PCAOB chairman James Doty recently did an important interview with Caijing, which I have had translated into English. There has been little news on the PCAOB’s struggles with China since a deal was cut to allow sharing of documents with respect to investigations. The more important issue of inspections remains outstanding, and the interview exposes Doty’s increasing frustration with lack of results after nine years of negotiations. Doty indicates the nuclear option of deregistering accounting firms and kicking Chinese companies off the U.S. exchanges is very much alive. “We don’t want to come to this situation, but unfortunately there’s not much time left”
Doty expresses hope that the comprehensively deepening reforms that come from China’s Third Plenum will break the deadlock. I share that hope. The Third Plenum announcements say nothing about the PCAOB, or overseas listed Chinese companies either, but I they set a framework that might allow for resolution of two of the major overhangs for Chinese companies listed in the U.S. – regulatory standoffs with the PCAOB and SEC, and variable interest entities.
Included in the detailed reform plan that came out of the Third Plenum meetings was an odd statement that restrictions on foreign investment in accounting and auditing firms would be relaxed. What is odd about that is that China already has the loosest rules for foreign investment in auditing and accounting on the planet.
Last year China struck a deal with the Big Four accounting firms to convert their expiring joint ventures into limited liability partnerships. China, like virtually every other country, requires owners of CPA firms to be CPAs. That was a problem for the Big Four, since many of their partners are expatriates (mostly from Hong Kong) who are mostly not Chinese CPAs. The Chinese CPA examination is open to foreigners, but it iis notoriously difficult and more than a few Big Four partners have been humiliated by it. The Big Four firms negotiated a sweet deal with Chinese regulators. They would be allowed to have up to 40% unlicensed partners (the partners are required to have some sort of foreign license) in their limited liability partnership, although that 40% will ratchet down to 20% over five years.
The SEC yesterday banned Sherb & Co. from auditing public companies. The firm was also fined an insignificant $75,000 to settle charges related to audit failures on China Sky One Medical, China Education Alliance Inc., and Wowjoint Holdings Ltd., all Chinese reverse mergers.
Sherb failed to properly plan and execute audits, failed to obtain sufficient audit evidence on sales, revenue, and bank balances, and ignored clear red flags.
This is the second action by the SEC against Chinese reverse merger auditors in recent months. On September 30, the SEC banned Patricio and Zhao LLC (P&Z) from auditing public companies. P&Z was found to have done a failed audit on Keyuan Petrochemicals, Inc. I expect to see more actions like this against CPA firms that audited reverse mergers in the coming months as the SEC completes its efforts to bring to account the gatekeepers on failed Chinese reverse mergers.
Both of these firms were based in the United States and had been inspected by the PCAOB. The PCAOB cannot inspect accounting firms in China but since these firms were based in the U.S. they were inspected, even though the act of removing the audit work papers from China likely violated Chinese law.
There was an interesting article by Dune Lawrence and Belinda Cao of Bloomberg looking at the status of Muddy Water’s attack on NQ Mobile. The article reaches a mixed conclusion on the accounting.
Several experts interviewed by Bloomberg said the high days sales outstanding (DSO) was a red flag. High DSO usually is a red flag, but a fraud perpetrated in this way would be quite small compared to what Muddy Water’s alleges. Muddy Water’s says that over 90% of the business is fake, and you can’t cover that up by edging up DSO.
The second issue is whether the cash is there. I consider that the true test of whether the company is a fraud. If the cash is there, I see no way that any fraud could be of the scale alleged by Muddy Waters. The company is taking some extraordinary steps to clear this issue up. The Level 1/Level 2 controversy is meaningless.
The movement of funds is more interesting. Muddy Water’s alleged that it was impossible for NQ Mobile to transfer the proceeds of the offering to the VIE without violating Chinese law. A couple of experts disagreed with that.