The CICPA has issued their annual rankings of Chinese CPA firms for 2013. It is bad news for the Big Four. BDO’s Chinese affiliate Lixin jumped over both KPMG and EY to kick EY out of the Big Four in China. RSM and Crowe Horwath’s shared affiliate Ruihua pushed KPMG out when it passed both EY and KPMG last year. PwC continues to be the largest CPA firm in China, extending its lead over Deloitte. PwC’s growth was a modest 4%, while Deloitte actually shrunk by 5%.
Here are the top ten CPA firms in China in 2013:
In most parts of the world the top accounting firms release information on their performance. Although they are private companies, they are public interest entities and the public deserves to look in their drawers just as they look into everyone else's. In China and Hong Kong, however, the Big Four are intensely secretive about their operations. The CICPA data is the only look inside. I believe that the data are generally reliable. It is used by the CICPA to set dues, so cheating upward would be expensive, and cheating downward could risk their right to practice. The revenue includes only audit fees. The Big Four operate their consulting practices in WFOEs and local firms report consulting revenues separately.
Reports are that Hong Kong officials are headed to Beijing to lobby against proposed rules that would require auditors of overseas listed Chinese companies to use mainland affiliates. The mainland proposal appears to be related to fears that Hong Kong accountants could disclose state secrets to foreign regulators. A Hong Kong judge last week ordered EY Hong Kong to turn over working papers related to Standard Water to the Securities and Futures Commission (SFC). EY had refused to turn over the working papers because it had outsourced the audit to its mainland affiliate. The mainland affiliate refused to turn over the papers citing China’s rules. EY’s case was significantly undermined when it was dis-covered at trial that EY actually had the working papers on a hard drive located in Hong Kong.
The mainland proposal would require auditors of all overseas listed Chinese companies to follow EY’s example and outsource the audit work to their main-land affiliate. The mainland offices already audit many, if not most, overseas listed Chinese companies. Over the past decade, the mainland offices of the Big Four have grown to be considerably larger than the office in Hong Kong. Lan-guage barriers and the high cost of sending staff from Hong Kong forced that change long before Chinese regulators thought about requiring it. The proposed rules will not change the way audits are conducted for most overseas listed Chinese companies.
It is unsurprising that the HKICPAs will be opposed. The proposal, if it goes into effect, will decimate the profession in Hong Kong. The proposal will also put U.S. based CPA firms that audit many small U.S. listed companies out of the business.
The proposal probably has little overall effect on the Big Four. The Big Four will simply shift their work to the mainland, where the mainland member firm has the expertise and the required U.S. and Chinese licenses to do the work. The Big Four offices in Hong Kong will likely shrink considerably in size.
The Hong Kong Stock Exchange will need to change the rules and allow the Big Four mainland affiliates to sign off on Red Chips and P-Chips, just as they now allow these firms to sign H-Shares.
There is a fatal flaw in the Chinese proposal. It requires that the overseas firm delegate all of the audit work to its mainland member firm yet retain full responsibility for the audit. The HKICPAs points out that would violate the auditing standards under HKSA 600. It would also violate the principal auditor rules of PCAOB auditing standards. The auditor who does the work needs to take responsibility for it and sign the opinion.
In a carbon copy of the SEC’s case against the Big Four, a Hong Kong High Court judge has ruled that EY cannot withhold working papers on Standard Water, a mainland company that pursued a listing in Hong Kong. The ruling is a major blow to the accounting profession in Hong Kong.
The Securities and Futures Commission (SFC) brought the case against EY. While EY Hong Kong was the accountant of record, they apparently outsourced the audit to EY Hua Ming, EY’s mainland affiliate. When SFC asked to see the working papers, EY Hong Kong demurred, saying they did not have them and that EY Hua Ming had refused to provide them because Chinese laws prohibited doing so.
I am surprised that SFC was not able to work out a compromise with Chinese regulators along the lines of the PCAOB agreement. The PCAOB deal, which allows for a rigorous redaction process, might have been unacceptable to the SFC. Chinese regulators might have been reluctant to give up any turf for fear that the precedent would work against them with the SEC.
The SEC has released some procedural filings related to the Big Four’s appeal of the administrative trial judge decision that banned the Big Four from SEC work for six months. Briefs will not be completed until September, making it near certain that the decision on the appeal will not come within the seven months that SEC guidelines suggest. If the firms lose the appeal, which I expect they will, the decision could happen at the worst possible time – near the end of the calendar year. That would be right at the beginning of audit season for calendar year companies. Unless the Big Four are successful at getting a Circuit Court of Appeals judge to stay the decision, U.S. listed companies on a calendar year will all miss their required annual filings in April 2015.
The best outcome at this point is a negotiated diplomatic solution. The most likely time for such an agreement is the annual Strategic and Economic Dialogue between the U.S. and China that will be led on the U.S. side by Jack Lew and John Kerry. That meeting is expected to be in July in Beijing, but details have not been released.
The South China Morning Post (SCMP) has two articles today that say that Chinese regulators are cracking down on Hong Kong firms coming into China to do audits. According to the SCMP, the proposal will require firms to use their mainland affiliates to staff engagements.
Prior to this proposal, it was possible for an overseas firm to obtain a temporary audit practice certificate to come to the mainland to audit a specific company. The process was cumbersome and often ignored.
Now the mainland affiliate will have to supply the staff for the audit. I believe that was already the case in most Big Four audits. But the rule, if implemented, will highlight the principal auditor issue that I raised on Alibaba last week. Based on Alibaba’s risk disclosures, it appears that the PwC was using mainland staff for a significant part of the audit. This proposed rule will simply make sure they do that, and will likely mean that PwC Zhong Tian instead of PwC Hong Kong signs the audit report.
As the SCMP articles explain, the practice of Hong Kong firms signing mainland audit reports is institutionalized in Hong Kong, and the loss of this franchise will hurt the Hong Kong profession. I observe that all large SOE audits are signed by the Hong Kong member firm of the Big Four, even though I believe that all of them are actually audited by mainland staff.
Alibaba is audited by the Hong Kong member firm of PwC, or at least that is what the audit opinion says. I am a bit skeptical about that claim. While there may be a Hong Kong partner assigned to the account, I will bet dollars to donuts that a large portion of the hours on the audit were done by mainland staff. This raises the question of whether the audit should have been signed by PwC’s mainland member firm instead of the Hong Kong member firm.
Who signs the audit report matters to investors. I have read bloggers who are arguing that investors should trust the Alibaba accounts because the Hong Kong member firm of PwC and not the mainland member firm audited them. The mainland firm is currently appealing a judge’s order to suspend them from practice before the SEC – a ban that does not apply to Hong Kong. I have previously written about the practice of signing China reports in Hong Kong and said it is the same consumer fraud as a Chinese shirt maker sewing ‘Made in Italy’ labels on shirts made in Wenzhou.
Alibaba filed its long awaited Form F-1 to begin the formal march to its U.S. IPO. Alibaba is too big to qualify as an emerging growth company under the Jobs Act, so it was not allowed to do a confidential filing. Most Chinese IPOs file under the Jobs Act, meaning we see only the penultimate filing right before the IPO takes place. This filing is likely to go through several rounds of SEC review and I would speculate that the IPO is not likely to happen until early autumn. Significantly, the document presently includes audited financial statements for 3/31/13 and I expect it will need to be updated with the 3/31/14 accounts before it goes final.
There is a lot to absorb in this filing, so I focused on the headline news about Alibaba’s use of the variable interest entity. As expected, Alibaba has a lot of VIEs since much of its business is in restricted sectors. There is an interesting discussion of how Alipay was extracted from Alibaba in 2011 included in Footnote 4. Alipay is not in the deal, although 49.9% of its income is included through the deal to settle the VIE dispute and Alibaba will get at least $2 billion up to $6 billion if Alipay does an IPO. But it might be worth much more than that.