Financial Fraud Crisis in China: A Case Study of Dandong Xintai Electric Co. Ltd.

Financial fraud in China’s listed companies has been a persistent issue since the securities market opened two decades ago. Misleading financial information can lead investors to make incorrect investment decisions, causing significant economic and legal consequences. In this article, we examine the financial fraud scandal at Dandong Xintai Electric Co. Ltd., which was delisted from the market in 2016.

Background

Financial fraud in China’s listed companies can distort financial information and lead to incorrect investment decisions, causing losses and misallocation of resources. High-profile cases, such as Guangxia (Yinchuan) Industry Co. in 2001, Guangdong Kelon Electrical Holdings Co. in 2006, and Wanfu Biotechnology (Hunan) Agricultural Development Co. in 2013, have highlighted the need to understand motivations and mechanisms behind financial fraud.

Understanding Financial Fraud

Three theories - the Principal-Agent Problem, GONE theory, and the Fraud Risk Factor theory - help explain the individual and environmental factors contributing to financial fraud.

Principal-Agent Problem

The Principal-Agent Problem arises when an agent (a company’s management) has conflicting interests and asymmetric information from a principal (shareholders). This makes it difficult for the principal to ensure the agent is acting in their best interest.

GONE Theory

Bologua’s GONE theory suggests financial fraud results from four factors: Greed (moral factors), Need (motivation), Opportunity, and Exposure (environmental factors).

Dandong Xintai Electric Co. Ltd. Case Study

Established in 1960, Dandong Xintai Electric Co. Ltd. was listed in 2014 and primarily focused on energy-efficient power transmission and transformation equipment, and reactive power compensation devices. However, in 2016, the company was found to have engaged in financial fraud, including illegal adjustments of accounts receivable and illegal write-downs of material costs.

Illegally Adjusting Accounts Receivable

To reduce accounts receivable, Wen, the Chairman, and Liu, the Chief Accountant, used various methods, such as:

Borrowing money
Sending bank drafts endorsed by clients
Counterfeiting bank bills and payments

These actions resulted in understated bad-debt provisions and overstated net cash flow from operating activities.

Illegal Write-Down of Material Costs

The company reported a lower-than-actual market price for purchasing silicon steel sheets, reducing the company’s reported profit by more than 25 million Yuan.

Reasons for the Financial Fraud

The financial fraud at Dandong Xintai Electric Co. Ltd. can be attributed to:

An incomplete capital market system
An inadequate regulatory enforcement system
Low violation costs
The lack of legal consciousness and greed of management

Preventing Financial Fraud

To prevent financial fraud, it’s essential to address the contributing factors:

Perfecting the Relevant Laws

Establish a standardized compensation mechanism for investors, enhance supervision, and improve the system and relevant laws and regulations for information disclosure.

Enhancing Law Enforcement Efforts

Implement heavier fines, more intense civil liability, and a more efficient delisting system.

Change the cooperation mode between listed companies and intermediaries, and explore new modes to calculate audit fees.

Build a complete moral education system, establish an internal supervision system, and create a right cultural air to educate and cultivate related jobholders.

In conclusion, the financial fraud scandal at Dandong Xintai Electric Co. Ltd. serves as a warning for the Chinese securities market, highlighting the need for improved laws, regulatory enforcement, and moral education to ensure transparency and prevent fraudulent activities. By addressing these issues, China can build a more reliable and robust financial system.