Case Study: Due Diligence in the Acquisition of a Chinese Company

As part of our mission to provide business intelligence on the legal, tax and operational issues of doing business in China, China Briefing presents the next installment in a series of case studies based on the practical experience of Dezan Shira & Associates professionals.

Scenario

An American manufacturer of sprockets (“Sprock Co.”) considered acquiring a Chinese competitor company (“Sino Sprock”), and approached Dezan Shira to conduct due diligence on their take-over target.

Sprock Co. wanted to thoroughly examine the financial position and internal operations of Sino Sprock before deciding on the takeover. Sprock Co. was especially interested in finding out whether the target’s financial information was fairly represented and in reviewing Sino Sprock’s internal control systems to avoid unhappy surprises after the sale of the company.

Unfortunately, fraud and private dealing by employees is all too common in Chinese companies. For example, hawkers selling ‘fapiao’ (official invoices) are a common sight around train stations. They sell receipts for taxi rides, hotel stays or plane tickets. An employee on a business trip may take the metro and sleep in a cheap motel, but use the purchased fapiao to declare higher expenses. He or she then pockets the difference.

Other examples include factory employees reporting a higher amount of defective goods than was actually the case, and then removing and selling some of the goods themselves. It is also common for company purchasers to buy products from a friend or family member at an inflated price and pocketing a commission in the process.

In the course of our investigation of Sino Sprock, we discovered several compromising pieces of information. As our team reviewed the financial statements, some of the transactions were unclear in nature. A portion of the target company’s business transactions were present on one of the owner’s personal accounts, meaning he had been mixing personal and company transactions. Also, information from the inventory management system was inconsistent with the accounting department’s books, indicating potential fraud.

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In particular, the mixing of company and private assets was a red flag. If one of the shareholders in a company is privately taking payments for services or products delivered by the company, he or she could be withholding profits from the company and its other shareholders. Also, the revenue will still be taxed, even though the company has not actually received any money.

If a shareholder has been making personal transactions in the company’s name, such as taking out loans, the company could be liable for his/her personal dealings. The company or other shareholders may sue the delinquent shareholder for losses incurred from his/her private dealings, but it could take months before they see their funds returned to them, and by that time the damage may already have been done.

For this reason, investors are well-advised to perform in-depth due diligence before purchasing any substantial part of a Chinese company, and be specifically on the lookout for discrepancies in inventory and financial records, and other indications of self-dealing.

Dezan Shira & Associates offers due diligence services for foreign investors looking to purchase equity in Chinese firms. For foreign companies with a subsidiary in China, the firm provides internal audits and risk management advice to prevent irregularities and investigate fraud.

The following chart gives an impression of the kind of irregularities our experienced team would look for during a typical audit. Our Business Advisory team regularly assists foreign investors with implementing a variety of measure to guard against any inconsistencies in your China operation.

In the case of Sprock Co., we advised the client of the legal and tax risks discovered through our investigation, and recommended measures that the company could implement to reduce inconsistencies in its accounting books. Based on a fuller disclosure of the target company’s information, Sprock Co. was able to better evaluate the risks involved with the takeover and make a well-informed decision. Sprock Co. then renegotiated its deal with Sino Sprock based on the information derived from our research.

Merger & Acquisition Regulations in China
In this issue of China Briefing, we return to a popular subject – China’s M&A regulatory framework. With the global economy slowly coming out of recession, and Chinese businesses wanting to expand both domestically and overseas (both issues driven by state policy), we expect to see a gradual upswing in the number of M&A deals being conducted with Chinese companies in the forthcoming months.

Annual Audit and Compliance in China
In this issue of China Briefing, we discuss annual compliance requirements for foreign-invested enterprises, including wholly-foreign owned enterprises, joint ventures and foreign-invested commercial enterprises, as well as the less demanding requirements for representative offices. We also highlight the most recent tax and legal changes that will significantly influence the way companies do business in China in 2014.