
�Clear out the crooks�, says Commission
The European Commission has responded quickly to the collapse of Parmalat in extending its agenda of raising audit standards. Significantly, as well as considering enforced audit rotation and strengthening group audits, the Commission is examining the difficult question of how special purpose vehicles should be audited. SPVs are an obvious factor in the two most shocking recent corporate crashes - Enron and Parmalat.
The Commission has defined SPVs as �artificial structures that are created by companies to �hide� liabilities, which (in substance) they control, but which nominally are owned by different shareholders. Therefore, liabilities such as loans or debt could be omitted from a company�s balance sheet where they arguably should be included.� But there could be difficult discussions on how to provide a definition or means of working which will adequately address SPVs.
While the Commission has talked for a couple of years of improving audit practices in respect of SPVs, internal market commissioner, Frits Bolkestein, told the European Parliament that, in the wake of Parmalat, this had become a priority. Measures would include a requirement for �full disclosure in the company accounts of offshore special purpose vehicles, including why the company uses these offshore structures and much stricter verification by the group auditor of their content�.
Bolkestein used his speech to indicate that the Commission intends to take a much tougher line on auditors and corporations. Bolkestein also had strong words about the wider sector: �the financial services industry had better get its act together, and do so fast,� he said. �We need some real industry leadership to stand up and take charge: to clear out the crooks, expose their unscrupulous practices and curb excessive greed.�
The commissioner disclosed that, later this month, he will propose a revised Company Law Directive dealing with statutory audit. This will strengthen controls over the audit profession, introducing independent oversight, strengthened inspection, stronger ethical and educational principles, and higher quality audit standards. In the light of the Parmalat collapse, it is also likely to provide for full group auditor responsibility for consolidated accounts of a group of companies, obligatory independent audit committees for listed companies and stricter auditor rotation requirements, backed up by stronger sanctions. There is also to be consideration of the roles and conflicts of interest in the work of financial analysts and credit rating agencies.
There is an irony in Bolkestein�s comments, because by failing so far to approve the implementation of IAS 32 and 39 because of the row over the impact of fair value treatment of derivatives (see separate story, page 14), the Commission has also delayed putting in place a platform to tackle the reporting of SPVs. IAS 32 and 39 are drafted to deal with a range of
off-balance sheet assets and liabilities, including SPVs, not just derivatives and hedges.
Addressing SPVs through
new standards
Michael Bromwich, professor of accountancy at the London School of Economics, believes that the International Accounting Standards Board is correct in addressing SPVs through the new standards. �In the end it comes down to control and these standards [32 and 39] are control-based, so to that extent they are helpful,� he said.
But Bromwich lacks confidence that, in themselves, IAS 32 and 39 will resolve the problem of hidden SPVs. �Clearly the IAS has paid more attention to SPVs than the FASB has. I think 32 and 39 would help. But the problem is more that people hide these things and they will continue to do so. If you had people entirely willing to abide by standards the problem would go away, but that is not true with everyone.�
Bromwich suggests that more focus on after-the-event penalties for management and auditors guilty of wrongdoing is the factor most likely to address the problem of SPVs. �I don�t see how you can write a standard saying you must be honest,� he argued. However, greater risk awareness and attention to where the money comes from and goes to would do much to raise the quality of audit, said Bromwich. �The audit could be better, because these things have cash flow which are useful to the firms - or, in the case of Enron, the cash flow seemed to go the other way. I guess auditors will now pay much more attention to this.�
Commissioner Bolkestein also announced that the Commission intends to step up its level of
co-operation with regulators in other jurisdictions, including with the SEC and PCAOB in the United States. �Capital markets, today, are global. And regulatory co-operation must be global too to match them,� said Bolkestein.
Companies unprepared?
However, two recent reports suggest that many European companies with US operations are unprepared for incoming regulations that strengthen reporting requirements. A study from software company, HandySoft, found that European companies listed on US stock exchanges face a 35% increase in audit fees as a result of mandatory compliance with the Sarbanes Oxley Act. By the deadline for European companies of 2005, only three-quarters of affected companies are likely to have in place systems and procedures that provide the required internal financial controls and which can respond quickly to discovered anomalies. These are key requirements of the Sarbanes Oxley Act. The measures will bring average external audit costs for a US-listed European company up to 5.2m euros, an increase of some 1.35m euros over current average audit costs.
Wendy Cohen, director of sales at HandySoft, said: �Companies that choose not to meet the SOX [Sarbanes Oxley] schedule are likely to find the analysts and the credit rating experts marking their stocks down. Suffering this kind of ignominy during a tentative market recovery, and in a period when institutional shareholders are increasingly exercising their muscle and influence, is a CFO�s or CEO�s worst nightmare. This is especially the case for European companies whose home economies are only just showing the first faint signs of recovery.�
The findings of HandySoft�s research appeared to be confirmed by PricewaterhouseCoopers� latest Management Barometer, which concluded that boards of large European multi-nationals are behind US companies in improving corporate governance standards. While almost two-thirds of US boards had increased their focus on governance last year, this was true of only a third of European boards.
But there was an increased focus on improving the effectiveness of audit committees in both Europe and the US. Some 44% of European audit committees increased their time and effort over the past year, compared with 68% in the US, said PwC. -
Problems are growing for the two principal firms involved in auditing Parmalat. Deloitte & Touche�s wealth management advisory company has been fined £750,000 by the UK�s Financial Services Authority for poor administration. It was guilty of what the FSA called �serious compliance failings� relating to its conduct in selling pension and investment products. Gerry Paisley, managing partner responsible for regulation and risk management at Deloitte & Touche, responded: �We very much regret this matter, which arises from regulatory failures in our subsidiary Deloitte & Touche Wealth Management Ltd between 1997 and 2001. When the issue was identified, swift and decisive action was taken to shut down the business. It was subsequently restarted under entirely new management in 2002.�
Meanwhile, the SEC has initiated enforcement action against Grant Thornton�s US practice over allegedly assisting a mortgage broker in �violations of the anti-fraud and reporting provisions of the federal securities laws�. The charges relate to audit client MCA which is accused of making false statements to inflate its assets and income. The SEC says the firm�s auditors �knew that MCA failed to disclose several million dollars of material, related party transactions�. Stephen M Cutler, director of the SEC�s Division of Enforcement, said: �Grant Thornton.... �rented� out its name and prestige to the audit work of a smaller firm without taking adequate care to ensure that the audit was properly staffed and performed.� Grant Thornton in the US failed to respond to our request for a comment.
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