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PCAOB disciplinary actions

The PCAOB this week issued an order instituting disciplinary proceedings, making findings, and imposing sanctions against Brock, Schechter & Polakoff, LLP (BSP), and audit partner James Waggoner. BSP and Waggoner were found to have violated PCAOB rules and auditing standards on the audits of three China-based and Taiwan-based companies. Local Chinese CPA firms had approached BSP to sign off on audits of their clients. The local Chinese firm did substantially all of the audit work. PCAOB audit standards do not allow a firm to sign off on audits that are done by another firm.

The use of local Chinese accounting firms to do substantially all the audit work on U.S. listed Chinese companies where a U.S. CPA signed the report was discussed in Staff Audit Practice Alert No. 6 issued on July 12, 2010. The alert disclosed that during the 27-month period ending March 31, 2010 at least 40 U.S. based CPA firms with fewer than five partners and 10 staff had audited U.S. listed Chinese companies. The alert reported that the Board’s inspection staff had identified situations where U.S. based auditors had signed off on audits without even visiting China during the audit.   

MOF on localization of Big Four

Yan Min and Liu Guangzhong, representatives of the Ministry of Finance responded to recent foreign press reports concerning the localization of the Big Four.  Most press reports have correctly analyzed the new rules as following international practice that requires a local CPA license before a person can own an interest in a local CPA firm.  

Yan said two points needed to be clarified.  

First, Yan indicates that the intent of the rule is not to force out foreign partners.  Yan indicates that about 50% of Big Four partners currently are not locally qualified, most of who are Hong Kong CPAs. Since the new rules limit non-licensed ownership to 40%, all of the unlicensed partners will not be able to continue as partners, and I expect Yan is signaling that it is acceptable for them to be retained as principals. The title of principal is commonly used in the firms for individuals with partner status but without the necessary license to practice. 

Second, Liu said that audit quality would be retained through the changes. He indicated that the core management structure changes will be gradual and will not affect the firm’s management pattern. That is a curious statement, given that the rules require a significant and immediate change in the management committee of the firms and the replacement of the senior partner with a Chinese national within three years. Perhaps Liu is signaling that the current arrangements under which the firms operate Hong Kong and China as a single firm will be allowed to continue. That would make the new rules merely symbolic in effect. 

PCAOB, SEC and Localization

Last week saw three significant developments with respect to accounting in China. First, James Doty of the PCAOB told reporters that he anticipated that the PCAOB would reach agreement with Chinese regulators to observe their inspections of Chinese accounting firms. Then the SEC charged Deloitte with securities laws violations for refusing to turn over working papers on a U.S. listed company.  Finally, Chinese regulators announced rules for the restructuring of the Big Four into locally controlled entities. Taken together, these three events shape up an interesting six months ahead for U.S. listed Chinese companies and their shareholders, who risk getting caught in a regulatory crossfire. 

If Doty is able to close the deal to allow PCAOB staff to observe Chinese regulators as they inspect Chinese accounting firms, he will have achieved a remarkable diplomatic breakthrough. It may set the table for an eventual agreement on joint inspections. I am sure that the Chinese hope that the observations will convince the Americans that they can rely on their inspections. The PCAOB, however, cannot rely on Chinese inspections, and they should not. Chinese regulators are going to be unfamiliar with U.S. GAAP and PCAOB auditing standards. They are also unlikely to have any experience with the major Chinese issue of variable interest entities, since this structure is not used with companies listed in China. 

Local Big Four partners face a big decision

The pending restructuring of the Big Four was big news yesterday. I spent the day talking to reporters from all over the world and in a TV studio near my home. This morning I Googled my name and found I was quoted in 212 newspapers yesterday. Of course, that is part of what the university pays me to do – to provide to the public my analysis of the important social issues of the day. 

What surprises me is the near complete radio silence by the Big Four. The Big Four public response to what is probably their biggest issue in their 30 years in China is mostly “no comment”. One exception came from one of the colonial remnants in Hong Kong who said that China needed to offer its CPA examination in English. (China offered that in WTO negotiations provided that the U.S. offer its CPA examination in Chinese, an offer that the Americans rejected).

I think it was foolish for the Big Four to allow others to define the meaning of this important issue. The near 100 comments on the Wall Street Journal article mostly reflect concern that the changes will undermine audit quality in a market where audit quality is already suspect. The Big Four need to hire public relations advisors. 

Local partners to take over the Big Four

China Ministry of Finance has issued guidelines for the restructuring of the Big Four in China. As I have previously reported, the joint venture terms for the Big Four expire in 2012 for three of the firms with PwC getting an extra five years. Because of a WTO exception, the joint ventures have allowed control by partners who are not Chinese CPAs. Upon expiration of the JVs, the firms must restructure into limited partnerships, which Chinese law (like most other countries) requires be owned by locally qualified partners. 

The MOF guidelines (in Chinese) provide significant relief to the Big Four. The firms can have up to 40% foreign partners with overseas qualifications, ten years of experience and five years in China. The 40% limit drops to 20% by December 31, 2017. Partners have to be at least 40 years old and not older than 65.  

Similar rules apply to the management of the firms. The management committee must not have more than 40% foreigners from 2012 also reducing to 20% by 2017. The senior partner must be a Chinese national and a Chinese CPA. None of the present Big Four senior partners meet this requirement. For them, there is also a transition. They can remain in their existing post for up to three years. 

SEC charges Deloitte China

The SEC today commenced administrative proceedings against Deloitte Touche Tohmatsu Certified Public Accountants, which is the member firm of Deloitte in China for its willful failure to provide audit working papers to the SEC. 

The SEC refers to the firm as D&T Shanghai, which has caused great confusion. This is the member firm that operates all of Deloitte’s offices in China. It was organized in Shanghai and all of the other offices are branches or representative offices of this company.

The SEC had earlier subpoenaed Deloitte’s working papers related to Longtop. Deloitte has refused; saying that to do so would violate China’s state secrets laws and lead to the dissolution of the firm and its partners jailed for life. Enforcement of the subpoena now lies in federal court, and the SEC calls this a “separate matter” in its announcement today. Deloitte filed its response a few weeks ago and the judge has ordered the SEC to respond late this month.  

The administrative proceedings are a separate action that could lead to Deloitte being punished for violating the Sarbanes/Oxley Rules that compel auditors to supply working papers. The SEC says the judge will determine the appropriate remedial sanctions if the judge finds in favor of the SEC staff. 

PCAOB reports China progress

There are two articles out today reporting on an interview given by James Doty, Chairman of the PCAOB. Doty indicates in the interview that progress was achieved during his recent visit to China where he met with CSRC chairman Guo Shuqing and senior MOF officials. 

"We ought to be able to observe the inspections they conduct in the late summer or fall, and certainly by the end of the year" Doty is reported to have said.  Chinese regulators suggested that PCAOB inspectors observe Chinese inspections of the audits that are done in China of U.S. listed companies. Doty cautioned, however "one can never guarantee the outcome of this". Doty indicates that the PCAOB has a number of Chinese speaking inspectors.

Observations of Chinese regulators will not meet the statutory requirement of a PCAOB inspection of all auditors of U.S. listed companies, but it is a good start.  This is an important step forward that may avert the disaster that would occur if the PCAOB were forced to deregister all Chinese auditors.  There is still a lot of hard negotiating ahead, but this is the first good news in some time. 

Big Four restructuring deadline looms

The deadline for Big Four restructuring in China is looming. As I have explained earlier, the joint ventures under which the Big Four operate in China expire in 2012 for three of the firms as they reach the end of their twenty-year life. PwC gets an extra five years because it formed a new joint venture in 1997. Back in the summer of 1992 KPMG rushed to become the first joint venture firm. The other firms all established their joint ventures during the last half of 1982, and they will all (except PwC) begin to expire this summer. 

China is forcing the firms to restructure into limited partnerships owned by Chinese CPAs. The problem is that the firms are presently owned in majority by foreign, including Hong Kong and Taiwan, partners. In order to become Chinese CPAs, these partners would have to pass the arduous Chinese CPA examination. Few have succeeded at doing that. 

The Big Four have been silent about this process, until now. Dennis Nally, global chairman of PwC gave an interview to Dena Aubin at Reuters. Nally reported that PwC was participating in the talks with Chinese regulators, even though its joint venture still has five years left. He said the firms are near an agreement with Chinese officials that will provide a transition period of several years before the ownership of the firms has to change. Nally said that PwC was in better shape than some of the other firms, indicating that some of the firms were having difficulty finding enough locally licensed senior partners to take over ownership.  

U.S.-China SED Update

The fourth meeting of the U.S.-China Strategic and Economic Dialogue took place in Beijing this week. The American delegation for the economic track consisted of 19 people, including Treasury Secretary Tim Geithner, Ambassador Gary Locke, Fed Chairman Ben Bernanke, and PCAOB Chairman James Doty.

Foreign journalists seem to have ignored the Dialogue, focusing instead on the sideshow of Chen Guangcheng. Xinhua reported that the talks yielded tangible results, although those results are hard to find in the joint communications. Mostly, the parties seem to have agreed to keep talking. 

There are two matters related to accounting that are notable – one by its presence and one by its absence. 

The joint fact sheet (which provides much more detail than the U.S. version) reports that China and the U.S. support the objective of a single set of high quality global accounting standards. That means the U.S. agrees to support IFRS, since China claims its accounting standards have already converged with IFRS. In February, the SEC Chief Accountant said an SEC decision on the use of IFRS by U.S. public companies was a few months away. Perhaps this is a hint on the decision. 

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