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With China Small-Caps, It's Shorts vs. Auditors

So we have a real acid test under way here. Which of them, Deloitte or the shorts, will turn out to have egg on their faces? Is this company a dazzling profit-maker or a fraud that will deep-six Deloitte's reputation?

If the worst-case scenario comes to pass, it won't be for lack of waving red flags. Many of these Chinese small-cap companies came into being through reverse mergers, which also was the path to the public markets for many a penny stock shell-company frauds in bygone days. The Public Company Accounting Oversight Board issued an alert last summer, pointing out that "some U.S.-based firms issuing audit reports based on work performed by others outside the United States are not properly applying PCAOB standards." Instead, they rely on the work of overseas auditors. The PCAOB specifically mentioned Chinese companies in its alert.

Deloitte is far too reputable to do that. Or is it? Will this fine, upstanding company turn out to be as much of a sad sack as Frazer Frost, the auditor of the Chinese accounting fraud poster child RINO International (RINO)? Or it will be more on the order of Orient Paper (ONP), another Chinese reverse merger whose shares tanked on fraud allegations, but which was cleared in an internal probe aided by none other than Deloitte & Touche?

It doesn't help that these stocks are prone to extreme volatility abetted by online gabbing, as has been experienced by other small-cap Chinese stocks such as Universal Travel Group (UTA), Fuqi International (FUQI) and China North East Petroleum Holdings (NEP). So even if their financials are as rock solid as the Magna Carta, their share prices are still going to be subjected to spasms.

In the final analysis, it doesn't matter what the auditors of these companies happen to be, whether they are high-priced companies in shiny office buildings in New York or no-name firms in Sheepshead Bay. They can be audited by all of the Big Four in tandem, or they can be audited by the hapless Frazer Frost, a list of whose clients was helpfully posted on Zero Hedge. The supposed prestige of the major firms isn't worth very much, not at a time when Big Four firms miss no opportunity to prove their uselessness, as I pointed out in this space in September.

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