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Longtop 1113

By Audrey White,2014-11-18 18:27
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Longtop

    Case

    Xiaohan Cui

    Jiayi Li

    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.

    20062007200820092010Red Flag?

    Dechow Fraud Model F Schore1.361.581.071.63Y

    Red Flag each year?YYYY

    Valuation ratio

    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

    profitability ratio

    profit margin88.00%83.72%60.61%66.04%62.72%Y

    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

    liquidity ratio

    current ratio1.3793.3447.2426.3644.920N

    debt ratio

    debt to equity1.3041.9050.1530.1580.237Y

    debt to asset0.5660.6560.1330.1360.191

    other

    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

    right G/L”.

    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

    changes hands.

    ; 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

    examining debt:

    ; 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.

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