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Caterpillar Scandal

Jessica Murphy/MEDILL

Caterpillar Inc. unearthed accounting fraud in one of its Chinese companies, making them yet another example of the heightened risk companies face when investing in China.

Cat duped in China deal, but U.S. investors aren't deterred by latest scandal

by Jessica Murphy
Jan 31, 2013

Chinese profitability

Jessica Murphy/MEDILL

Despite instances of accounting misconduct, U.S. companies continue to see profit and potential in Chinese investments.

Caterpillar Inc. is the latest company hit by duplicitous accounting practices in China, but experts say  the potential for growth and profits won’t keep U.S. investors away.

Caterpillar announced Jan. 18 that it would write down $580 million in its fourth quarter after uncovering “deliberate, multi-year, coordinated accounting misconduct” in one of its recently acquired subsidiaries.

The Peoria-based construction and machinery giant bought ERA Mining Machinery Limited in June for about $700 million. The acquisition included Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., a subsidiary of ERA that produces mining equipment.

Caterpillar launched the initial investigation after discovering discrepancies between inventory recorded in Siwei’s accounting records and actual physical inventory, officials said.

It its fourth quarter ended Monday, Caterpillar reported earnings of $1.04 per share, including an 87 cent per-share charge related to Siwei. That was down from $2.32 per share in the fourth quarter of 2011. Sales for the whole year, however, were $65.8 billion, up 10 percent from $60.1 billion in 2011.

Caterpillar’s substantial hit could cause some investors to question its due diligence prior to acquiring a foreign company. But the company said in a release that its due diligence process was “rigorous and robust,” and the misconduct at Siwei, a publicly traded company with audited financial statements, “was concealed by the persons responsible.”

Chinese government restrictions coupled with a lack of regulatory bodies may have put blinders on the company’s judgment, according to experts.

Although China is moving toward implementing International Financial Reporting Standards, it lacks institutions to provide strong, independent oversight, said Kevin Der Arslanian, a business analyst at Chinese Marketing Research Group in Shanghai.

“Most firms rely on their auditors. However these are hired directly by the firm, leading to conflicts of interest,” Der Arslanian said.

Kelly Pope, an associate professor of accounting at DePaul University who specializes in corporate malfeasance and white-collar crime, is not surprised by Caterpillar’s debacle. She said given the parameters that the Chinese government allows companies to work within, Caterpillar exercised the appropriate due diligence.

“We are at the mercy of the governing regulations when doing business abroad,” Pope said. “China imposed such severe restrictions, which in turn limited Caterpillar's ability to identify the accounting fraud.”

An acquisition meant to expand leadership and capitalize on coal production in China is now an embarrassing stain on Caterpillar’s image, but the company is far from alone in its plight.  Fraudulent accounting within Chinese companies has led to the downfall or disgrace of many companies in recent years.

In June of 2011, equity research firm Muddy Waters Research released allegations that Chinese timber company Sino-Forest Corporation had inflated its assets and earnings.

Sino-Forest’s stock plummeted. An investigation by the Ontario Securities Commission ensued and in March 2012, the company filed for bankruptcy. The scandal resulted in a $750 million loss for the Toronto-traded company.

In December 2011, Muddy Waters accused Chinese digital advertiser Focus Media Holding Limited of reporting fraudulent numbers and information regarding its products and acquisitions. Focus Media denied the allegations and announced a year later that it would be going private.

Despite the risks, multinational corporations are drawn to the size and growth rate of China’s market. “Being a global leader cannot be done without being a major player within the Chinese market,” Der Arslanian said.

According to a 2012 survey by the U.S.-China Business Council, 89 percent of U.S. companies had a profitable year in their Chinese operations. The survey also found that 22 percent of U.S. companies ranked China as their top strategic priority while 72 percent said it was in their top five.

The heightened risk of accounting fraud or misconduct will, of course, play into U.S. companies’ decisions to invest,  Der Arslanian said, but the size and potential pay-off of China’s market makes this a risk that “most are willing to take.”