GAAP difference or accounting fraud? Evidence from Chinese reverse mergers delisted from U.S. markets

In 2012, one in four federal securities class-action lawsuits filed in the U.S. involved Chinese Reverse Merge companies (CRMs). However, these lawsuits sometimes have encountered difficulties in court due to insufficient direct evidence of accounting fraud. We propose a new method for fraud detection: use Chinese companies dual-listed in the U.S. and China to establish a benchmark for the normal GAAP difference between the two countries. Using this methodology, we find that only a small fraction of the discrepancies between delisted CRMs’ financial statements filed in the U.S. and those filed in China can be attributed to GAAP difference. This suggests that the remaining discrepancies, which are large and unexplained, are indeed due to accounting fraud. Therefore, it is reasonable to conclude that delisted Chinese Reverse Merger companies enticed U.S. investors with favorable and fraudulent accounting and financial data.