The Public Company Accounting Oversight Board has proposed new auditing standards that will significantly affect audits of US listed Chinese companies. The proposed standards address two of the problems with audits of US listed Chinese companies.
The first problem relates to the Big Four in Hong Kong signing off on audits that are mostly or completely done by the China member firm. I have called that practice consumer fraud – no different than a Wenzhou shirt maker sewing a made in Italy label on a garment. This practice has caused problems – most notably the case of Standard Water where EY Hong Kong signed off on accounts yet was unable to turn over working papers to SFC when demanded because it actually did not do the work. There is also the problem of some firms having their Hong Kong affiliate sign off US listings even where the work is done by the mainland firm.
The proposed standard makes it clear that, to act as lead auditor, an audit firm must itself audit a meaningful portion of the financial statements. That will end many of the practices currently used by the Big Four in Hong Kong where the report is issued on Hong Kong letterhead despite most or all of the audit being done by the mainland affiliate. It also creates a conflict on many entities listed both in the US and in Hong Kong. The Hong Kong Stock Exchange (HKSE) generally requires that Hong Kong listed companies be signed off by a Hong Kong CPA firm, not its mainland affiliate. But as we learned in Standard Water, these audits are not necessarily done by the Hong Kong CPA firm, but rather by its mainland affiliate. Hong Kong authorities have tolerated this practice despite the reality that it violates ISA 600, presumably because the practice favors Hong Kong CPA firms. For example, PetroChina, listed in Hong Kong, New York, and Shanghai, has KPMG Hong Kong sign its accounts filed with both Hong Kong and the US. The new rules will require KPMG Hong Kong to have audited a meaningful portion of the financial statements itself, rather than relying on its China member firm. The right answer here is to recognize the reality of the situation, and have KPMG’s China member firm sign the report if it is doing the work, although that may require a change in HKSE rules.
The second problem is the China offices set up by many smaller US CPA firms that enabled them to serve smaller US listed Chinese companies. Many of these firms have set up consulting wholly foreign owned enterprises (WFOEs) in order to employ local accountants and open offices. Auditing is outside the permitted business scope of these companies and none to my knowledge are licensed as CPA firms in China. The proposed standard may shut down this practice. It requires that the auditor obtain a representation from each other auditor that the other auditor is duly licensed to practice under the applicable laws of the relevant country or jurisdiction. Since the WFOEs are not licensed to practice auditing in China, I don’t see how they can make this representation.
These are good proposed standards that will improve auditing practices in China and help protect investors.