Auditing Fraud Risk in China and Emerging Markets

Auditing fraud risk in China is not just a technical challenge it can mean auditing businesses that don’t exist.

In this episode, Wayne Basford and Judith Leung explore how audit fraud risk in China and emerging markets operates at a fundamentally different level. Drawing on real-world cases and lessons from the China Hustle, they explain why standard audit procedures can fail when transactions, customers, and even bank evidence are deliberately fabricated.

The discussion highlights why audit fraud risk in China requires a different mindset one grounded in deep scepticism, local insight, and practical verification.

🎧 In this episode, you’ll learn:

• Why audit fraud risk in China can involve businesses that don’t exist
• Why traditional audit evidence like confirmations can be unreliable
• How fake customers, invoices, and cash flows are constructed
• Why site visits and tax records are critical audit evidence
• What auditors should do differently before accepting high-risk engagements

Financial Reporting Conversations is brought to you by Basford Consulting helping professionals go beyond compliance and get financial reporting right.

For technical insights, training, and resources that make the unknowns in financial reporting known, visit basfordconsulting.com

🔗 Connect with us:
LinkedIn: Wayne Basford & Judith Leung
YouTube: @BasfordConsulting
Website: basfordconsulting.com

Transcript

SPEAKER_01 0:00

Welcome to Financial Reporting Conversations brought to you by Basic Consulting.

SPEAKER_00 0:04

We're here to make an unknown annoyance of accounting and auditing and command standards nothing so we can avoid the blindfreddy mistakes and do financial reporting better.

SPEAKER_01 0:13

Each episode will appear what the standards really say, what the meaning point is.

SPEAKER_00 0:18

Whether you're a preparing auditor, director, or litigator, is to help you get it right. Hello and welcome to Financial Reporting Conversations. I'm Judas Lang, and as usual, I'm joined by Welling Basford. So last year, in one of my episodes, we talked about the fraud triangle. Welling, you've talked us through the pressure and incentives, rationaliz rationalization and opportunities, and how fraud occurs when these elements come together. Now in a few months' time, we'll be uh you'll be presenting a webinar, and I know you're writing an ice spring course on auditing in China. And from what I know, auditing in an emerging market like China can take fraud risk to a whole new level. And in the webinar, I know there will be a big focus on fraud. Can you take us through this?

SPEAKER_01 1:08

Auditing in China or in emerging markets takes fraud to a whole new level. So and I would the name of the web the way the name of the webinar, the name of the Icepring course will be the China Hustle. And that is stolen from a great documentary that was produced for Netflix, and I believe it is now available on YouTube. It is available on YouTube, and every auditor should watch the China Hustle. Anyone that wants to do business in China, is thinking of investing in China, needs to watch the China Hustle.

SPEAKER_00 1:46

So and they're real stories in the China Hustle, not they're actually more like a documentary, right?

SPEAKER_01 1:54

The China hustle, and it and it's not for auditors, it it is it's actually people, investors, and looking at those people that raised money from listing China's companies on Nasdaq uh in New York back in the in the noughties. So the early 2000s, it was very, very fashionable and lucrative to list mate Chinese manufacturing companies, particularly Chinese mining companies, and the way it happened in the in the early noughties was there were reverse acquisitions, a reverse acquisition, a Chinese operation, a Chinese factory manufacturer reversed into a listed American shell. But noting this happened quite a lot in Australia, but not to the same extent as in New York. And all of these companies or were tended to be audited by the major auditing firms. And again and again, it turned out the companies didn't really exist, their business models didn't exist. And the Chinese the China hustle, the documentary, takes through wonderful examples of sitting outside factories that should have, according to their accounts, should have about a thousand trucks going out every day. And when they put the camera there and watch the factory, there is one truck going out every week, and just the scale of the financial reports say this turnover of hundreds of millions of dollars, and the reality was there was no turnover, there was no customers. They didn't expressly say the PRC, and it lists Indonesia, it lists other emerging markets, but includes the PRC, and it says, beware, auditors beware. You might be auditing that something that doesn't exist, you might be auditing something where it hasn't got customers, you might be auditing something that the assets don't exist or don't belong to your entity. Auditors beware, you might be getting false bank confirmations. So all of this was highlighted, known to the auditing profession back in 2008, and people kept on auditing, people kept on getting wrong, and you know, part of the reason why we're putting out this iceprint course is it would appear that potentially listing Chinese entities is becoming fashionable again. I'm getting quite a lot of calls from uh auditors around the world saying, Wayne, I I know that you've I've heard that you've done a lot of Chinese audits. What do you think? Should I get into it, what do I need to know? So it's becoming relevant again.

SPEAKER_00 5:38

Yeah, so thanks. So yeah, like I know you've done have firsthand many firsthand experiences auditing numerous, done numerous audits in China. So when you are auditing a market like China, what are some of the specific red flags that auditors should be particularly be alert to? What do you tell the people who called you up and ask? What do they need to know?

SPEAKER_01 6:02

It it is watch the China Hustle, read the PCIP Alert 8. And assume going back to the this fraud triangle, the opportunity is just make up a set of records. There is great diligence to recreate false records. So assume the business doesn't actually exist. So they have no customers, they have no product, but you can still actually fabricate a set of accounts. All you need to do is raise an invoice. You know, it it is classic double entry creation. They all really, or I think most of these frauds are the same. I haven't got a customer, but I will create records to show that I've got a customer. So it is as simple as I raise an invoice, and then I collect cash from that invoice. And the trouble with an auditor is you know, a great audit technique is the best audit documentation is confirmation. So auditors do a DELA circuit, write to the uh customer and say, Is it correct that you owe me hundred million R and B, etc.? They get uh confirmation, and then they go and test subsequent events and they can see yes, the customer paid 100 million R and B, it's fine. But it's completely it's completely false. There is no customer, there were no goods shipped, and you can actually manipulate the the banks the collecting cash in two ways. One is you can actually just round robin, you y y y y all you need is a million dollars to keep on pa going round the bank. You can you can create a fabricated bank by just saying, Oh, I collected a million dollars and then I paid a supplier a million dollars. I collect and you just circulate it within related parties. Or if that's actually too much hassle, or you've not got a million dollars to keep on circulating, you just f falsify your bank records. And you then come up with a mechanism of falsifying the bank confirmation. Um you know the the red flags is does the business make any sense at all? You know, the business models I've seen or people have suggested to me, it doesn't make any sense. We make fertilizer from twigs. And you know that's you compost twigs, you don't make fertilizer from it. We sell fertilizer to Chinese farmers in four litre polybottles or one kilogram plastic bags. It it doesn't make sense. The other one is go and visit go and visit the production facility and it feels wrong, it looks wrong. There aren't enough people around, the the facility looks closed or the facility looks almost derelict. So those are the classic red flags you and whatever you do, you need to go and visit the site and you know audit theory audit theory says fraud, you should consider surprise visits. Whatever you do in China, you really should consider a surprise visit. Go to the factory when they're not expecting you to be there and see whether that factory is A operating or B whether it's changed whether it's actually changed uh name.

SPEAKER_00 10:07

Yeah.

SPEAKER_01 10:07

Because there is a possibility, and this is all the assertions, there is a possibility, a factory exists, a mine exists, but it's not yours. But there'll be collusion for the day that they'll repaint it, re-badge it, and show the auditor this is our our factory. It is fraud, fraud taken to a whole new dimension.

SPEAKER_00 10:31

Yeah, I definitely remember watching the China Hustle where that guy actually, the investor actually went and visit to where the supposed factory site was and then and then sort of then find out it was all sort of bogus. Um so besides um you know visiting factories and surprise visits, what other order procedures that um approaches that becomes particularly important in this kind of um engagement?

SPEAKER_01 10:58

A lot of it is trust the tax records, you know, for for all of this conversation. China is a very well regulated environment and the Chinese government expects people to lodge VAT invoices, expects correct lodgement of documents, uh tax documents. So go and check sales invoices to the VAT system. Go and check tax returns, what was lodged officially with the Chinese government and in what name? Make sure that you're matching up what would be the registration documents and you're not confusing those. Go and try and get and see independent uh shipping documents, who shipped them, what was the carrier, what evidence have we got that a third party actually shipped the goods out. Go and visit, and you you know, almost as as a key thing to do, you have to go and visit customers and then be be aware that they're quite likely and quite capable of fabricating a customer. That you need to go and see the customer's factory exists. The customer has a requirement for the widgets that they're allegedly buying from you. The customer isn't just some weird guy in a little shopping centre or in a rented office on the fourth floor of uh some uh shopping centre, it's a real customer with a real facility. And you know, as in the PCIB thing, you hand deliver bank confirmations, but again, and I speak from personal experience, you need to make sure that you hand deliver it over the counter so you're not g getting a picked it member of the banking staff to hand deliver it to that the client may have bribed. Oh, we are that we're a very important customer, this is our bank relationship manager who comes from behind the the tills, etc., and you give it to an individual who may have been bribed, encouraged to then falsify the bank confirmation. It is skepticism, it is being aware, this base idea that the records you only raise an invoice if w we've sold something, and our issue is whether the amount is collectable, that's not the risk in China. The risk in China is that customer doesn't exist.

SPEAKER_00 13:47

If you're finding this discussion useful, please take a moment to click like, subscribe, and share. It helps others in the financial reporting community discover financial reporting conversations and keeps you up to date with every new episode. So you briefly mentioned talked about professional skepticism. Do you think auditors sometimes underestimate how important that is when they're dealing with unfamiliar markets or different business cultures? Because obviously, China has a very different business culture to Australia.

SPEAKER_01 14:18

We're grounded our own skepticism that you know what could go wrong. Well, we all know that people might dispatch something a few days early, people might put something on a truck a few days before the year end and it's not being dispatched to a to a customer, people might be aggressive on invoicing, but you can't it's walking in with the these people will could be completely lying to everybody. They will lie to you when you're asking questions. The whole board, you know, the whole board is false. Nobody everybody knows this business doesn't exist, we are just here to achieve a certain outcome. And classically, you know what, and looking back from some of my own experiences and reading a load of stuff on it, it is classic, you only deal with one or two people. So a real business, if you're auditing properly, you would speak to the sales manager, the production manager, you'd go and chat to the storekeepers, etc. But when you're auditing overseas, well, it's a wonderful barrier. Well, the only there's only four people that can speak English. You know, the language barrier, and again, for even to all my Singaporean friends and Malaysian Chinese friends, their putting noir is not necessarily that good. And even they're working through people that they can communicate more easily with rather than ask direct questions of what should be, you know, there should be a workforce of a thousand people, but there might only be five. And when you look at who the auditor spoke to, they only spoke to the five. And you may actually get deliberate situations where the financial controller might actually not be even in China. That allegedly the financial controller is either in a major city, not where the factory is alleged to be, or you might get the financial controller is allegedly in KL or in another non-Chinese entity. So you're you're actually auditing somebody who may have been subject to the fraud themselves. That person is the bookkeeper, that person's trying to desperately process the invoices and records they're being given from China, and that person is being that person's being paid, they're the group CFO, they're the group reporting manager, but they're actually not close to what should be the factory or the production facility.

SPEAKER_00 17:18

I mean, obviously, Malaysian and Singaporean business culture is very different to China, so even though uh maybe um people who are doing the work maybe they can speak Chinese, there's the the culture is still um quite different.

SPEAKER_01 17:33

I was auditing in Singapore back in '99, back in 2000, and I was watching Singaporean entities, Singaporean government entities be losing millions because even though they can speak pretty good Mandarin and have all the traditions, for all fairness, the cultural differences between doing business in Singapore, a very honest, very well regulated environment, and doing business in China and the business practices in China, that those guys just weren't equipped to be real Chinese.

SPEAKER_00 18:15

Well, for auditors who may not have worked in China before, what would be the most important thing they should understand before accepting any sort of engagement in China?

SPEAKER_01 18:25

Go and read PCOB Alert 8. Check with their affiliate firms in in China. Don't assume that it is possible to audit China without a good Chinese speaking team and a team that's got experience of performing audits uh in China and assume uh f full skepticism. For the primary risk is this business doesn't exist. My primary business is the factory doesn't exist, I've got no customers, or if the factory exists, it's not mine. And you know, your client acceptance uh what how are they gonna prove to you because we're you know this isn't a uh an unknown situation, we all know it. How do they prove to you that it's a legitimate business? What are your vouching, what's their reputation of the of the board? What's their connections uh uh uh does the business make sense? So i uh it is it's doable, but I I I still to this day believe the opportunities for dual listings, cross-border listings, it should it should work. It should be mutually beneficial for for Australia for the PRC. But it's it's got its risks as attached with it.

SPEAKER_00 20:01

And with ACES 600, there's a lot more onus on the the the engagement partner.

SPEAKER_01 20:09

You could never say, okay, somebody please go and audit China and tell me it's okay, and I'll sit here in in Australia and say, yep, thank you very much. It's it's always gotta be there now. 600, which is two and 220. The engagement partner has to be sufficiently involved in the audit of the Chinese subsidiary, has to be able to go there, review it, direct it. So you can't delegate in any group audit, you can't delegate responsibility to a component auditor. But you know, 600 says, can you do the audit without a component auditor? And in reality, you need to be involving to us to whatever degree you need to be involving Chinese auditors. The tax, you know, let's go and check the the tax work, let's go and check the VAT work. You know, doing searches on customers, who is this customer, what do they buy? What's their results? You know, according to my records, I've sold a hundred million to them, but according to all the Chinese records, they're a sort of two RMB shell that buys TVs or something, you know, that that you can actually verify customers, and you need to verify customers, you need to verify suppliers. Chinese records, Chinese information is really good. But there's a lot of it that's only accessible to the Chinese. Like quite rightly so. But so therefore go and use your Chinese component auditors, go and use your your network firm in China, in the province in China.

SPEAKER_00 22:01

The Great War, Information War of China.

SPEAKER_01 22:10

But which I think is very valid and very sensible. But when you're in China and you are a registered company auditor in China, subject to great regulation, you actually can do your job and you can access all that information that in all fairness, in in a lot of cases, China is a lot more technologically efficient than than Australia. So the records that are available are very good, providing you're allowed access to them.

SPEAKER_00 22:44

Thanks, Myan. So let's wrap up here. Um your Southside, there are there are actually not sound, but there are very practical insights here for auditors working in China.

SPEAKER_01 22:56

And Judith, if I can just it's not just the auditors. Remember, part of the China problem is entities, big entities, have spent millions of dollars buying businesses in China, buying assets in China, and with due diligence by the larger accounting firms, with audits by the larger accounting firms, and then have actually discovered the business didn't exist. Or they've got a great opportunity, you know, the magnet of 1.3 billion people, second largest economy in the world. I am going to sell some product into China, and I need a business partner in China, I need a distribution network in China. Well, there's a lot of businesses that have spent a lot of money and have been subject to the same sort of issues. They bought a business that didn't exist. We're going to live in the century of China. We need to do business with them, but be aware of the risks of doing it.

SPEAKER_00 24:04

And like you said, Chinese listings um are coming back into fashion. So um, yeah, so plenty of insights here. And if you'd like to explore these issues in more detail, you know, as I've said before, Wayne will be presenting a webinar and we also will have an Iceprin course on auditing in China. So um, if you're interested in the webinar series, we'll love for you to join us. Please go to bassfoodconsulting.com, or you're very welcome to get in touch with us. Thanks again for joining us for this episode of Financial Reporting Conversations, and we hope to see you at some of our training.

SPEAKER_01 24:40

Thanks for listening to Financial Reporting Conversations. For guidance on applying accounting and auditing standards, or to access our online training programs, please visit BassfordConsulting.com.

SPEAKER_00 24:51

Don't forget to like, subscribe, and share this episode with your colleagues and contacts. We'll see you next time where we make the unknowns in financial reporting known.