China Life today announced that it has changed its auditor for the US Form 20-F from Ernst & Young to Ernst & Young Hua Ming. Ernst and Young Hua Ming is the mainland China affiliate of Ernst & Young.
Ernst & Young Hong Kong resigned due to “requirements for project manage-ment”. Those requirements are likely proposed PCAOB standards that make it clear that the lead auditor must sign the audit report. I am certain that the China Life audit was actually done by the mainland affiliate. The Hong Kong office signed off on the audit because that had become standard practice of the Big Four, even though I believe that the practice violated US and international auditing standards.
I previously pointed out that KPMG was doing this on many of its overseas listed companies and that the practice was misleading to investors.
Auditing standards require that the audit be signed by the principal auditor. AS 1205.02 requires the auditor to decide whether his own participation is sufficient to enable him to serve as the principal auditor and to report as such on the financial statements. The PCAOB proposed new rules on April 12, 2016 that make it clear that reports must be signed by the principal (proposed to be called lead) auditor.
In discussing the proposed standard, the PCAOB said:
Over the years, there have been numerous observations from inspections and enforcement activities where the lead auditor failed, under existing PCAOB standards, to appropriately determine the sufficiency of its participation in an audit to warrant serving as lead auditor. These deficiencies occurred at large and small firms, domestic as well as international. In the most egregious examples, the lead auditor failed to perform an audit or participated very little in the audit and instead issued an audit report on the basis of procedures performed by other auditors.
That was exactly what was happening in China when the Hong Kong affiliates of the Big Four signed off on audits that were actually done by their mainland offices. While the proposed rules clearly put a stop to this practice, they are currently in proposed form and will likely not take effect for some time. I expect that EY is adopting the proposed rules early since new disclosure requirements effective in 2017 will force them to disclose how much of the audit is actually done outside of Hong Kong.
Investors should not be concerned about this change. It really is not a change. I believe all of these audits have always been done by the mainland affiliate, and I don’t believe there is a quality difference between the mainland and Hong Kong affiliates. Correcting these reports may be a little embarrassing for the Big Four, but it is a good thing for investors, since they will know the firm that actually conducts the audit. Firms will also be required to disclose on a PCAOB database the name of the audit partner, which I believe will improve the quality of audits. Investors and audit committees will be able to determine whether audit partners have been involved in failed audits. I expect auditors with problem audits in their past are going to find it difficult to find clients that will accept them. That should make auditors more careful,to the benefit of shareholders. Unfortunately, the disclosures are not retroactive, and will accordingly not be very useful until we have a few years of disclosures available.