Ye Fan Ye Qinhua Huang Shizhong: Identification and Response to Accounts Receivable Fraud: Based on the case study of Guangdong Rongtai
Original Ye Fan et al Finance & Accounting
Accrued items, such as receivables and receivables, advance payments, other receivables and receivables, have always been the key subjects for analyzing financial fraud and the quality of accounting information. A typical academic research application is a series of models represented by the Jones model (1991) to detect the degree of management of a company's accrued surplus. In the field of financial management, accrual items are an important embodiment of the ability of enterprises to use upstream and downstream funds and commercial credit. However, with the increase in transaction fraud financial fraud methods (Huang Shizhong et al., 2020), there have also been some new changes in the use of accrued items, especially accounts receivable with fraud, such as the use of real capital flows to fictitious sales collections to reduce accounts receivable, or the use of factoring, pledge financing and other businesses to remove accounts receivable from the balance sheet, thereby posing new challenges to the identification and response to accounts receivable fraud.
In 2020, with the implementation of the revised Securities Law, regulators have stepped up penalties for financial fraud. In July 2021, the CSRC notified the first batch of financial fraud cases applying the new Securities Law, in which Guangdong Rongtai (600589) was identified as a typical case of concealment and use of new or complex financial instruments by fraudulent means. Although the amount of fraud in Guangdong Rongtai is much smaller than that of Kangmei Pharmaceutical and Kangdexin, its fraud methods involve not only the use of fictitious accounts receivable by related parties, the inflated income of factoring business, but also the situation of false reduction and concealment of accounts receivable, which is a new trend worthy of attention. Taking Guangdong Rongtai as an example, this paper analyzes and extends the possible characteristics and verification ideas of accounts receivable fraud according to the five-dimensional financial fraud identification model (Ye Qinhua et al., 2021).
I. The "First" of Penalties under the New Securities Law
Guangdong Rongtai was listed in 2001 and engaged in the production and sales of chemical materials. After the wholly-owned acquisition of Beijing Senhua Yiteng Communication Technology Co., Ltd. (hereinafter referred to as Senhua) in 2016, Guangdong Rongtai began a dual main business model, adding Internet data center (IDC), cloud computing, content distribution network business (CDN) and other businesses. Since then, its segmented revenue sources have been divided into three categories: ML amino composites; phthalic anhydrides, dioctanes and other chemical products; and Internet integrated services. Since its listing, the major shareholder of Guangdong Rongtai has been Guangdong Rongtai Advanced Porcelain Tool Co., Ltd.
Guangdong Rongtai's financial fraud problem originated from the inability to disclose the annual report on time: On April 29, 2020, Guangdong Rongtai was unable to reach an agreement with the audit institution and the assessment agency, unable to disclose the 2019 annual report and the 2020 first quarter report on time, and then suspended trading, and on the same day, it received a regulatory work letter from the Shanghai Stock Exchange; on May 7, 2020, the Guangdong Securities Regulatory Bureau requested the company to rectify the problem of failure to disclose on schedule. On May 21, 2020, the CSRC decided to file an investigation into Guangdong Rongtai's violation of laws and regulations on information disclosure. In 2021, Guangdong Rongtai received the advance notice and decision of the Guangdong Supervision Bureau of the CSRC. The issues disclosed include: failure to disclose annual reports on time; failure to disclose related party relationships and related party transactions; use of fictitious sales proceeds by related parties to reduce accounts receivable, thereby inflating profits; and fictitious accounts receivable factoring business to inflate profits. It is worth noting that listed companies should truthfully disclose various announcements, otherwise they will be punished. During the CSRC's investigation, Guangdong Rongtai made a clarification announcement on the media report that "Guangdong Rongtai suspected of concealing the affiliations of the three major suppliers with a total procurement of more than 450 million yuan in 2018", and this clarification announcement was also found to have a false record. In the end, as the first case to apply the new Securities Law, Guangdong Rongtai was fined 3 million yuan, the chairman was fined 3.3 million yuan, and the financial director, board secretary and a number of supervisors, directors and independent directors were fined between 200,000 yuan and 1.6 million yuan, with a cumulative fine of 14.5 million yuan, which was much higher than the cumulative maximum penalty of 5.95 million yuan for Kangmei Pharmaceutical cases under the provisions of the old Securities Law. In addition, Guangdong Rongtai will also face civil claims lawsuits from investors.
Guangdong Rongtai's 2018 and previous annual reports were audited by Guangdong Zhengzhong Zhujiang Certified Public Accountants, all of which are standard unqualified opinions; in December 2019, it was replaced by Dahua Accounting Firm, and the 2019-2020 annual reports were all qualified opinions, involving issues such as procurement that could not confirm the affiliation relationship and commercial substance, internal control defects of subsidiaries, case filing investigation, provision for bad debts, asset impairment provision and inventory loss, and related party capital occupation. Although the 2019 annual report was released after the case was filed and investigated, as stated in the penalty letter, one of the reasons why the annual report could not be disclosed as scheduled was that the audit institution held different opinions, which showed that the audit institution played a certain role in "exposing" this fraud incident.
II. "Hiding" and "Using" Accounts Receivable
It can be seen from the penalty letter that Guangdong Rongtai's financial fraud belongs to the type of "real money and silver", which uses the typical method of constructing undisclosed hidden related parties, assisting in fictitious transactions, and fictitiously collecting money to achieve inflated profits. The special point is that the implicit related parties constructed by Guangdong Rongtai are used to achieve the dual purposes of "concealing accounts receivable to avoid being fully accrued for impairment provision" and "concealing related party transactions"; they are used to "reduce costs", that is, to "hide" abnormal accounts receivable with long account periods or difficult to recover, according to which bad debt provisions and inflated profits are also used to "generate income", that is, to "use" false accounts receivable, fictitious related factoring business income, and further inflate profits. How to find the "clues" of accounts receivable fraud from the previous perspective? This article will discuss this issue from different dimensions of the financial fraud identification model. In addition, accounts receivable anomalies may have multiple sources and manifestations, such as from the manipulation of other accounts such as revenue, which constitutes a linkage anomaly between these accounts and accounts receivable, so this article will also be interspersed with other fraud cases for a brief analysis of this.
(1) Financial and tax dimension: The linkage between income and accrued items is abnormal
The source of accounts receivable should be operating income, table 1 shows Guangdong Rongtai's operating income and related accounts from 2017 to 2020 (this article analyzes the data before error correction), of which 2018-2019 is the financial fraud period.
First of all, Guangdong Rongtai is mainly engaged in the production and sales of chemical materials such as amino composite materials (new materials), phthalic anhydride and plasticizers, and in 2015, it added a second main business Internet service through mergers and acquisitions, strategically changing from a single chemical main business to a "chemical + Internet" dual main business, and intends to transform into a single Internet service main business. During this period, Guangdong Rongtai was affected by the overall downturn in the chemical materials industry of the first main business (the 2017-2018 annual report continuously reminded that the chemical materials industry it was in was affected by domestic economic restructuring, the demand of downstream enterprises was flat, the industry was overcapacity and other factors, and the market demand for products may remain sluggish for a long time), and the growth rate of operating income has declined significantly since 2018. The decline in cash flow from operating activities and net profit was even greater (net profit in 2020 after fraud was exposed was negative and fell sharply). The secondary industry revenue data of the "manufacturing industry - chemical raw materials and chemical products manufacturing industry" of the Financial Intelligent Early Warning System of Tianjian Cai judgment (due to the special products of Guangdong Rongtai, it is difficult to accurately find comparable companies with exactly the same products, so it is replaced by industry data) shows that the revenue growth rate of the industry has also slowed down from 2017 to 2020, especially the growth rate from 2018 to 2019 has dropped from 27.21% in 2017 to 15.49% and -3.17% respectively. However, an unusual sign is that in the case of Guangdong Rongtai's revenue decline in 2017, its revenue in 2018 rose sharply by 25.32% against the trend, which deviated from the industry boom.
Secondly, the growth rate of receivables of Guangdong Rongtai since 2018 is much higher than the growth rate of revenue. From the perspective of the proportion of accounts receivable to revenue, the proportion from 2017 to 2020 has continued to increase, and it is significantly higher than comparable data in the same industry. From the perspective of the proportion of receivables to assets, the proportion has reached 15.55% by 2019. The vast majority of its receivables are accounts receivable.
It can be seen that the performance of Guangdong Rongtai during this period was not good, and the linkage between income and receivables accounts was abnormal. From a business point of view, the linkage anomaly is not a good signal, in addition to may reflect the decline in the quality of sales revenue, may also point to revenue fraud. At this time, it is necessary to pay attention to whether Guangdong Rongtai has inflated the income of the chemical industry or there are signs of adjusting the provision for bad debts of receivables? Such as the externalization of funds.
In addition, other accrual items of Guangdong Rongtai also cross-corroborate this problem, that is, the overall "income is not enough", of which: the growth rate of prepaid accounts and the proportion of total assets are also higher; accounts payable are much smaller than the more binding notes payable, which have a growth rate of 45.71% in 2018 and -35.11% in 2019.
(2) Financial and tax dimension: The linkage between accounts receivable and bad debt provision is abnormal
Revenue is the source of accounts receivable, bad debt provision and write-off losses, recovery of payments, conversion into financial instruments are the possible destinations of accounts receivable, which is another way to cross-verify the authenticity of accounts receivable. Table 2 shows the accounts receivable and bad debt provisions of Guangdong Rongtai, which can be seen that the proportion of bad debt provisions in 2017 to the balance of accounts receivable is extremely low; in 2018, when accounts receivable grew faster than revenue, the proportion of bad debt provisions also increased significantly, showing the pressure on accounts receivable to become bad debts. In 2019, revenue declined and accounts receivable continued to rise, but the proportion of bad debts was reduced, and there was a possibility of "manipulating" the proportion of bad debts. Judging from the fact that the proportion of bad debts in 2020 is as high as 46.74%, there is a possibility of under-accruing bad debts in previous years. In the case of Guangdong Rongtai, the abnormality of accounts receivable and bad debt provision is not easy to find, because the proportion of bad debts in 2018 is still rising, and how to judge whether the increase is sufficient is a difficult point. Therefore, it is necessary to further and carefully verify whether there are abnormalities in the debtor, such as business conditions, whether they are related parties, etc., and whether the treatment method of credit loss itself is reasonable.
In summary, the source of accounts receivable is income, and there are two possibilities behind the abnormal linkage of the two: first, the income is real, but due to poor sales collection, credit policy changes and other reasons, the accounts receivable have risen, but in order to avoid affecting profits and not reasonable provision for bad debts; the second is income fraud, and there is no sufficient external capital flow support to lead to the simultaneous inflated accounts receivable.
(3) Financial and tax dimension/internal control dimension: The linkage between gross profit margin and inventory procurement is abnormal
Another anomalous subject in Guangdong Rongtai is inventory, although the growth rate has been negative since 2018, but the proportion of inventory to total assets has continued to rise. This paper takes the industry data of Tianjian Financial Judgment Financial Intelligent Early Warning System as a reference, as shown in Table 3, the proportion of Inventory Assets of Guangdong Rongtai is much higher than the industry average. The linkage with inventory is abnormal is the gross profit margin, which is also much higher than the industry level, and the results remain unchanged after excluding the impact of the second main business Internet service. This linkage anomaly points to the problem of whether the cost carry-over is complete, whether the scale of production and marketing matches, and whether the inventory is inflated.
In addition to verifying inventory anomalies, it can also analyze whether there are abnormalities in suppliers, such as whether there is an implicit relationship with suppliers through industrial and commercial information analysis. In june 2020, Guangdong Rongtai's audit report pointed out that it had a significantly more than normal purchase of goods with some suppliers. In August 2020, the media further launched a field investigation and found that among the top five companies in Guangdong Rongtai's bills payable, Jieyang Zhongyue Agricultural Materials Co., Ltd., Jieyang Hetong Plastic Co., Ltd. and Jieyang Yongjia Agricultural Materials Co., Ltd. (hereinafter referred to as Hetong Plastics, Yongjia Agricultural Materials, and Zhongyue Agricultural Materials) had abnormal characteristics: the three suppliers were registered in similar places and were the lessees of Guangdong Rongtaiyuan Actual Controller Company; the three suppliers had the same shareholders and executives; further using industrial and commercial and judicial information to dig deeper. It can be found that the supplier has the same executives or employees as Guangdong Rongtai; the supplier has the same email address and contact telephone number as the company in the Guangdong Rongtai system. In addition, the penalty letter also pointed out that Guangdong Rongtai first paid the payment to the related party, and the related party paid the real supplier; the related party earned a gross profit margin of 1%; the related party had no warehousing and production business, and Guangdong Rongtai directly received the goods. It can be seen that the arrangement of implicit correlation of suppliers, coupled with the characteristics of "insufficient income" in Guangdong Rongtai accrual project, these anomalies indicate that Guangdong Rongtai has the possibility of building a hidden related party and transferring funds out of the body.
(4) Financial and tax dimension/internal control dimension: Add "financialization" business such as accounts receivable factoring
1. Use accounts receivable factoring to inflate income
The penalty letter pointed out that in April 2019, Shenzhen Jincaitong Commercial Factoring Co., Ltd., a subsidiary of Guangdong Rongtai, and related parties such as Hetong Plastics, Yongjia Agricultural Materials, and Zhongyue Agricultural Materials fabricated the accounts receivable factoring business, that is, Guangdong Rongtai contributed and transferred the accounts receivable of related parties to earn interest income, but this was not disclosed in the reports of each period.
In view of some methods with shorter counterfeiting cycles and novel counterfeiting methods, it is an effective way to make full use of the information in the quarterly and interim reports to identify abnormalities. Table 4 shows the situation of Guangdong Rongtai's largely changed monetary funds and other current assets (due to changes in accounting policies, the amount of wealth management products added to other current assets can be compared vertically), which can be seen: in 2019, monetary funds decreased significantly during the year but rebounded sharply at the end of the year; other current assets increased significantly during the year but decreased sharply at the end of the year, reaching a maximum of about 624 million yuan, and the reason for the change was entrusted wealth management in other current asset details. However, Guangdong Rongtai has not disclosed the specific content and object of entrusted financial management in more detail. According to the analysis in Table 4, one possibility is that the business is presented in the "Other Current Assets" account in the form of entrusted wealth management. Then, in view of the abnormal linkage of monetary funds and other current assets in the second and third quarters of 2019, it is necessary to further verify the commercial essence of the entrusted wealth management business and verify whether there is any misappropriation or misappropriation of internal funds by major shareholders. In addition, the penalty letter also points out that the accounts receivable of related parties do not really exist, so when verifying the authenticity of the factoring business of accounts receivable, it may also be necessary to analyze the authenticity and recoverability of the accounts receivable itself in order to understand the commercial essence of the business.
2. Use accounts receivable factoring to reduce bad debts
Accounts receivable factoring, as a new type of financial instrument, is used in this case for fictitious income of the transferee. Conversely, the transferor can also reduce the abnormal accounts receivable in this way. For example, in the great wall fraud case of China, it terminated the recognition of accounts receivable by signing a factoring business with a third-party factor. However, in fact, the factoring payment of the receivables was paid to the factor by the related parties of the Great Wall of China, and the receivables were not actually transferred. In the case of the fraud of the Thousand Yam Machine, the Thousand Yam Machine did not record the accounts after the factoring of the accounts receivable was lifted, and the accounts receivable were falsely reduced. The advantage of derecognition of accounts receivable through factoring business is that the arrears are recovered on the books, the second is that there is no need to make provisions for bad debts to inflate profits, and the third is that the potential loss of assets is externalized and more hidden. At this time, the focus of the verification is whether the factoring business itself is reasonable and whether the rights and obligations are truly transferred; and whether the verification of the accounts receivable itself is true and recoverable is also helpful to judge the commercial essence of the factoring business.
(5) Corporate governance dimension: abnormal behavior of major shareholders and actual controllers
Analyzing the abnormal behavior of major shareholders and actual controllers from the perspective of corporate governance can assist in analyzing the motives of financial fraud. Moreover, such abnormal behavior is often more likely to occur when it involves the appropriation of funds and the transfer of in vitro cooperation fraud, and the Guangdong Rongtai case is no exception. First of all, the major shareholder Guangdong Rongtai Advanced Porcelain Furniture Co., Ltd. in 2018 the equity pledge ratio was as high as 84.03%, reaching 70% in 2019, reflecting the greater financial pressure of the major shareholders. Secondly, at the end of 2015, Guangdong Rongtai's high-priced acquisition of Senhua also made a performance commitment, and the final performance commitment accurately met the standard, and the completion rate was about 100%, but the performance fell sharply after the expiration of the performance commitment. Fulfilling performance commitments is also a major motivation for financial fraud. Finally, Guangdong Rongtai sold its subsidiary Jieyang Jiafu Industrial Co., Ltd. to related parties, resulting in approximately RMB528 million in other receivables and RMB239 million in investment income, up significantly from other years. Therefore, it is necessary to pay attention to the problems of fraud motives that may be involved behind the high equity pledge rate and performance betting, and the performance adjustment and capital embezzlement that may be involved behind abnormal related party transactions.
In summary, the accounts receivable problem of Guangdong Rongtai can be identified from the linkage analysis of income, inventory, monetary funds and other subjects, and its rationality can be further verified by commercial substance judgment, capital flow payment destination, and implicit related party verification. At the same time, the phenomena that may involve the motivation for fraud, such as new financial businesses during the period of financial fraud, performance betting accompanied by the transformation of the main business, and frequent capital operations of major shareholders, are also worthy of attention. In 2020 after the fraud period, Guangdong Rongtai still has the suspicion of "taking a big bath", which has accrued a large amount of credit impairment and asset impairment losses, and the balance of monetary funds, inventory, fixed assets and projects under construction has plummeted, resulting in the qualified opinion report of the certified public accountant and the inquiry of the regulator, which also indirectly confirms the problem of financial fraud in the previous period.
3. Inspirations and Recommendations
Combined with the analysis of the Guangdong Rongtai case, we can summarize five possible manifestations of abnormal or fraudulent accounts receivable: one is to inflate accounts receivable to match the inflated income fraud; second, accounts receivable are abnormally high due to problems such as industry downturn or poor management; third, the use of accounting manipulation methods such as adjusting the proportion of bad debts to undercount the provision for bad debt losses; fourth, fictitious "real" cash collection to avoid abnormal accounts receivable; fifth, the use of new financial instruments such as factoring and pledge financing to transfer accounts receivable. The first two involve the source of accounts receivable and the latter three involve whereabouts. In the recent "thunder" Shanghai Electric incident, it is also suspected that there are huge business problems such as account receivable factoring and pledge financing, which shows that this subject shows high-risk characteristics. Behind these appearances, the problem that needs to be solved is how to identify the abnormal accounts receivable according to the linkage analysis between different subjects, and how to use external information to verify the relationship between the abnormal accounts receivable and financial fraud. In view of the fraud identification of accounts receivable, this paper puts forward the following three enlightenments and suggestions:
(1) Attach importance to the linkage analysis of accounts receivable related to accounts receivable
From the point of view of "covering up" the fraud of accounts receivable, the best way is to achieve the recovery of the purchase price, which can both prove its recoverability and assist in showing that the income is real. To build a closed loop of sales collection, two elements are needed: one is the real inflow of funds, which often requires the "reserve" of externalization of funds in the body; the other is that the debtor cooperates with fraud, that is, to build and hide related parties. Financial fraud is increasingly becoming a "systematic" project, and fraud in one subject may need to be combined with abnormalities in multiple subjects in order to cross-verify and form a logical closed loop.
Based on this, when the certified public accountant finds that there are abnormal signs of accounts receivable, it should focus on the following special anti-fraud procedures, and should also first expand the accounts receivable to all receivables for consideration, because these receivable items are often interrelated: (1) quarterly linkage analysis with monetary funds, random inspection and verification of whether there is abnormal behavior of third-party payment collection in the current year; (2) if it involves third-party payment collection, it can be further verified with the help of databases such as industrial and commercial justice whether the third party is a related party or a hidden related party ;(3) Linkage analysis with accounts such as inventory and other current assets, extended verification of the source of funds for sales proceeds, and linkage analysis of whether there are abnormal signs of capital exogenation of funds. At this point, a longer chain of logic may be involved, requiring the auditor to have more external transfer powers.
(2) Focus on verifying the commercial substance of new financial businesses such as accounts receivable factoring
The analysis of this case shows that accounts receivable factoring, as a new type of financial business, can assist the transferor and the transferee to implement financial fraud respectively, which has a certain degree of concealment and is difficult to identify. Based on this, the certified public accountant found that when the source of new receivables factoring or large receivables financing business in the current year is accounts receivable rather than notes receivable, the following special anti-fraud procedures should be implemented: (1) verify the commercial rationality of the business model itself, whether there is a right of recourse, whether it is truly transferred, etc.; (2) verify whether the business corresponding to the receivables as a "business entity/carrier" is only a simple trading business, whether it has a real trading background, and whether it comes from a real business operation (3) Verify whether the new business transaction object is a related party or an implicit related party, and whether there is a community of interests between its major shareholders, customers and suppliers, and comprehensively determine whether such business has commercial substance.
(3) Attach importance to regulatory inquiry letters and external early warning information provided by certified public accountants
The lag cycle from the occurrence of financial fraud to the identification of penalties generally takes 3 to 5 years, and Huang Shizhong et al. (2020) found that less than 30% of fraud was identified and punished within 3 years. The Guangdong Rongtai case is both typical and atypical, and its abnormal characteristics are not particularly obvious and difficult to find; but unlike other cases, it was punished by regulators from the implementation of fraud in 2018 to 2020, with a cycle of only about 2 years, which was discovered earlier. The reason for this may be that there are two events that play a key role: first, the certified public accountant did not issue the 2019 audit report as scheduled, and after the extension, the "non-standard" audit report with a qualified opinion was also issued. According to the "Annual Securities Audit Market Analysis Report" released by the CSRC, in recent years, the number of non-standard audit opinions issued by certified public accountants has increased significantly, accounting for 3.5%, 6.0% and 7.1% in 2017-2019, respectively, and the role of certified public accountants as the "gatekeeper" of the capital market continues to improve. Second, since the 2018 annual report, Guangdong Rongtai has received a total of 26 non-punitive inquiries and related reply announcements from the Shanghai Stock Exchange, and the regulatory inquiry letter and related replies have contained a large amount of "useful information", which to a certain extent warns the regulatory authorities of their continuous attention to the quality of their accounting information. For example, in the May 2019 post-inquiry letter for the 2018 annual report, there were inquiries and prompts on performance betting, abnormal monetary funds, and the reasonableness of large amounts of goodwill; in the August 2020 post-inquiry letter for the 2019 annual report, there were inquiries and prompts for suspected related parties and related capital transactions. It is foreseeable that with the attention of regulators and the improvement of audit quality, external early warning information such as audit reports and regulatory inquiries will have a stronger information content, and certified public accountants and users of external statements can also make full use of such information to identify financial fraud in a more timely and accurate manner.
▷Author: Ye Fan | Xiamen National Accounting Institute; Ye Qinhua | Department of Accounting, Xiamen University; Huang Shizhong | Dean of Xiamen National Accounting Institute.
▷Originally published in: Finance and Accounting, Issue 21, 2021
▷ Responsible editor: Ren Yuxin
▷ Duty Editor: Chen Lihua Li Feiran
▷ Typography design: Liu Ying