My Wall Street Journal Op/Ed explains my view that the MOU falls well short of what is needed, but I remain optimistic that these issues will soon be resolved. Here is how I see the end game working out.
I believe that the breakdown in the SEC’s negotiations over access to audit working papers that led to charges being filed against the accounting firms caught Chinese regulators by surprise. They had been playing a cat and mouse game with the PCAOB and SEC and had finally been called out on it. My initial assessment was that the SEC actions were going to make it very difficult for both the PCAOB and the SEC to make a deal, since any deal would have to involve China backing down. We know that the CSRC and MOF made some recommendation to the State Council in December, and while we don’t know what that was, we do know that nothing happened for months.
I think that this became an issue that rested on the direction of the U.S.-China relationship. If the U.S. and China wanted to have a fight, this was a good one. Everyone could claim victory – the U.S. was not going to let China cheat on the rule of law, China was not going to let the U.S. push it around, U.S. exchanges are the gold standard, and investors might even be rewarded when the stocks relisted in Hong Kong at higher valuations - and as always, the lawyers, accountants and investment bankers would make out like bandits. The damage would be containable – unlike a fight over currency. But if the U.S. took the “nuclear” option and kicked Chinese companies off the U.S. stock exchanges, that would have marked a contentious direction in U.S.–China relationships.
China’s new government may have decided to go in another direction. Chinese President Xi Jinping and Barack Obama will hold a summit this weekend in California, and while I would be shocked if they discussed accounting regulation, I think a successful meeting will set the stage to resolve the remaining issues on U.S. listed Chinese companies.
The important event will be the annual Strategic and Economic Dialogue, scheduled to take place in Washington the week of July 8 -12. I expect that one of the outcomes of this dialogue will be an agreement to provide working papers to the SEC and to allow joint inspections of accounting firms by the PCAOB.
That agreement should allow the accounting firms to turn over their working papers to the SEC and, in turn, I expect the SEC will drop the cases against the firms. That, together with an agreement on joint inspections, eliminates the risk of a mass delisting of Chinese stocks by U.S. exchanges. That might be enough a catalyst to kickstart the IPO market, although there are certainly plenty of other problems. A deal to settle the same issue in Hong Kong would seem possible at any time.
For the accounting firms, however, their nightmare may only be beginning. I expect that inspections will begin by autumn. Fredrik Oqvist had an interesting post suggesting where the PCAOB ought to start. The Big Four in the United States has been experiencing failure rates on PCAOB inspections of about 40%. I expect that rate will be higher in China.
Findings take a long time to be publicly released. Clients are not told by the PCAOB of inspection findings, although in my opinion audit committees should be asking for them. When an audit failure is found, the firm is required to remediate the failure, so if the auditor suddenly starts reopening issues from earlier years, that is a pretty good indication that a PCAOB inspection did not go well.