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PCAOB leniency program

The PCAOB has announced a new policy that offers leniency if firms turn themselves in for violations of PCOAB rules. The SEC has similar rules. These leniency programs make sense – they discourage firms from covering up and protect investors by getting at the problems quicker. 

Given that the PCAOB cannot do inspections in China at present, I doubt many Chinese audit firms are planning to turn themselves in. They should probably think twice about that. 

If there is a breakthrough in negotiations between U.S. and Chinese regulators over audit working papers and inspections, the problems of the firms may just be beginning. I expect that U.S. regulators will arrive loaded for bear. They will likely find a target rich environment, since I don’t believe most Chinese auditors have any idea about PCAOB inspections. Every U.S. audit partner I have talked to who has been through one says he would have traded it for a root canal any day. 

My recommendation is that the firms start making a list. At the top of that list I would put violations of the principal auditor rule. There are a number of situations where the Hong Kong firm is signing off on the accounts of U.S. listings while all of the audit work is done on the mainland. I have previously written about that problem with Hong Kong listed companies, but it also exists with a number of U.S. listed companies. 

Deloitte loses in federal court

A U.S. District Court judge has lifted the stay on the enforcement of the SEC’s subpoena of Deloitte’s working papers on Longtop Financial Technologies. The SEC had asked for the stay last July so that it could attempt to negotiate access to the working papers with Chinese regulators. The SEC gave up on that in December and asked the judge to lift the stay. Deloitte protested, pointing out it was already in the dock with the rest of the Big Four and BDO over the same issue and it was unfair to single them out for early punishment. 

Unsurprisingly, the judge was unimpressed by Deloitte’s arguments and has lifted the stay. Now the SEC and Deloitte will be back in court on May 1 to argue whether the subpoena should be enforced. If that goes badly for Deloitte they will be ordered to cough up the working papers, and when they inevitably refuse to do that (since China has told them doing so would land them in jail), they will be back in court again talking about what penalty should be imposed for contempt of court. I expect that they get banned from auditing U.S. listed Chinese companies, but not the Chinese operations of their MNC clients like General Motors and Microsoft.  But Deloitte inevitably appeals...

IFRS convergence in China

The global accounting association ACCA has released a report it commissioned on IFRS convergence in China. Chinese accounting standards converged with International Financial Reporting Standards (IFRS) by 2007. In layman’s terms, the study attempts to determine whether investors rely more on the new IFRS based financial statements than they did on the statements prepared under old Chinese accounting standards (CAS). In other words, does accounting information prepared under IFRS move the market more than accounting information prepared under old CAS?  

Prior research results were inconclusive, so the authors added more explanatory variables, looking at industry classification, regional development, state control, foreign ownership, delisting regulations, and state subsidy.  

The study finds that there is a significant increase in value relevance after IFRS convergence. That is, investors now pay more attention to financial statements than they used to. There are a number of secondary findings – the financial statements of firms in developed regions, those involved in manufacturing, and those with foreign ownership are relied on more.

Chinese CPA profession to step up?

Simon Rabinovich of the Financial Times has an interesting article about comments recently made by Zhang Ke, senior partner of ShineWing, one of China’s leading local accounting firms.  

Zhang Ke is reported to have said that his firm has all but stopped signing off on bond sales by local governments over concerns that the debt may have become unserviceable. 

At first blush it appears that Zhang is simply stating the obvious – local government debt is out of control. What is remarkable is that his firm is standing up to local governments, and that Zhang is talking so openly about it. I think this may mark the beginning of a new era for CPAs in China. Are CPAs about to take a greater role in governance in China – speaking the truth to power?   

In my opinion, Zhang Ke is the top CPA in China, more powerful than any of the Big Four senior partners. He once headed Coopers & Lybrand’s joint venture in China, only to leave in 1998 to start his own firm after a falling out upon the merger of Coopers & Lybrand and Price Waterhouse. His firm, ShineWing, has prospered, even though he eschewed aligning with second-tier international firms, as have most other large Chinese CPA firms. Instead, Shinewing has tried to build its own international network, a quixotic adventure given the 150-year head start of the Big Four. 

Four fronts in regulatory war

This post is an update of the continuing struggle over accounting regulation for Chinese companies listed abroad. There are currently four fronts in this battle.

SEC v. Deloitte

This was the first case and relates to Deloitte’s refusal to provide audit working papers related to alleged fraud Longtop Financial Technologies Ltd. The case was back in federal court this week for a 90-minute hearing. The SEC wants to lift a stay that the judge imposed back when the SEC still hoped for a negotiated settlement with Chinese regulators. The SEC gave up on that last December and wants the court to force Deloitte to turn over the papers.  Deloitte argues that lifting the stay would put the court in the middle of an international dispute between China and the U.S., and might undermine negotiations for a settlement. The judge asked both sides whether the opinion of the State Department ought to be sought. U.S. Secretary of State John Kerry was in China this week, but I expect he was too busy talking about Kim Jong Un to spend much time on audit working papers. 

Beware of large dividends

The variable interest entity (VIE) structure has many problems. Every Form 20F of a Chinese company using the VIE structurewarns investors that Chinese regulators may decide that the VIE structure is ineffective at circumventing Chinese rules that restrict foreign investment in certain sectors, effectively putting the company out of business. Or the shareholder of the VIE might just decide to disregard the VIE arrangements and take the operations for himself. That has happened a couple of times, often enough to put a permanent VIE discount on the value of these stocks.   

One of the other problems with asset heavy VIEs is that they become impossible to operate over time. The idea behind a VIE is that the public company can get access to the VIE's profits through service charges. That does not work well in practice. It is difficult to explain to tax authorities that all of the profits of the business should be extracted through service charges by a wholly foreign owned enterprise (WFOE) that does not actually do much to deserve them. If the tax authorities disallow a deduction for the service charges to the VIE, the tax rate soars. Even if the deduction is allowed, service charges are subject to business tax at 5%. The other problem is that if all the profits are taken out of the VIE, the cash ends up in the WFOE. The business scope of the WFOE will not allow it to loan the cash back to the VIE, where it is needed for working capital. Because of these problems, many VIEs just continue to accumulate cash in the VIE. 

EDU's VIE disclosures

New Oriental Education & Technology Group Inc. (NYSE: EDU) filed an amended Form 20F for the fiscal year ended May 31, 2012 on February 22, 2013. The amended 20F has been reported in the Chinese press as having been filed on April 3, but I think that is the day they discovered it. The stock was hammered yesterday, but I doubt that relates to the discovery of the filing. 

The amended filing was a consequence of continued SEC attention to EDU’s VIE structure. EDU says the document “does not reflect events after the filing of the original report” but then immediately discusses the reorganization of Deloitte into an LLP, which happened on January 1, 2013. From my review of the document, the most significant change is the signing of a new power of attorney on December 3, 2012 (also after the original report). The power of attorney is between EDU’s WFOE and Century Friendship, Chairman Michael Yu’s private company. The power of attorney allows the WFOE to unilaterally act for Century Friendship on New Oriental China, EDU’s master VIE. The new power of attorney replaces one signed on April 23, 2012, which was presumably not strong enough for the SEC. 

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