Luckin Coffee Financial Reporting Investigation PDF

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Financial Reporting Investigation...

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Luckin Coffee Financial Reporting Investigation

Executive Summary

Luckin Coffee, once a respected, profitable, company, has been caught up in financial statement fraud. In an effort to beat out their competitors and maintain astonishing performance, Luckin Coffee conducted purchasing schemes and altered accounting records. They fabricated more than $300 million in revenue sales. However, Luckin’s acts did not go unnoticed. They were investigated by the SEC and other Chinese regulators. Luckin was charged with multiple different charges and ended up paying a $180 million penalty to resolve the charges (Luckin).

Luckin employees were able to accomplish all of this because there was a severe lack of internal controls. High personnel, such as the COO, had unlimited access to financial reports and none of his actions were checked by other employees. Although not fully preventable, internal controls can help mitigate the risk of fraud.

Luckin’s actions impacted investors greatly. The SEC has a limited ability to enforce investorprotection laws in different nations (Michaels). This makes it riskier for American investors to take a significant interest in foreign companies. This is an important thing to be aware of when looking into businesses that need investments.

Background

Luckin Coffee is a China-based company that was founded in June 2017. Being a coffee company, its main competitor is Starbucks (Reuters). The two corporations have very different business strategies. Luckin Coffee has locations that function more like kiosks, with little to no seating. Orders must be placed and paid on the Luckin Coffee app (Wang). Meanwhile, Starbucks is known for their in-store cafes where you can order and pay for your drink. They also have drive-throughs that allow for quick service. Despite the limited purchase options for Luckin Coffee, they proved to be very successful during their first year in business. They had one of the most successful U.S. IPOs by a Chinese company in 2017. This helped them attract interest from prominent U.S. investors (Reuters). As their success grew, they wanted to continue to appear profitable. This led to Luckin falsely appearing to have increased profitability and having met the company’s earnings estimates (Luckin).

Discovery of Inappropriate Conduct

Carson Block was a short seller whose firm, Muddy Waters Research, exposed fraud. His firm had a suspicious feeling about Luckin Coffee. Luckin had generated such a large amount of revenue in such a short amount of time. It seemed impossible that they had successfully done this. However, Muddy Waters could not get the proper evidence to support their suspicions (Wang).

Shortly after, Block was approached by a fund manager who was overseeing a probe into Luckin’s operations. This person did not want their name to be the one that released the report on the information they had gathered in the probe. They allowed Muddy Waters to publish the report without their name (Wang). Once this report was released, Luckin Coffee issued an external

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audit. This external audit was overseen by a special committee of its board of directors (Michaels). The external audit confirmed the report and Luckin reported all of this to the SEC. The Sec then began an internal investigation (Luckin).

Inappropriate Conduct

From at least April 2019 to January 2020, Luckin intentionally fabricated more than $300 million in retail sales. They did this by using related parties to create false sales transactions through three separate purchasing schemes (Luckin).

The first scheme involved employees transferring money from controlled individual bank accounts to certain WeChat and Alipay accounts. These WeChat and Alipay accounts were used to create fake customer orders. Revenue was then recognized from these fake orders (Gorman).

The second scheme involved certain employees fabricating coupon sales tied to four fake corporate customers. This began in May 2019. Each fake corporate entity was controlled by Luckin employees. In this scheme, Luckin received double the amount of revenue that it received in the first scheme (Gorman). The third scheme involved combining additional entities with the ones used in the first and second scheme. This time, instant funds were transferred into Luckin’s bank accounts. Bank statements were altered so it appeared that the money originated from agents rather than the companies used to make the payments. The money was tied to fake coupons, fictitious customer orders, and fake redemptions. This scheme generated about 90% of the USD $311 million in total fabricated revenue (Gorman).

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Certain employees tried to cover up these schemes by inflating company expenses by more than $190 million, creating a fake operations database, and altering accounting and bank records to reflect the false sales (Luckin). Chief Operating Officer Jian Liu was one of the staff members that fabricated these sales. All of the employees who were responsible were suspended during the investigation (Reuters).

Enforcement Actions Upon being alerted about the fraud that was occurring at Luckin Coffee, the SEC began an investigation (Luckin). This investigation would be based on the information that was shared by Chinese regulators. Chinese regulators were also conducting their own investigation. China’s top business and commerce regulator accessed information pertaining to the company’s accounts, transaction records, and internal systems (Michaels). The SEC charged Luckin with defrauding investors by materially misstating the company’s revenue, expenses, and net operating losses. They also charged Luckin with violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws (Luckin).

Luckin has paid a $180 million penalty to resolve the charges. This payment can be offset by certain payments to its security holders. This transfer of funds to the security holders will be subject to approval by the Chinese authorities. Many believe that this settlement with Luckin was designed to help ensure that harmed investors have the best available opportunity to receive aid (Luckin).

Remediation Effort 4

In an effort to repair the image of Luckin Coffee, the employees who were found responsible for these fraudulent acts were promptly fired (Luckin). Among these fired employees was CEO, Jenny Zhiya Qian. Shareholders also voted to oust chairman, Charles Zhengyao Lu. Any remaining shares of Luckin Coffee were promptly delisted from Nasdaq (Wang). Luckin Coffee also implemented internal accounting controls in order to prevent a scheme of this magnitude from occurring again (Luckin).

Impact of this Scandal

This scandal shows us two things. It shows the risk that comes with investing in a foreign company, and how financial statement frauds can occur when there is a significant lack of internal controls.

There is a lot of tension when Chinese companies go public on U.S. stock exchanges. This is because the SEC has a limited ability to enforce investor-protection laws across national borders. The SEC has also faced obstacles for years when looking into cases of fraud with Chinese firms that raised money from American investors (Michaels). In order to try and combat this, senate approved a bill that requires Chinese companies with U.S. listings to submit to scrutiny by the PCAOB (Luckin). In order to try and prevent fraud from occurring, businesses should establish a fraud risk management policy, perform regular fraud risk assessments, implement internal controls, and monitor fraud risk. Luckin Coffee was not doing any of these things. They did not have a strong tone at the top and they did not have internal controls in place. Their CEO and COO were involved in the fraudulent acts that were taking place. There should have been segregation of

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duties in place, making it impossible for a single employee to perform an act without it being checked by someone else. There also should have been access controls which would have limited certain employees’ access to things such as financial statements. If these things had been in place, the fraud could have been caught at an earlier time and would not have created such a large loss.

Sources

Gorman, T. (2020, December 17). Luckin Coffee Settles Financial Fraud Action. SEC ACTIONS. https://www.secactions.com/luckin-coffee-settles-financial-fraud-action/.

Luckin Coffee Agrees to Pay $180 Million Penalty to Settle Accounting Fraud Charges. SEC.gov. (2020, December 16). https://www.sec.gov/news/press-release/2020-319.

Michaels, D. (2020, April 29). SEC Investigates China’s Luckin Coffee Over Accounting Scandal. Wall Street Journal. https://www.wsj.com/articles/sec-investigates-starbuckschina-rival-luckin-over-accounting-scandal-11588152604.

Reuters. (2020, December 17). China’s Luckin Coffee to pay $180 million penalty to settle accounting fraud charges. CNBC. https://www.cnbc.com/2020/12/17/chinas-luckin -coffee-to-pay-180-million-penalty-to-settle-fraud-case.html.

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Wang, & Campbell. (2020, July 29). Luckin Scandal Is Bad Timing for U.S. Listed Chinese Companies. Bloomberg Businessweek. https://www.bloomberg.com/news/features/2020 -07-29/luckin-coffee-fraud-behind-starbucks-competitor-s-scandal.

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