Security Deletions on the OTC Bulletin Board

There has been enormous confusion last week, surrounding the deletion of more than 1000 microcap stocks, including many Chinese ones, from the OTC Bulletin Board. The daily list of changes for the OTCBB gives a reason for those deletions: "Failure to comply with Rule 15c2-11." Subsequently financial websites as Google Finance or Yahoo Finance will no longer list those securities as "OTC quoted", instead they will change the market segment to "Pink Sheets" or just "PINK" (example: Weikang Bio-Technology, WKBT, Yahoo Finance, Google Finance). Additionally, Yahoo Finance and most brokers will no longer use the ending ".OB" for those stocks, but replace this indicator with ".PK" for the Pink Sheets or "Other OTC".

What seems to be a negative development, a demotion for those stocks, is actually just a change of the quotation platform. There is absolutely no reason to worry for investors, those companies are still U.S. registered and fully reporting with the U.S. Securities and Exchange Commission (SEC). Price declines over the past week, following the deletion from the OTC Bulletin Board, are not justified, as the change was not caused by any action or inaction of the company, nor did the company fall short of its reporting requirements.

Here is a little bit more about the background. The OTC Bulletin Board was owned and operated by the Financial Industry Regulatory Authority, or FINRA, the Wall Street regulatory authority. In late 2009, FINRA decided to part with it to focus on its core business, and in September 2010 the U.S. investment bank Rodman & Renshaw agreed to buy the trademark and website in a deal that is expected to close this quarter. Rodman said it plans to expand its "quality services and products offered to the financial community," and wants to diversify its revenue base.

But long before that sale, a competing platform, OTC Markets Group, had emerged as the dominant player for OTC securities. At the end of 2010, about 94% of all market maker quotes were published on OTC Markets Group's platform vs. just 6% on the FINRA Bulletin Board. Most brokers have migrated from the telephone-based OTCBB quotation system to the electronic OTC Markets platform since 2008, but for the time being almost all OTC securities were dually quoted on both platforms. That is changing now.

A deletion notice on the OTC Bulletin Board website simply means that the stock has completely migrated to the OTC Markets platform and is no longer quoted on the OTCBB. However, OTC Markets is not recognized by most financial websites and brokers as "OTC", which led to the current "Pink Sheets" confusion. OTC Markets Group is a privately owned company that has its origins with the National Quotation Bureau (NQB). In June 2000, NQB changed its name to Pink Sheets LLC and introduced a financial information portal for unlisted securities under www.pinksheets.com. In April 2008, Pink Sheets LLC announced that it changed its name to Pink OTC Markets Inc., and finally this year, on January 18, they got rid of the "pink" completely to become OTC Markets Group Inc. The website has been renamed to www.otcmarkets.com since, and free real-time quotes are offered for all fully reporting securities on that site.

OTC Markets organizes OTC securities into three tiers, where OTCQB, their middle tier stands for "OTC-traded companies that are reporting with the U.S. Securities and Exchange Commission (SEC) or a U.S. banking or insurance regulator." A .CSV file of all stocks quoted on OTC Markets' platform is available online. Those tiers, also OTCQX and OTC Pink, are not recognized (yet) by most quotation websites and brokers, which makes it difficult for investors to identify an unlisted but fully reporting stock through a third party provider. Very few companies have informed investors about the platform change the way China Tel Group did.

Trading China has set up a list of all Chinese OTC Securities (as of February 25, 2011) and their current quotation platforms: Chinese OTC Securities

China Watchlist for the Next 4 Weeks

Lihua International (LIWA) is currently trading at $10.82, down 3.74% for the year and down 17.09% from its November 11 high at $13.05. The Trading China Tracker Score is 9 (Buy).

LIWA is currently trading at about 6x earnings for 2011 on a fully diluted basis. The company has a $15 million share repurchase program in place, a Top 10 auditor with a strong China team (Crowe Horwath), and additionally Deloitte has been contracted to do an internal control implementation and review. The stock has come under pressure from short sellers last year, and management responded with posting their Chinese SAIC filings on its website. Rodman & Renshaw confirmed the authenticity of those filings for both subsidiaries - Lihua Electron and Lihua Copper - and concluded that there are no inconsistencies between Lihua's SEC and SAIC filings. Rodman has a $20 target on the stock, and Global Hunter calls it "the single best pick in the US-listed China space."

We are waiting for the 10-K filing in early March, and possible FY 2011 guidance which we expect to come in around $1.85 earnings per share. LIWA's short interest is among the highest in the sector, having reached over 27% of the float by the end of January. We wouldn't be surprised to see another attempt to attack the stock before the annual report is filed, which we would use to start building a position.

ChinaCast Education (CAST) is currently trading at $7.02, down 9.54% for the year and down 12.15% from its November 9 high at $7.99. The Trading China Tracker Score is 5 (Hold).

ChinaCast is in the post-secondary education (universities) and e-learning business in China. Nothing much happened to CAST's stock price in the last two years. The stock closed in the $7-8 range both 2009 and 2010 and is now still trading at this level. But the company looks rock-solid and I wouldn't be surprised to see the stock finally breaking out to the low double digits this year.

We asked the company for a comment on the ongoing credibility crisis in the US-listed China sector:

Trading China: Can you reassure investors that your company is not a possible target for the SEC investigation?

ChinaCast: When ChinaCast was originally formed and did a Series A investment with Intel Capital and Hughes back in 2000, our US investors mandated that we use a Big 4 auditor (in this case, Deloitte Touche-DT) from day one and we've been using DT now for over 10 years. We actually went public via a traditional IPO on the Singapore Stock Exchange back in May 2004, which believe me is a much more vetted process than the reverse merger and in some cases IPO process to get listed on US exchanges. While we did do a reverse merger to move our listing from Singapore to the US, it was through a public tender offer process that was highly scrutinized by the Singapore Stock exchange regulators, the SEC, Deloitte, as well as the shareholders of both companies.

We are now a Delaware listed company (fully audited 10K reporting) and have been Sarbanes-Oxley 404 compliant for the past 3 years. I'm not sure how many other PRC companies listed in the USA file fully audited form 10K, have a Big 4 firm as their auditor for the past 10 years and are SOX 404 compliant but probably less than 10%. Our management team have a long, successful history of working in global multinational companies and have run other publicly listed companies and we have a very experienced, shareholder friendly board of directors.

In addition, the senior management team and board have purchased approximately $9.5M worth of common stock during the past year. We believe that is a clear differentiator and if any regulatory body were evaluating targets we believe this would send a clear message on where management stands in its conviction of the business and the numbers. With that being said, we also strongly welcome the opportunity to host investors and analysts to our corporate facilities, network operations centers and universities in China to meet our executives and to conduct due diligence at our facilities. (Michael J. Santos, President-International, ChinaCast Education Corporation)

We are adding CAST to the Trading China Model Portfolio today.

Watchlist for the Next Four Weeks:




Model Portfolio Changes:

Lotus Pharmaceuticals (LTUS.OB) is currently trading at $1.84, down 28.96% for the year and down 38.26% from its November 10 high at $2.98. The Trading China Tracker Score is 14 (Strong Buy).

We are closing our position here for a loss of 1.08% or $52. The ongoing discussion about the expensive land purchase in Inner Mongolia will likely hang over the stock until the land is actually sold. We believe LTUS will continue to trade on depressed multiples for the coming months.

Trina Solar (TSL) is currently trading at $29.41, up 25.57% for the year and down 7.78% from its October 14 high at $31.89. The Trading China Tracker Score is 8 (Buy).

Trina Solar is set to report earnings this Tuesday. While we expect another beat and raise quarter, we also believe that the focus will shift to H2/2011 where solar bears will argue big oversupply pressure will be looming. Most solar stocks had a stellar year so far and a pullback is likely, especially after market leader First Solar (FSLR) will report on Thursday. First Solar's stock is massively overvalued compared to its Chinese peers and an expected sharp drop after the Thursday report won't leave the Chinese names unaffected. We are closing our position for a gain of 24.04% or $1,197.00.

JinkoSolar (JKS) is currently trading at $29.67, up 47.46% for the year and down 28.94% from its November 4 high at $41.75. The Trading China Tracker Score is 11 (Buy).

The second solar stock we are selling today is Jinko Solar, a relatively new player in the sector with a less established customer base and higher vulnerability to rising raw materials prices. JKS had a great run, but for reasons explained in the TSL paragraph, we feel it's prudent to take profits here. We are closing the position for a gain of 25.18% or $1,253.00.

Prepare Yourself for the 10-K Season

We are at this point in time again! The sector of U.S.-listed China stocks has reached new lows, the sentiment couldn't be worse, most longs have been scared away, sitting on the sidelines, and shorts are looking for new trading ideas on a daily basis. The sector has been demonized by a group of self-proclaimed "research firms" nobody has ever heard of before 2010, including Muddy Waters LLC, J Capital or LM Research. And influential financial media like Barron's, TheStreet.com or CNBC are joining the fun by covering the China sector with an almost exclusively negative bias.

This development doesn't come as a surprise, though. As I wrote back in November (Preparing for the RINO Fallout), the downfall of RINO International (RINO) set a precedent of Chinese fraud on the NASDAQ and would likely be exploited to the utmost degree. You can bet your house on the fact that every serious short seller group on the planet spent the month of December digging holes into other Chinese companies' business models and financial statements, and from January on the frequency of new short attacks has increased accordingly. Some of the assaults were pretty laughable (YONG, CAST), while others raise valid points and can not just be shrugged off by investors (CAGC, CEU).

To be clear, there are many companies in the China space that should never have become public. Most have massive transparency issues, many are not entirely truthful about their businesses, and some are outright fraudulent, including several names the market has probably not uncovered yet. There is no doubt that we will see more Chinese stocks following RINO to the pink sheets, go dark entirely, or have to face regulatory pressure incl. SEC investigations, auditor and management resignations, major restatements and lawsuits. Cautious investors who don't have the time or means to dig through those companies' histories, financials and business models, should probably avoid the sector for the time being.

We should appreciate the short sellers' efforts as they help clearing up the space, help to distinguish the quality stocks from those that share similar traits with RINO. Of course this is not their intention - the only thing they want is making money, and we have seen many allegations that were completely unfounded or even based on seemingly manufactured documents - but the outcome will nevertheless be a better environment for investing in U.S.-listed China stocks, as most companies have to go out of their way to prove they are legit, credible and transparent.

Now we are at this point again where the whole group is in an over-correction. Liquidity has dried up, demand is at record lows, fear and uncertainty at record highs. The last time we reached these levels was back in September 2010 when the focus was on stocks like Orient Paper (ONP) and China-Biotics (CHBT). Back then I concluded that "the months-long sell-off in U.S.-listed China stocks has created unreasonable or even ridiculous valuations for many highly profitable high-growth companies, and the market will recognize it as soon as the sentiment changes and big money comes back" (Don't Be Afraid).

Trading China established a Model Portfolio on that day (September 24, 2010), and this portfolio is up 32.18% since, in less than five months. Don't believe anyone who is trying to tell you that there is no money to be made for longs in China stocks, you have the proof right there. Naturally in this environment, not all our positions were winners - we have been wrong at times in the past and we will be wrong with some of our picks in the future. But we surpassed our goal of beating the general U.S. markets with a balanced China portfolio of fundamentally solid picks and speculative growth ideas by a wide margin.

Annual Reports

Should we put our money to work now? Yes and no! Yes only if you have done the kind of extensive diligence that makes you feel comfortable enough in the business model and management, corporate governance and underlying fundamental models and growth prospects of your pick. This is not the time to proceed with a valuation-only approach, it is all about if you can believe the numbers or not. If you haven't done your work then you probably shouldn't invest now, instead use the time to prepare yourself for the upcoming 10-K season. Most China stocks have a regular fiscal year so they are scheduled to file their 10-K's by the end of March. Those annual reports will be audited, and you will see if the auditor signs off on the 2010 numbers, where until now you have only the company's word for how its business was doing.

Here lies both a major risk and an opportunity. Many Chinese companies have announced auditor upgrades late in 2010, mostly to the Big Four, in an attempt to increase transparency and strengthen credibility after the year of turmoil in the space. Those new auditors haven't done much work yet, and their reputation is on the line with the ongoing fraud discussion, a fact I believe those firms are very well aware of. That leads to the assumption that top auditors will run many additional procedures for the full-year audit and won't sign the report quickly. This should be true not only for the Big Four, but also for BDO, Baker Tilly or Crowe Horwath.

The major risk lies in a delayed annual report. Any company that files for an extension without giving a clear time frame will likely see its stock getting destroyed, as the automatic assumption will be that the auditor found severe problems that made it impossible to finish the audit on time. We just have to look back at FUQI or DYP to see the results of a non-filing for investors. Should we get many of those delays we will likely see even more pressure across the entire group of U.S.-listed China stocks.

But if the 10-K is filed on time next month, the 2010 audit completed, the interim quarterly results confirmed, and if no restatements are necessary, then we investors can in fact benefit from the increased pressure on the auditors. A tier one firm that signs off on the numbers of a small cap China stock, in the midst of this "China Fraud" hurricane, is vouching for the accuracy of those financials with their good name. And reputation means everything in this business!

Prepare yourself for the annual reports! If you are using a value-oriented approach to investing, check and double-check the value you see in your company. Don't just go for EPS projections and the like, try to prove that the business model works, use more sources than just your company's filings. Then try to get comfortable with the numbers you find. Do reported profits and margins, projected growth and earnings make sense to you? How do they compare to the industry average, to peers listed on domestic exchanges? What about capital resources, recent financings, does the management seem competent to you? Have there been past issues that are not yet fully resolved?

The bar has to be elevated for China stocks, and if you find several names that you are comfortable with then my approach would be to start building a position in those stocks over the next four weeks on significant dips or general weakness in the sector. But don't use up all your powder as the near term catalyst will be the filing of the annual reports. High-quality, low-valuation stocks that got the green light from their tier one auditor should see significant price appreciation this spring. This is where the big opportunity lies now.

We will make several changes to the China Model Portfolio this weekend.

RedChip - Tomorrow's Blue Chips Turned Pink

RedChip Companies is an investor relations firm that has become very popular with small cap Chinese stocks. The majority of the 31 clients that are currently listed on RedChip's website are Chinese, among them several names that are listed on a national exchange - such as AMCF, BEST, CDM, CELM, CHNG, CIL, CWS, DHRM, KGJI, LLEN, LPH, NIV, RCON, and ZSTN - but also many OTC-quoted stocks as BFAR, CBLY, CECX, CHCC, CHNC, CMDI, LTUS, SGAS, WEMU, and WKBT.

RedChip began in 1992 as a small-cap research firm, and praises itself as having discovered Starbucks (SBUX) and Nike (NKE) back in the days before they became 'blue chips', accordingly the firm's slogan is "Discovering Tomorrow's Blue Chips Today"! Its website contains enthusiastic testimonials by several past and present clients, and also impressive looking performance charts. And those very charts prompted this research article.

Longwei Petroleum (LPH) is an oil storage operator in Shanxi province that is currently trading at $2.49 or a measly P/E-ratio of under 4. RedChip's performance chart reveals that their campaign for the stock began in December 2008 when it was trading at $0.20 and the stock is "up 1875%" at $3.95, the all-time high reached on November 8, 2010. Funny enough their campaign started exactly at LPH's all-time low, the stock has never traded below 20 cents, I call that perfect timing. RedChip's performance chart ends in November 2010, so it doesn't show the 37% drop in the last three months.

Another example of misleading performance charts is the one for Kingold Jewelry (KGJI). According to this chart, RedChip started their campaign at a price of $8.00 and notes "up 49%" for performance as the stock reached a high of $11.95 shortly after. The KGJI chart presented ends in December 2010 when the stock was trading just below $7.00, however with RedChip's logic the performance is still "up". KGJI - still a client of the firm today - is currently trading at $2.84, significantly below the $8.00 start price.

I began to get really interested in RedChips track record, but I couldn't find a list of their past clients on their web presence. But anything that has ever been published on the internet can still be found with a little effort. So let's have a look at yesterday's "blue chips for tomorrow", and how they passed the test of time.

Tomorrow's Blue Chips as of August 22, 2008: (Reference Link)



Out of RedChip's 32 clients from August 2008, 10 (31%) have now been demoted to the pink sheets. 5 stocks (16%) are trading significantly higher now with ZAGG being RedChip's biggest success. I haven't checked how much of the 10-fold rise can be attributed to RedChip's work, depends on for how long ZAGG was a client, but let's not nitpick here as anyone who purchased the stock during RedChip's reign has a big winner now. However, those are the exception from the rule. 24 out of 32 stocks (75%) are now trading significantly lower, and more than 40% (13 stocks) have lost more than 90% of their value - 15 stocks (47%) are trading at a share price below 10 cents, 10 stocks (31%) at or below a penny.

Tomorrow's Blue Chips as of August 20, 2007: (Reference Link)



The performance for RedChip's 2007 clients could hardly be worse. Yes, there is one stock - China Kangtai Cactus (CKGT) - that is not red, but it's up only a measly 8.5% in the past 3 1/2 years. Everything else is blood red, 55% of RedChip's clients (12/22 stocks) have lost 90% of more of their value, 50% have been demoted to the pink sheets, 10 stocks are trading below 10 cents, and 6 stocks (27%) under a penny.

Tomorrow's Blue Chips as of August 31, 2006: (Reference Link)



And for 2006 the returns don't look any better: 19 out of 20 stocks are red, and a whopping 80% have lost more than 90% of their value. You find 65% of those wannabe-Blue Chips (13 stocks) on the pinks today, 60% are trading below a penny or have since de-registered their shares for a total loss.

I must confess that I would have never expected such a disastrous picture. Had I thrown some darts on all the available ticker symbols, I am sure I'd found a group of stocks that would have outperformed RedChip's past clients by a wide margin. To be fair, most of those names have probably suffered their steepest losses after the investor relations campaign has ended, but that is not the point here. A company that hires an investor relations firm wants to get their story out to the world, to retail investors, brokers, hedge funds and institutions. In the end the performance of its business will determine the performance of its shares. If there is no story worth telling then a credible IR firm should probably not take the account in the first place.

Now that we have seen what happened to all those "blue chips for tomorrow" of the past, I am getting a tad concerned about the names on RedChip's list of current clients. Is it reasonable to assume that the company has learned from past mistakes and screens potential new clients for quality before they take on the account? Time will tell, I guess.

It would be interesting to compare RedChip's performance to its competition from other investor relations firms. Maybe someone wants to take over that task, I am seeing red already from all those -90% results.

Yongye International (YONG) - Truly Good

In a ridiculous attempt to damage Yongye's reputation, blogger Ian Bezek - whose bio says he works in distressed real estate - published an article on Seeking Alpha, where he claims that the company's fertilizer "probably doesn't work." His primary argument for why YONG shouldn't be trusted was the large number of Yongye-branded stores: "How on earth could you open 20,000 stores, more than 40 each day, with only 399 workers? Are you familiar with any other companies that can grow so rapidly without hiring more workers?"

What the author fails to realize - or maybe leaves out intentionally to support his short thesis - is that Yongye neither opens and owns, nor staffs those stores. All 20,000 stores are independently owned, Yongye does not have any employees working in those stores, instead they are Yongye-branded with shelving, window signs and displays to support the sale of Shengmingsu, the fertilizer product. YONG responded to Bezek's article in a press release, and explains that "all of our branded stores are existing agriculture stores in rural villages. As such, no stores need to be "opened." These are existing stores recruited to join our distribution network. In addition to selling Yongye's products, these stores also carry other agriculture products such as seeds, pesticides, and fertilizers. The store recruiting work is primarily driven by thousands of staff from our various levels of distributors."

Now everyone who has ever looked into YONG's business model could have spotted all the mistakes in Ian Bezek's piece instantly. That includes Seeking Alpha editors, who have confirmed the article for publishing and distribution. Could it be that China bashing articles generate the most page views these days? The only authority Ian Bezek got came from getting published on Seeking Alpha, and the editors there should be aware of their potentially market moving influence, and check submissions for basic mistakes that are very easy to spot.

YONG is down 6% for the week. We are in an environment where momentum traders hit any China stock the very moment a negative article is published. Most of them don't even know the company's name, nor do they have any idea about its business model. I can't blame them, this strategy was very profitable in the past, and they get served by short sellers with a new "hit piece" almost on a daily basis. However, when the effect of Bezek's article faded, YONG got hit by a downgrade from Brean Murray. The firm removed their price target, and downgraded the Chinese fertilizer sector to HOLD, citing "severe cold weather and serious droughts" that have hit China since late 2010.

Brean Murray concluded that while they are "impressed by Yongye's fast top-line growth and success in improving operating cash flow," they believe "it's difficult for a fertilizer company to be immune to natural disasters and doubt YONG's ability to maintain a triple-digit revenue growth rate in the face of tough weather conditions." But Brean Murray is alone with this view. Yongye issued a statement saying that their fertilizer is actually helping crops survive Northern China's current drought conditions, and one important benefit of the product is to help plants counteract the effects of water deprivation.

The company announced that Shengmingsu was purchased by some county level governments in northern provinces including Hebei, Shanxi, Shandong and Xinjiang to assist local farmers in combating the conditions. Yongye said "in recent months we have continued to see strong demand from our distributors, who are actively promoting our products as an effective nutrient product for local farmers to counteract the drought."

Yongye's peer China Green (CGA) lists the benefits of this group of coal-based liquid fertilizers as "to stimulate growth, yield, and protect plants from drought, disease and temperature damage while improving soil structure and enhancing soil fertility.

Safety/Risk Model - Internal Controls

(Back to Introduction)

Internal Controls

(accounts for 5% of the final score)

Internal Control over Financial Reporting (100/100)

The Sarbanes-Oxley Act (SOX 404) requires management and the external auditor to report on the adequacy of the company's internal control over financial reporting. Management is required to add an "internal control report" to each annual report with the SEC, which must "contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting." (U.S. Code, Title 15, §7262)

In this report, management will give details on identified control deficiencies, and if any or all of those constitute material weaknesses, as defined in the standards established by the PCAOB, it will conclude that internal controls are not effective. The cost of complying with Sarbanes-Oxley 404 impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment. To address this issue, the SEC granted an extension for the outside auditor assessment, currently (with the latest extension of October 2, 2009) until fiscal years ending after June 15, 2010. This temporary rule permits most U.S.-listed Chinese companies to provide only a management report, and the auditor is not required to express an opinion on the effectiveness of the Company's internal control over financial reporting. The PCAOB filed a 62-page document about audits of internal controls, with special guidance for auditors of smaller public companies. It's an interesting read.

• 100/100 - Effective
• 0/100 - Not Effective

Safety/Risk Model - PCAOB Inspection

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

PCAOB Inspection (5/100)

The Public Company Accounting Oversight Board (PCAOB) inspects all registered public accounting firms that regularly issue audit reports for companies and other issuers. In general, they are inspected at least once every three years. Inspection reports are available on the PCAOB Website with the date of the always latest inspection. You will not find reports for CPA firms based in mainland China or Hong Kong, as Chinese regulations block the PCAOB from doing inspections there. Here is a list of all Chinese audit firms that are currently registered with the PCAOB.

Mainland China: AGN China Regal, Alliott, Shanghai J&J, Anthony Kam & Associates, APEX, Baker Tilly China, BDO China Guangdong Shu Lun Pan, BDO China Li Xin Da Hua, BDO China Zhonglian Mindu Shu Lun Pan, Beijing Anshun International, Beijing Ever Trust, Beijing Huaweixin, Beijing Senheguang, Beijing Topson, Beijing Yongtuo, Beijing ZhongXingYu, Beijing ZhongXuanYu, Crowe Horwath China, Deloitte Touche Tohmatsu, Ernst & Young Da Hua, Ernst & Young Hua Ming, Fortune, Gansu Hongxin, Grant Thornton, Grant Thornton Beijing, Guangzhou Good Faith, Guangzhou Zhongxincheng, Henny Wee & Co., Hua-Ander, JTC Fair Song, Kabani International (Consulting) , KPMG, KPMG Huazhen, LehmanBrown Lu Hua, Lvr Financial Consulting, Moores Rowland, Nanjing Shu Lun Pan Yonghua, PricewaterhouseCoopers Zhong Tian, Reanda, RSM China, Shandong Haoxin, Shanghai Linfang, Shanghai Mazars, Shanghai Perfect, Shanghai RISMO, Shanghai Zhonghua, Shenzhen Chengxin, Shenzhen Kung Ming, ShineWing, Shu Lun Pan, Vocation International, Wuhan Zhonghuan, Zhejiang Pan-China, Zhong Cai, Zhonglei

Hong Kong: AGCA, Albert Wong & Co., Anderson Li & Ho, Andrew Ma DFK, Aoba, Arthur Li, Yau & Lee, Baker Tilly Hong Kong, BDO Limited, CCIF, Chan And Chan, Clement C.W. Chan & Co., Cosmos, Crowe Horwath (HK), CWCC Co., Deloitte Touche Tohmatsu, Dominic K. F. Chan & Co., East Asia Sentinel, Ecovis David Yeung, Edward Lau & Co., Ernst & Young, Gary Cheng & Co., Grant Thornton, HLB Hodgson Impey Cheng, Ho And Ho & Co., Ho, Sneddon, Chow, Hong Kong Great Wall, Hopkins, Horace Ho & co., James Ngai & Partners, K.P. Cheng & Co., KL, KLC Kennic Lui & Co., Lau & Au Yeung, Lee, Au & Co., Lo And Kwong, Louis Lai & Luk, Mazars, Moore Stephens, Morison Heng, Morrison, NHL, Parker Randall CF H.K., PKF, PricewaterhouseCoopers, RIW, RSM Nelson Wheeler, ShineWing (HK), Tai Kong, Tom Chan & Co., UHY Vocation HK, Wong Brothers & Co., Wong Lam Leung & Kwok, World Link, Y. H. Lai & Co., Yeung, Chan & Associates, Zhong Yi (Hong Kong), ZYCPA

• 5/5 - PCAOB Inspected
• 0/5 - PCAOB Inspected (Quality Control Criticisms NOT addressed)
• 0/5 - Not PCAOB Inspected

Safety/Risk Model - History of Auditors

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

History of Auditors (30/100)

Auditor changes are very common in the group of small cap Chinese companies, and it's not necessarily a bad thing if an audit committee finds such a change desirable. As a rule of thumb for the general U.S. markets (statistics from 2007), about two thirds of auditor changes were initiated by the companies (dismissing their previous auditors), while in the remaining cases the auditor resigned.

Companies may dismiss their auditors for reasons that are welcomed by investors, such as enhancing overall audit quality, looking for a new auditor that spends more time with the client, or engaging a new auditor with best-of-class reputation in the market to enhance credibility and strengthen investor confidence. But they might also dismiss their auditors just for getting cheaper audits, or even for avoiding all those unpleasant questions and demands their current accounting firm might force upon the company for signing off on the financials. If auditors disagree with management on key areas of accounting, companies might shop around for an audit firm that agrees with their viewpoints. There are many examples for all those reasons in the China small caps space.

Auditor resignations are similarly ambivalent. We will likely see more small firms, especially U.S.-based firms with no permanent presence in China, to resign from Chinese accounts, in order to avoid the now stricter compliance requirements of the PCAOB. Some small firms might decide to generally withdraw from auditing public companies. There might also be personal reasons, disagreement on the fees, or any other company-specific reason that is not necessarily indicative of any wrong-doings in the audited company. However, auditors that resign are more likely to have reasons that should concern investors. The CPA firm might just decide that this client is no longer worth the risk, there might be restatements looming or the company lacks sufficient internal controls over financing reporting and inadequate professional staff. A worst-case scenario would be that the auditor simply no longer trusts management.

Investors are usually left in the dark when it comes to the real reasons for auditor dismissals and resignations. Confidentiality rules prevent the CPA firms to go public with their findings, and the companies will do everything they can to present auditor changes in a positive light. That makes adding auditor continuity to our safety/risk model a tricky task, and investors are encouraged to dig into the details of frequent auditor changes with Chinese companies. We give the highest weight to a stable, long-term relationship between a company and their auditor, and to companies that have initiated an auditor upgrade when they reached a certain level of maturity as a public company.

• 30/30 - No Changes (Last 2 Years)
• 25/30 - One Change (Upgrade, Last 2 Years)
• 10/30 - One Change (No Upgrade, Last 2 Years)
• 0/30 - Two or More Changes (Last 2 Years)