Following the financial crisis that began a decade ago, many private companies — and notably many China-based companies — pursued reverse mergers to gain access to U.S. capital markets more quickly and cheaply than they could via a traditional IPO.

Melanie Chen

Unfortunately, these companies weren’t subject to the same degree of scrutiny as typical IPOs are, because of the far lighter financial-reporting regulations in China.

Some of the reverse-merger companies may have looked like ideal acquisition targets or business partners, but it was generally impossible to determine a correct valuation based on the available information. Several of the companies have since been outed as frauds, including AgFeed, Oriental Paper, and Rino International.

While these reverse-merger frauds have been discovered in the decade since the financial crisis, their deceptive practices and fraudulent activities bear striking resemblance to prominent domestic examples from the early 2000s such as Enron and Worldcom. Essentially, many of these frauds were perpetrated by flouting basic accounting and auditing principles.

To be sure, the risks inherent in dealing with such companies are still present today, and they particularly apply to any company looking at acquiring, merging with, or investing in another company. For finance executives playing critical roles in such potential deals, it is imperative to closely scrutinize information about a target’s assets, liabilities, revenues, and profits to ensure they do not rely upon false valuations.

There are several items that finance executives should consider red flags when conducting due diligence. These warning signs are particularly relevant when dealing with companies governed under foreign jurisdictions with less stringent reporting requirements, but they should also be considered for domestic acquisitions.

Unusual high volume or complex related-party transactions: In 2012, the Securities Exchange and Commission charged the CEO of China Natural Gas with concealing a $9.9 million loan issued through a sham borrower to a real estate firm, which was owned by his son and nephew. The CEO was also charged with hiding a $4.4 million loan to a company that was controlled by his friend as the general manager.

Unexplained large increase in inventory: A large unexplained increase in inventory may be caused by insufficient inventory obsolescence reserve or fictitious inventory-in-transit. Another cause is product returns, with revenue not properly reduced or product-return reserve not properly estimated. This scenario may give financial-statement readers a false impression of revenue.

Unusual variance in gross margin: Observing the gross margin within the company’s industry is an effective way to spot an unusually high gross margin. In 2014 the SEC charged that Agfeed, an animal feed company, inflated the weights of hogs it sold because fatter hogs bring higher market prices. The company was charged with falsely reporting $239 million in revenue by creating fake invoices for the sale of feed and purported sales of hogs that did not exist.

Significant sales volume near the ends of quarters or year-end: Large revenue may be recognized near period ends in order to meet a certain revenue target; then that revenue may be reversed and product returned in the next few months.

Management bonuses related to year-end profit: Management override of control is always a fraud risk when executives can increase their compensation by artificially boosting profitability.

Large volume of transactions not supported by signed contracts: Verbal contracts could be evidence of transactions’ existence but are not as durable as a written record. Well-managed companies with effective internal control always have comprehensive documentation of vendor/customer lists, budgets, purchase/sale orders, contracts, receiving/shipping documents, etc.

Old uncollected receivables: Aged accounts receivables may be an indicator of improper revenue recognition. During the IPO or fundraising stage, fictitious customers can be created and higher revenues recognized. Accounts receivable thus may be left uncollected and end up being written off in the following years.

Recent high turnover of senior executives: Pay attention to changes within the management team. Consecutive resignations of executive officers and audit committee members are often a red flag. If a company frequently changes its auditor, it could be a sign of fraud.

Unusual amount of professional fees: Professional fees normally include audit, accounting, legal, and advisory fees. If such fees increased significantly in a short time span, especially legal fees, it may be an indicator that the company was involved in litigations and potentially has to pay large settlements.

Unusually high customer concentration: Customers representing more than 10% of total revenue or accounts receivable should be disclosed. A limited number of fraudulent customers may be created and maintained to manipulate revenue and conceal fraudulent activities.

Any of the aforementioned scams can go undetected for years. Results can include disastrous losses for investors and companies, the enactment of new regulations or legislation, and even prison sentences for those involved.

The good news is that in many cases fraudulent practices are not the result of complex strategies. Instead, they share common and seemingly noticeable elements of basic accounting irregularities and false documentation. Executives therefore should usually be able to identify identify a fraudulent company before formalizing any sort of business transaction or relationship.

Melanie Chen leads the China Group at UHY Advisors. She directs cross-border tax planning and business consulting services for companies doing business between the United States and mainland China, Hong Kong, and Taiwan.

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