On December 20, 2012, the PCAOB announced that the SEC has approved a new auditing standard on communications with audit committees. James Doty, PCAOB Chairman said: "The standard moves the auditor's communication with the audit committee away from compliance checklists, and decisively in the direction of meaningful, effective interchange.”
Among other things, the new rules require that the auditor explain to the audit committee: “The basis for the auditor's determination that the auditor can serve as principal auditor, if significant parts of the audit are to be performed by other auditors.” The principal auditor is the one that signs the audit report. Because of all of the problems with mainland auditors, it matters who signs the audit report.
This change will have a significant effect on auditing practices in China. Driven in large part by Hong Kong Stock Exchange rules, many overseas listed Chinese companies have audit reports issued by the Hong Kong member of the accounting firm. In many of these cases, most, if not all, of the audit is actually conducted by the mainland member firm, yet when investors look to the audit opinion, it references only the Hong Kong firm. The Hong Kong rules were changed a couple of years ago for H-shares and the mainland firm now signs off on many H-shares. Red chips, however, continue to be signed off by the Hong Kong firm.
I will be on China Radio International on Christmas Day in China at 10am (9PM EST Christmas Eve in the U.S.) We will be discussing the SEC charges against the accounting firms. I guess this provides an alternative for hedge fund managers who don't like watching bowl games. It is a normal working day here in China.
About the show: Today, China Radio International's flagship news chat show, is broadcast live Monday through Friday on AM846, Beijing, China; FM88.0, Canberra and FM104.9 Perth, Australia; Northern California, AM 1540, Galveston, TX, AM 1320, Houston, AM 880, Hawaii, USA; FM 97.9, Ottawa, and AM1540, Toronto, Canada.
The show will be rebroadcast on CRI relay stations worldwide.
I thought that if the PCAOB was going to act before December 31, they would have done so on last Friday. They did not, and Lew Ferguson indicated that they were not concerned about letting the deadline pass. I think that means they still hold out hope for a negotiated settlement. I expect that has to come fairly soon or the PCAOB will feel compelled to act.
Thomas Shoesmith of Pillsbury has an interesting analysis of the PCAOB’s December 31 deadline to complete inspections. Here is what Shoesmith says:
The PCAOB is facing a December 31 deadline to complete its international inspections—including inspections of Chinese accounting firms. The deadline has been extended once before, from December 31, 2009. If it is not extended again, or if the regulators don’t work out a compromise, on January 1, there will be no PCAOB-registered Chinese accounting firms.
I don’t agree with his conclusion. I have been saying that I expect the PCAOB to act before this deadline passes, but by means of a rulemaking change that begins the process of deregistration. If this does not happen today, however, the holiday schedule makes it unlikely that the PCAOB will do anything before December 31. I don’t think the passing of this deadline will automatically result in the deregistration of the firms, but it will put the PCAOB out of compliance with its own rules.
If the PCAOB does not act in the coming days, I think it will be because negotiations with China are bearing fruit. From the experience of the SEC, however, we have learned that actually concluding a deal is quite difficult. I would expect that the major hang-up with a deal will not be over joint inspections, but on whether the PCAOB can punish firms that are found deficient. PRC regulators would not allow this with Hong Kong regulators when they negotiated access for mainland accountants to audit H shares, and it seems it would be difficult for them to agree to allow U.S. regulators the right to punish Chinese firms. The PCAOB would always have the nuclear option – to deregister firms, but that is too severe a penalty and too unlikely to be used to have the desired effect of encouraging firms to up their audit game.
The U.S. Chamber of Commerce has sent a letter to the CSRC and SEC asking them to find a way to solve the impasse over audit working papers, indicating that it is damaging economic relations between the countries.
The question for the next few days is whether the PCAOB will act before year end. Under Rule 4003 of the PCAOB, there is a December 31, 2012 deadline to complete foreign inspections which the PCAOB will miss. It would seem unusual to me if the PCAOB were to let this deadline pass without action or comment.
Investors should watch carefully in the remaining days of 2012.
Caixin has an extensive story (in Chinese) about the SEC/PCAOB issues with China. The story is largely consistent with Western accounts, but includes some reaction from local regulators. I have posted a translation here.
The picture that is painted illustrates that U.S. and Chinese regulators are looking at the situation differently. Both appear to be pursuing a situation based on the rule of law, but there are conflicting laws. China wants the U.S. to allow it to conduct and control all investigations in China, which is unacceptable to U.S. regulators.
Near the end of the article it is reported that some CSRC officials privately admit that part of the problem is that the use of offshore parent companies by the China concept stocks has created a loophole. That is the point I have been making in my recent editorials. Closing this loophole is the best way to resolve this situation.
There has been a great deal of discussion about the implications of the SEC case against the five Chinese accounting firms and its potential impact on multinational companies operating in China. I posted on this when the issue first came up, and it is worth a more detailed look.
There are two possible actions involved here. First we have the present case already filed by the SEC against the firms. Next we have a potential change in the rules by the PCAOB that would deregister Chinese accounting firms. The PCAOB has yet to act.
The SEC case could lead to the Administrative Trial Judge penalizing the five firms for failing to provide working papers to the SEC. Those penalties could range from censure to completely banning the firms from practice before the SEC. A complete ban could include prohibiting them from serving multinationals. I think the chance of that is remote. More likely, the judge will ban them from auditing foreign private issuers and will leave the MNC clients alone. In that case, there is no issue for MNCs. Nonetheless, I think the SEC process will be subsumed by a PCAOB rulemaking process that proposes to deregister accounting firms that it cannot inspect.
The SEC’s reply memorandum in the Deloitte case in now available online. It was filed with the U.S. District Court for D.C. on December 3. This is the court case seeking to compel Deloitte to produce the Longtop working papers.
It is mostly dry legal arguments, about half of which deal with the enforceability of the subpoena. Deloitte’s former attorney accepted service of the subpoena, and from the government’s arguments that appears to have been a grave mistake. I guess that is why the attorney is referred to as the “former” attorney. Sadly, he is not named.
The most interesting reading to me is the declaration of Alberto Arevalo. Arevalo is an Assistant Director in the Office of International Affairs (OIA) of the SEC. He appears to have been the point person in negotiations with the Chinese over access to audit working papers. He details the whole sordid story of how the SEC made 21 requests for assistance from the CSRC in 16 ongoing investigations, including three requests for audit working papers. They got none of the working papers and did not receive any meaningful assistance from the CSRC.
I am trying to focus attention on the underlying problem that audit inspections and SEC access to documents need to solve. That problem is the high incidence of fraud among U.S. listed Chinese companies.
In my view, a major reason we have seen so much fraud is that the U.S. listed Chinese companies operate in a regulatory hole. They have structured themselves with offshore companies with variable interest entities to circumvent Chinese law. These efforts successfully (so far anyway) got them out from under Chinese regulation. One of the defenses the Chinese have used against U.S. complaints is that Chinese regulators have no authority over Cayman Islands companies. Yet China does not allow U.S. regulators to step in and fill the regulatory hole. It bans U.S. regulators from taking action on Chinese soil, where all the people and records reside.
In academia there is actually a theory of holes. Structural holes are gaps between parties with complementary information. Structural holes in markets can be exploited by entrepreneurs who step in to fill them and connect the separated parties. Regulatory holes work similarly, but instead of entrepreneurs stepping in to fill them, fraudsters step in to exploit them. Regulatory holes are the perfect environment to pull off a scam.
SEC Commissioner Luis Aguilar spoke at an American Institute of CPAs conference on December 3. He says it is past time for the audit access issue to be resolved. If audit firms "are unable or unwilling to comply with U.S. law, the question to ask is whether the companies they audit should be allowed to trade in the U.S. securities markets". I have copied the relevant portion of his speech below.
U.S. Investors Must Be Able to Rely on the Integrity of Foreign Audits
This is not just important in the United States. It is also important to recognize that capital formation is a global process. Many large U.S. companies have operations all over the world, and businesses of all sizes from other countries come to the United States to access our capital markets. Accordingly, foreign operations of U.S. issuers are often reviewed by foreign auditors, including the local affiliates of the major global accounting networks, as well as independent firms.
U.S. investors rely on the work product of these foreign auditors when making investment decisions, often without knowing the role the foreign accounting firm played in the audit. This lack of transparency, made worse by news reports of audit failures in China and other countries, can create uncertainty in the capital markets. Last year, with a goal toward improving transparency, the Public Company Accounting Oversight Board (PCAOB) proposed amendments that, among other things, would require disclosure in the audit report of other accounting firms that took part in the audit, including foreign firms. This transparency regarding the audit participants would be a step forward for investors.
The SEC filed charges on December 10, 2012 against Huakang “David” Zhou, who had brought 22 Chinese reverse mergers to market. One of them, China HGS Real Estate (Nasdaq; HGSH), made it to Nasdaq though a scheme developed by Zhou. HGSH recently was relisted on Nasdaq after suspension because of its stock falling below $1, yet it has risen spectacularly, going from 42 cents on October 31 to a high of $4.35 on November 29, before falling back to $3.74 yesterday. Zhou was charged with numerous violations, including failing to disclose questionable wire transfers and stealing money from investors. The SEC press release and complaint make good reading for anyone interested in the reverse merger story.
The issue of questionable wire transfers piqued my interest, since the reports on the Bo Xilai case explained how wealthy individuals circumvent China’s currency laws. It appears Zhou used a similar technique to move IPO proceeds back to China.
Zhou controlled all the offering proceeds. He also hired all the accountants and lawyers for the companies. He was well positioned to do what he wished with the proceeds.
Tong Daochi, director general of the CSRC spoke in Hong Kong on Wednesday, November 28, at a conference. I was not at the conference, but I obtained a transcript of his remarks from someone who was.
The SEC filed its charges the following Monday, yet it appears Tong was trying to calm the markets. I don't know what days the SEC and PCAOB met with the CSRC in Washington that week, but if it was Tuesday, Tong had little time to prepare his remarks. Of course, if the CSRC knew what they would do in Washington, this could have been a preemptive strike.
Here is what he said:
The audit papers are very important to maintain market integrity and CSRC is ready to co-operate with other jurisdictions on this issue.
Audit working papers are an important document in investigations and enforcement to act on fraud. The issues come up not only with the U.S., but also with Hong Kong and other jurisdictions as well. We have about 1000 companies listed overseas, but numerous companies go around our regulations by listing and registering in other jurisdictions such as the Cayman Islands.
Yesterday’s International Herald Tribune has a good article about the U.S./China auditing spat.
Most interesting to me is a comment made by Tong Daochi, CSRC Director General of International Affairs, at a conference last week in Hong Kong. Tong is reported to have said “Audit papers are very important to maintain market integrity and the CSRC is ready to cooperate with other jurisdictions on this issue.” Tong further indicated that with respect to the discussions with the U.S. “We are making progress and I think we should be able to work out a way to get them out”.
Tong was speaking in Hong Kong while his colleagues were in Washington meeting with the SEC and PCAOB, and based on the SEC’s actions since, I think we know how that meeting came out. So why would Tong say something so incongruous with his colleagues?
I believe this points to an internal conflict within the Chinese bureaucracy.
The accounting profession in China is jointly regulated by the CSRC and the Ministry of Finance (MOF). Because the audits at issue are mostly for companies that are not listed in China, the MOF is really the lead regulator. The CSRC, under the leadership of Guo Shuqing, has always seemed more globally oriented, recognizing that participation in global capital markets requires accepting global standards and close cooperation with foreign regulators. MOF may be more ideological, less interested in globalization, and more protective of China’s sovereignty.
The SEC case against the Big Four and BDO has gotten the headlines this week. Shares of U.S. listed Chinese companies fell sharply after the announcement, but they appear to have stabilized by the end of the week. My hypothesis, not supported by hard data, is that conservative investors such as mutual funds that cannot risk a period of illiquidity have sold and will sit this out. Investors with a willingness to risk illiquidity while the companies find a new place to list see value and have stopped the slide.
Legal experts think that the SEC case will be resolved faster than the 300 days that the judge is allowed. That is because the facts are straightforward and the legal issues have already been developed for the Deloitte case. The SEC has restarted the Deloitte case that was stayed in July, and a decision could come quickly. All the lawyers I talk to seem to think the case against the firms is a slam dunk for the government. The judge will have a wide range of punishments available, but the most meaningful would be to revoke the practice rights of the firms. That would mean their clients need new auditors, and that is likely to be difficult for them since all the big firms in China have been charged. I expect, however, that the firms will appeal the decision, delaying its implementation for some time.
The SEC’s actions against the Big Four and BDO in China may be followed by PCAOB action to deregister accounting firms in China because of the inability of the PCAOB to inspect China based firms. The most apparent result of that action would be to jeopardize the listings of U.S. listed Chinese companies. The action would also potentially have an adverse impact on U.S. multinationals (MNCs) with China operations.
For the last two decades, China has been near the top of the league tables for inbound foreign direct investment, much of which has come from U.S. MNCs. These MNCs are typically audited by the same Big Four firm in the United States and in China. The U.S. firm takes overall responsibility for the audit, but farms out work to its affiliates around the world that then audit local operations.
Under PCAOB rules, any firm that “plays a substantial role in the preparation or furnishing of an audit report” must be registered with the PCAOB. If the China member firms of the Big Four (and second tier firms like BDO) lose their PCAOB registration they can no longer play a substantial role in those MNC audits. That could lead to the inability of the U.S. firm to sign off on the audit of the MNC, since it has no way to audit the China operations.
Chinese regulators had meetings in Washington last week with the PCAOB and SEC. They must not have gone very well.
The SEC yesterday charged the Big Four and BDO in China with violations of U.S. securities laws and the Sarbanes-Oxley Act for failing to provide audit working papers for U.S. listed companies. This follows the earlier charges against Deloitte for the same issue, and the Court action against Deloitte for failure to produce the working papers for Longtop Financial Technologies.
The Big Four issued statements pointing blame at diplomatic failure.
I believe that this marks the beginning of the process to deregister Chinese accounting firms from the PCAOB and to ban them from practice before the SEC. Unless resolved, this will likely lead to the delisting of U.S. listed Chinese companies. Multinational companies in China may also face issues since PCAOB rules require an auditor playing a substantial role in the audit of an MNC be registered with the PCAOB. There are situations where the China Big Four are playing a substantial role in the audit of U.S. MNCs that have substantial operations in China. They may need to resolve this by dividing the work among several firms so that no single firm plays a substantial role.
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.