New rules restricting the activities of foreign CPAs in China went into effect on July 1. Today, the South China Morning Post reports that Hong Kong CPAs have been largely exempted from these new rules.
Hong Kong CPA firms will be required to leave their working papers on the mainland. That should cause considerable concern to Hong Kong and US regulators who will be unable to review the work of auditors without the cooperation of Chinese regulators.
I believe the real crackdown to come is over the US listed Chinese companies that are audited by small US based accounting firms. Most of these companies came to market through reverse mergers and trade thinly, if at all, on over-the-counter boards. These companies have had a high incidence of fraud and have embarrassed Chinese regulators who have no authority over them. After the NYSE and NASDAQ cracked down on reverse mergers by requiring a seasoning period before listing, the reverse merger market for Chinese companies in the U.S. died, replaced by China’s National Equities Exchange and Quotations (NEEQ – China’s third board). NEEQ has listed over 2,000 small Chinese companies with an average market cap of under $75 million.
Those US CPA firms with a significant client base in China are going to have more serious problems complying with these rules. Some of these firms have set up consulting practices in the form of wholly foreign owned enterprises (WFOEs) that do the audit work on the mainland. Such WOFEs are clearly violating Chinese law by doing auditing, and since most have not registered with the PCAOB, they are also violating US laws. Regulators have looked the other way, until now, perhaps.
The audit committee of any firm audited by an overseas CPA firms should seek written assurance from its auditor that it will be able to comply with the new rules. The SEC should demand that companies disclose the material risk that the auditor may be unable to complete the audit if the auditor is not in compliance with the new rules.
The Big Four all have significant mainland affiliates and should not face any difficulties in complying with the new rules.
Local Chinese CPA firms mostly audit companies listed on NEEQ. While the incidence of fraud among Chinese companies listed in China has been less than for Chinese companies listed abroad, I expect that will change with NEEQ. I predict it is only a matter of time before we see another rash of fraud among these companies. China provides limited opportunities for short sellers to profit from outing these frauds, so it may take more time for the frauds to become known.
Chinese regulators need to step up to the challenges that are presented by the rapid expansion of Chinese equity markets. That includes significantly increasing the number of examiners of accounting firms and listed companies.