KPMG in deep trouble in HK | China Accounting Blog | Paul Gillis

KPMG in deep trouble in HK

Matt Miller of Reuters has an interesting update on the troubles KPMG is having in Hong Kong with a failed US listed Chinese company. In my view the problems are of its own making.

KPMG Hong Kong was the auditor of China Medical Technologies Inc., which failed after management was charged by the US Securities and Exchange Commission with looting over $400 million from the company. The company was put into liquidation in 2012 in the Cayman Islands, where it was incorporated.

Actually, KPMG Hong Kong was not the auditor, and that is the problem.

Several years ago I wrote about KPMG’s labeling problem where they had a practice of using Hong Kong letterhead to sign audit opinions on audits done by KPMG Huazhen, KPMG’s China affiliate. To me, this was like a Wenzhou shirt maker sewing a made in Italy tag on a shirt made in China.

KPMG Hong Kong issued the audit report, yet when liquidators asked to see their working papers they said they did not have them since the actual audit was done by KPMG Huazhen, its mainland affiliate which was prohibited under Chinese law from sharing them. Auditing standards require that the principal auditor sign the audit report. Only the principal auditor can sign the report. It appears that KPMG Huazhen was the principal auditor of China Medical and should have signed this audit report. Had they done it right, this case would never have ended up in a Hong Kong court.

Under US SEC rules (SEC Financial Reporting Manual Section 4140.1), the principal auditor is generally expected to have audited or assumed responsibility for at least 50% of the assets and revenues of the consolidated entity. That would seem impossible to demonstrate when another firm does the entire audit and keeps the working papers.

KPMG Hong Kong is in a terrible place. They signed off on an audit without doing one. The Hong Kong Institute of CPAS (HKICPAs), regulator of Hong Kong accountants, should investigate this violation of auditing standards, but I think it is unlikely they will. The HKICPAs is a feckless regulator and is unlikely to pursue a case against a Big Four firm, especially a case that relates to a company not listed in Hong Kong. There are legislative proposals to strengthen audit regulation in Hong Kong, but the proposals will likely have no effect on this case.

KPMG was the most egregious at mislabeling their audit work, but all of the Big Four in Hong Kong have had this problem, which I believe came about because the firms failed to recognize the importance of respecting their legal structure. While the China member firms of the Big Four have generally been managed from Hong Kong since the early 2000s, they have always been separate legal entities.

This issue arose with Alibaba since PwC signs Alibaba’s accounts from Hong Kong despite the company being headquartered in Hangzhou. The SEC raised this issue with Alibaba after I wrote about it on this blog. Alibaba responded to the SEC explaining that PwC’s mainland affiliate had done less than 50% of the audit work for 2012-2014. However, the company admitted that 70% of the audit for 2012 was done by the mainland affiliate. Surprisingly, the SEC accepted this answer despite the absence of any rule that allows the calculation to be done on a three-year basis. The 2012 audit was 70% done by PwC ZhongTian indicating that PwC Hong Kong was not the principal auditor for that year and the SEC should not have accepted their 2012 report that was included in the IPO filings.

KPMG seems to be addressing this problem, as it has changed the reporting accountant to KPMG Huazhen on many on its mainland clients. Yet the issue continues to give KPMG fits. In the present case it appears the judge may get tough with KPMG. The judge issued a contempt summons against 91 individual KPMG partners which may ultimately get their attention. KPMG’s problem is that turning over the working papers would likely get them in trouble with Chinese regulators, but in the end it appears the KPMG partners may have to decide between a Chinese jail or a Hong Kong jail.

Copyright 2018 Paul L. Gillis all rights reserved