Variable interest entities (VIEs) are used to include companies in consolidated financial statements in situations where the company is controlled through contracts instead of the more conventional control provided by ownership. Control by contract is often inferior to control through ownership, and investors have suffered badly when VIE arrangements go wrong.
Most of the attention to VIEs and their risks has been focused on U.S. listed Chinese companies. These companies make extensive use of VIEs (about half of the U.S. listed Chinese companies use them) primarily as a means of circumventing Chinese regulations that restrict foreign investment in certain sectors. VIEs have also been increasingly used to circumvent other cumbersome regulations and a few have been used for no discernable reason. Hong Kong regulators recently announced that they would not approve the use of VIEs for companies listed in Hong Kong unless the VIE operated in a restricted sector – a rule apparently designed to stop wider use of VIEs.
Academia is a second career for me. While I enjoy the classroom the most, a close second is working directly with students on research. It is rewarding to see their minds open up as they struggle with a new idea. Many of the posts in this blog come from their work.
I am quite proud of Quintus Dienst, a German exchange student from last year, who just won the best thesis award from Zeppelin University in Germany. He focused on the taxation of VIEs and has the first original work I have seen in this area. His thesis is linked here and it is a good read for those interested in this topic. I have asked him to do a couple of guest posts on taxes and VIEs – a topic that is timely since the New Oriental scandals. The posts should be up in a few weeks.
I have a new crop of graduate students looking for interesting research topics, so I am crowdsourcing here. I like to encourage research that has practical application for investors. If you have any ideas for academic research related to accounting in China or overseas listed Chinese companies, post them here or send me an email. I am also looking for China focused funds that could participate in our Consulting Practicum where MBA students do a project under joint supervision by the fund and a faculty member.
Lew Ferguson, Board Member of the Public Company Accounting Oversight Board, today talked about the problems the PCAOB is facing in China at a speech at the California State University 11th Annual SEC Financial Reporting Conference in Irvine, CA. His comments are the most expansive to date from a senior PCAOB official on the issues related to inspections in China. The full speech is linked here.
Ferguson indicates that a tentative agreement on observational visits has been reached:
As a first step toward further cooperation, we are working toward and have tentatively agreed on observational visits where PCAOB inspectors would observe the Chinese authorities conducting their own audit oversight activities and the Chinese could observe the PCAOB at work. This would not be a substitute for a PCAOB inspection but would be a trust building exercise between regulators. Initially, such observations would focus on quality control examinations of the audit firm being examined rather than a substantive review of a specific audit. We hope such exercises will build trust and lead to further cooperation.
Sullivan & Cromwell has published a brief, but excellent, guide to new requirements for listing companies using VIE structures in Hong Kong.
Hong Kong allows use of the VIE structure but is imposing more requirements than the SEC. For example, in cases where VIE structures are adopted for companies in unrestricted industries, the listing division refers the case to the listing committee, and if a business becomes unrestricted, it must be removed from the VIE. That is a requirement that New Oriental shareholders may wish was in place in the U.S.
VIE is actually a U.S. accounting term. Hong Kong requires use of HKFRS, which is essentially the same as IFRS. Nevertheless, similar rules apply under U.S. GAAP and IFRS for consolidation of VIEs and the same result can be obtained under either standard. You won't likely see the term VIE in Hong Kong financial statements, however. That has made it difficult to determine if a Hong Kong listed company uses a VIE structure. The new disclosure requirements, however, will make that clear.
There is growing concern that the Securities and Futures Commission (SFC) suit against Ernst & Young in Hong Kong for failure to produce working papers could lead to the same delisting risk that U.S. listed Chinese companies face. I think that concern is misplaced. Hong Kong is not going to delist Chinese companies, but it might blow up its own accounting profession to keep them.
The current issue relates to Standard Water, a company with a failed IPO in Hong Kong. E&Y Hong Kong was the reporting accountant. But when SFC came to ask for the working papers, E&Y demurred, saying it was actually their Mainland affiliate who did the work and that China’s state secrets laws precluded it from turning over the working papers.
While that seems similar to the cases that have put Deloitte in China at odds with the SEC, there is a big difference. In the Standard Water case, it was E&Y Hong Kong that actually signed the audit report. That matters.
If you sign an audit report, you are first supposed to do an audit. While you can subcontract out parts of the audit to others, the signing auditor still has to do most of the work and take full responsibility. And taking that responsibility also includes keeping a set of working papers that support the audit opinion.
The ChinaHR annual list of top employers in China is out. It ranks companies based on compensation, brand, corporate culture, and career development. State-owned enterprises dominate the list, yet 18 of the top 50 are foreign companies, an increase of eight from last year.
Three accounting firms made the cut. PwC breaks into the Top 50 at 30th place. It was unranked last year. In the United States, a similar study by Fortune places PwC at 48th.
KPMG comes in at 37th. It was also unranked last year. In the U.S. KPMG is 94th.
Deloitte is ranked 47th in China. It was not ranked last year. It is 67th in the Fortune study.
Ernst & Young did not make the top 50 in China. It is 59th in the U.S.
The top five slots went to:
1. China Mobile
2. Proctor & Gamble
Google is ranked #1 in the US.
Enoch Yiu has an interesting piece in the South China Morning Post today about Ernst & Young's battle with Hong Kong's Securities and Futures Commission (SFC). SFC is dragging E&Y into court over its refusal to turn over its working papers on Standard Water, a Chinese company that had a failed listing in Hong Kong.
E&Y's defense is that it cannot produce the working papers because of China's state secrecy laws. That is the same argument that Deloitte has made in its fights with the Securities and Exchange Commission in the United States. In this case, however, the article suggests that SFC may have already received the consent of mainland regulators to see the working papers.
While E&Y Hong Kong was the reporting accountant on Standard Water, it appears that E&Y Hua Ming, its Mainland joint venture actually did the work. Under Chinese rules E&Y Hua Ming is not supposed to share its working papers with its Hong Kong affiliate. But that happens all the time. KPMG has its Hong Kong affiliate sign all of the reports on its clients with U.S. listings, even though the audit work is often done by the Chinese firm. A Hong Kong firm can use a Mainland firm to help with an audit, but if it is going to sign off on the accounts its working papers must fully support the audit.