China MediaExpress Holdings, Inc. (fka CCME)

[martych]

Here was my reply.
Tracy
I appreciate your writing your article on cash fraud and following up on the CCME story. I must say however that your article appears to be written without much attempt to do any original research to form an opinion on the specific claims and facts in this story. I don't disagree that fraud exists in some companies and that auditors rarely find it during a normal engagement. If this management team was truly committed to a massive fraud scheme they clearly could have manufactured enough evidence and manipulated enough transactions to get to this point without being caught. However if the standard of proof to claim fraud is what could have happened, then quite a lot of public companies trading on US exchanges are very overvalued.

First a comment on audit guidelines. The audit standard for fraud awareness and risk assessment is something that wasn't mentioned in your articles. Anyone interested can find an article in the Journal of Accountancy that describes SAS 99 in some detail (http://www.journalofaccountancy.com/Issues/2003/Jan/AuditorsResponsibilityForFraudDetection.htm). It's also worth noting that the 2009 audit and the 2010 audit will likely be dramatically different. In 2009 there was no hint of fraud and if the auditors didn't find anything suspicious they would have followed normal audit testing procedures. The 2010 audit would have been constructed to more aggressively pursue the issue of fraud do in no small part to the media attention, the "Deloittewatch" website and the Research Reports you refer to. Suggesting otherwise is just not based upon the realties of how the Big 4 audit firms conduct business with their Liason offices likley interacting with SEC regulators who are already looking at the claims.

Some specific reaction to comments you made above:
- Why would you report that profit grew from $2m to $85m in one year? The reported net income from the company's 10K are as follows: CY07 $6,967, CY08 $26,367, CY09 $41,711

- Did you read the company press release that disclosed the Apple product relationship? Doesn't appear to be the case so here it is (http://www.ccme.tv/eng/ir/press/p101228.pdf). The relevant disclosure was: "CME has already signed contracts with many prestigious global and Chinese domestic companies or their distributors such as Apple..." The Muddy Waters report says: "AAPL only has two online distributors in China, one of which is Amazon.com subsidiary Joyo(www.amazon.cn). AAPL does not have any agreement with SWITOW (or CCME). Further it does not permit its China licensees to sub-license. Therefore, CCME is abjectly lying about this agreement." So look at these two statements and decide. Did CCME claim they had an agreement with Apple or were a distributor or subdistributor? I read that they claimed to have a signed agreement with a distributor. If you do the research you'll find that this retail endeavor is not anything close to a distributor relationship but rather more akin to a commissioned sales agency. I don't see any statement that Apple has approval rights over commissioned sales people or agents so why is this problematic in your view?

Here is the text of what Global Hunter's due diligence was: "We called or met 16 top advertisers, who verified a total of approximately $105MM of revenue or ~50% of our estimated 2010 revenue. We called China Telecom, and the exclusive advertising agents for Coca Cola and L'Oreal, who confirmed they have placed ads on CCME's platform. We also spoke to 17 bus operators, who confirmed that they have signed in aggregate 14,191 buses with CCME, or 52% of the total number of buses CCME reported. The amount of revenues and buses these advertising customers and bus operators confirmed with us matched the numbers in the contracts we reviewed at CCME."
-You state that this doesn't give you comfort because the company would have "had people in place to verify things" and you don't know what questions were asked. So let the reader draw their own conclusion. What is the likelihood this company had the ability to plant moles in significant companies like China Telecom to respond to Ping Luo's inquiries? Note that this company has the exclusive advertising contract with among others Coca Cola so it's pretty unlikely they were conplicit in the arrangement. Yes it's possible that CCME was able to plant someone there in 2007 or 2008 to start assisting in this so call conspiracy without China Telecom's awareness so they could be there to respond to this type inquiry. However improbable that seems it's far more improbable to assume it was done in 15 other companies big enough to do $100m of business with a small upcoming company like CCME.

Your comments on cash audit procedures are pretty minimalist to say the least. I'll paint a very different picture of what is likely happening for the 2010 audit.
- Many engagements start with auditing the November balances and do a roll forward of December activities. It would be logical that this happened here given the timing of the Chinese New Year as it gets some of the work done earlier. While I don't know if this is the case, In 15 years I worked with outside auditors it was always the approach. That would mean they are reviewing more transactions and activity during the last month of the year.
- Audit engagements undergo a subsequent transaction test of transactions from the date of the audit until the date of the audit opinion. That means that there is a review of subseqent receipts and disbursements from 12/31 until around 3/15. Large transactions are being given a little more carefully so if there is anything close to the type of unusual infusion and subsequent withdrawal of cash it would have to be quite cleverly documented or broken down into lots of smaller transactions that are supported by balances at 12/31 in either receivables or liabilities. As you know the reason this is done is to search for unrecorded liabilities or to document the validity of receivables through subsequent C/R.
- An interesting article written by a Chinese professor of accounting can be found here (http://www.chinaaccountingblog.com/schooling-the-auditors.html). In summary he agrees that the confirmation process used in Chinese audits of cash can be forged effectively fooling auditors. However he goes on to say: "I think we can expect that there will be few stones unturned in this audit. I am confident that Deloitte will not sign unless they are comfortable with all of the issues raised by investors."

I'd recommend anyone interested in this story to read Professor Gillis' article for themselves. He appears to be actively following the story and while he is open to the possibility of fraud, is balanced in his review. Unlike this article where it appears the author is already convinced by the articles written by MW and Citron and made no real effort to research or confirm the allegations.

In closing everyone should remember that this company wasn't suspect of fraud until the two reports came out. Muddy Waters in particular claimed that the 2009 revenue of $95m couldn't have been more than $17m. Their rationale? "We estimate that CCME generated 2009 revenue no greater than $17 million. We base this estimate on the metric of revenue per employee in sales and marketing" and "CCME’s 10-K suggests that it has only seven sales people."
I suggest readers look at the 2009 10K since Tracy didn't appear to. The company makes two disclosures on Page 15: " For the year ended December 31, 2009, CME derived 78.6% of its revenue from selling advertising time slots to advertising agencies" and "As of December 31, 2009, CME employed an advertising sales force of 65 employees." Hard to use a metric of revenue per employee to justify fraud when almost 80% of the sales effort is outsourced and your starting point of employees is off by a factor of 10x. So this is what started the discussions about fraud. Now everyone appears to be backing off the original outrageous claims while trying to argue that a less significant degree of fraud could exist. Sure that's possible but again remember that the conversation only started because of outrageous claims that most are now distancing themselves from.