A former senior executive of a Chinese company that listed on the Nasdaq in 2005 says investors need to stay wary of new initial public offerings (IPOs) from the mainland, because many firms keep multiple sets of books.
"I've been investing in China for the last 10 years and there's one thing I've learnt - with many Chinese companies there are usually two sets of books, and whenever there are two sets of books, there are usually three," Eric Rosenkranz, Chairman and Founder of strategy consulting firm E.Three and a former Vice Chairman of Focus Media China told CNBC on Monday.
Rosenkranz says the first set of books, which tends to minimize profits and taxes, is generally submitted to the government; the second set, usually shown to investors, aims to maximize earnings. But it's the third set of books, that reflects the true information on the company, which investors need to seek before investing, he adds.
Rosenkranz recommends investors check off three boxes before betting on a listing. First, whether the company is listing on a "reputable" exchange such as the NYSE, Nasdaq or Hong Kong stock exchange.
Second, if it’s a new or reverse listing. Rosenkranz says investors should avoid reverse mergers that use U.S. shell companies to list, noting that of the 200 Chinese companies that have gone public in the U.S. over the last four years, 75 percent had done so via reverse listings.
And third, Rosenkranz says, invesors should look at whether the company is using one of the “big four” accounting firms: KPMG, Ernst & Young, Deloitte and PWC.
"Failing any one of those three things is a worrying sign and the investor should run away," he said.
Of the three points flagged, the use of a reputable auditor is most crucial, says Rosenkranz.
Rosenkranz is currently the independent non-executive director of Focus Media Network (a company unrelated to Focus Media China), which listed on the Hong Kong stock exchange's GEM board in July 2011. He says Focus Media Network keeps only one set of books, passed the tough regulations of the Hong Kong exchange, and retains PricewaterhouseCoopers as its accounting firm.
"Over the last 3 years there have been 40 U.S. accounting firms with less than 10 employees auditing Chinese IPOs," Rosenkranz said. "Now let's not forget that one of the reasons Bernie Madoff was able to get away with what he did - he used a three-man ‘mom-and-pop’ shop to audit his books."
But even “big four” accounting firms haven't been immune from controversy. Deloitte for example has come under scrunity over possible accounting fraud at the Chinese financial software firm Longtop Financial, which it audited. Rosekranz suggests that this incident was different and was largely a result of the lack of SEC oversight of accounting firms in China.
"It's not Deloitte U.S., it's a subsidiary of theirs, which is a Chinese company and one of the issues is U.S. regulators are not allowed into China to look at the books. So the U.S. regulators from the SEC have been forbidden because of country sovereignty issues from looking at the books," he said.
Longtop, which was listed on the New York Stock Exchange in 2007, had its shares suspended in May, and resumed over the counter trading in August.
Rosenkranz says Deloitte was working to fix the issues and he expects a change in regulations in the next three months, which would give the SEC broader oversight of Chinese accounting issues.