Introduction

Luckin Coffee is a Chinese beverage chain that fabricated sales figures worth $310 million in 2019. The figures comprised more than 40% of Luckin Coffee’s 2019 revenue.¹ The COO, Liu Jian, CEO Jenny Qian Zhiya, and several executives were incriminated and fired. Ernst & Young was Luckin Coffee’s external auditor. They identified the non-conformance of auditing standards in Luckin Coffee’s financial statements. This case study explains the Luckin Coffee scandal and the role of external audits in uncovering fraud.

Timeline: Luckin Coffee’s Rise and Fall (2018-2020) ^{2 3}

• January 2018: CEO Jenny Qian Zhiya and two senior executives founded Luckin Coffee. Luckin Coffee marketed its goods and services towards younger people by focusing on takeaways and cashless payments
• June 2018: Luckin Coffee raised $200 million in a series A fundraising round, reaching a valuation of $1 billion. Its investors included Singapore sovereign wealth fund GIC and Chinese investment firms Centurium Capital and Joy Capital
• December 2018: Luckin Coffee raised $200 million in a series B fundraising round, reaching a valuation of $2.2 billion. A few months earlier, it partnered with a Chinese technology firm, Tencent, to co-develop offline retail payment technology.
• April 2019: Luckin Coffee raised $150 million from investors, reaching a valuation of $2.9 billion. It announced plans to open 2,500 new cafes.
• May 2019: Luckin Coffee filed for an IPO at $17 per share. Opening trades increased to $25 per share on its first trading day and closed at $20 apiece, totalling $645 million.
• December 2019: Luckin Coffee overtook Starbucks as China’s biggest coffee chain with 4,500 domestic outlets. 
• January 2020: Luckin Coffee raised $865 million in a post-IPO expansion offering. It rolled out vending machines selling snacks and freshly brewed hot beverages to occupy more of the Chinese market. 
• February 2020: California-based due diligence firm Muddy Waters Research released an anonymous 89-page Luckin Coffee fraud report containing evidence of Luckin Coffee’s alleged inflated sales numbers. It questioned Luckin Coffee’s financial flows, claiming it would short its stock. Luckin Coffee denied all allegations, claiming that the report methodology was flawed. Shareholders filed the Luckin Coffee lawsuit after Muddy Waters Research’s report was released.
• April 2020: Luckin Coffee announced an internal probe into the allegations, which revealed that its COO, Liu Jian, and other employees had fabricated sales figures, including creating false transactions and inflating expenses from April to December 2019. The announcement caused its shares to drop by as much as 80%, eroding its market value by nearly $5 billion.
• May 2020: Luckin Coffee fired COO Liu Jian and CEO Jenny Qian Zhiya.
• June 2020: NASDAQ delisted Luckin Coffee and suspended its shares trading.
• December 2020: The US Securities and Exchange Commission charged Luckin Coffee with issuing false and misleading financial statements regarding revenue, expenses and losses to deceive investors about its financial performance. Luckin Coffee paid $180 million for fraud and accounting irregularity charges.

Luckin Coffee Latest News

Luckin Coffee has moved on from the incident. In May 2022, its first-quarter earnings showed a nearly 90% increase in revenue and profits despite pandemic lockdowns. It maintained 6,590 domestic stores, more than Starbucks’ 5,650 outlets in China.

Current CEO Guo Jinyi acknowledges investors’ scepticism, given the Luckin Coffee scandal. However, Luckin Coffee hired external lawyers to review its internal operations and restructured its teams to prevent fraud.⁴

Luckin Coffee stock prices doubled in 2023 due to management changes, corporate governance strategy improvements and prioritisation of profit growth over rapid expansion. By August 2023, Luckin Coffee had opened five outlets in Singapore, showing potential for further development into the Southeast Asian and East Asian markets.⁵ 

Should I buy Luckin Coffee Stock?

The company improved its corporate governance processes. It has a reasonably good growth rate and expansion potential.⁶ Its stock offers good value, and shares are cheap, with a price-to-sales ratio of 3.7. Its balance sheets are healthy, with no material debt. However, Luckin Coffee stock may not be ideal for value investors who want fast-growing shares with high future returns.⁷

Role of Luckin Coffee’s External Auditors

Ernst & Young Hua Ming LLP (EY) was Luckin Coffee’s external auditor. They audited Luckin Coffee’s 2017 and 2018 financial reports and issued two public statements about their role in uncovering the fraud.⁸

Statement 1 (April 2020): Ernst & Young found fabricated revenue and expenses from 2019 and reported this to the board. 

Statement 2 (July 2020): Ernst & Young found and flagged irregularities in January 2020.

What Caused Luckin Coffee’s Accounting Irregularities? ⁹

Financing rapid expansion: Luckin Coffee aimed to overtake Starbucks to become China’s biggest coffeehouse brand. Their aggressive expansion strategy relied heavily on pickups and delivery orders. They issued promotions and discounts to attract customers. However, revenue from their low-value beverage products and services was insufficient to recoup capital costs spent on publicity and business operations. Luckin Coffee had to present good financial performance in its statements to attract investors and fund expansion.

Poor internal controls: Three people held a significant proportion (62%) of Luckin Coffee’s shares. Founder Lu Zhengyao had the largest share, followed by CEO Jenny Qian Zhiya and Lu Zhengyao’s sister. Luckin Coffee’s highly centralised decision-making structure created poor internal controls and increased the possibility of fraud. 

Lack of regulation: Luckin Coffee operated in China while listed on NASDAQ, the American stock exchange. Differences in the country of operations and listing obstructed effective regulation of Luckin Coffee financials, making it easier to commit fraud.

Conclusion: Lessons Learned

The Luckin Coffee scandal shows how external audits are essential for detecting and preventing fraud. Auditors recognise and flag irregularities in financial statements to protect investors’ interests. Businesses need good accounting practices to gain investor trust. 

Read our Hyflux and KPMG case study for more insight on the importance of audits. 

CorrectCounts helps small businesses with accounting, bookkeeping, and audit processes. We identify areas of improvement in internal controls to help your company uphold healthy corporate governance processes to win over investors.

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References

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7. Ebiefung, W. “3 Reasons Luckin Coffee’s Rally Is Just Getting Started.” The Motley Fool. 20 August 2023. https://www.fool.com/investing/2023/08/20/3-reasons-luckin-coffees-rally-is-just-getting/ (Accessed 12 December 2023).

8. Chung, E. “Case Study: Luckin Coffee Accounting Fraud.” SevenPillarsInstitute. 27 August 2021. https://sevenpillarsinstitute.org/case-study-luckin-coffee-accounting-fraud/ (Accessed 12 December 2023).

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