There has been a great deal of discussion about the implications of the SEC case against the five Chinese accounting firms and its potential impact on multinational companies operating in China. I posted on this when the issue first came up, and it is worth a more detailed look.
There are two possible actions involved here. First we have the present case already filed by the SEC against the firms. Next we have a potential change in the rules by the PCAOB that would deregister Chinese accounting firms. The PCAOB has yet to act.
The SEC case could lead to the Administrative Trial Judge penalizing the five firms for failing to provide working papers to the SEC. Those penalties could range from censure to completely banning the firms from practice before the SEC. A complete ban could include prohibiting them from serving multinationals. I think the chance of that is remote. More likely, the judge will ban them from auditing foreign private issuers and will leave the MNC clients alone. In that case, there is no issue for MNCs. Nonetheless, I think the SEC process will be subsumed by a PCAOB rulemaking process that proposes to deregister accounting firms that it cannot inspect.
If the PCAOB moves to deregister the firms, then the risk for MNCs is more serious. PCAOB rules require any firm that plays a substantial role in the audit of a U.S. listed company must be registered with the PCAOB. If the firms lose their registration, then they cannot play a substantial role.
Here is the definition of substantial role from the PCAOB rules:
(p)(ii) Play a Substantial Role in the Preparation or Furnishing of an Audit Report
The phrase "play a substantial role in the preparation or furnishing of an audit report" means –
-1 to perform material services that a public accounting firm uses or relies on in issuing all or part of its audit report with respect to any issuer, or
-2 to perform the majority of the audit procedures with respect to a subsidiary or component of any issuer the assets or revenues of which constitute 20% or more of the consolidated assets or revenues of such issuer necessary for the principal accountant to issue an audit report on the issuer.
Note 1: For purposes of paragraph (1) of this definition, the term "material services" means services, for which the engagement hours or fees constitute 20% or more of the total engagement hours or fees, respectively, provided by the principal accountant in connection with the issuance of all or part of its audit report with respect to any issuer. The term does not include non-audit services provided to non-audit clients.
Note 2: For purposes of paragraph (2) of this definition, the phrase "subsidiary or component" is meant to include any subsidiary, division, branch, office or other component of an issuer, regardless of its form of organization and/or control relationship with the issuer.
Note 3: For purposes of determining "20% or more of the consolidated assets or revenues" under paragraph (2) of this Rule, this determination should be made at the beginning of the issuer's fiscal year using prior year information and should be made only once during the issuer's fiscal year.
If we apply those rules to a typical MNC with operations in China, we first ask if the China auditor performs more than 20% of the total engagement hours or fees. The total engagement hours and fees would include all fees and hours around the world to audit the company, including the hours and fees of the home country team. If the China firm does more than 20% of those totals, it must be registered with the PCAOB.
If it is not required to be registered under the 20% of total hours and fees rule, then we look to whether the China firm is performing the majority of audit procedures with respect to a subsidiary, division, branch or component that makes up 20% or more of the consolidated assets or revenues of such issuer. Because most MNCs have many subsidiaries in China, this test may be easy to pass since even when total China assets or revenue are over 20% of the MNC, no single subsidiary may trip the wire. The first test, whether the China accounting firm has more than 20% of the total worldwide fees or hours, is probably the key test.
It is my belief that few, if any, MNCs will have a problem with this rule should their China accounting firm be deregistered. MNC fees and hours tend to be heavily weighted to the headquarters, so even where the MNC's China assets and revenues may be higher than 20%, the hours and fees are likely to be less than 20%. Should the PCAOB propose deregistering the firms, disclosure of the impact on MNCs should be required by the SEC immediately so that investors are properly informed.
A suggestion has been made that the Hong Kong member firm could simply sign the reports to avoid the PCAOB issue. That won't work. Chinese regulators have forbid the PCAOB from inspecting Hong Kong firms with respect to China work, so those that do China work will likely be deregistered along with the mainland firms. There are a host of problems related to a foreign accounting firm (including Hong Kong firms) practicing in China that probably make it impossible for any other foreign accounting firm to do it either.
As of today, there are 45 accounting firms from mainland China that have registered with the PCAOB. Only eight of these firms have issued reports, seven firms report that they played a substantial role in an audit, two firms audited a broker-dealer, 25 registered for no apparent reason, and 4 firms did not report. Based on the rules above, I think the seven who claim to play a substantial role ought to take another look as to whether they really do. Why are the 25 registered with the PCAOB? Why subject themselves to regulation if they are not required to do so? My guess is that these firms voluntarily registered because they thought it would give them more credibility, and make it easier to sell services. Chinese like to collect diplomas and certificates, but PCAOB registrations are poor wall ornaments.
(By the way, I pity the investor who has money with a broker-dealer who uses a small Chinese accounting firm).
Another interesting finding in the PCAOB list of registered firms is that KPMG Huazhen reports that it issued no audit reports but played a substantial role in the audit of at least one issuer. KPMG Hong Kong is registered with the PCAOB as issuing reports on issuers. A check of the audit reports of KPMG clients in China showed this to be accurate. KPMG Hong Kong signs all the audit reports. That raises two questions. First, why was KPMG Huazhen charged by the SEC, if KPMG in Hong Kong actually issues the reports? The answer to that question may be that KPMG Huazhen does all the work and has the working papers that the SEC wants to see. That leads to the second question, how does KPMG in Hong Kong sign the audit report if it does not do the audit?
The signing of audit reports by the Hong Kong firm when the mainland firm does the work is a common practice in Hong Kong. Most of the red chips listed in Hong Kong are done this way. H-shares used to be done the same way, although most now have reports signed by the mainland affiliate. The practice of Hong Kong accountants signing reports when they outsource all the audit work is under attack after Hong Kong regulators were unable to get audit working papers from Ernst & Young on failed IPO Standard Water. Ernst & Young’s defense was that the work was done by its mainland affiliate, which could not release the working papers under Chinese law. That case is working its way through the Hong Kong courts and is virtually identical to the SEC case against the firms.