The Public Company Accounting Oversight Board (PCAOB) has not been allowed to inspect accounting firms in China, despite the fact that hundreds of Chinese companies are listed in the United States and their auditors are required to be inspected. China has blocked the inspections because they consider allowing foreign regulators to enforce foreign rules against Chinese persons on Chinese soil to violate China’s national sovereignty, and because of concerns that audit working papers might contain state secrets. Recent academic research suggests it may be in China’s best interest to allow the inspections.
MIT professor Nemit Shroff authored a study titled Real Effects of Financial Reporting Quality and Credibility: Evidence from the PCAOB Regulatory Regime. Professor Schroff examined the clients of non-US auditors that were inspected by the PCAOB and found that audit quality on all of their clients improved, not just those listed in the US and subject to PCAOB and SEC jurisdiction. In other words, there is a spillover effect. PCAOB inspections improve all of the audits, not just the US audits.
Schroff measured audit quality using discretionary accrual levels. That method has been commonly used in academia, but may not actually measure audit quality. Audit quality is a term that has escaped definition. The PCAOB has been working on developing audit quality measures, but the metrics suggested have been based mostly on opinion rather than empirical evidence.
Professor Shroff further found that when the PCAOB inspection reports are subsequently made public, the companies were able to increase long-term debt (investment) and become more responsive to investment opportunities. Again, these benefits extended to clients of these auditors who were not listed in the U.S.
The point here is that the credibility of the financial statements depends in part on the credibility of the auditor, and the presence of a PCAOB inspections increases the credibility of the auditor. That has benefits in the ability to raise capital.
Many of China’s large state owned enterprises are listed in China, and often have an additional listing in Hong Kong. A handful of the largest are also listed in New York. Most of them are audited by China’s Big Four (although the Hong Kong office signs most of the reports). The study suggests that these companies would have greater credibility in their financial statements if China were to permit the PCAOB to inspect the Big Four in China and Hong Kong. The benefits would extend even to Big Four clients not listed in the U.S.
I am hoping that China and the PCAOB soon reach a deal to do inspections in China. Looks like a win/win situation.