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.”

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…