China Hongxing (CHHS SP)

China Hongxing Sports designed, manufactured and marketed athletic shoes in China under the Erke brand. In FY08, the company reported that it had 3,824 stores; footwear accounted for 61% of sales, apparel 34% and accessories 5%. It listed in Singapore in 2005, raising an initial RMB176m. It then raised a further RMB481m in FY06 through convertible preference shares and RMB2.4bn in FY07 through an international offering. The company appeared to be hugely profitable whilst it was raising capital from FY05 to FY08, triggering a full 4 points under our Fake Cash Flow model; however, profitability faltered in FY09 owing to a sharp deterioration in sales and then the company reported substantial losses in FY10. Indeed, although gross profit fell 10% in FY10, selling and distribution expenses rose 318%, which appears counter-intuitive. Either this was the one of worst marketing campaigns ever, or a way of extracting cash out of the company. Giving credence to our theory, the company’s external auditors, Ernst & Young (the internal auditors were Foo Kon Tan Grant Thornton), encountered difficulties in verifying the cash balances, receivables, payables and other expenses for the finalisation of the FY10 audit[1]. This led to its shares being suspended from February 2011 onwards. A subsequent special auditor’s report concluded that China Hongxing had overstated its cash and bank balances by RMB1.15bn in FY10 while payments were made without board approval at two key subsidiaries.

We think that the company was faking sales in order to raise external capital, and subsequent losses were a way of reversing fake profits and real cash out of the financials. In September 2017, the company’s former chief executive Denis Wu Rongzhao made an RMB100m offer to acquire the company’s businesses[2], which has since been accepted. China Hongxing Sport is, arguably, a good example of the profit inflation and subsequent deflation of a fraud.

Accounting irregularities were noted by China Hongxing Sports Limited’s auditors Ernst & Young for 2010 year-end.  The irregularities discovered involved significantly overstated cash and bank balances, accounts receivables and irregularities with accounts payables, and other expenses. The discovery of these accounting irregularities was subsequently followed by trading suspensions and a special audit investigation. Previous auditors resigned prior to irregularities found by E&Y.

Stock has been suspended since 2011.

[1] Chona Hongxing Sports: Financial Statements 2010

[2] Singapore Straits Times: Ex- CEO of China Hongxing Sports makes $20.5m offer to buy its operating subsidiaries, 21 Sep 2017

CPA Australia: Corporate Governance Case Studies, May 2013

China Hongxing: Half Year Financial Statement Jun 2010Annual Report 2008

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