Neng Fan Sun
November 13, 2013
Q1. Were there any “warning sign” of fraud at Longtop from the IPO onward?
We found several warnings from the IPO onward.
1. On April 26, 2011, Andrew Left of Citron Research published a report to question the cash
amount of Longtop. This was a clear warning for the public. On May 4, 2011, a Morgan Stanley
analyst figured out the stock price of the company has been very volatile in recent days amid
fraud allegations that management has denied. It seemed that the management of the company
was trying to hide the true financial situation of the company. On May 17, 2011, the Big 4 audit
firms did not say why but expanded its procedures related to cash, the largest balance sheet
item. It seemed that the Big 4 started to look into the cash amount of the company. This should
be a warning sign to the external investors to think about their investment to Longtop. On May
17, 2011, Longtop announced the Big 4 was not its auditor. Longtop was trying to block the Big 4
to get the bank reconciliation from the bank. This was a deliberate interference to Big 4 to audit.
2. From the following exhibit, we can find that price to sale ratio is much lower than benchmark.
Profit margin percentage is substantially higher than benchmark. Sale growth index is
surprisingly higher than normal. From all these three abnormal financial ratio related to sale,
we have to doubt that some fake revenue exists and the potential risk of inflate revenue. From
the following exhibit, we find that debt to equity ratio is much lower than the benchmark after
2008. The warning sign is that Longtop underestimate or conceal the debt.
3. From the Dechow Fraud Model, we find that the F score is high than red flag critical value 1 from
2007 to 2010. It means that we should substantially doubt the financial report. Its stock will not
be attractive in the market as it showed or some fraud items exist.
4. More and more Chinese companies pursue to list in US stock market, which will improve their
reputation. It provides them the incentive to make the fraud financial report to make their name
big and qualify to list on US stock market. Currently China does not regulate Chinese companies
listing in the US and accounting firm in China do not need to hand in the audit work paper to US
SEC, making the Chinese company not to be strictly supervised by US SEC and to provide the
opportunity to fraud.
Dechow Fraud Model F Schore1.361.581.071.63Y
Red Flag each year?YYYY
price to book 4.7732.8043.5813.467N
price to earning83.333228.75025.23829.714N
price to sale 0.4070.2770.2000.185Y
price to OCF0.8750.5380.5050.495
return on asset 22.64%6.56%1.48%12.72%9.74%N
return on equity52.17%19.05%1.70%14.73%12.04%N
Asset turnover ratio
receivable turnover 1.9232.2632.5382.1632.522N
debt to equity1.3041.9050.1530.1580.237Y
debt to asset0.5660.6560.1330.1360.191
sale growth index1.7201.5351.6061.594Y
Q2. If so, how could such “warning signs” have led to additional audit work to uncover this fraud?
We think the auditors should focus on the cash and revenue more. And we figured out some
ways to audit cash and revenue. We still have to do additional audit work for the debt.
1. Audit cash efficiently. There are 3 concerns of this part: “how” to audit, “when” to audit
and “what extent” cash auditing procedures should be applied. We thought auditors should
read G/L carefully. Auditors should be aware of “if the right cash amount flow in/out the
To obtain the goal, there are several things the auditors should be noticed: (1) unusual
amounts or postings, (2) transactions or general journal entries greater than the lower limit
for individually significant items, (3) checks or disbursements to be used in support tests,
and (4) other unusual matters. Documentation of the procedure should include the
parameters of the test, the exceptions the test revealed and the resolution of the
exceptions in a spreadsheet, memo or other working paper (Larry Perry, 2012).
To avoid the risk of material misstatement of cash flow, we think auditors should (1)
investigate the beginning and ending balance of the accounts, (2) compare the accounts
balances between years and pay attention on the significant increases and decreases, (3) compare the current ratios of the current year with the historical data.
The auditors should also ask for the bank reconciliation of the company. Compare the bank reconciliation with the company G/L activities to check if they are match or not. Corruption the bank confirmation process is serious in China. To make the bank confirmation more reliable, the accounting firm can consider get the bank confirmation from the headquarter where seldom tell lies instead at the local branch level. Another step is to assist with the police to use some specific method and tools to know how much money the client really in the bank.
2. Pay more attention on auditing revenue. Revenue is important to the audit because it’s one
of the two major business processes. It is also the major account in which the auditors look for instances of financial misstatements. Because most financial statements under audit have to comply with generally accepted accounting principles (GAAP), auditing revenue is a two-part process:
; Sample and test the income statement revenue accounts: Revenue accounts on the
income statement reflect all income earned during the period, regardless if cash
; Sample and test the balance sheet account: accounts receivable: The client’s
accounts receivable account shows the amount of money that customers for goods
and services provided.
Revenue accounts, accounts receivable and sales are considered high risk accounts because there are many opportunities for misstatements. To simplify the audit, we look at the cycle approach, which refers to the aggregate of transactions and how they impact the financial statements. It's important for auditors to keep the cycle in mind because it helps them take the logical, sequential steps for tracing transactions. The numbers presented on the financial statements are assertions which the auditor must match with a transaction in the cycle. The integrated audit approach of revenue accounts includes a few basic steps such as evaluating risk of misstatement, performing analytical procedures, identifying and understanding controls, performing tests of controls and evaluating results, and performing substantive tests. Each step can be tailored to the specific account being audited. For example, accounts receivable should be examined for unusually large sales at year's end during the analytics stage, otherwise known as channel stuffing. Auditors must also be knowledgeable about schemes to inflate revenue such as false customer sales orders. Internal and external risk factors must be kept in mind as well if the auditor is to continue the engagement. Such examples include weak internal audits and industry trends, respectively.
Increased attention to the risk of improper revenue recognition will improve the chances of early detection or even preventing it in the first place. Ensuring an effective control
environment, linking employee goals to organizational goals, implementing and monitoring internal controls and effectively using analytical procedures are significant and effective steps a CPA can take to minimize the possibility of improper revenue recognition going undetected.
3. Audit completeness of the debt: There are three tasks auditors must perform when
; Review the board of directors meeting minutes: During your review, make sure that
any new loan agreements or bond issuances are authorized.
; Look at client agreements: Check out the loan documents to make sure they
reconcile with information in the minutes of the board meeting. Note the principal,
rate, and length for loans. Use this information to make sure the balance sheet
shows the correct outstanding balance for each loan.
; Examine cash transactions: Trace any large cash disbursements made by the client
or cash receipts hitting its bank statements to the appropriate source documents.
The company may be trying to artificially inflate sales by recording a loan as sales
revenue. The source document in this case would be the customer invoice. Follow it
through by checking the shipping documents to make sure the order was indeed
shipped to a customer.
4. The auditors should be independent and withdraw from the clients. In Chinese culture, we
should eat dinner with the clients to make the good relationship with the clients. The accountings firms are always want to build great relationship with their clients but the auditors should be independent in the auditing process. This is the most important thing for auditors. When they audit cash or revenue, they could not believe in any rumors from their “friends” who work for the companies. We should use brain when inquiring the clients.
When we find the fraud that the clients refuse to correct or disclose or the manager integrity is questionnaire, we should report it to the governance committee and withdraw from the clients.
5. Subsequent events or omitted procedure: the auditor should close looks the subsequent
event to decide whether we should make additional journey entry or disclose them in the notes. For the material omitted procedure, the auditor have make the analytical procedure claim the auditor report is not reliable.
6. Agreement between US SEC and Chinese regulation law should be made to supervise Chinese company in US and eliminate the Chinese company’s fraud opportunity in US.