Fitch Report Highlights Key Weaknesses in Chinese Companies

July 19, 2011 Posted by China Briefing Reading Time: 3 minutes

Jul. 19 – International funding of Chinese-listed companies may face increasing challenges in the near term following a string of allegations recently regarding fraud and accounting irregularities.

Following its competitor Moody’s Investors Service, which had just released a report last week warning of “red flags” at 61 Chinese companies for accounting and governance risks, the global rating agency Fitch Ratings has also highlighted “key weakness indicators” of 35 rated Chinese companies in a recent report.

The report released on Monday followed Fitch’s announcement last week to review its Chinese corporate portfolio due to “a spate of allegations” about Chinese companies. Rating most Chinese private companies at the “BB” level (more prone to the changes in the economy) or below, and state-owned or state-supported companies at investment-grade, Fitch says its ratings for Chinese companies have already incorporated “the overall Chinese framework of an under-developed legal system and documentation standards, distinct business practices and weak corporate governance.”

The “key weakness indicators” listed in the report include accounting, governance and financial stresses. It is notable that even the exchange-listing venue has been considered a relevant gauge of the company ratings. The Shanghai listings of several companies and the Toronto listing of Sino-Forest – the Chinese timber company which Fitch withdrew its ratings for recently – are both highlighted as “key weakness indicators.”

Fitch believes companies’ choice of auditor and use of accounting standards are the two most concerning parts that could affect the reliability of their financial reports. The report stressed that the adherence to International Financial Reporting Standards (IFRS) will make it more difficult for companies to perpetuate fraudulent statements.

Although a recent report in China’s Guangzhou-based Southern Metropolis Daily (SMD) argues the country’s accounting standards have been improving over past few years, and the Fitch report has also acknowledged the fact that China’s “2006 Accounting Standard for Business Enterprises (2006 ASBE)” that is being used by some companies is already quite similar to IFRS GAAP “with mainly reclassification issues,” the ratings agency still classified the use of ASBE as a “key weakness indicator” for several companies.

Companies’ ownership and board composition are seen as pointers to governance quality in the report. For example, Fitch noted the Nasdaq-listed China Medical Technologies Inc – which is rated B+ – has a small number of individuals holding a large bulk of company’s shares and independent directors who have served on the board for too long. Some 23 percent of the company’s stock falls into the hand of the company chairman, and there is at least one independent director that has been on the board for more than five years.

Financial measures such as revenue increases, working capital, taxes and profit margins have also been screened. Several companies rated at non-investment grade – including China Medical Technologies and Sino-Forest – are found to have a significant growth in revenue, but make deficient tax payments. In addition, Fitch also pointed out that most of China Medical Technologies’ assets are technology platforms that are difficult to value, and Sino-Forest sees considerable expansion in its capital expenditures and pays no tax on cash earnings.

While the recent fraud allegations have led to a sell-off in China-related equities, and even suspension of trading in several stocks of overseas listed Chinese companies, Fitch said such negative impressions on Chinese companies are not likely to fade away in the near term.

“Overseas investors are now undertaking the job that China’s under-developed capital market has hitherto struggled to address – challenging Chinese corporate management to adopt higher international standards,” said John Hatton, Fitch’s group credit officer for Asia-Pacific companies.

Compared to the Western rating agencies that collectively accuse some Chinese companies of their questionable accounting practices and weak governance, the SMD report uttered a different voice. It believes that although the ratings do reflect the problems of some Chinese companies, they may also have something to do with some Western financial institutions’ intention to “short” China. Without specifying the actual purpose of “shorting” China, the report concludes such intentions should be blamed, while Chinese private companies also need to make further attempts to improve company management.

Dezan Shira & Associates is a boutique professional services firm providing foreign direct investment business advisory, tax, accounting, payroll and due diligence services for multinational clients in China, Hong Kong, Vietnam and India. If you need help with an Audit in China, please contact Dezan Shira & Associates.

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