The Big Four has been in China since it opened up – actually some of the Big Four reopened offices that had operated before 1949. Like many foreign companies, they started with representative offices and upgraded to joint ventures in 1992. When China negotiated to enter WTO, it argued for national treatment, which meant that only Chinese CPAs could own Chinese CPA firms. Most countries require CPA firm owners to be locally licensed. The problem is that most Big Four partners in China are foreigners, including many from Hong Kong. The Chinese CPA examination is notoriously difficult, and is offered only in Chinese. Few Big Four partners have attempted the exam, and fewer have passed it. Charlene Barshefsky, negotiating for the U.S. (and indirectly the Big Four), argued that the CPA examination should be offered in English. Chinese negotiators countered that they could agree to that if the U.S. CPA examination were offered in Chinese. Failing in this direction, the Big Four then successfully lobbied to have an exception to national treatment included in China’s WTO accession that allowed the Big Four to continue to have foreign ownership in their existing joint ventures. That solved the problem in 2001.
Most Chinese companies that use the VIE structure have chosen to list on U.S. stock exchanges and use U.S. Generally Accepted Accounting Principles (U.S. GAAP). Some Chinese companies using the VIE structure have listed on other exchanges, most significantly in London, Toronto, Hong Kong and Singapore. While Canada just converted to IFRS, London, Hong Kong, and Singapore have been using it for some time.
U.S. GAAP, has specific rules for variable interest entities (the term VIE actually comes from U.S. GAAP). These have been improved over time and require extensive disclosures about the VIE and the judgments made in deciding to consolidate the VIE in the financial statements. IFRS did not specifically deal with the concept of VIEs, yet the rules were broadly enough written that some companies concluded that they could consolidate VIEs under IFRS. Disclosures are often absent, and it is almost always difficult to determine whether the company actually owns what it claims to be subsidiaries.
Reporter Lou Kilzer of the Pittsburgh Tribune-Review published an article today on Chinese frauds. While the article breaks no new ground (other than libeling me by calling me a lawyer), an accompanying analysis of Chinese frauds is very interesting. The Trib found 105 Chinese companies that are the subject of federal enforcement action or investigation, fraud lawsuits or delisting. It is a good read.
Section 10A of the Securities and Exchange Act of 1934 requires reporting by auditors to the Securities and Exchange Commission (SEC) when, during the course of a financial audit, an auditor detects likely illegal acts that have a material impact on the financial statements and appropriate remedial action is not being taken by management or the board of directors.
Big Four watchdog Francine McKenna has an extensive post on her re: The Auditors blog where she mostly discusses her frustration in trying to find out how many Section 10A filings were done by Chinese auditors in connection with the rash of accounting frauds uncovered in the past year or so. She tried to get this information out of the SEC through a freedom of information act (FOIA) request. Her unsuccessful efforts are chronicled in a post that is both a testament to bureaucracy and a guide on the worst ways to write a FOIA request.
I am betting the answer is zero, and I believe she thinks that too. Most Chinese auditors are probably not even aware of the requirement. Section 10A filings are rare for U.S. companies, since the board usually takes the appropriate remedial action. In many of the Chinese fraud situations, the board or management never did take appropriate action. Although the companies were delisted, it appears that Section 10A filings should have been made.
The Canadian Public Accountability Board (CPAB) fills a similar role to the PCAOB in the United States. It just issued a report blasting auditors for the quality of audits done on Chinese companies listed on the Toronto Stock Exchange. Sino-Forest is the highest profile case of Canadian listed Chinese companies, but the report indicates that there are many more potential problems. The report is a must read for anyone auditing Chinese companies, listed in Canada or not.
The reports indicates that CPAB identified 24 higher-risk reporting issuer audits based in China; 12 of those were audited by national firms and 12 by regional or local firms. Unfortunately neither the firms nor the auditors are named.
CPAB says it is disappointed in the results of its review of these audits. The findings include misapplied fundamental audit procedures, notably around cash confirmations as well as a failure of the auditors to have a sufficient understanding of the entity and its environment. CBAP found a lack of professional skepticism when auditors are confronted with evidence that should have raised red flags regarding potential fraud risk. CBAP says the findings should be a wake-up call for Canada's accounting profession.
AdChina filed for a potential $100 million IPO on Nasdaq on Friday.
Until recently, Chinese companies seeking to do an IPO in the U.S. were allowed to do “confidential filings” that were reviewed by the SEC staff but were not publicly available. That allowed companies to clean up the offering document based on SEC comments before a near final version became available for investors to read. That changed last year and now the initial filings are immediately available on the SEC website. I think the change is good, since the public may raise questions about these IPOs that the SEC staff might have otherwise overlooked, preventing the kind of last minute surprise that appeared to help doom the La Shou IPO last year.
The U.S. IPO market for Chinese companies has been dead since Tudou listed last August. An initial filing by AdChina Ltd was made last Friday, suggesting that the company hopes to soon break the logjam. Fredrik Oqvist pointed out this filing to me, and I dove into it because I am interested in the adjustments that companies are making to deal with the VIE controversy. AdChina uses a typical VIE structure.
China Medical Technologies Inc (NASDAQ:CMED) missed a December interest payment on its $125 million, 6.25% convertible senior notes. NASDAQ has halted trading. The default seems unusual, given the company reported $206.5 million of cash on its September 30th balance sheet. Of course, this could be another case of missing cash that has been covered up through fake bank confirmations. Kerrisdale Capital has posited that the company may be preparing to go dark. Kerrisdale defines going dark as management simply disappearing into the sunset. These companies stop filing reports with the SEC and stop communicating with shareholders. While NASDAQ and the NYSE are quick to delist any company that stops filings, it often takes a while for the SEC to catch up with them. Recently the SEC put 21 Chinese companies on administrative notice that they are in danger of having their shares deregistered after failing to file periodic reports in a timely fashion. Going dark might just work for these companies. The SEC appears to be unable to do anything more than deregister the companies since Chinese authorities are not going to allow them to enforce U.S. laws in China. While the number of class action lawsuits against U.S. listed Chinese companies exploded to 33 in 2011, it remains to be seen if shareholders will be successful in collecting anything. Collection is even more remote in cases where the assets are held in variable interest entities. CMED does not use the VIE structure.