Shandong Molong Petroleum Machinery : RESULTS OF INTERNAL CONTROL REVIEW

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RESULTS OF INTERNAL CONTROL REVIEW

Reference is made to the news release published by The Stock Exchange of Hong Kong Limited (the "Stock Exchange") on 6 September 2019 and the announcement dated 27 September 2019 of Shandong Molong Petroleum Machinery Company Limited (the "Company", and together with its subsidiaries, the "Group") in relation to the appointment of internal control adviser (the "Announcement").

INTERNAL CONTROL REVIEW REPORT

As part of the remedial measures implemented by the Company to improve its internal control system, the Company has appointed Crowe (HK) Risk Advisory Limited ("Crowe") to conduct a review of the effectiveness of the Group's internal control system covering the areas of organizational structure of major business segments and processes/locations, financial statements and operating structure, contact list and duties of key employees, as well as the systems and processes of the Company ("Internal Control Review"). The purpose of the Internal Control Review is to review and improve the internal control system designed and implemented by the Company's management according to the Group's Practical Regulations on Corporate Governance and as required under the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the "Listing Rules"), and to assess the adequacy of the systems, structures and monitoring measures formulated by the Group and whether they are sufficient for the directors of the Company (the "Directors") to make an appropriate assessment of the financial position and prospects of the Company.

The internal control defects found by Crowe in the Internal Control Review and the recommendations for improvement are as follows:

1. Improvement for whistle-blowing mechanism is required (Risk grading: Medium) Entity

Shandong Molong Petroleum Machinery Company Limited

Findings of the Review

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The Company is a listed company in Hong Kong, therefore the senior management of the Company places great importance to good corporate governance. As such, the Company has established the "Regulations for Complaining and Whistle-Blowing" to standardize the whistle-blowing procedure and handling method for malpractices in accordance with the Listing Rules.

Pursuant to the current "Regulations for Complaining and Whistle-Blowing", the administrative office is designated to handle all complaints or reports. The administrative office classifies the complaints and reports according to whistleblowers' identity, and they will be reported to handling units designated by the "Regulations for Complaining and Whistle-Blowing" for investigations. But under the current management structure of the Company, the administrative office participates in the Company's operation and reports to the general manager and deputy general manager, thus it may not have the independence required to appropriately handle all complaints and reports.

Further, the Company has set up complaining and whistle-blowing hotlines, email address and correspondence address. But the current whistle-blowing mechanism and the contact channels are not publicly disclosed for employees and other stakeholders to confidentially report their issues concerned to that independent department.

Recommendation

It is recommended that the Company designates an independent department or personnel (e.g. the audit committee) to directly handle complaints and reports.

The Company should also ensure the whistle-blowing mechanism (including confidential contact means and the handling procedures) reaches employees and other stakeholders through effective channels (such as staff handbook, annual report, company website, etc.) to provide whistle-blowing method for parties in need.

2. Improvement for mechanism of notifiable transactions and connected transactions is required (Risk grading: Medium)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company is currently listed on both the Hong Kong Stock Exchange and the Shenzhen Stock Exchange, and has always strived to comply with relevant Listing Rules. For the management of notifiable transactions and related party/connected transactions, the Company established "Management System of Decisions on Material Transactions" and "Administrative Measures for the Related Party Transactions" respectively, which cover the procedures such as the scope, consideration/decision making and disclosure of notifiable transactions and connected transactions.

The Company confirms that the current "Management System of Decisions on Material Transactions" is based on the requirements under the listing rules of the Shenzhen Stock Exchange, and is subject to improvement for fully covering the requirements related to notifiable transactions under Chapter

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14 of the Hong Kong Listing Rules, to effectively standardize and review the procedure of notifiable transactions under relevant requirements.

Further, other than the "Administrative Measures for the Related Party Transactions", the Company has established "Related Party Information List" setting out a list of connected legal persons and connected natural persons to help identify the potential or actual related party/connected transactions. But the Company confirms that the "Related Party Information List" is subject to improvement for fully reflecting the connected persons under Chapter 14A of the Hong Kong Listing Rules to ensure the completeness of the "Related Party Information List", and effectively comply with the Hong Kong Listing Rules for identifying and disclosing relevant connected transactions.

Recommendation

The Group should refer to Chapter 14 and Chapter 14A of the Hong Kong Listing Rules for improving the current "Management System of Decisions on Material Transactions" and "Related Party Information List" to ensure the comprehensive identification, monitoring and disclosure of notifiable transactions and connected transactions.

Targeting the management of notifiable transactions, the Group should ensure the "Management System of Decisions on Material Transactions" covers the definition and announcement requirements of notifiable transactions under Chapter 14 of the Listing Rules to identify and disclose notifiable transactions, especially including:

• Classification of the transactions pursuant to the five percentage ratio tests (i.e. assets ratio, profits ratio, revenue ratio, consideration ratio and equity capital ratio) as set out in Rule 14.07 of the Listing Rules; and
• Establishment of the reporting, shareholders' approval and announcement requirements for notifiable transactions.

Targeting the management of connected transactions, it is recommended that the Group updates the "Related Party Information List" according to the contents as set out in Rule 14A.07 of Chapter 14A of the Listing Rules, and shall be regularly reviewed by the members of the board of Directors to confirm its completeness, and delivered to relevant departments for identifying, reporting and disclosing connected transactions. Should a member of the board of Directors discover the need to amend his/her connected person list, he/she shall report to the board of Directors through the office to the board in writing promptly, and the office to the board will update the "Related Party Information List".

3. Improvement for independent review of settlement at the end of financial period (Risk grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

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The Company has established the Summary of Checkout Items for Settlement to inspect and monitor the settlement of monthly financial statements. However, it was found part of the checkout items is inspected by the deputy manager of Finance Department (i.e., the Finance Department) and is supervised by the same deputy manager of Finance Department. The process of independent review should be improved.

Recommendation

After the completion of the settlement of monthly financial statements, the deputy manager of Finance Department should pass the Summary of Checkout Items for Settlement to an independent person, such as the manager of Finance Department or chief financial officer, for confirmation and review.

4. Original documents of sales and delivery have not been filed completely (Risk grading: Medium)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

A sum of estimated provisional revenue was identified during the review. Although the Company has provided relevant invoices and recognised such income has been collected, the Company could not provide relevant delivery or customers' receipt confirmation documents of such sales revenue to fully support the estimated provisional sales revenue account.

In addition, while the Company has established the Management System of Sales Business to standardise the sales delivery process, supervision of keeping original delivery documents is yet to be improved.

Recommendation

The Company should keep properly the delivery documents related to sales (including delivery orders by delivery staff, shipping transportation certificate by outsourcing driver, delivery invoices/weighing lists with customers' verification, pickup confirmation letter and etc. ), and it should be passed to Finance Department and Sales Department for verification in the accounting of monthly estimated provisional income.

Meanwhile, the Company should optimise the existing Management System of Sales Business including the regulations of keeping delivery documents.

5. Improvement for supervision of overdue accounts receivable (Risk grading: Medium) Entities

Shandong Molong Petroleum Machinery Company Limited

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Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company determines the credit period for each customer according to their credit rating and products. In general credit period of domestic oil casing customers is 3 to 6 months after invoicing; credit period of petroleum machinery parts is two months. The Company's accounts receivable with aging over one year accounted for approximately 19% of the balance of accounts receivable, in which over more than three years accounted for approximately 18% of the balance of accounts receivable.

The collection of accounts receivable of the Company is jointly follow-up by the staff from Finance Department and Sales Department. However, the current monitoring process of accounts receivable from Sales Department has not been reported to the board regularly for seeking further follow-up comments to speed up the collection progress of accounts receivable.

Recommendation

Sales Department should optimise the current collection system of overdue accounts receivable, prepare and submit written records of the collection of accounts receivable regularly for the review and further follow-up (if the board decides to take legal procedures to recover prolonged overdue receivables) by the board.

6. Enhancement for management process of customers' credit and credit limits (Risk grading: Medium)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company has established the Management System of Customers' Credits to monitor the investigation and evaluation of customers' credit and assets, formulate and approve the credit limit process. Sales Department reviews the sales and repayment of customers to update the Customers' Credit and Assets Survey and Evaluation Form, and to revise customers' credit limit.

During the review period, it was found that an export customer's accounts receivable was past due for over 4 years, yet, the Company has still carried out business with the customer during the year, which led to additional accounts receivable arrears.

In addition, according to the current Management System of Customers' Credits, no credit will be given to Grade C customers, however, it was found a Grade C customer has obtained credit limit, and Sales Department has not obtained and kept any special approval records from the management for the special situation which deviates from the relevant management system.

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Recommendation

The Company should strengthen customers' credit monitoring by establishing an effective mechanism to prohibit the provision of credit to customers who has prolonged overdue arrears, or to require the repayment of all overdue arrears before entering new sales transaction. For special circumstances, special approval from the management has to be obtained to carry out credit sales.

In addition, it is recommended that the Company should offer customers with appropriate credit limits strictly in accordance with the Customers' Credit and Assets Survey and Evaluation Form. In case of special circumstances which require special credit limits to be offered, such as Grade C customers, special written application should be submitted to appropriate management, such as the general manager, to obtain the approval and keep relevant records. The application content should specify the reason for granting a special credit limit to enhance the management process of credit and the supervision of customers' credit risk.

7. Enhance the independence of tender evaluation personnel to bidding suppliers or subcontractors in the bidding process (Risk grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company has established the "Material Procurement Management System" and "Tender Management System" to monitor the tendering and procurement processes. The procurement department is required to conduct procurement with an amount over RMB500,000 by tender. The tender evaluation group designated by the tendering office would review the quotation of suppliers. However, there was no mechanism for declaration of interest in place when the tendering office formed the tender evaluation group to ensure the independence of the members of the tender evaluation group to potential suppliers.

Recommendation

The Company should prepare a form for declaration of independence for members of the tender evaluation group. All members of the group shall sign for confirmation when the tender evaluation group was formed to declare their independence to potential bidding suppliers in order to ensure the independence and fairness of the tender evaluation process, minimize the occurrence of conflicts of interest and secure the interests of the Company.

8. Failure to conduct inventory stock-take in accordance with the current management system (Risk grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

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Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company has established the "Inventory Management System" which requires the warehouse department to conduct a complete stock-take at least every two months using cycle count method. However, in practice, the warehouse department only conducted monthly spot check on the inventory that has movement in that month. Therefore, it failed to ensure that the stock-take was conducted in compliance with the mechanism specified in relevant management system.

Recommendation

The Company should, in accordance with the current "Inventory Management System", carry out a complete stock-take at least every two months using cycle count method. Accounts should be adjusted if any discrepancy is found in order to ensure consistency of accounts and actual inventory status.

9. Enhance the monitoring for reducing long-term inventory backlog and improving inventory turnover (Risk grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company stated that, in response to the urgent needs of customers and the uncertainties in production (such as loss, delay, etc.), the production quantity would be more than the quantity of the sales orders for urgent need. Therefore, some inventory would be accumulated for a long time for sale pending orders from customers.

The management of the Company stated that the Company's inventories will not be damaged due to long-term storage. Therefore, the inventory with long storage duration can still be used and sold. For such, the Company conducts impairment test on inventory annually to estimate the net realizable value of the inventory and make provision for loss in value. However, the Company has not established a policy in response to the long-term backlog of inventory for promotional sales or disposal.

Recommendation

The Company should establish a plan for disposal of the long-term backlog of inventory, such as promotional sales, use existing raw materials to produce, improve slow-moving goods to cater for customers' needs, and report to the board of Directors regularly for monitoring and approval.

10. Written records of the internal impairment test of fixed assets should be maintained (Risk

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grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Finance Department of the Company conducts an impairment test annually. If preliminary indication of impairment exists, a valuation will be conducted by the external third party to assess whether the existing fixed assets need to be provided for impairment. However, there is currently no written record of the assessment of impairment indication of fixed assets.

Recommendation

The Company shall properly maintain the written record of the assessment of impairment indication of fixed assets, which shall be submitted to the person-in-charge of the Finance Department for approval after preparation by the personnel of the Finance Department. If personnel of the Finance Department consider that there is a need for impairment test and provision for impairment after the assessment, it is subject to the approval of person-in-charge of the Finance Department. Relevant complete written records shall be maintained.

11. The plants have not obtained the real estate ownership certificates (Risk grading: Medium) Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

Certain properties and plants of the Company have been put into operation and set up for production. However, the real estate ownership certificates of the plants are still in the application stage. No real estate ownership certificates and related property ownership certificates issued by Shouguang City Real Estate Administration and Weihai City Real Estate Administration have been obtained.

Recommendation

It is recommended that the Company shall maintain a schedule of the application for the real estate ownership certificates to record the expected application date and actual progress of the application for the real estate ownership certificates. The Group shall promptly follow up the status of the application for the real estate ownership certificates to Shouguang City Real Estate Administration and Weihai City Municipal Real Estate Administration, and obtain the official real estate ownership certificates and related property ownership certificates as soon as possible.

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12. Improvement on the control of liquidity is required (Risk grading: Medium) Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The Company has not formally established effective mechanism and measures to specifically forecast and control the liquidity in the following 12 months so as to reduce the current liquidity pressure and risks of the Company.

Recommendation

The Company shall improve the existing monitoring of liquidity to specifically forecast the working capital of the Company for the following 12 months, implement specific measures to improve the withdrawal of monetary funds, and report to the board of Directors for approval regularly, including but not limited to:

• Forecast the annual cash flow budget based on current financial position, all operating and non- operating expenses in the coming year (including accounts receivable, accounts payable, bank loan repayments and interest, etc.); and
• Implement corresponding operational plan and establishment to reduce the liquidity risk, including but not limited to speeding up the collection progress of accounts receivable (especially long-term overdue receivables), improving inventory turnover (especially long-term backlog of inventory), and pledge with group assets (such as plants and new equipment), and actively obtaining long-term loans at low interest, etc.

13. The division of duties and responsibilities of the office automation system approval list shall be improved (Risk grading: Low)

Entities

Shandong Molong Petroleum Machinery Company Limited

Shouguang Baolong Petroleum Equipment Company Limited Weihai Baolong Special Petroleum Materials Co., Ltd

Shouguang Maolong New Materials Technology Development Company Limited

Findings of the Review

The approval and management of users' access of the Company's office automation system are all managed by the information administrator. Other than being responsible for assigning users' access based on employee responsibilities, the information administrator also reviews all users' access on a monthly basis. However, the distribution and review of access of the system users are operated by the same information administrator and there is no sufficient division of authority.

Recommendation

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The Company should assign different personnel for distribution of users' access and review of users' access. For example, the distribution of users' access would be assigned to information administrator while regular review should be conducted by the head of information center.

Opinions of the Audit Committee and the Board of Directors

After considering the Internal Control Review report and the actions that the Group has taken/to be taken, both the Audit Committee and the board of Directors consider that the measures recommended by the Company are adequate and sufficient to deal with the findings of the Internal Control Review report and that the Group will formulate an adequate internal control system to meet its obligations under the Listing Rules.

By order the Board of

Shandong Molong Petroleum Machinery Company Limited*

Liu Yun Long

Chairman

Shandong, the PRC

21 November 2019

As at the date of this announcement, the Board comprises the executive Directors, namely Mr. Liu Yun Long, Mr. Liu Min, Mr. Zhang Yu Zhi and Mr. Li Zhi Xin; the non-executive Directors, namely Mr. Yao You Ling and Mr. Wang Quan Hong; and the independent non-executive Directors, namely Mr. Tang Qing Bin, Mr. Song Zhi Wang and Mr. Cai Zhong Jie.

• For identification purposes only

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