China Evergrande was founded in 1996 and went public in 2009 on the Hong Kong Stock Exchange,
raising a billion dollars in the IPO. In 2012 Citron Research published a report accusing
Evergrande of using accounting shenanigans to mask their insolvency, pay bribes to build a land bank
and overstate their asset values. Citron claimed that Evergrande had made several
reckless investments, and that they were using Ponzi style financing,
where new investments were being used to pay out returns to old investors.
The Hong Kong regulators held a Market Misconduct Tribunal and found Citron
Research – not China Evergrande culpable of market misconduct. The Tribunal stated that
Citron had used sensationalist language, made false and misleading allegations that
were likely to alarm ordinary investors and that the report was reckless and negligent.
In 2016, Hong Kong-based accounting research firm GMT Research published a report called
"CHINA EVERGRANDE: Auditors Asleep" which raised concerns that Evergrande's financial statements
did not present a true and fair view of its financial position and performance.
GMT visited 40 Evergrande development sites and concluded that 23 billion dollars of asset
write downs were needed — which came to around three times shareholders’ equity at the time.
GMT claimed that Evergrande had allowed failed projects such as abandoned hotels to build up on
its balance sheet for years without appropriate write downs. They took issue with how Evergrande
classified the car parking spaces and commercial properties in its residential developments
in its accounts. GMT said that Evergrande had “persuaded” PwC to accept the classification
of these as investment properties, rather than as inventory of assets to be sold.
GMT concluded that Evergrande’s financial statements were not presenting “a true and fair
view” of its financial position and performance. They questioned why Evergrande's auditor – Price
Waterhouse Cooper - had allowed this to happen. “Are its auditors asleep?” GMT wrote. “The company
is insolvent by our reckoning and its equity is worth nothing.” – that was five years ago…
A year ago, in September 2020 GMT wrote a follow up report highlighting Evergrande's vast unsold
assets that generated little or no return and were mostly funded by expensive debt. They argued that
these were weighing down its balance sheet, which continued to grow, largely financed by
expensive new debt. All of these reports can be found on the websites of Citron research and GMT.
It might thus surprise you that in Evergrandes most recent annual report, published this spring,
it got a clean bill of health from its auditor - PricewaterhouseCoopers.
PWC did not include a going concern warning, in fact they wrote that they “conclude on the
appropriateness of the directors’ use of the going concern basis of accounting based on the audit
evidence obtained. Basically, they signed off on Evergrandes accounting methods and on the firm’s
ability to stay afloat for at least 12 months. Now as we all know, just a few months later,
Evergrande is on the edge of financial collapse and Beijing is reported to be
telling local officials to prepare for its potential downfall. If Evergrande was listed
on a US or European exchange, we would be hearing outraged demands from regulators and politicians
to examine the work of their auditors. Only in its most recent accounts - for the
first half of this year, did Evergrande express concerns about the company’s ability to continue
as a going concern. This was the first time the company publicly acknowledged its serious
financial problems – and this acknowledgment is in an unaudited financial statement.
Just to be clear this type of problem is not just an issue in China. We have seen numerous companies
collapse with no warning from the auditor. The Public Company Accounting Oversight Board,
which oversees audits of U.S.-listed companies, said the fact a company goes under
before a going-concern warning is issued doesn’t necessarily mean the auditor was at fault.
"The auditor is not responsible for predicting future conditions or events," according to the
PCAOB website. They state that that the absence of a going-concern warning "should not be viewed
as providing assurance as to an entity’s ability to continue as a going concern."
Nonetheless it is surprising that firms like Citron and GMT were able to spot these issues many
years ago and the auditor who will have received significantly more access than these research
firms did, missed all of the red flags. PWC earned over forty million dollars in
fees auditing China Evergrande since 2009 and signed off on the figures presented to them by
management for all of those years. It is difficult to imagine that the auditors will not have known
about the negative research reports, which were all over the news at the time. PwC is likely to
face criticism over the level of push back they gave to management over accounting policies that
could have shown warning signs about the company’s financial health many years before the collapse.
Around the world, auditors have faced criticism when companies have collapsed,
and auditor negligence cases have become more common in recent years. In the UK The Financial
Reporting Council has begun a probe into the accountancy firms that audited Greensill Capital
and Wyelands Bank, a bank controlled by Sangeev Gupta which lent money to his other firms and
is central to the Greensill scandal. NMC Health, Luckin Coffee and Wirecard
are three recent financial scandals and one factor that they have in common, is that EY,
through its affiliates in various countries, was the auditor for all three.
A British high court ordered EY to pay a large settlement to a former partner in Dubai last year,
for retaliating against him for blowing the whistle on
an alleged money-laundering scheme by a client.
These cases have dealt a series of heavy blows to EY’s credibility and integrity,
even though EY has said it was unaware of longtime financial shenanigans by its clients
and was duped along with everyone else. I’m not sure how that looks a whole lot better…
In Asia, the audit firms have so far avoided this type of public humiliation
but their reputations are getting tarnished. China’s Ministry of Finance announced recently
that it intends to improve the quality of company audits by enforcing “strict law
enforcement and strict supervision” Under U.S. accounting standards,
the decision on whether a going-concern warning is needed is made initially by the company’s
management. The auditor then makes a separate assessment and can decide to issue a warning,
even if the management disagrees. A going-concern warning doesn’t have to be
issued by the auditor unless it is probable that the company will be unable to meet its debts as
they come due over the next 12 months. Even then, a warning can be avoided if the management can
show the auditor that they have a plan that will adequately deal with the potential cash crisis.
It is hard to look at this situation and think that PWC did not entirely drop the ball. One of
the problems with situations like this is that the auditor, is supposed to protect investors,
but they are incentivized to continue charging their audit fees and get on with company
management rather than call out wrongdoing. They possibly viewed it as prestigious to
audit Evergrande - one of the largest firms in China, and might have worried about losing other
clients if they were seen by the market as being difficult to deal with. Let me know your thoughts
in the comments section below. See you later, bye.