Reports are that Hong Kong officials are headed to Beijing to lobby against proposed rules that would require auditors of overseas listed Chinese companies to use mainland affiliates. The mainland proposal appears to be related to fears that Hong Kong accountants could disclose state secrets to foreign regulators. A Hong Kong judge last week ordered EY Hong Kong to turn over working papers related to Standard Water to the Securities and Futures Commission (SFC). EY had refused to turn over the working papers because it had outsourced the audit to its mainland affiliate. The mainland affiliate refused to turn over the papers citing China’s rules. EY’s case was significantly undermined when it was dis-covered at trial that EY actually had the working papers on a hard drive located in Hong Kong.
The mainland proposal would require auditors of all overseas listed Chinese companies to follow EY’s example and outsource the audit work to their main-land affiliate. The mainland offices already audit many, if not most, overseas listed Chinese companies. Over the past decade, the mainland offices of the Big Four have grown to be considerably larger than the office in Hong Kong. Lan-guage barriers and the high cost of sending staff from Hong Kong forced that change long before Chinese regulators thought about requiring it. The proposed rules will not change the way audits are conducted for most overseas listed Chinese companies.
The proposed rules may force a change in audit reporting. For U.S. listings, most auditors have the mainland affiliate sign the audit report. KPMG is the notable exceptionsigning most of its reports in Hong Kong, and there are a few except-ions at other firms such as the Alibaba engagement by PwC. H-Share listings have been permitted for several years to use mainland accounting firms, includ-ing the Big Four mainland affiliates, and many have done so. However, Red Chips and P-Chips (non-state controlled) are required by Hong Kong rules to be signed by a Hong Kong auditor. It is this rule that apparently led EY Hong Kong to agree to sign the report on Standard Water even though the work was done by the mainland affiliate. The MOF proposal nods to this situation, requiring that the overseas affiliate take full responsibility for the audit.
That is where the problem lies. Under professional standards, an accounting firm cannot take full responsibility for an audit unless it actually conducts an audit. Only the principal auditor can sign the report. In the case of most overseas list-ed Chinese companies the principal auditor is the mainland firm, and under the MOF proposal it will most certainly be the mainland firm.
The HKICPAs has observed that having the Hong Kong firm take full respons-ibility for the audit would violate Hong Kong’s audit standards as codified under HKSA 600. They seem to have overlooked that if the proposed practice would violate Hong Kong auditing standards, present practices already violate those standards. The principal auditor, who is usually the mainland affiliate, should sign audits of Chinese companies listed overseas.
The judge in the EY case pointed out that HKSE rules required EY Hong Kong to be Standard Water’s auditor, even though EY Hua Ming did all the work. That does not excuse the violation of auditing standards. The Big Four have tended to treat their mainland and Hong Kong firms as if they were a single firm. But they are not, especially after the formation of the limited liability partnerships on the mainland. The judge in the SEC case against the Big Four observed that if the firms found themselves between a rock and a hard place, it was only because they chose to go there. That applies in this case as well. The appropriate pro-fessional behavior for the accounting firms when asked to sign work in Hong Kong that was done on the mainland should have been to refuse to do so. That would have created a crisis, since the exchange rules required their signature, but it would have forced a proper resolution of the issue. Breaking one rule to comply with another is not professional behavior.
The problem here is not the MOF proposal to require firms to outsource work on overseas listed Chinese companies to their mainland affiliates. That has mostly already happened. The problem is that Hong Kong rules require the use of Hong Kong auditors. That is the rule that needs to change. The HKSE must accept audit reports of the firm that actually does the audit – the principal auditor.
As to the issue of SFC getting audit workpapers to effectively regulate Chinese companies listed in Hong Kong - I quote the immortal word of Joe Pistone(alias Donnie Brasco): fugetaboutit. I don’t see China allowing Hong Kong regulators the right to regulate anything on the mainland, including Chinese companies listed in Hong Kong.