Muddy Waters and NQ Mobile Inc (NASDAQ:NQ) have been involved in a back-and-forth scuffle which is becoming more interesting by the day. Carson Block, founder of the research firm, broke the relative calm of the last few days dropping the bombshell on Friday that NQ Mobile will be delisted within a year, sounding very confident. While speaking with Stepahnie Ruhle on Bloomberg TV, he said that he had no doubts about what they had said before – NQ Mobile cannot run a sham for long and asserted that 90% of the company’s revenues are fake.

NQ Mobile

With each day, more firms and experts are siding with one party and supporting their claims. As it happens, the shortseller always gets less support except for the brief shakedown of share price which eventually recovers. We have seen this happen with many public shorts: the panicked selling, the show of support from analysts, the defense from the company and then the relief rally. Shares of NQ Mobile plummeted 60% in the three days following Muddy Waters’ bearish report, and then had gained back more than 40% – that is, until last Friday.

NQ Mobile’s largest customer does not exist

The tussle broke on October 24, when the research firm released a report saying that NQ Mobile has fraudulent business and management practices and almost nothing on its balance sheet is close to truth. Muddy Waters said that NQ Mobile, a mobile phone software security firm, is not just running an accounting fraud, the company is running just an outright fraud in China.

The blunt allegations from the shortseller, famous for bringing down Sino Forest Corp, are getting more and more pointed. MW has alleged that the company’s largest customer is actually just itself. MW claimed that NQ Mobile’s largest customer Yidatong is a shell setup, where NQ Mobile’s former employee Xu Rong has a 75% ‘nominal’ stake. MW has said that Yidatong is figment of imagination with no offices at five of the ten listed addresses in China.

NQ Mobile: Why no level 1 assets?

One of Muddy Waters’ allegations that has generated the most hype is NQ Mobile sorting cash and cash equivalents as Level 2 assets on its balance sheet. Allen Huang, an accounting professor at Hong Kong University of Science And Technology, said that classifying cash as level 2 is not wrong in essence but there is usually some cash at level 1. NQ Mobile has nothing. In response to Barrons’ Shuli Ren, Huang said,

“The fact that all their cash and cash equivalent is in level 2 means they have no cash at all, only short term debt security, and those securities has no trading in active market. So I would seriously worry if a firm doesn’t have any cash on hand and no active market to sell their so-called cash equivalents.  If you can’t even trust the cash, what can you trust?”

In response to this, NQ Mobile said that classifying cash and cash equivalents as Level 2 is in accordance with the U.S. GAAP guidance of fair value measurement. The company also referred to the analysis of a an accounting professor at Peking University, Paul Gillis, who said that reclassification to Level 2 asset is not such a big issue and is in agreement with the accounting guidelines. In response to our request for comment, Prof. Gillis said,

“The kerfuffle over how cash was reported at NQ Mobile has been blown way out of proportion.  Level 1 or Level 2 refers to the methods used to value the accounts, not the liquidity or validity of the accounts.  Level 1 assets are those you can find identical quotes on – mostly listed securities.  You can’t find listed quotes on Level 2 assets, like bank deposits and certificates of deposit, but they are easily valued by reference to other quoted assets like newly issued CDs and actual currency.  NQ didn’t report any Level 3 assets – those are hard to value ones like derivatives or hedge fund interests.”
Other than the technical issues with the accounting standards, Prof.Gillis went on to point out the more important questions that needed deliberation,
“The real issue at NQ is whether the cash and CDs actually exist.  Many Chinese companies have fallen when it is discovered that the company was giving fake documents to the auditors to cover up missing cash, sometimes with the help of banks.  Auditors have upped their game in this area and I would be surprised if PwC was duped in the NQ case.”

While Gillis and bullish NQ Mobile analysts may be hopeful that auditors are not duped these days, it has happened many times in the past. Like Carson Block pointed out in an interview, that they have seen companies defraud auditors numerous times in China with forged bank statements. He shared an anecdote: “One of my team members tells a story of reviewing a bank statement dated February 31st once in their work in the China investment world. Anyone who has an Inkjet can forge statements.”

Muddy Waters has little favor with accounting experts

The latest survey from Bloomberg finds little enthusiasm in accounting experts regarding the validity of Muddy Waters’ claims, their analysis being in line with Prof. Gillis. David Bassett, an analyst at CFRA, a accounting and analytics company, also said that the reclassification of assets at level 2 on its own cannot prove that the cash does not exist. However, he said it is suspicious

Regarding the claim that NQ Mobile’s only customer is itself and that it had fake addresses, Bloomberg found the primary address to be valid and Yidatong employing more than a dozen people. Xu Rong said that the addresses that Muddy Waters called fake were ‘virtual addresses’ that were set up to comply with regulations. Cadwalader Lee of Wickersham & Taft LLP in Beijing said that as long as the cash is real, the customer being a related party does not exactly constitute fraud.

NQ Mobile: Daily sales outstanding, a red flag

Rather than the ‘blatant’ loopholes that Carson Block referred to in his report, one professor of Georgetown University found the allegations that sounded less worrisome more convincing. James Angel said that the near five month lag that the company faces in getting paid from its customers, especially in Middle East and Southeast Asia, is a red flag. He explained, “This is one of the classic signs of a fraud. You can easily manufacture sales with the stroke of a pen, but if you don’t have cash, what you have is a receivable.”

According to Bloomberg, the company’s Daily Sales Outstanding (DSO) was 144 days in second quarter, in stark contrast with competitors like Qihoo 360 Technology Co Ltd (NYSE:QIHU) that had DSO of  22.4 days in 2012 and Tencent Holdings Ltd (HKG:0700) with 18.2 days.

Marcum Bernstein & Pinchuk LLP is siding with NQ Mobile; the analyst firm has met with the company’s management and is probing the worth of MW’s allegations. Bernstein has said that there are other Chinese companies who have even longer DSO.

Chinese media; lies or truth?

It appears that the Chinese media also has some insight into whether NQ Mobile is being truthful about its partners or not. According to Muddy Waters’ research, companies that NQ Mobile have claimed it has pre-installation agreements with are denying that any such business exists between them and the internet security firm.

ZTE Corporation (SHE:000063), Huawei Technology Co Ltd (SHE:002502), Lenovo Group Limited (OTCMKTS:LNVGY) (HKG:0992), said that they had  no pre-­installation contracts with NQ Mobile, according to interviews conducted by a Chinese reporter.

While other companies have refused to comment on their partnerships with NQ Mobile, Brion Tingler, a New York-based spokesman for Lenovo said, “We can confirm

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