Official resistance to performing due diligence on companies in China is growing and calls into question how effectively fraud at Chinese companies can be policed.
Is there a problem though? Are these companies more fraudulent than foreign peers? The Transparently.AI platform suggests that the relative extent of accounting manipulation in the Middle Kingdom is nuanced.
Nevertheless, it’s possible that manipulation is likely to increase if due diligence undertaken by foreign research groups is increasingly denied, making it vital to do quantitative checks on China from outside the country.
It’s possible that manipulation is likely to increase if due diligence undertaken by foreign research groups is increasingly denied.
Beijing’s attitude towards international consultancies and research groups tasked with performing due diligence within China is increasingly unreceptive. These groups are under intense scrutiny from the police and the Ministry of State Security, the frequency of raids is increasing; and some staff have been apprehended.
China due diligence
Recent changes to China’s anti-espionage laws drastically increase the scope of what might be considered illegal monitoring. Under China’s anti-espionage laws, it has always been impossible to perform due diligence on individuals. Under the revised laws, any investigative work will be risky. The scope and quality of due diligence work within China could suffer.
Worsening transparency will further dim perceptions of the quality of governance at Chinese firms, making it increasingly difficult for them to access international capital markets.
This situation is unfortunate for Chinese companies that have worked to improve governance standards. Many now demonstrate low account manipulation risk, according to our system.
This situation is unfortunate for Chinese companies that have worked to improve governance standards.
While China-domiciled companies do have a higher-than-average manipulation risk score than global peers, our platform suggests the situation is more nuanced than is widely perceived.
Take for example, China’s larger real estate firms, which we discussed last week. (We define ‘larger’ as being in the top four deciles globally by market capitalization.) We found that Chinese real estate firms of this size exhibit an average manipulation risk score of 28.8%, which is high internationally for firms of this size.
However, the score partly reflects the sector. Real estate is a sector prone to accounting fraud. Comparing the average risk score of China domiciled real estate companies with that of similarly sized real estate companies elsewhere, we find that the China risk is high but by no means exceptional.
Real estate companies in Luxembourg and Germany, for example, have a higher average risk score than Chinese companies. Hong Kong also has a higher score but many of these firms, though classed as having a Hong Kong domicile, are actually based in China.
China consumer cyclicals
Accounting manipulation risk varies among sectors and China’s relative position can change drastically depending on the sector and depending on the size of the company. Once again, a nuanced understanding is necessary.
In the consumer cyclicals sector, for instance, we find that China domiciled companies in the six largest market cap deciles have significantly lower manipulation risk scores than equivalently sized companies in the US or the rest of the world. In deciles seven to 10, however, the situation reverses.
This situation exists because in China this sector has a lot of large and medium sized state-owned enterprises, especially in the auto sector. These companies typically have heavy social obligations. Profit maximization is not the top priority of the managers of these companies, most of whom are political appointees. It is natural that the risk of account manipulation at these firms will be low because there is no incentive to manipulate.
Most of the remaining large and medium-sized private companies in the consumer cyclicals exhibit a high degree of management ownership.
These companies are highly visible to Beijing and are under pressure to share their profits either with the government or by investing in community projects. Managers in these firms are incentivised to understate their profits not to exaggerate them.
Once again, therefore, the risk of account manipulation is likely to be lower than average, at least in the ways that our system attempts to measure it.
To conclude, observers calling for caution over the less receptive environment in China to due diligence would do well to appreciate that a more nuanced understanding of the country’s corporate environment is necessary.
It is possible that if foreign consultants are unable to perform due diligence effectively, offshore investor appetite for newly listed Chinese firms in Hong Kong and elsewhere may evaporate.
For those firms that remain listed, investors will increasingly need to rely on quantitative checks performed on public data from outside the country. Transparently.ai is well positioned to help those requiring this service.