Audit rotation in China | China Accounting Blog | Paul Gillis

Audit rotation in China

The Wall Street Journal printed an op/ed about the auditing of China’s big banks. The op/ed makes a number of misleading or incorrect statements about what is going on with the auditing of China’s big banks.

The piece says that Chinese banks are about to select new auditors because of Chinese rules “seemingly designed to unfairly promote the interests of less-experienced-and more easily influenced-local accounting firms”. What they are talking about is the mandatory audit rotation rules that have been put in place for state-controlled enterprises. What the authors seem to have missed is that this rotation has already taken place.

All of the Big Four banks have already rotated auditors. I wrote about this process last October. Rotation is required every five years, and three of the Big Four banks rotated auditors for 2013. China Construction Bank fired KPMG in 2010 over a fee dispute and selected PwC. CCB will rotate again in 2015, the others in 2018. Despite the author’s fear that “less-reputable” accounting firms will get the work, the Big Four accounting firms captured all of the Big Four banks. Despite the “rule” cited by the authors that no accounting firm can have two banks, PwC now serves two.

I am aware that Chinese regulators encouraged local firms to enter the bidding process, but in the end none won. A partner in one of the larger local firms told me his firm declined to bid on the big banks, suggesting that they be awarded some smaller banks so that they could build banking expertise. Then, in five or ten years when the banks rotate again, they might be ready. China's Big Four banks are some of the largest banks in the world, and none of China’s local firms presently have the capability to do these audits. Even in five years, they will need to poach some expertise from the Big Four if they wish to win those jobs. I expect that is exactly what they will do.

The piece has a number of other significant errors. First, the Big Four are not practicing in joint ventures with local accounting firms. They operate their audit practices in limited liability partnerships owned by their partners, at least 60% of whom must have local accounting qualifications (that goes up to 80% over the next five years). The joint ventures were terminated last year, except for PwC, which recently terminated its joint venture and moved its practice to an LLP.

The authors are also critical of changes that allowed Chinese accounting firms to audit H-share in Hong Kong using Chinese accounting standards. While this change was widely resisted in Hong Kong, mainly because it broke the cartel of Hong Kong accountants on audits of companies listed in Hong Kong, it has had little effect on audit quality. The audits of these companies were already done on the mainland, and all that changed was the letterhead of the audit firm from the Hong Kong office to the mainland office that had been doing the work all along.Analysts were pleasantly surprised to find out that disclosures imprved. Chinese GAAP, while compliant with IFRS, is more restrictive in accounting choices and requires more extensive disclosure. Over time, I expect that Chinese auditors will be allowed to also audit red chips, and I expect that non-Big Four firms will win a bigger share of the market. But that is not cause for alarm.

The authors are critical of the process used by Chinese authorities to select new auditors. The banks were required to appoint a “panel of unspecified outside experts” to make the decision. That seems to me to be a move towards better corporate governance. Isn’t the audit committee that is supposed to decide on uditors really a panel of outside experts? Did politics enter the process? Probably, but these are state owned enterprises and what would you expect?

Despite the flaws in this op/ed, I share the author’s concerns about the auditing of China’s big banks. Audit rotation is a hot topic around the world. China is an early adopter of this practice, which is so controversial that a committee of the U.S. House has proposed that the PCAOB be banned from putting it in practice in the U.S. Proponents say auditor rotation will enhance auditor independence and objectivity. Critics argue that the increased costs and the loss of accumulated knowledge and experience with the client will decrease audit quality. Both views have merit.

I am mostly concerned with the fact that audit fees on the Big Four banks in China decreased significantly in the latest round of rotation. Desperate to retain market share, the Big Four have engaged in a dangerous practice of low-balling. A first year audit always involves a lot more work and the firms are going to do this work with a lot less fee. Something has to give – audit quality or partner income – or both. I think both.

Copyright 2017 Paul L. Gillis all rights reserved