By Dune Lawrence and Belinda Cao

     Nov. 4 (Bloomberg) -- Research firm Muddy Waters LLC was

correct to focus on NQ Mobile Inc.’s delays in collecting

customers’ payments as part of an 81-page report that labeled

the Beijing-based mobile service provider a “massive fraud,”

according to three accounting experts.

     At the same time, accountants, professors and a lawyer

interviewed by Bloomberg News said the report’s criticism of

NQ’s cash accounting and the way the Chinese company got funds

from its U.S. public offering may be unfounded. On other points

Muddy Waters raised in its Oct. 24 report, it’s still hard for

observers to gauge their validity.

     That mixed scorecard helps explain why the stock declined

more than 60 percent three days after the report, then pared the

loss to 44 percent by the Nov. 1 close in New York. It fell 4.5

percent to $12.20 at 11:02 a.m. in New York today. Muddy Waters,

run by Carson Block and best known for exposing fraud at Sino-

Forest Corp. in 2011, gave NQ a strong sell rating and called it

“a zero.”

     “I am on the fence,” said Rocky Lee, Asia managing

partner and head of Greater China corporate practice at

Cadwalader, Wickersham & Taft LLP in Beijing. “When I see a

short seller report, I expect it to be indisputably convincing

and this one, unlike some of Block’s other, better reports, does

not do it for me.”

     NQ has defended itself vigorously, in a conference call,

presentations, press releases and interviews.

                         Uncollected Payments

     The report criticized NQ’s delays in collecting payments

from customers, evidenced in a measure called daily sales

outstanding. At the second quarter’s end, the company’s DSO

measure was 198 days, according to Muddy Waters, which made the

calculation based on NQ’s revenue for the 12 months to June 30.

That would mean the company’s customers are taking more than six

months to pay, on average.

     NQ calculated a DSO figure of 145 days for the second

quarter of 2013, based on the average of accounts receivable for

the first and second quarters, according to Michelle Ma, the

company’s head of investor relations. The company is working to

shorten the time it takes to get paid, Matt Mathison, vice

president of capital markets, said on a conference call on Oct.

25, particularly in the Middle East and Southeast Asia where

delays are the longest.

     Data compiled and calculated by Bloomberg show NQ’s DSO for

the second quarter at 144 days. That’s almost five months.

                         ‘Red Flag’

     A high DSO “to me sounds like a red flag with a siren

going off,” said James Angel, a finance professor at Georgetown

University. “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.”

     NQ’s public filings say the company offers customers credit

terms ranging from 60 to 210 days in international markets and

30 to 90 days in China. The Muddy Waters report also alleged

that it took the company 167 days on average in 2012 to collect

payments from Tianjin Yidatong Technology Development Co.

despite a contract requiring settlement within 30 days. Tianjin

Yidatong is a payment processor through which NQ collects 22

percent of its revenue in China, according to NQ filings.

     Xu Rong, Yidatong’s owner, said in an e-mail that his

company pays NQ within 30 days of collecting from users. Still,

it can take 90 days or more for Yidatong to collect from

corporate customers, which pushes its payments to NQ to 120 days

or longer, Xu said -- “a common thing” in the industry.

                         Carriers’ Delays

     During the Oct. 25 conference call, NQ’s Mathison also

cited the time it takes to collect from mobile carriers as the

reason his company’s DSO within China, excluding international

markets, is in the range of 90 to 100 days.

     “Accounts-receivable balances that dwarf the stated

payment terms, that’s always a red flag, it always increases the

risk of fraud or misstatement,” said David Bassett, an analyst

covering Asia at CFRA, a New York-based forensic accounting and

analytics company.

     Qihoo 360 Technology Co., operator of China’s second-

largest search engine and maker of a competing mobile security

application, had daily sales outstanding of 22.4 days in fiscal

2012. Tencent Holdings Ltd. measured 18.2 in fiscal 2012.

                         Longer Terms

     It takes larger customers longer to make payments,

according to Drew Bernstein, co-managing partner of Marcum

Bernstein & Pinchuk LLP, a New York-based accounting firm

focused on Chinese companies, who said he’s seen companies with

collection periods of as long as two years in China. AsiaInfo-

Linkage Inc., a Beijing-based telecom software developer whose

main customers are the biggest phone carriers in China, measured

189.5 days for sales outstanding in 2012.

     Bernstein said his firm, which provides services to

companies’ audit committees and management teams as well as to

investors, has met with NQ’s management since the Muddy Waters

report was published. NQ hasn’t retained his firm, he said.

     Bernstein and Block have squared off previously. In 2010,

Muddy Waters accused Orient Paper Inc., a paper maker based in

Baoding, of overstating revenue in 2008 and 2009. Bernstein was

the chairman of the company’s audit committee.

     “I believe we ran a very thorough and credible process to

address his claims,” Bernstein said in an e-mail.

                         Accounting Criticized

     After Muddy Waters labeled Orient a fraud, the company

appointed Loeb & Loeb LLP, Deloitte & Touche Financial Advisory

Services and TransAsia Layers to probe the allegations. That

four-month investigation found no evidence to support the short-

seller’s claims, the company said. Orient paper’s share price,

which was $8.33 on June 28, 2010, the day the report was

published, fell by more than 50 percent in the two months

afterward. Though it recovered to $7.28 by November 2010, it

closed at $2.37 on Nov. 1. Muddy Waters hasn’t covered the

company since 2010.

     The Muddy Waters report on NQ also lambasted its accounting

treatment of its cash, cash equivalents and term deposits, which

the company reclassified as so-called Level 2 inputs, from Level

1, in 2011. Companies use three levels to classify assets, with

1 being the easiest to value and 3 the most difficult.

     Level 2 assets are those that don’t necessarily have public

quotes, like a stock price, but which can be valued using data

from public markets.

     Treating cash and term deposits that way constitutes

“significant red flags,” Muddy Waters’s report said. “This

raises questions about how NQ is claiming to hold its cash, and

how NQ’s auditor confirmed the balances.”

                         Rules Change

     NQ appears to have changed the classification to meet a

change in accounting rules, according to Paul Gillis, a

professor and co-director of the International Master’s of

Business Administration program at Peking University’s Guanghua

School of Management in Beijing. The company is following proper

accounting procedures and all U.S.-listed Chinese companies

should follow its example on this, Gillis wrote on his China

Accounting blog on Oct. 27.

     While the Muddy Waters report says the change was

suspicious, the change alone doesn’t suggest any issues, said

CFRA’s Bassett.

     “I don’t think you can conclude that the cash is

nonexistent because it’s classified Level 2,” he said. “Cash

is a hard thing for us as outsiders to really audit, but it’s

not a conclusion that I would go with.”

     NQ’s accounting for its cash is in line with U.S.

accounting rules, the company said in a presentation responding

to the Muddy Waters’s report on Oct. 25.

                         Possible Clue

     NQ is alone in having all cash classified as Level 2, Block

said in a telephone interview on Nov. 1, including the ones

cited by NQ’s management in their response to Muddy Waters.

Classifying all of the company’s cash as level 2 may also be a

clue that NQ’s auditor hadn’t done the cash verification the way

they would have liked to do it, he said.

     Web portal Sohu.com Inc. and its listed online games unit

Changyou.com Ltd. have more than 30 percent of their cash

classified as Level 2 according to calculations based on their

2012 annual reports. Perfect World Co., another Chinese online

gaming company, had 17 percent of its cash balances classified

as Level 2. NQ cited the three companies during its conference

call.

     A related allegation -- that NQ reported moving cash from

its U.S. public offering into its China operations “in a way

that almost certainly would not have been permitted” -- may

also be more red herring than red flag.

                         Complex Structure

     NQ uses a complex corporate structure designed to get

around Chinese government restrictions on direct investment by

foreigners in sectors including the Internet and

telecommunications. The listed company doesn’t technically own

the main business or assets in China, but has a right to profits

from them based on contracts with a “variable interest entity”

-- a domestic Chinese company that owns and operates the main

business. The structure is used by many Chinese companies listed

in the U.S.

     Even under the VIE arrangement, transferring cash from

abroad into China is complicated by the country’s controls on

its foreign exchange. NQ’s disclosures show that its U.S.-listed

company transferred $47 million in IPO proceeds directly to its

VIE, according to Muddy Waters. Such a loan from offshore into a

VIE would require permission from one of two Chinese government

agencies and is almost impossible for a private company to get,

according to Muddy Waters.

                         Connections Count

     “NQ’s purported implausible movement of funds makes it

easier to divert funds without detection,” the report says.

“This claim is reminiscent of Sino-Forest, which also purported

to have moved cash in ways that contravened China’s exchange

controls.”

     A well-connected company can work around such rules, said

Bernstein of Marcum Bernstein. “I would certainly classify NQ

as a company that is well connected,” Bernstein said. The issue

may be poor disclosure rather than fraud, he said.

     “Our lawyer’s take on it is, first of all these people

don’t have that kind of political clout,” Block said.

     There’s more than one way to transfer money directly into a

VIE, said Cadwalader’s Lee, who’s an expert on the corporate

structure. For example, a company might make a directed loan to

an offshore bank and then the same bank, onshore in China, lends

to an individual shareholder of the VIE. That borrower injects

the money into the VIE, he said.

                         Security Concerns

     “It’s not illegal,” Lee said. “I might want to disclose

it, but that’s the company’s decision. The key question is

whether the actual money arrived in the VIE entity.”

     Moving beyond accounting questions, the Muddy Waters report

also attacks NQ’s products, calling its antivirus application

“spyware” that’s “unsafe for sale to consumers,” based on

analysis of the code and its functioning by software engineers

that the report doesn’t name.

     The application creates vulnerabilities in users’ phones

that make them less secure, sends far more data than necessary

to servers in China, doesn’t use basic industry standards to

secure the data and creates fake alerts for viruses, according

to the report.

     An analysis obtained by Bloomberg news of NQ’s Mobile

Security & Antivirus application by ViaForensics, a mobile

security app and testing company, found that the application has

poor security leading to leaked sensitive data. The app does

appear to generate fake virus alerts, according to ViaForensics’

analysis, which also found indications that it sends contacts

and contents of text messages back to the company, “a serious

privacy concern.”

                         Virus Database

     “In terms of the data it collects and sends back to the

vendor, that’s not atypical, because antivirus apps need to

collect a lot of data to protect the phone,” said Thomas

Cannon, director of research and development at Oak Park,

Illinois-based ViaForensics. “The concern is the security is

very poor. You wouldn’t expect that in a security application.”

     NQ Chief Product Officer Gavin Kim denied that NQ sends

sensitive private data to China in the Oct. 25 conference call

with investors. He also said that the virus alerts mentioned by

Muddy Waters are simply a notice to new users of the company’s

virus database about the latest virus discoveries.

     Some of the issues Muddy Waters raised remain difficult to

parse. The report alleged that Yidatong, the payment processor,

is secretly controlled by NQ, calling that revenue into

question. Muddy Waters reported visiting 10 addresses pulled

from China filings, Yidatong’s website and NQ filings, and

finding that five did not exist at all.

                         ‘Virtual Addresses’

     Bloomberg News visited the address that NQ said on Oct. 25

was Yidatong’s “main operating facility,” in a business park

21 kilometers (13 miles) southwest of Beijing. There, about 15

of its workers share space with another company -- both of them

owned by Xu Rong. The 10 addresses that Muddy Waters visited

were “virtual addresses” set up to comply with regulations

that the company have a registered address in each region where

it processes payments, Xu said.

     While Muddy Waters may be correct that Yidatong is a

related party, that alone doesn’t suggest fraud, Cadwalader’s

Lee said.

     “In principle I have no problem with that,” he said. “So

long as the customer is a captive company of theirs under NQ’s

control and the money is real, I am then less worried.”

     Block expressed confidence that time will prove Muddy

Waters’s portrait of the company as a “massive fraud.”

     “Our goal is to get this thing delisted and I think it’s a

very good candidate for that,” he said. “It’s not a close

one.”

                         ‘Higher Bar’

     Omar Khan, NQ’s co-chief executive officer continued the

company’s campaign of defense in an interview on Bloomberg

Television on Nov. 1.

     “We just hold ourselves to a higher bar, frankly,” he

said. “You’ve seen our responses in the last week after these

false and malicious accusations. We did nothing but completely

open up and be very transparent.”

     Determining who’s right may take time. For NQ, “there are

probably some issues that the company at the very least has to

address, and there are aspects in Carson’s report that are

correct,” said Bernstein. “There’s a big leap between a

company that commits fraudulent acts and, perhaps, very bad

management positions.”