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PCAOB's Doty on China

PCAOB Chairman James Doty spoke at an audit conference at Baruch College in New York on Thursday. The PCAOB has not released a transcript of his remarks, but Michael Cohn of Accounting Today has reported on them. Doty’s reported comments on China are interesting:

Doty also discussed the PCAOB’s efforts to conduct inspections of auditing abroad, including China. He noted that to date the PCAOB has conducted inspections in nearly 40 foreign jurisdictions, and one-quarter of their scheduled inspections are outside the U.S. The PCAOB has also entered into bilateral cooperative agreements with regulators in 14 other jurisdictions to conduct inspections jointly with the local regulator. However, China remains a problem. “I am disappointed that we still face resistance from some countries where there are registered firms we are required to inspect,” he said. “Since October 2010, we have not approved any applications for registration submitted by firms in jurisdictions that resist inspections. I am encouraged that Chinese authorities are at least continuing to talk with us about ways we might work together. We were invited to observe an inspection by Chinese authorities earlier this year. The exercise was helpful. It was educational, and it began to build working relationships among staff. But we have not been allowed to inspect any Chinese firms that are registered with us, notwithstanding the fact that those firms continue to issue audit reports that are filed with the SEC and relied on by U.S. investors.

China's Big Four and the PCAOB

The Big Four in China have been required to restructure into Special General Partnerships (SGP) on the expiration of their joint ventures in China. Three of the Big Four joint ventures expire in 2012 with PwC not expiring until 2017. I understand that PwC will be transferring its practice into an SGP in the near future. 

The SGPs must be at least 60% owned by locally qualified CPAs, allowing foreign (including Hong Kong and Taiwan) CPAs to own 40%. The 40% goes down to 20% over five years. In addition, the Senior Partner of the SGP must be a Chinese national, although existing senior partners can continue in their present roles for three years. The Chinese national requirement is probably a violation of China’s WTO commitments which generally prohibit nationality-based restrictions, although I think the firms are unlikely to challenge it. 

I have heard that each of the firms have selected a Hong Kong partner as senior partner of the SGP, although the process at PwC remains unsettled. Although the SGP is controlled by local partners, I understand the senior partners are being installed during the set-up process before the local partners get the right to vote. 

Approaching the PCAOB deadline

Last week, I attended a meeting of the Standing Advisory Group of the Public Company Accounting Oversight Board (PCAOB), of which I am a member. In his introduction, PCAOB Chairman James Doty gave an update of the international inspections program. 

There are 240 non-US audit firms in over 50 jurisdictions that issue opinions and accordingly need to be inspected triennially. The PCAOB has inspected 220 of these firms in 40 jurisdictions. One fourth of 2012 PCAOB inspections were conducted outside the United States. 

There have been legal impediments to inspections in Europe and China. Doty reported that the PCAOB has been making great progress in reaching agreements on cooperative inspections. In 2012, new cooperative inspections began in Germany, the Netherlands, and Spain, and there was continued cooperation in Norway, Switzerland, and the United Kingdom.  

Doty reported that negotiations had concluded at the staff level with France and Finland. Agreements were close with Denmark, Luxembourg, Poland, and Sweden. Negotiations are continuing with Italy and other EU countries. 

Whistleblowers

Last week, the SEC released its first report on the Whistleblower Program that was brought in by Dodd-Frank. Under the program, informants can receive a reward if their tip leads to the SEC collecting a penalty from a securities law violator. 

Awards are made when the information submitted by the Whistleblower leads to monetary sanctions of over $1 million. Awards are required to be paid in the amount of 10% to 30% of the monetary sanctions collected.  

The SEC received 3,001 whistleblower tips in the fiscal year ended September 30. 2012.   Only one reward was paid out. On August 21, 2012, a whistleblower who helped the Commission stop an ongoing multi-million dollar fraud received an award of 30% - the maximum percentage permitted by law - of the amount collected. Although a penalty was imposed of over $1 million, the government was only able to collect $152,464 during the year so the reward was only $45,739.  The company involved is not disclosed to protect the whistleblower. 

There were 31 whistleblower tips from China (including Hong Kong (2) and Taiwan (2)). China could be a fruitful location for making whistleblower claims. There are many Chinese companies listed in the U.S. and they have had a particularly high incidence of fraud. The problem is that the fine has to be more than $1 million to qualify for a reward and the SEC has to collect the fine. I think it is going to be very difficult for the SEC to collect fines from U.S. listed Chinese companies. 

Deloitte dodges a bullet

Last Wednesday a federal judge dismissed Deloitte from the class action lawsuit that had been filed on behalf of shareholders of Longtop Financial Technologies (Longtop). Longtop collapsed in 2011 under allegations of fraud. Deloitte resigned as Longtop’s auditors after finding out that the bank confirmation process had been corrupted. Deloitte had been the reporting accountants for Longtop for six years. 

While Longtop and its Chinese executives were also included in the class action lawsuit, they have yet to make an appearance, leaving only former CFO Derek Palaschuk to answer the suit. Deloitte was the best chance for shareholders to make any recovery. 

The judge issued a 40 page opinion explaining his decision to let Deloitte off the hook. The case against Deloitte alleged a violation of Section 20(a) of the Exchange Act. I am no lawyer, yet my reading of the statute and the judge’s opinion is that Deloitte had to be found to have knowingly or recklessly aided in the fraud to be held liable under this rule. This follows the Private Securities Litigation Reform Act of 1995 (PSLRA) that requires proof that the defendant acted with a particular state of mind. PSLRA has made it very difficult for investors to sue auditors. Under the PSLRA standard, Deloitte had to either have participated in the fraud or acted so recklessly that they allowed it to happen. 

PCAOB progress in China

In an interview with Reuters yesterday, PCAOB Chairman James Doty reported that talks were expected before year-end between Chinese and U.S. officials on access to audit working papers in China. According to Reuters, Doty said that while obstacles remain, the upcoming talks could result in a “major breakthrough”. However, he also told Reuters “no deal was in sight”.

A PCAOB team recently returned from a visit to China where they observed Chinese regulators inspecting Ernst & Young’s China operations. The PCAOB team was not permitted to review actual client working papers; they were only allowed to observe Chinese regulators reviewing internal firm quality practices. As such, the observations fall far short of the PCAOB’s mandate to inspect all accounting firms auditing U.S. listed companies. 

According to the PCAOB’s website, there are currently 47 Chinese accounting firms registered with the PCAOB, although only 9 of those actually issue reports on U.S. listed companies. In addition, there are 48 Hong Kong accounting firms that have registered with the PCAOB of which 16 issue reports. China has blocked the PCAOB from inspecting Hong Kong firms to the extent that the audit relates to mainland clients. 

Overstating revenue growth

Foreign currency accounting can be confusing. I will try to simplify it and point out how some Chinese companies distort results. 

Every company has a functional currency. That is the currency in which most of the business is done. For Chinese companies, this is always the RMB. Sales are made in RMB and suppliers and employees are paid in RMB. Under China’s currency controls, there really is no alternative.  

Companies are not required to report their financial results in their functional currency; rather they can report in any currency they wish. Multinational companies usually report in their home country currency.  It would be impossible for these companies to report unless they converted everything into a single currency. Foreign currency accounting can be quite complicated, but for most Chinese companies it is fairly simple. For those who want to dig into the details, this article provides more information.

While some of the larger U.S. listed Chinese companies use the RMB as their reporting currency, many report in U.S. dollars. I have been looking into the reasons why these companies choose to do this. Reporting in a different currency is much more work and it can distort financial reporting. People tell me that U.S. investors are more comfortable looking at U.S. dollars, but that seems to be a silly answer. I think it is because reporting in dollars makes revenue growth look better in an environment with an appreciating currency.

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