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PCAOB inspections a win for China

The Public Company Accounting Oversight Board (PCAOB) has not been allowed to inspect accounting firms in China, despite the fact that hundreds of Chinese companies are listed in the United States and their auditors are required to be inspected. China has blocked the inspections because they consider allowing foreign regulators to enforce foreign rules against Chinese persons on Chinese soil to violate China’s national sovereignty, and because of concerns that audit working papers might contain state secrets. Recent academic research suggests it may be in China’s best interest to allow the inspections.

MIT professor Nemit Shroff authored a study titled Real Effects of Financial Reporting Quality and Credibility: Evidence from the PCAOB Regulatory Regime. Professor Schroff examined the clients of non-US auditors that were inspected by the PCAOB and found that audit quality on all of their clients improved, not just those listed in the US and subject to PCAOB and SEC jurisdiction. In other words, there is a spillover effect. PCAOB inspections improve all of the audits, not just the US audits.

Related party rules miss the mark

A recent activist short selling report on Hong Kong listed China Zhongwang Holdings (1333 HK) alleges an elaborate scheme the heart of which is the alleged sale of billions of dollars of aluminum to companies controlled by the Chairman’s family and proxies. I have no opinion as to whether the allegations are correct, but they do illustrate a problem I see as a major obstacle to corporate governance in Asia.

The report lays out what are alleged to be undisclosed related parties. Hong Kong has strict rules about related party disclosures, probably because Asians seem to have a preference in doing business with the family. That is, of course, of great concern to investors, since profits can easily be tunneled out to insiders by mispricing related party transactions. 

From what I can tell, however, most of the alleged undisclosed related parties may not be related parties under the rules, or it may be impossible to prove that they are. The rules that define a related party are set forth in Hong Kong Standard on Auditing 550 and define a related party as one of these situations:

Will China let the PCAOB in?

One of the major problems with Chinese companies that use the US capital markets has been the inability of US regulators to effectively regulate them. The Public Company Accounting Oversight Board (PCAOB) regulates auditors of all US listed companies, but has been banned from conducting inspections of these accounting firms in China because China has viewed the enforcement of foreign laws on Chinese soil by foreign regulators to be a violation of its national sovereignty.

The PCAOB has been unsuccessfully negotiating for access for over a decade. A measure of cooperation was reached in 2013 when Chinese regulators agreed to cooperate with the PCAOB on enforcement matters. Enforcement, however, is a small part of the PCAOB’s mandate, and they have remained blocked from doing inspections on Chinese soil. That included Hong Kong to the extent the matters related to the mainland. China has blocked the removal of audit working papers from the mainland, meaning there was no alternative way to conduct the inspections.

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