New China Accounting Scandal Flies Under the Radar. And Where There’s Smoke …

By Doug Young

A highflying Chinese Starbucks imitator called Luckin (LKNCY.US) made global headlines around this time two years ago, tumbling from grace after admitting to massively cooking its books. Now a much lower-profile but similar scandal is brewing at a Chinese cloud services company called Cloopen (RAAS.US), which is saying as much as 10% of its sales in last year’s second quarter and up to 20% in the third quarter may have been faked by rogue employees.

All this comes as the U.S. and China are hammering out an agreement that would give the U.S. securities regulator access it has long sought to the audit records of U.S.-listed Chinese companies. China has previously banned such access, but seems to realize giving it to the U.S. is ultimately in everyone’s interest by forcing Chinese companies to be more honest about their business.

That raises the interesting question of whether we may see more of these scandals emerge as a bilateral information-sharing deal draws closer.

The answer could quite possibly be “yes.” In the case of Luckin and now Cloopen, external pressures were the catalyst that ultimately uncovered the accounting fraud, rather than any internal checks. In Luckin’s case the company launched an internal investigation after an anonymous report alleged the faked sales. The company ultimately admitted to faking around $300 million in sales in 2019, equal to roughly 40% of its sales for that year.

In Cloopen’s case the company was alerted to similar fraud by its auditor, the China arm of global giant KPMG, which recently resigned the account as a result of the matter. The amounts are much smaller here but still significant, with Cloopen saying that 5% to 10% of its second quarter revenues last year and 15% to 20% of its third quarter revenues may have been bogus. That would translate to roughly 80 million yuan in faked sales, bringing the company’s previously reported 40-50% growth for both quarters down to the 15-35% level.

This kind of temptation to inflate sales isn’t uncommon in China, where growth is an obsession and bosses often announce their lofty goals to staff, who then sometimes do whatever it takes to reach those goals. In the past these companies’ auditors, often China arms of big global accounting firms, could quietly look the other way when they suspected potential misdeeds. That’s because they could hide behind the Chinese ban on sharing their records with the Public Company Accounting Oversight Board (PCAOB), the body that works with the U.S. Securities and Exchange Commission on fraud investigations.

Now that these auditors know they may soon need to take greater responsibility for their audits of Chinese companies, many may become more aggressive in their checks before signing off on such audits. That could help to restore investor confidence in U.S.-listed Chinese companies in general. But it could also result in more cases like we’ve just seen with Cloopen, where an auditor raises the alarm over practices that it might have quietly overlooked in the past.

Doug Young is the editor in chief at Bamboo Works

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