The Public Company Accounting Oversight Board today announced the new members of its Standing Advisory Group(SAG), and my name was on the list. The SAG was created to advise the PCAOB on the development of auditing and related professional practice standards. The SAG includes auditors, investors, public company executives and others.
I will be the only foreign based member of the SAG. My main area of interest is transnational regulation of accounting, and in particular the challenges that face the PCAOB with respect to U.S. listed Chinese companies.
I will continue to write about issues related to the PCAOB in this blog. My writings reflect my personal opinions and do not represent the views of the SAG or the PCAOB.
It was inevitable as the election year approaches that politicians would jump on the issue of the PCAOB's trouble getting access to China. Chuck Schumer, Democratic senator from New York has sent a letter to James Doty, Chairman of the PCAOB.
In the letter, Schumer tells Doty that he has waited long enough and that it is time for some action on the auditors of U.S. listed Chinese companies. "In the case of Chinese audit firms, the board is failing to do its job".
Separately, the PCAOB released findings of inspections of PwC and KPMG in the U.S. and found greater deficiency rates than in prior inspections. This is a sign that the PCAOB is getting tough on auditors. In the case of PwC, deficiencies were found in 28 of 75 reviewed audits.
Chinese auditors must be wondering what will be worse - getting their registration revoked because the PCAOB cannot examine them, or actually getting examined.
Here are some data I just put together on who audits U.S. listed Chinese companies. These data are by total fees collected in US$.
PwC and KPMG dominate mostly because they do most of the giant SOEs that are listed on NYSE. The biggest audit in China is China Mobile, which paid KPMG $14 million in 2010. This table does not include the many OTCBB and Pink Sheet companies, most of which were reverse mergers and use small accounting firms.
Here are the number of clients for each firm:
Deloitte has the largest number of clients, yet are third in total fees. That is mainly because Deloitte has none of the big SOEs.
The Big Four have 88% of the market. The Herfindahl Hirschmann Index is 2149. Anything over 1800 is generally considered highly concentrated.
The data come from Audit Analytics. I combined three BDO firms and three Crowe Horwath firms in the table.
The FASB issued an exposure draft on November 3, proposing changes to the consolidation accounting advice for variable interest entities. Given the great controversy over VIEs in China that sure got my attention. Upon examination, however, the proposed rules have no effect on any China VIEs that I am familiar with.
It turns out that the VIE rules inadvertently caused certain mutual fund managers to have to consolidate the funds that they were managing, largely because their fee was determined in part by the profits of the fund. That is not what anyone intended, and the rules are proposed to be modified to eliminate VIE treatment for these kinds of deals. The proposed changes have no effect on the types of VIE structures used in China. Those VIEs can continue to be consolidated.
The VIE rules were a reaction to the abuses of Enron and others who used the old consolidation rules that focused on stock ownership to keep debt off the balance sheet. By having someone else own the stock (Andy Fastow in Enron's case), they took the position that the debt holding entity did not have to be consolidated. The VIE rules ended that, requiring a focus on control and economic interest instead of stock ownership.
Zhou Qinye, vice general manager of the Shanghai Stock Exchange made some very interesting comments at a conference today. Here is what he said according to the Reuter's report:
"The current situation is the result of some institutions seeking to politicize the matter, and it's difficult to predict where things are heading," Zhou told a conference.
"One way is for overseas-listed companies to delist there and come back home, including Chinese and Hong Kong stock exchanges."
"For the Shanghai and Shenzhen stock exchanges, this could be an opportunity as we know that many overseas-listed Chinese companies are not bad. So we welcome those China stocks to return home," Zhou added.
I don't disagree with Zhou's conclusion that the situation has become political and unpredictable. And while he says he welcomes these companies to come home, the reality is that many of them cannot find their way back. But he is on the right track - the many problems that we face with with U.S. listed Chinese companies, including the reverse mergers, the accounting frauds, the use of VIE structures and the inability of the SEC and PCAOB to effectively regulate all stem from a single cause. That cause is the failure of China to properly develop the institutions necessary for private enterprise to prosper in China. Private enterprise became legal at the beginning of China's reform thirty years ago, but it did not become legitimate until Jiang Zemin invited entrepreneurs into the Communist Party in 2001 as part of his Theory of the Three Represents.
Here is a guest post from Pauline Law, a third year law student at Penn. She analyzes going concern issues and NYSE and Nasdaq listing standards. I am not expecting to see a rash of going concern opinions on Chinese companies but this will be useful information as the standards for going concern opinions are further developed and applied in the Chinese environment. It also provides an interesting analysis of the delisting process at U.S. exchanges.
As regular readers of the China Accounting Blog know Paul has regularly discussed the issue of whether or not VIEs were a going concern. More recently, the PCAOB started examining whether auditing standards with respect to going concern issues should be enhanced. In light of the recent attention paid to VIEs by regulators and the investing community alike, auditors may well begin to issue qualified going concern opinions based on the uncertainties inherent to the VIE structure.
In the event of the issuance of a qualified going concern opinion to a Chinese company using the VIE structure, what would happen to the company’s ability to list in the United States? This post attempts to answer this question by examining how NYSE and Nasdaq have approached companies announcing going concern opinions in the context of the exchanges’ rules.
I apologize in advance for the sarcasm of this report.
Longtop Financial Technologies stood alone among the many frauds that have been outed in China in the past year. It had come to market as a regular IPO rather than through the dubious reverse merger route. It had bulge bracket investment banks, a white shoe law firm and Big Four firm Deloitte as advisors. It had a multibillion-dollar market cap. The fraud caught everyone by surprise.
Investors have been screaming for justice. The SEC has been investigating and issued a Wells Notice to the company in August indicating it was planning to bring an enforcement action against the company. But the SEC investigation quickly ran aground. China does not allow American securities regulators to come to China citing national sovereignty. Deloitte refused to turn over its working papers citing Chinese rules that prohibit doing so. The PCAOB has also been unable to come to China to inspect Deloitte’s work.
Now the SEC has finally acted. They have charged Longtop with failing to file current and accurate financial reports with the SEC. No, they have not charged the company or any executives with fraud. They charged the company with late filings. The company now faces the horror of administrative proceedings in front of an administrative law judge. The judge could really throw the book at Longtop, possibly suspending trading in Longtop shares on the pink sheets for twelve months or taking the draconian measure of actually revoking its registration. Revocation would be especially harsh for Longtop, since they would be unable to sell the public shell to another fraudster.
I have written twice before about the issue of whether auditors should be challenging companies that use the VIE structure as to whether they are going concerns. The issue present is whether the substantial uncertainty that lawyers point out in the VIE structures rises to the level of substantial doubt that would lead auditors to give a going concern qualification. One of the problems is that the auditing standards provide no clarity as to what constitutes substantial doubt. That may be about to change.
At the PCAOB Standing Advisory Group meeting tomorrow in Washington, Keith Wilson, PCAOB Deputy Chief Auditor, and Brian Degano, PCAOB Associate Chief Auditor are announcing that the PCAOB has a project to consider revision to the auditing standard on the auditor's evaluation of a company's ability to continue as a going concern. They observe that current PCAOB auditing standards (AU sec. 341) do not define the term "substantial doubt".
The project does not appear to be specifically focused on the issues related to VIEs. Instead, the project team is considering:
Adam Jones of Financial Times has an interesting article out today reporting on his interview with James Doty, chairman of the PCAOB. Doty is quoted as saying: "In my view it is not tenable to continue to indefinitely allow Chinese firms to remain registered with the PCAOB if the PCAOB cannot inspect their US-related audit work."
Doty has hinted at this before, but this is a clear statement that he believes the PCAOB may be forced to terminate the registrations of Chinese accounting firms should the PCAOB fail in its negotiations with China for access to inspect Chinese CPA firms.
The impact of such a decision would be severe. Mostly affected would be the Big Four's China affiliates, who audit most of the U.S. listed Chinese companies. All of these companies, from PetroChina to Baidu, would be suddenly without auditors. A CPA firm must be registered with the PCAOB before it can audit U.S. listed companies. These U.S. listed Chinese companies will not be able to find another China based firm to audit them, since they will all be deregistered. In theory, they could select a U.S. based accounting firm, even the U.S. affiliates of the Big Four, but those firms would be required to obtain temporary practice certificates in China. One of the conditions for obtaining those certificates will be that they leave the working papers in China, which is exactly the problem that the PCAOB is trying to deal with. So that hardly seems a viable alternative.
Some readers know that I was with PwC for 28 years. I took early retirement at 50, played a lot of golf, and then decided I needed to do something more intellectually challenging. I decided to get a Ph.D at Macquarie Graduate School of Management in Australia. It was the hardest, and most rewarding thing I have done in my life.
This blog was originally conceived of as a way for me to put out some of the findings in my research so that I could get some feedback as I wrapped up the thesis. To my surprise, the issues I had studied suddenly became very popular. This blog gets 6,000 readers a month.
Some readers have asked for a copy of my thesis, and then have told me that I should make it widely available. A publisher offered to make it available on Amazon, but rather than collect the $25 or so in likely annual royalties I will just give it away here.
Here is the abstract or you can download the thesis:
This study is a historical critical analysis of the role of the transnational professional services firms known as the Big Four in the development of the accounting profession in China. China emerged in the early 1980s after decades of seclusion and began an economic transformation that would make it the world’s second largest economy by 2010. China did not have an accounting profession after the founding of the People’s Republic of China in 1949 until the accounting profession restarted in 1980 as the country opened up to foreign investment. The Big Four, as members of the globalizing transnational capital class came to dominate the accounting profession in China with the support of other members of the transnational capital class including investment bankers, international lawyers, and transnational institutions such as the World Trade Organization. Grounded in Marxist theories of class struggle, particularly in Gramsci’s theory of hegemony, this study explores how ideology, expressed as normative roles for independent accountants, enabled the Big Four to dominate the market. Using mixed research methods with archival and interview data, this study finds that the Big Four achieved its dominant position through three hegemonic projects: foreign direct investment, the reform of State-owned enterprises through international capital markets, and the enabling of private enterprise to access international capital markets. This study also explains how indigenous accounting firms followed Dutschke’s counter-hegemonic strategy of a “long march through the institutions” that reformed the domestic accounting profession and gave it access to the coercive power of the state to challenge the hegemony of the Big Four. This study finds that the globalization of accounting markets leads to regulatory holes, gaps in the transnational regulation of accounting firms. This study provides recommendations to the Big Four, indigenous firms, and local and transnational regulators.
In a bombshell of an announcement, Hong Kong listed China High Precision Automation Group (CHPAG) announced the suspension of trading in its shares after KPMG disclaimed an audit opinion on the company's results for the year ended June, 30. 2011.
CHPAG has apparently not provided information that KPMG wants to see.
CHPAG is not a state-owned enterprise. It manufactures automation and horological instruments. CHPAG lawyers determined that giving KPMG the information it requested would violate state secrecy laws. This is a new version of the arguments being put forth for why Deloitte cannot produce its working papers on Longtop to the SEC. It is not clear whether any Chinese regulators were involved in the decision.
It is a fundamental principle of auditing that auditors must have complete access to a company's records. Any restriction on this access results in a limitation on the auditor's scope that leads them to disclaim an opinion - meaning the financial statements are unaudited. The failure to present audited financial statements usually leads to delisting.