Should Caterpillar Have Noticed This Red Flag?

A filing submitted with the Securities and Exchange Commission by Caterpillar (NYSE:CAT) on January 16 showed that its acquisition of ERA Mining Machinery, including its subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing, was impaired. As a result, the company will be writing off $580 million, or almost the entire value of the $654 million deal.

Caterpillar “uncovered deliberate, multi-year, coordinated accounting misconduct concealed at Siwei” in an internal investigation, the company said in a press release. While the Chinese mining equipment company did nothing that was illegal, governance experts told Reuters that the transactions should have been red flags for Caterpillar, prompting the company and its accountants to “ask some searching questions before pulling the trigger on the deal.”

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ERA corporate disclosures that were filed before Caterpillar’s acquisition showed unusual transactions, reported the publication. Several directors lent the company money at relatively high interest rates and assets were transferred between Siwei and related parties, all with the intention of overstating Siwei’s profitability.

The fact that ERA needed to borrow more than $9.5 million from its directors should have been a concern. The loans generated close to $500,000 in interest for the company’s four creditors, including U.S. businessman Emory Williams Jr., and Li Rubo, a former Chinese government official. These rates were among the highest on its balance sheet…

“It wouldn’t necessarily mean there are cash flow problems but it would be a massive red flag,” a U.S. lawyer experienced with China transactions told Reuters anonymously via email, as the 8 percent interest rate called into question whether the financing was in the company’s best interest. In comparison, ERA’s commercial bank loans were charging rates of 4.9 percent to 7.4 percent at the time, according to the publication.

ERA even came by Siwei in a somewhat unusual manner; Williams and Li financed the 2007 purchase with a $2.95 million interest-free loan, and a portion of those funds came from a $2.565 million loan borrowed from another company where they were both directors.

Caterpillar first became aware of the problems in November 2012, when discrepancies were found between the inventory recorded in Siwei’s accounting records and the company’s actual inventory.

While the $580 million charge is steep, Caterpillar group president Steve Wunning said that the company continues “to believe that the Siwei acquisition is well aligned with our strategy to expand our role as a leading equipment and solutions provider for the Chinese coal mining industry.”

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