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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.

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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.

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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: Peoples Republic of China SAS: Statement on Accounting Standards SEC: Securities and Exchange Commission SOE: State-owned Enterprises SOX: Sarbanes-Oxley SPE: Special Purpose Entities

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CONTENTS

CONTENTS

Acknowledgement Abstract Abbreviations

Chapter 1

Introduction.............................................................................................1

1.1. Backgrounds and motivations.1 1.2. Aims and objectives2 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. Introduction4 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 risk11 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 audit17 2.2.6. Auditor independence..18 2.3. Fraudulent Accounting..20 2.3.1. Introduction..20
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CONTENTS 2.3.2. Concept of fraudulent accounting21 2.3.3. Causes of fraudulent accounting..24 2.3.4. Fraud techniques..26 2.3.4.1. Overstatement of revenues26 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 environment37

Chapter 5

Case Study39

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. Materiality43 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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CONTENTS 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 fraud62 5.3.7. Implications.63 5.3.7.1. Generalize Accounting Standards.....63 5.3.7.2. Auditor independence64 5.3.7.3. Rationality of investment..65 5.3.7.4. Corporate governance66 5.3.7.5. Lacking of comprehensive statue..67

Chapter 6

Conclusion.69

6.1. Problems69 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 accounting75 6.4.1. Tenure of audit firm..75 6.4.2. Non-audit services75 6.4.3. Supervision..76 6.4.4. Internal control77 6.5. Limitations78 Bibliography...79 Appendix86

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CHAPTER 1

CHAPTER 1 Introduction

1.1. Backgrounds and Motivations

Financial statements, as the mirror of a companys 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 organizations 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
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From 1994 to 2004, 117 out of about 1260 listed companies in China were exposed for fraudulent accounting by media (Han, 2005). -1-

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CHAPTER 1 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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CHAPTER 1 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

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 companys 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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CHAPTER 2 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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CHAPTER 2 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 Chinas 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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CHAPTER 2 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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CHAPTER 2 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 auditees 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.,
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In the early 1990s, General Motors suffered a lease fraud of over $10M by a Long Island dealer. -8-

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CHAPTER 2 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:

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.

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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CHAPTER 2 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 auditors 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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CHAPTER 2 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:

risk: the risk that the auditor may express a qualified opinion (say something is amiss) on financial statements that are not materially misstated; and

risk: the risk that the auditor may express an unqualified (clean) opinion on financial statements that are materially misstated (p. 57).

In practice, risk is very rare; therefore, the term audit risk is generally mean 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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CHAPTER 2 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:

the risk that the unaudited financial statements are materially misstated in one or more respects. (Inherent risk and internal control risk); and

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 error occurring (Non-Controllable Risk) Inherent risk

Risk of failing to detect material error (Controllable risk) Quality control risk Failure to collect sufficient appropriate audit evidence and/or evaluate it properly

Internal control Sampling risk risk Business Risk

Management Integrity

Account Risk

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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CHAPTER 2 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 clients strategy and business processes and a number of recent studies examine whether a business process focus affects auditors effectiveness when
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CHAPTER 2 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 clients 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 (ODonnell 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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CHAPTER 2 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 companyensuring 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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CHAPTER 2

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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CHAPTER 2 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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CHAPTER 2 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 entitys 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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CHAPTER 2 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 clients 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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CHAPTER 2 Comparing with the incentives of deliberate fraudulent financial reporting by management, ethical considerations relating to an auditors 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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CHAPTER 2 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 organizations 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 companys 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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CHAPTER 2 periods 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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CHAPTER 2

Accounting Choices Within GAAP Conservative Accounting Overly aggressive recognition of provisions or reserves Overvaluation of acquired in-process R&D in purchase acquisitions Overstatement of restructuring charges and asset write-offs

Neutral Earnings

Earnings that result from a neutral operation of the process

Aggressive Accounting

Understatement of the provision for bad debts Drawing down provisions or reserves in an overly aggressive manner. Violates GAAP Recording sales before they are realizable Recording fictitious sales Backdating sales invoices Overstating inventory by recording fictitious inventory

Fraudulent Accounting

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 auditors 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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CHAPTER 2 neither primarily nor specifically geared with regard to disclosing defalculations and irregularities. Thus, although an auditor may discover a fraud by chance, an auditors 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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CHAPTER 2 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 companys 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 Enrons 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 (Oconnor, 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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CHAPTER 2 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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CHAPTER 2 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 companys 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 companys cash flow position (Griffiths, 1987, p. 23). A careful analysis of the relationship between creditors and debtors can give an important indication of companys 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 companys 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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CHAPTER 2 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 companys 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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CHAPTER 2 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. Corporations 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

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 Yins, 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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CHAPTER 3 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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CHAPTER 3

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

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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CHAPTER 4

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 auditors 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 companys 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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CHAPTER 4 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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CHAPTER 4 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 buyers 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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CHAPTER 4 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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CHAPTER 4 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 Chinas auditing are unsatisfactory or poor, and more than half ranked the auditing industrys 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.

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CHAPTER 5

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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CHAPTER 5 5.2. Backgrounds of Guangxia Fabrication Case

Guangxia-Timeline of Events

Year 1992

Events 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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CHAPTER 5 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 Guangxias 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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CHAPTER 5

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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CHAPTER 5 227 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 companys 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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CHAPTER 5 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).

Actual investment (178 million YUAN) Other use (122 million YUAN)

Figure 4: Total reported investment (million YUAN)


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CHAPTER 5

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) Registered Actual

Guangxia(Yinchuan) 44.29% 30%

Guangxia(Tianjin) 35% -

Total 75.35 million 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 Guangxias 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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CHAPTER 5 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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CHAPTER 5 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 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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CHAPTER 5 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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CHAPTER 5 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 companys 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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CHAPTER 5 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:

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 Guangxias 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.

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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CHAPTER 5 diligent, they should have enquired the income source and relevant information (Fu, 2005), for example,

Firstly, enquire Fidelity Trading GmBH. Although it might not respond, it at least shows that auditors are of due care.

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. 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. 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.

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.

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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CHAPTER 5 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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CHAPTER 5 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 auditors 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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CHAPTER 5 tied with the companys. 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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CHAPTER 5 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
500 400 300 200 100 0 -100 -200
restated net profit/loss reported net profit

1999

2000

Figure 6: Reported net profit vs. Restated net profit/loss

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CHAPTER 5

Fiscal Year 1999 Reported Restated

EPS () 0.510 -0.20

Net margin (%) 13.56 -6.7

Operating sales (/million) 526.038 287.052

Total equity (/million) 2429.896 2218.959

Net equity per share () 3.73 2.96

Table 2: Key financial ratios and figures of 1999

Fiscal Year 2000 Reported Restated

EPS () 0.827 -0.30

Net margin (%) 34.56 -33.5

Operating sales (/million) 908.99 154.99

Total equity (/million) 3151.295 2401.586

Net equity per share () 2.39 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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CHAPTER 5 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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CHAPTER 5 YUAN
2.5 2 1.5 1 0.5 0 -0.5 EPS Net equity per share Reported Restated

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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CHAPTER 5

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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CHAPTER 5 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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CHAPTER 5 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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CHAPTER 5 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

Guangxias 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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CHAPTER 5 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 todays 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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CHAPTER 5

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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CHAPTER 5 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 companys basic performance when making investment decisions than on the names of the companys 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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CHAPTER 5

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 pocketsactions 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 governments 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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CHAPTER 5

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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CHAPTER 5 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

CHAPTER 6 Conclusion

6.1. Problems

In todays 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 organizations 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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CHAPTER 6 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

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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CHAPTER 6 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, Enrons share price drops by 75% in a day.

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.

Corporate governance. Both Guangxia and Enrons 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 Guangxias board of directors is controlled by a minority of directors and insiders, most importantly, Guangxia has no audit committee until the fabrication is exposed.

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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CHAPTER 6 and may mislead external users.

6.2.2. Differences

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.

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.

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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CHAPTER 6 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
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An investigation carried out by National Audit Office of the Peoples Republic of China in 2002 on 16 randomly selected audit firms shows that 14 of them have serious profession problems. - 73 -

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CHAPTER 6 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 (OConnor, 2002).

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CHAPTER 6 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 Peoples 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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CHAPTER 6 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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CHAPTER 6

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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CHAPTER 6

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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Bibliography ODonnell, E., J. L. Bierstaker, and J. Schultz. (2005), Strategic-systems auditing: The influence of laternative task structures on auditor sensitivity to risk factors. Working paper, Arizona State University. OECD (Organization for Economic Cooperation and Development) (1999), OECD Principles of Corporate Governance (OECD, Paris). Pi, J. N. (2006), Analysis of the relationship between supervisory board and audit committee. Technology and Economics, 11. pp. 37-38. Porter, B., J. Simon, and D. Hatherly, (2003), Principle of External Auditing. 2nd edition. John Wiley & Sons, Ltd. England. Reider, R. (2007), Financial Audits: Taking an Operational View. The Journal of Corporate Accounting & Finance. May/June, pp. 19-25. Robarts, A. (1978), What the Auditor Needs to Know about Fraud? Journal of Accountancy. December.pp. 46. Sen, P. K. and E. L. Inanga, (2003), Creative Accounting in Bangladesh and Global Persepectives. Working Paper. Scott, D. R. (1941), The basis of accounting principles. The Accounting Review. Shibano, T. (1990), Assessing Audit Risk from Errors and Irregularities. Journal of Accounting Research, 28 (September), pp. 110-147.

Shi, S., Weisert, D. (2002), Corporate governance with Chinese characteristics, The Chinese Business Review, 29 (5), pp.40-44. Singleton, T. W., A. Singleton, (2007), Why dont we detect more fraud? The Journal of Corportate Accounting & Finance. May/June. pp. 7-10. Smith, R. (1992), Audit and research, British Medical Journal, 305, No. 6859, pp. 905-906. Smith, T. (2002), Accounting for Growth: Stripping the camouflage from company accounts. 2nd edition. Random House Business Books. Song, Y. X. and R. Yang, (2003), Research American Corporate Governance from Enron Crisis. Wuhan University Journal (Social Sciences). 56(1), pp. 82-86. Sun, Z., Z. H. Huang, L. H. Xu, (2005), Some Revelations of Sarbanes-Oxley Act to
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Bibliography Our CPAs. Market Modernization. 11.pp. 17-18. Tackett, J., F. Wolf, G. Claypool, (2004), Sarbanes-Oxley and Audit Failure: A critical examination. Managerial Auditing Journal. 19(3), pp. 340-350. Tellis, W. (1997), Application of a Case Study Methodology, The Qualitative Report, 3(3), September. Troy, M. (2002), Truth in disclosure catches up with creative accounting. DSN Retail Today. 41(10).pp. 21-25. Vinten, G. (2003), Enormities-Dispelling the Disease. Managerial Auditing Journal. 18 (6). pp. 448-455. Wan, F. and J. Tian, (2003), On Supervison and Control over the Junket Companies in China: Takeing Yinguangxia Event as an Example. Journal of Southwest University of Science and Technology. 20(2), pp. 31-35. Wang, Q. G. (2006), Research on the True and Fair View and Its Inspiration for China. Business Economics and Administration. 174(4), pp. 60-63. Wang, J. S. (2004), Commission and Delegation in Corporate Governance and Internal Control. Journal of ShanXi Finance and Economics University. 26(3). pp. 77-79. Wang, J., M. Liu,. (2004), Analysis of Chinese listed companies in current auditing environment. Auditing and Finance. (9). pp. 34-35. Woolf, E. (1997), Auditing Today. 6th edition. Prentice Hall. UK. Xu, G. P. (2003), Charm of Justice. The Journal of Contemporary Law. (1). pp. 17-21. Yin, R. K. (1984), Case study research: Design and methods. Newbury Park, CA: Sage. Zhang, R. (2001), After the exposure of Guangxia case. The Journal of Policy and Management. (9). pp.31-35. Zhang, T. (2006), The Futures of Guangxia. The Journal of Chinese Enterprise Accounting of Villages and Towns, (3), pp. 27-28. Zhang, W. X., (2005), An analysis of unreliability of financial statements of listed companies, Market Modernization, November, No. 450, pp. 236-237.
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Bibliography Zhang, Y. (2003), A Comparative Study of Chinese and American CPAs Skullduggery and the Corresponding Supervision System. Journal of Sichuan University(social science edition). 4. pp. 30-35. Zhou, Y. D., (2003), An assumption of auditor tenure system. Accounting Monthly, A5, pp.48-49. Zhou, S. M. and X. Liu, (2006), The analysis of Chinese auditing market. Northern Economy, 2, pp. 52.

Websites Guo, H. C. and Y. Ma, (2004), High audit fee charged by Big 4 dominates Chinese audit market. http://finance.sina.com.cn/b/20041031/14091121345.shtml (Last accessed: 08/09/07) He, J. S. and Z. S. Han., (2002), Updated news of Guangxia Case, Sinafinance, http://finance.sina.com.cn/t/20020526/212378.html (Last accessed: 08/09/07) Oconnor, S. M. (2002), The inevitability of Enron and the impossibility of auditor independence under the current audit system. Pittsburgh School of Law. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=303181 (Last accessed: 28/09/07) Pfefferle III, B. L. (2004), The Sarbanes-Oxley Act: Implications for Environmental Management BAKER & HOSTETLER LLP, www.bakerlaw.com (Last accessed: 27/08/07) Soy, S. K. (1997), The Case Study as a Research Method. Certified Archivist. http://www.gslis.utexas.edu/~ssoy/usesusers/l391d1b.htm (Last accessed: 08/09/07) Wikipedia, Accounting Scandals, http://en.wikipedia.org/wiki/Accounting_scandals (Last accessed: 06/09/07)

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Appendix

Appendix

Correction of Annual Reports of Guangxia (Yinchuan) Industry Co., Ltd. 1. 2. 3. Annual Report of 1999 Annual Report of 2000 Chapter 2 of Annual Report of 2001

The Latest 3-Year Accounting and Financial Figures Items Restated


Operating Revenues Net Profit Assets Shareholders Equity (excluding Minority Interest) Earnings Per Share(Diluted) Earnings Per Share(weighted) EPS(excluding Non-recurring Profit and Loss) Net Asset Value per Share NAV per share (adjusted) Cash flow per share from Operating activities Return On Net Assets -838,724,923.99 -0.78 -0.78 -0.39 -1.66 -2.14 0.27 -47.01 -340,353,948.53 -0.27 -0.27 0.04 -0.67 -1.28 0.25 -39.9 145,209,011.90 -394,441,413.39 1,390,560,083.26

2001 (YUAN) Pre-restated


130,261,227.08 -135,823,810.33 1,429,597,831.23

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Appendix

Items
Operating Revenues Net Profit Assets Shareholders Equity (excluding Minority Interest) Earnings Per Share(Diluted) Earnings Per Share(weighted) EPS(excluding Non-recurring Profit and Loss) Net Asset Value per Share NAV per share (adjusted) Cash flow per share from Operating activities Return On Net Assets

2000
154,988,746.19 -149,401,045.14 2,401,586,437.83

1999
287,024,660.01 -50,031,926.03 2,218,958,802.98

445,901,823.33 -0.30 -0.30 -0.30 0.88 0.64 -0.23 -33.5

746,881,282.46 -0.20 -0.22 -0.17 2.96 2.65 -0.02 -6.7

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Appendix

Balance Sheet
Current Assets Cash and cash equivalents Investments - Short term Accounts receivable Dividends receivable Interests receivable Net Receivables Prepayment Allowance receivable Inventories Prepaid expenses Long term equity investment due within one year Other current assets Total current assets Long term investment Long term investment on equity Long term investment on credit Total long term investment Provision for long-term investment Net long term investment
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1999-12-31 315,294,402.44

1998-12-31 24,633,236.64

339,172,464.96 160,674,222.52 2,600,000.00 441,040,627.45 2,976,440.92

408,963,481.93 63,449,913.40

472,323,174.60 1,656,023.74

1,261,758,158.29

971,025,830.31

98,659,143.03 6,540.40 98,660,183.43 22,839,011.21 75,821,172.22

101,165,072.16 6,540.40 101,171,612.56 22,839,011.21 78,332,601.35

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Appendix
Variance of investment Fixed assets Fixed assets-cost Accumulated depreciation Fixed assets-net value Provision for fixed assets Project goods and material Construction in progress Disposal of fixed assets Total fixed assets Intangible assets and other assets Intangible assets Long term deferred and prepaid expenses Other long term assets Total Intangible assets and other assets Deferred taxes Deferred taxes debit Total assets Liabilities and owner's equity Current liabilities Short term loans
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20,196,000.00

20,808,000.00

678,528,636.48 102,823,014.25 575,705,622.23

255,506,824.41 62,031,612.13 193,475,212.28

247,985.41 238,184,818.20 980,966.70 815,119,392.54 386,517,919.80 193,042,707.52

31,654,829.46

21,136,379.78

34,605,250.47

32,331,120.55

66,260,079.93

53,467,500.33

2,218,958,802.98

1,489,343,851.79

410,282,931.23

410,007,178.60

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Appendix
Notes payable Accounts payable Accounts advanced from customers Accrued wages Accrued welfares Dividends payable Tax payable Other fund in conformity with paying Other payables Withholding expenses Foreseeable liabilities Long term liabilities due within one year Other current liabilities Total current liabilities Long-term liabilities Long-term loans Dividends payable Payables due after one year Government grants payable Other long term liabilities Total long term liabilities Deferred taxes
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1,321,800.00 60,877,011.76 35,145,452.84 759,182.10 5,953,905.52

400,000.00 89,536,935.47 41,989,754.52 1,290,236.60 4,678,346.82

35,971,777.53 828,043.77 147,609,798.54 7,588,125.56

29,782,926.72 377,798.51 79,187,985.94 14,176,271.80

74,814,882.50

58,777,526.76

781,152,911.35

730,204,961.74

403,975,686.00 116,941,080.67 1,382,502.12

53,166,666.70 66,917,712.00 1,028,622.15

522,299,268.79

121,113,000.85

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Appendix
Deferred tax credits Total liabilities Minority interest Shareholders Equity Share capital Capital reserve Surplus reserves Public welfare fund Undistributed profit Total shareholders equity Total liabilities and shareholders equity -49,033,587.51 746,881,282.46 26,555,658.70 495,014,641.87 252,630,690.00 220,203,297.00 1,303,452,180.14 168,625,340.38 851,317,962.59 143,011,247.33

467,329,282.63 197,858,109.01 75,954,897.34 50,397,577.16

2,218,958,802.98 1,489,343,851.79

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Appendix

Profit & Loss Account

Items
Operating Revenues LessSales discounts and allowances Net sales Operating costs Tax and associate charge Operating income Add: Income from other operations Less: Selling & Distribution expense Corporate administration expense Financial expense Operating income Investment income Subsidy income Non-operating income LessNon-operating expense Income before tax LessIncome tax Minority interest income Net income
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1999
287,052,068.55 27,408.54 287,024,660.01 226,874,637.72 14,071,122.03 46,078,900.26 771,107.54 23,728,125.74 42,997,446.79 41,550,225.59 -61,425,790.32 -430,920.70 2,600,000.00 7,564,119.69 932,083.29 -52,624,674.62 2,409,208.99 -5,001,957.58 -50,031,926.03

1998
549,644,594.58 17,091,586.17 532,553,008.41 310,897,451.16 22,044,407.52 199,611,149.73 845,480.56 20,611,879.65 39,376,514.06 13,592,079.54 126,876,157.04 -18,896,246.64 5,673,619.04 2,261,458.58 919,476.71 114,995,511.31 10,357,863.52 63,926,110.64 40,711,537.15

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Appendix
Add: retained profit Other transfer-in Profit available for distribution(-means loss) Less: Appropriation of statutory surplus reserves Appropriation of statutory welfare fund Profit available for shareholders' distribution 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 26,555,658.70 -23,476,267.33 12,778,660.09 12,778,660.09 -49,033,587.51 -49,033,587.51 3,675,013.39 44,386,550.54 8,915,445.92 8,915,445.92 26,555,658.70 26,555,658.70

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Appendix

Balance Sheet
Current assets Cash and cash equivalents Investments - Short term Accounts receivable Dividends receivable Interests receivable Net Receivables Prepayment Allowance receivable Inventories Prepaid expenses Long term equity investment due within one year Other current assets Total current assets Long term investment Long term investment on equity Long term investment on credit Total long term investment Provision for long-term investment Net long term investment
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2000-12-31 326,093,467.69

1999-12-31 315,294,402.44

407,028,382.79 198,004,949.85 2,600,000.00 399,121,753.08 1,537,929.40

339,172,464.96 160,674,222.52

441,040,627.45 2,976,440.92

1,331,786,482.81

1,261,758,158.29

151,334,734.04 1,040.40 151,334,734.04 20,576,471.97 130,758,262.07

98,659,143.03

98,660,183.43 22,839,011.21 75,821,172.22

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Appendix
Variance of investment Fixed assets Fixed assets-cost Accumulated depreciation Fixed assets-net value Provision for fixed assets Project goods and material Construction in progress Disposal of fixed assets Total fixed assets Intangible assets and other assets Intangible assets Long term deferred and prepaid expenses Other long term asset Total Intangible assets and other assets Deferred taxes Deferred taxes debit Total assets Current liabilities Short term loans Notes payable
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19,584,000.00

20,196,000.00

577,686,571.39 77,512,028.08 500,174,543.31

678,528,636.48 102,823,014.25 575,705,622.23

181,448.68 358,166,758.87 980,966.70 858,522,750.86

247,985.41 238,184,818.20

815,119,392.54

42,378,169.96

31,654,829.46

38,140,772.13

34,605,250.47

80,518,942.09

66,260,079.93

2,401,586,437.83

2,218,958,802.98

931,888,925.12 9,784,000.00

410,282,931.23 1,321,800.00

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Appendix
Accounts payable Accounts advanced from customers Accrued wages Accrued welfares Dividends payable Tax payable Other fund in conformity with paying Other payables Withholding expenses Foreseeable liabilities Long term liabilities due within one year Other current liabilities Total current liabilities Long-term liabilities Long-term liabilities Dividends payable Payables due after one year Payables due after one year Other long term liabilities Total long term liabilities Total long term liabilities
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89,985,85806 97,411,847.41 566,386.48 4,376,755.25 151,578,414.00 31,575,843.83

60,877,011.76 35,145,452.84 759,182.10 5,953,905.52

35,971,777.53

154,677.36 83,459,756.77 12,618,304.72

828,043.77 147,609,798.54 7,588,125.56

75,330,000.00 675,464.24 ,489,406,233.24

74,814,882.50

781,152,911.35

247,572,686.00 91,315,439.34 1,382,502.12

403,975,686.00 116,941,080.67

338,888,125.34

522,299,268.79

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Appendix
Deferred tax credits Total liabilities Minority interest Shareholders Equity Share capital Capital reserve Surplus reserves welfare fund Undistributed profit Total shareholders equit Total liabilities and shareholders equity 2,401,586,437.83 2,218,958,802.98 -433,542,332.86 445,901,823.33 -49,033,587.51 746,881,282.46 505,261,380.00 214,698,592.63 159,484,183.56 252,630,690.00 467,329,282.63 75,954,897.34 1,828,294,358.58 127,390,255.92 1,303,452,180.14 168,625,340.38

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Appendix

Profit & Loss Account

Items
Operating Revenues LessSales discounts and allowances Net sales Operating costs Tax and associate charge Operating income Add: Income from other operations Less: Provision for Inventory Selling & Distribution expense Corporate administration expense Financial expense Operating income Investment income Subsidy income Non-operating income LessNon-operating expense Income before tax LessIncome tax Minority interest income
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2000
154,988,746.19

1999
287,052,068.55 27,408.54

154,988,746.19 124,521,861.80 5,081,091.94 25,385,792.45 -121,896.71 7,094,359.78 6,223,139.34 74,175,402.36 59,957,774.82 -122,186,780.56 -27,205,229.74 3,569,500.00 879,755.35 449,098.81 -145,391,853.76 7,389,721.67 -3,380,530.29

287,024,660.01 226,874,637.72 14,071,122.03 46,078,900.26 771,107.54

23,728,125.74 42,997,446.79 41,550,225.59 -61,425,790.32 -430,920.70 2,600,000.00 7,564,119.69 932,083.29 -52,624,674.62 2,409,208.99 -5,001,957

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Appendix
Net income Add: retained profit Other transfer-in Profit available for distribution (-means loss) Less: Appropriation of statutory surplus reserve Appropriation of statutory welfare fund Profit available for shareholders' distribution 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 -433,542,332.86 -49,033,587.51 151,578,414.00 -198,434,632.64 41,764,643.11 41,764,643.11 -281,963,918.86 -23,476,267.33 12,778,660.09 12,778,660.09 -49,033,587.51 -149,401,045.14 -49,033,587.50 -50,031,926.03 26,555,658.70

99

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