Expert answer:answer the case questions
Solved by verified expert:please answer the questions in the attached case.
teaching_case_study_prc_10_15_2017_2_.pdf
Unformatted Attachment Preview
It’s not a secret anymore! – PRC company and audit firm collide
ABSTRACT
This case can be used in both undergraduate and graduate accounting courses to measure
students’ learnings objectives related to ethics, globalization, written communications and
critical thinking. It also enables students to get a better understanding of the importance of
cultural differences and developments of auditing and accounting standards on the transparency
of financial reporting. Throughout the analysis of this case, students in accounting, auditing and
international accounting classes will gain the necessary critical thinking skills to better compete
in the global market.
INTRODUCTION
The Securities and Exchange Commission (SEC) had been investigating twenty-four People’s
Republic of China (PRC) companies for possible fraud. The SEC had made it very clear to the
five largest audit firms who audit those firms under investigation; provide access to the working
papers. The problem was that the audit firms were all in agreement, that by providing these
working papers to the SEC the audit firms would be in violation of Chinese “State Secrecy
Laws”. Now the time was up, as the SEC felt it had no choice but to file a lawsuit to require the
audit firms to comply with the SEC request. The SEC charged all five accounting firms with
violating securities laws, as each of these PRC companies are trading in the United States (US).
The SEC charged that the auditors are violating the securities rules by failing to turn over the
PRC work papers for inspection. Loxon Shanghai CPA Ltd (Loxon) is part of this lawsuit.
LOXON SHANGHAI CPA LTD.
Loxon Shanghai CPA Ltd. (Loxon) is among the PRC’s leading professional services firms and
provides audit, consulting, IPO support services, and financial advisory services to clients in the
People’s Republic of China (PRC). Within the PRC, these services are delivered to many clients
including multi-national enterprises and major Chinese business entities. Loxon is an affiliate of
a US audit firm, and from an overall perspective, the global company employs thousands of
1
professionals world-wide. Loxon employs over 100 employees, including staff accountants,
senior accountants, managers and senior managers, and partners, along with administrative staff.
Many of the staff and senior accountants have less than five years’ experience, which is common
among many CPA firms. The managers and partners usually have at least seven years’
experience. The audit partners oversee the engagements and ensure that the audit complies. One
of the managing partners is Mr. Harrison. He is the oversight partner one of the accounts
involved in the SEC lawsuit, Great Lead Software (GLS).
MR. HARRISON
Mr. Harrison has been a partner with Loxon for over eight years and has been the managing
partner for GLS for the last four years. Mr. Harrison had previously lived in Washington, D.C.
(D.C.), but relocated to the PRC to work at Loxon. Loxon had been having trouble retaining
employees at the partner level, and he was asked to transfer from the DC office to the Shanghai,
China office. He has a wife, XiXi, and one son, and he decided this move would be a great
experience for the entire family. Mr. Harrison manages over ten companies, but one of his
companies, GLS, was being investigated by the SEC for possible fraud violations. His firm had
decided to withhold GLS’s working papers, as the managing partners were concerned that doing
so would violate Chinese laws. While he had voted with the other managing partners, Mr.
Harrison was concerned that not complying with the SEC could cause the firm detrimental harm.
Mr. Harrison had other concerns of late with the most recent audit of GLS and scheduled a
meeting with GLS’s chairman, Mr. Lin.
GREAT LEAD SOFTWARE
GLS is a software company based in Shanghai, China. The company provides software solutions
for many types of industries, including banking, insurance, and manufacturing industries. While
GLS offers many types of software solutions for companies, the three most common offerings
are supply chain management, inventory management, and accounting solutions software. The
company had been very successful in terms of net income and growth since it began seven years
ago. Four years ago, GLS changed auditors and hired Loxon. The company also began trading
on the New York Stock Exchange (NYSE) in the US five years earlier with much success. Mr.
Lin is the company chairman, and has been with the company since its beginning. Mr. Lin is
2
aware of the audit issues that have arisen over the past few months, and agrees to meet with Mr.
Harrison to discuss.
This case is not the only example of PRC firms involved in fraudulent activities. It is, however,
one of the largest in terms of the magnitude of the dollar amount of the discrepancies. These
PRC audit firms, while affiliated with major international audit networks, have never been
inspected by the PCAOB in the US. The Sarbanes-Oxley Act (SOX) requires those inspections
for accounting firms that audit companies that securities trade in the US, but the PRC has refused
any inspections.
STOCK MARKET CHALLENGES
In the US, concern was growing regarding a number of PRC firms that began to trade on various
US stock exchanges by using an “express method” known as the reverse takeover (RTs).
Accordingly, the Public Company Accounting Oversight Board (PCAOB) had expressed
concerns about the motives behind RTs and the Securities and Exchange Commission (SEC)
launched an investigation of these deals several years ago. The SEC has since issued a 5-page
investor bulletin regarding reverse takeovers. This bulletin indicated that investors should
proceed with caution when considering whether to invest in reverse takeover companies. Greater
oversight and regulation is currently under consideration by the SEC and stock exchanges. In
particular, foreign firms (especially Chinese) using RTs to obtain exchange listings in the US are
considered a concern and as such the SEC had revised its rules regarding the length of time a
foreign firm must be traded on a less liquid exchange in the US. Often the RT management is
inexperienced and ill-equipped to manage the day-to-day operations and often the RTs run into
issues that cannot easily be resolved.
REVERSE TAKEOVER
RTs are unique corporate control transactions in which a privately held company acquires a
public company in order to obtain its public listing. Unlike initial public offerings, which require
substantial capital investment by an investment bank and a large amount of required disclosure,
RTs can be completed quickly and with little oversight, and therefore have been the source of
concern by regulators. The surviving company is usually the private company assuming the
public company entity. Shareholders of the private company purchase control of the public shell
3
company and then merge it with the private company, creating one remaining public company.
The publicly traded corporation is called a “shell” since all that exists of the original company is
its organizational structure.
CHINESE STATE SECRECY LAWS
The PRC has taken measures to emphasize the importance of protecting the confidentiality of
state and business secrets. They have issued a number of regulations over the years to clarify
what is included under the umbrella of state secrecy laws. These were amended again to
recognize the rapid development utilized in the transmission and storage of information.
Unfortunately, these laws prove difficult to interpret, and the scope of the regulations is at times
broad and not specific. This ambiguity is of concern to many companies who fear they may fall
into a violation category. In fact, many of the summaries that describe PRC state secrecy laws
seem to clarify they are not sharing any state secrets, and are not to be followed from a legal
perspective.
WHISPERS GROW LOUDER
In the past year, several investors in GLS were growing concerned over the high amount of cash
reported, and voicing those concerns to the Loxon audit firm. According to GLS’s most recent
audited balance sheet, cash accounted for more than half of the company’s total assets, and
investors were questioning why the amount was so high and whether it existed at all. Six weeks
ago, Loxon received some information that proved troubling. As. Mr. Harrison described, “They
were strongly suggested to re-confirm the bank reconciliations”. He continued, “It was not until
we sent a few of our auditors to several of the banks where accusations of cash fraud were first
made where several of the bank employees confirmed they had known of the reconciliation
misstatements.”
GLS had been trading on the US NYSE since going public five years ago. The initial public
offering (IPO) was a success in terms of the stock price, and with each subsequent year, the
company valuation had continued to grow. However, the cash amounts, as well as several of the
expense amounts, such as cost of goods sold, and other operating expenses seemed low. Those
same investors are also questioning some of the debt information in the most recent published
4
financial statements. The cash balance seemed to be the most scrutinized area, and Mr. Harrison
scheduled a meeting with Mr. Lin today to discuss the current state of the audit.
The two men had entered the conference room at the Loxon audit firm in Shanghai earlier today,
and the tension was already at a high level. Mr. Harrison was angry with the alleged information
he had to discuss, and Mr. Lin was hesitant to have this meeting, as he knew he was going to
share some troubling information. The men had been discussing, and at many times, arguing,
many key points for some time. The meeting had become difficult for both parties, but Mr.
Harrison had become increasingly troubled as the meeting proceeded. We pick up the
conversation at a pivotal moment:
Mr. Harrison: “I want to clarify what I just heard; could you please repeat what you said?”
Mr. Lin: “I will confirm, there was fake cash recorded on the books. There had also been fake
revenue on the books in the past.”
Mr. Harrison: “This is very serious. You are telling me that individuals in your company have
committed fraud, and yet you seem so calm about this. You are making general statements
without providing any details. Provide specifics.”
Mr. Lin sat there silently for a few minutes, so Mr. Harrison continued.
Mr. Harrison: “Who changed the cash amounts? Who provided the fraudulent revenue
amounts?”
Mr. Lin: “Senior Management.”
Mr. Harrison: “How long have you know about this? I need the names of everyone involved.
How far back does this fraud span?”
Mr. Lin: “Three years”.
Mr. Harrison: “I scheduled this meeting to discuss some of the issues we were encountering
during the audit, as well as discuss some of the rumors your investors have communicated to me.
I had some concerns, but had no idea these issues were at the level you are stating. Do you
realize what will have to happen next? Do you?”
5
Mr. Lin remained silent, with his head lowered, and slumped into his chair.
Mr. Harrison: “We need to conclude this meeting, and I expect you will not speak to anyone
outside of your upper management regarding this meeting, if you speak to anyone at all.”
The meeting ended abruptly as Mr. Lin quickly left the building without saying another word.
Mr. Harrison realized he needed to work on damage control.
That was the beginning of the end. There had been concerns voiced from investors from the
United States (US) for the past year, and now those concerns were being confirmed.
Note: Please see Appendix A for the Balance Sheet/Income Statements for review
LOXON RESIGNS
Audit firms will include a statement in their client contract that gives the audit firm permission to
withdraw from an engagement if certain situations arise, such as finding any material
discrepancies that cannot be resolved. Such was the case here, as it was a combination of the
bank reconciliation fraud, statements of fake revenue reporting, and various other concerns such
as overstated revenue as well as cash, and understated debt, which lead Loxon to make the
decision to resign as the audit firm. The letter sent shock waves through the accounting
community, as this letter was subsequently posted online in its entirety. According to Mr.
Harrison, all of the key parties at Loxon agreed that they had exhausted any hope of a positive
resolution. Following is the letter:
6
BY EMAIL AND REGISTERED MAIL
The Audit Committee
Great Lead Software
No. 155 Tangzue Road
Shanghai, Jiangsun Province
People’s Republic of China
Attention Mr. Song, Chairman of the Audit Committee
During auditing the Company’s financial statements for the most recent year, it was determined that,
regarding the bank confirmations, it was proper to complete additional visits to the main banks. These audit
steps reported some very grave issues including: substantial differences regarding deposit balances reported
by the bank compared with the amounts in the bank reconciliations, reports by the bank employees that their
bank had no record of some of the transactions; and significant borrowings reported by the bank employees
not recognized in the bank confirmations.
Further, it has come to our attention that the confirmation process was abruptly halted, as several troubling
incidents occurred. Calls to the banks from Great Lead Software (GLS) indicating that Loxon was not their
audit firm were made, confiscation by GLS staff of all second-round bank confirmation documentation,
intimidations to prevent the audit staff from leaving GLS premises unless GLS was able to keep the Loxon
audit files, and confiscation by GLS of Loxon working papers.
Regarding this development, we contend that you immediately return our documents.
We bring these substantial issues to your attention in the context of the audit responsibilities under Statement
on Auditing Standards AU-C 240 (formerly SAS No. 99) “Consideration of Fraud in a Financial Statement
Audit” issued by the American Institute of Certified Public Accountants.
The motives for our resignation include: 1) the intentional interference by the GLS management in our audit
process, 2) the illicit confiscation of our audit files, and 3) the recognized falsification of GLS financial
records related to cash, revenue, and loan balances. These recent issues weaken our capability to rely on the
representations of the GLS management which is a vital element of the audit process; hence our resignation.
We have also reached the decision that we are no longer able to place reliance on management
representations relative to prior period financial statements. Accordingly, we request that the Company take
prompt actions to make the necessary 8-K filing to state that continuing reliance should no longer be placed
on Loxon audit reports on the previous financial statements and we refuse to be associated with any of GLS’s
financial communications during the three most recent years.
We also agree to a copy of this letter being provided to the SEC and the subsequent auditor to be selected.
In our view, the events described in this letter could constitute illegal acts for purposes of Section 10A of the
Securities Exchange Act of 1934. Accordingly, we remind the Board of its obligations, including the notice
obligations to the US SEC. You may consider obtaining legal advice on this matter.
Sincerely,
Loxon Shanghai CPA Ltd.
cc: The Board of Directors
7
THE SEC QUICKLY REACTS
With all of the public scrutiny that followed the auditor resignation, the SEC was certain to
follow with some type of action. Loxon had reported many audit discrepancies. GLS had failed
to file an annual report for their most recent year. GLS had also failed to provide the investing
public with annual reports containing audited financial statements post their former audit firm
resigning. So, it should come as no surprise that the SEC made a decision. “It is ordered that,
pursuant to Section 12(j) of the Securities Exchange Act of 1934, the registration of each class of
registered securities of GLS is hereby REVOKED. GLS was no longer permitted to trade on the
NYSE effective immediately.”
That was the final day of trading on the NYSE for GLS. At the height of the company trading,
the company had been valued at over 2.4 billion US dollars. When trading ceased, the company
had a valuation of only 1 billion. Post security revocation, the stock is deemed “worthless”. Any
revenues and net income were most likely a small fraction of what was actually reported. The
fact that GLS had significant debt means that whatever assets are remaining will be owned by the
banks, and the investors will be left out of the distribution. This is a difficult result for many
investors to fully understand, given that GLS was originally underwritten by Goldman Sachs and
Deutsche Bank. Morgan Stanley was a lead manager in a subsequent offering of additional
shares of stock. Major owners of the stock included hedge funds run by firms highly respected
in the financial community. A month before the audit issues imploded, an analyst for Morgan
Stanley, Sarah Chang, reported that while fraud allegations have arisen, GLS management firmly
denies these allegations. “Our analysis of margins and cash flow gives us confidence in GLS
and the company’s accounting methods. We believe it provides a good entry point for long-term
investors.”
In reality, GLS management had already begun to panic. In order to ease public as well as
investor concerns, only four weeks prior to the resignation of Loxon, GLS announced they were
planning to repurchase their own shares, to the amount of over $50 million US dollars. When
weeks had passed, and the company had not yet repurchased any shares, the company CEO, Mr.
Kakawin, had to respond. He stated “that the company has some very good news that we have
not yet released, but we were advised by our securities counsel that we should not be in the
8
market purchasing our own shares as this may be considered insider trading.” That “good news”
was never shared with the public.
SEC LAWSUIT IMPLICATIONS
Since the SEC had filed the lawsuit, many companies were concerned that the fallout from the
lawsuit will be overwhelming. Auditors who do not allow inspections from the SEC could be
barred from advising any US listed companies. If the courts rule in favor of the SEC, all PRC
based auditors could be barred from auditing any company which has securities trading on any
US stock exchange. This could make it very difficult for any PRC company to find an SECcompliant auditor. With so much at stake, many in the accounting community are waiting to see
how the court will rule.
9
DISCUSSION QUESTIONS
1. What is (are) the most significant auditing issue (s) of this case study? Please support
your answer.
2. What types of fraud were committed by the management of GLS? Was GLS responsible
for identifying the fraud earlier? What internal controls should they have implemented to
possibly prevent the fraud from occurring?
3. Did Loxon fulfill its responsibility regarding fraud on the GLS engagement on the most
recent year? In prior years?
4. What are the most significant implication(s) of China’s State Secrecy Laws regarding the
audit procedures and audit liability? Why are the financial statements in China considered
as State-sensitive information while in the USA they are public information?
5. Do you think that Loxon was justified in their initial reluctance to provide the working
papers to the SEC? Was the SEC justified in their reaction? Please support your answers.
6. The SEC had also issued Section 10A of the SEC ACT of 1934, requiring auditors to report
to the SEC when, during the course of an audit, an auditor detects: 1) illegal acts which
have …
Purchase answer to see full
attachment
How it works
- Paste your instructions in the instructions box. You can also attach an instructions file
- Select the writer category, deadline, education level and review the instructions
- Make a payment for the order to be assignment to a writer
- Download the paper after the writer uploads it
Will the writer plagiarize my essay?
You will get a plagiarism-free paper and you can get an originality report upon request.
Is this service safe?
All the personal information is confidential and we have 100% safe payment methods. We also guarantee good grades