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VIE rumors

I have been hearing several rumors about VIEs lately. While these all come from reliable sources, I don’t know how accurate they are. Nevertheless, the rumors illustrate real issues.

I am hearing that one company had VIE agreements that had an expiration date, and that they inadvertently let the agreements expire. They got the agreements back in place; however, there was a period of time when no agreements were in effect. No agreements, no control. No control, no VIE. No VIE, no consolidation. This company faces restatement. Worse yet, there might have been some backdating, and someone might be in deep trouble with the SEC on that. Auditors should be on the lookout for this problem.

I have heard of a couple of situations where the local Administration of Industry and Commerce (AIC) bureaus have been asking questions of the VIEs of multinational corporations. While the VIEs of U.S. listed Chinese companies have not been challenged, apparently some AICs are asking MNC VIEs to certify that they have no foreign control. This is a reasonable request since if the VIE is in a restricted or prohibited industry, it should not be controlled by foreigners. If the company signs that certification, I don’t know how they could justify continuing to consolidate the VIE. “We lied to the Chinese government, we actually do control the VIE?” Auditors ought to be looking for this as well.

Variable interest entities in China

I wrote a guest article for Forensic Asia, a Hong Kong based independent research firm that is 100% owned by Dr Jim Walker of Asianomics. This article consolidates much of my work on VIEs. Forensic Asia has given me permission to publish the reprinted article here

I hope to be writing for Forensic Asia from time to time. 

The terrible twos

This blog is now two years old. I originally conceived of it as a means to expose some of my doctoral research as I came close to completion of my PhD. I have continued it so I can make observations about accounting and financial reporting issues in China. I hope that I am having a positive impact.

Google Analytics provides some amazing data about my readers. There have been over 95,000 visits to this blog and it now sees about 6,000 visitors a month. There can’t be many more people than that interested in Chinese accounting!

The most popular post was the one I did on Explaining VIE structures. It has been looked at 36,000 times. It is a bit dated now, although it is still one of the most popular pages. I recently wrote a more comprehensive article on the topic and I will post that soon. 

My most loyal readers are from the SEC and PCAOB, which is not surprising given my content. Lawyers and accountants have told me that my blog has become a must-read for them, since many of the issues I raise in my posts end up in SEC comment letters a few weeks later. I take that as a confirmation that my work is having an impact. Investment banks, hedge funds, mutual funds, and the stock exchanges are also big readers. I get many visits from universities. My work has spawned a fair amount of academic work in the area. That is good, because I am too lazy to do it myself. 

China's Big Four banks rotate auditors

China has instituted mandatory auditor rotation for SOEs. China’s Big Four banks have now all selected new auditors, and the result will shake up the accounting profession in China. The Big Four banks are the biggest audit clients in China, and they rank among the largest banks in the world.  

The process began in 2010 when China Construction Bank fired KPMG for having the temerity to ask a for a fee increase. PwC replaced KPMG, and since PwC has not served a full five-year term it was not replaced in this cycle. The other three banks all selected new auditors:

Deloitte and PwC are the big losers, and KPMG is the big winner. Deloitte finds itself without a big bank. I have heard that Deloitte had poached a number of partners and staff from ICBC’s former auditor E&Y in anticipation of winning the bank, so it is a major blow to Deloitte since not only do they not have a bank to audit, they have a lot of bank auditors to pay. PwC replaced the giant BOC with ABC, but gets RMB 100 million less in fees. PwC will also lose CCB in three years when it comes up for rotation. I am sure Deloitte will be pulling out all stops to win that one. E&Y may have had a pyrrhic victory with BOC. The fee was slashed from RMB 215 million to RMB 148 million. I can’t imagine the audit will be very profitable at that fee. KPMG’s win at ICBC gets them back in the bank business; I bet they learned their lesson about asking for fee increases. 

Consolidating EDU's VIE

New Oriental Education & Technology Group (NYSE: EDU) has filed its delayed annual report on Form 20-F. EDU claims that the SEC has no objection to the consolidation of its VIE. However, the SEC has indicated it will continue to review EDU’s disclosure documents, including the 2012 Form 20-F, which would not have been provided to the SEC until now. In the Form 20-F the company says the SEC investigation is ongoing, so I don’t understand what is going on.   

If the SEC has blessed the consolidation of EDU’s VIE, this is big news for VIEs, and I am a bit surprised by the result. The investigation into EDU likely was a consequence of Muddy Water’s allegations against the company; allegations that appear to have been discredited. There is an issue present in EDU that Muddy Waters did not raise, but I thought that the SEC would. EDU has an asset-heavy VIE, that is, most of the business at EDU is in the VIE. Consolidation requires that the parent company have a right to the residual profits of the VIE. EDU claims a right to these residual profits because of a series of service agreements between EDU and the VIE. It is apparent that EDU is not distributing all of the profits through these agreements. The question that the SEC should have addressed is whether all that is necessary to consolidate a VIE is a agreement, or whether those agreements have to give access to the residual profits in practice. This is not just a technical accounting question; it also gets to the substance of the arrangements and what the shareholders actually own. If you do not take the profits out as you are entitled to them, will you ever be able to take them out and do you really own them?

Three hundred pieces of silver not buried here

 此地无银三百两。 (This place no silver three hundred money).  

In ancient times, a man called Zhang San had accumulated three hundred pieces of silver after a year of hard work. He was worried that his money would be stolen, so he put it in a wooden box and buried it in his back yard at the corner of his house. This did not completely ease his mind, so he posted a note on the wall saying:  "Three hundred pieces of silver are not buried here."

His neighbour, Wang Er, had noticed the activity in the yard. At midnight he took all the silver. In order to deceive Zhang San, he added a note to the one on the wall saying: "Your neighbour, Wang Er, did not steal the money." 

This is one of my favorite Chinese idioms and it has a lot of use in financial reporting. When management loudly claims that there is not a problem, the situation bears close examination and the problem is probably worse than thought. 

I was surprised to read the latest financial statements from New Oriental Education & Technology Group (NYSE: EDU) and find a statement that is completely inaccurate. Here is the statement, from Note 1 of the financial statements:

EDU: Is the SEC investigation really over?

New Oriental Education & Technology Group (NYSE:EDU) filed its delayed 2012 20F on October 12, 2012. In a press release, the company says this:

…New Oriental was informed by the staff of the SEC's Division of Corporation Finance that, based on the Company's representations made in response to the SEC's inquiries, the staff has no objection to the Company's consolidation of its variable interest entity, Beijing New Oriental Education & Technology (Group) Co., Ltd. ("New Oriental China")…

However, EDU also makes this curious statement in the press release:

The SEC staff has indicated that it will continue to review New Oriental's disclosure documents, including the 2012 Form 20-F.

So, is the investigation over, or not?  

The actual filing raises more issues:

On July 13, 2012, we were informed that the SEC had issued a formal order of investigation captioned “In the Matter of New Oriental Education & Technology Group Inc.” In that investigation the SEC’s enforcement staff has requested documents and information concerning the basis for the consolidation of New Oriental China, a variable interest entity of our company, and its schools and subsidiaries, into our consolidated financial statements and other issues related to certain allegations about us contained in a report issued on July 18, 2012 by Muddy Waters LLC. We are cooperating fully with the SEC in its investigation. We cannot predict the timing, outcome or consequences of the SEC investigation.

PCAOB deal, SEC next?

Chinese press is reporting today a deal between Chinese regulators and the PCAOB to observe inspections. Lew Ferguson, PCAOB board member, indicated on September 22, 2012, that a tentative deal had been reached. Apparently that deal has now been inked. No formal announcement has been made by the PCAOB.

According to the China Daily report, the PCAOB will be permitted to observe official auditor inspections in China, yet will not be permitted to observe detailed reviews of specific audits.  

PCAOB inspections have two parts. First, the PCAOB reviews certain aspects of the firm’s quality control system. This is the part of the Chinese inspections that the PCAOB is being allowed to observe. The second, more substantive part, of the inspections includes reviews of certain aspects of selected audit work performed by the firm. Every audit is not reviewed; rather a sample of audits covering a range of partners and offices is selected. The review of individual audits is the most important part of a PCAOB review, and this is the portion that the PCAOB is not being permitted to observe in China. 

Ineffective internal controls

An interesting academic paper presents some information about ineffective internal control disclosures of U.S. listed Chinese companies. Three professors at the University of Hong Kong, Raymond Reed Baker, Gary Biddle and Neale O’Connor, wrote the paper. 

Sarbanes Oxley requires companies to certify the effectiveness of internal controls and to disclose any material weaknesses. Auditors are required to attest to the effectiveness of the controls annually.  

The study compares U.S. listed Chinese firms with comparable U.S. firms. U.S. listed Chinese firms are broken down into two categories – cross-listed firms that also have a Chinese listing (which are all SOEs like PetroChina or China Life) and direct-listed firms, which are private companies like Baidu or Sina. 

Not surprisingly, private, direct-listed firms from China have significantly more ineffective internal control disclosures than comparable U.S. firms. Certain internal control deficiencies have become commonplace among these companies, including deficiencies caused by a shortage of qualified accounting staff. The study was based on 2009 data, which precedes the major run of frauds and the subsequent SEC scrutiny that the companies faced. I expect if the study were conducted with 2012 data the rate of deficiency among Chinese firms would be even higher. 

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