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In a shocking development, Caterpillar Inc. (CAT - Analyst Report) announced that it has unearthed accounting misconduct at its recently acquired company ERA Mining Machinery Limited (ERA) as well as its subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. (Siwei). 
 
Financial Impact & Impact on Shares
 
Following the discovery of the fraud, Caterpillar will incur a charge of approximately $580 million (87 cents per share) in the fourth quarter scheduled on Jan 28. Caterpillar, however, added that it will not have a significant impact on 2013 revenue or profit. With the break of this news, Caterpillar stock price fell 1.5% at $96.11 in late trading. 
 
A Brief Background of the Acquisition
 
In a bid to strengthen its presence in the Chinese mining industry, Caterpillar had announced its intention to acquire ERA in November 2011. ERA primarily engaged in the designing, manufacturing and supporting underground coal mining equipment in China through its wholly owned subsidiary, Siwei.
 
Siwei possesses a manufacturing base of 600,000 square meters in Zhengzhou, Henan province, where it manufactures and sells roof support equipment to underground mining customers in China. In June 2012, Caterpillar closed the deal after receiving a go-ahead from the Ministry of Commerce of the People’s Republic of China (MOFCOM).
 
Findings of the Investigation
 
The issue first came to the fore when discrepancies were identified in November last year between the inventory recorded in Sewer’s accounting records and the actual physical inventory. Caterpillar immediately initiated a comprehensive review and investigation. 
 
The investigation revealed that inappropriate accounting practices were being carried out for a number of years prior to Caterpillar’s acquisition of Siwei. This included improper cost allocation that resulted in overstated profit and also improper revenue recognition practices involving early and, at times unsupported, revenue recognition. Several Siwei senior managers had been identified involved in the malpractices. 
 
Corrective Measures Taken
 
Caterpillar has removed the erring senior managers and a new leadership team has been put in place. The responsibilities for Siwei manufacturing operations have been shifted to Caterpillar’s China Operations Division, which will now report to Kebao Yang, Caterpillar Global Mining General Manager for China and Korea.
 
Our View
 
Despite this setback, Caterpillar believes that the Siwei acquisition is well aligned with its strategy to expand its role as a leading equipment and solutions provider for the Chinese coal mining industry. Caterpillar continues to systematically strengthen its business in China and remains committed to providing the lowest owning and operating costs in the industry. 
 
However, signs of a slowdown in China have triggered concerns lately as it will have a negative effect on infrastructure and construction spending. This will in turn negatively impact on Caterpillar’s sales in the near term.  Furthermore, the company faces risks from a global economic slowdown and the expansion of big Chinese companies in the international arena. Furthermore, the slip on part of the management in not identifying the accounting problem will weigh on the shares in the near term. 
 
Peoria, Illinois-based Caterpillar Inc. is the manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. The company is one of the few leading U.S. companies in an industry that competes globally from a principally domestic manufacturing base. Caterpillar operates two divisions – Machinery and Power Systems and Financial Products. Caterpillar currently retains a Zacks Rank #4 (Sell). Joy Global, Inc. (JOY - Analyst Report), H&E Equipment Services Inc. (HEES - Snapshot Report) and The Manitowoc Company, Inc. (MTW - Analyst Report) retain Zacks Rank #3 (Hold) in the same industry.

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