The inspection cliff | China Accounting Blog | Paul Gillis

The inspection cliff

I was wrong. The PCAOB was supposed to complete its inspections of registered foreign accounting firms by December 31, 2012. This deadline was extended from December 31, 2009 by a previous rule making action of the PCAOB that was approved by the SEC. The PCAOB failed to complete the required inspections because of difficulty in securing agreements with a number of countries, most notably China. And it did nothing.

I had predicted that the PCAOB would not go off the “inspection cliff” without taking action of some sort. I thought that action would be in the form of a rule proposing to revoke the registrations of firms it could not inspect. It did not happen. PCAOB board member Lewis Ferguson told Reuters “we’ve had periods before where we ran over deadlines while trying to get things done”. Ferguson indicated that Chinese regulators were reviewing a PCAOB proposal they received in November and that “there is forward movement” and “the number of issues … has been narrowed significantly”.

I speculate that Chinese regulators could probably find a way to allow for joint inspections. The hang-up is going to be over what to do with the inspection findings. Chinese regulators are going to insist that they alone administer any punishment to wayward Chinese auditors. China insisted on this when they negotiated to open up H-share audits in Hong Kong to Chinese auditors. The idea that foreign regulators could punish Chinese accounting firms is likely a nonstarter for Chinese regulators. I think that the PCAOB must retain the right to punish firms. While the PCAOB would always have the ability to terminate the registration of a recalcitrant firm, that would probably not be an effective deterrent to bad auditing. The death penalty is so severe that firms would reasonably assume that the PCAOB would never use it.  

I expect that these negotiations will come to a conclusion in short order – probably before Chinese New Year. The PCAOB will come under increasing pressure to do something. The SEC filings present a picture of Chinese regulators dragging their feet in these negotiations with no intent to ever reach a deal, and I don’t expect the PCAOB wants to be played as fools.  

From the China side, there are indications that China recognizes that it needs to open up access to foreign capital markets. The proposed liberalization announced by the CSRC indicates that they will make it easier for Chinese companies to list directly abroad.  This is consistent with my recent calls for reform. The proposed CSRC changes may be directed more at the Hong Kong exchange than at the U.S.

Should an agreement be reached between the U.S. and China about audit inspections, it would seem fairly easy for the parties to find a way to settle the working papers dispute that is the substance of the SEC case against the Big Four and BDO. I expect that case would drop away quickly if the current PCAOB negotiations bear fruit.  

Undaunted by my failure to accurately predict the inspection cliff, I estimate about a 40% chance that there will be an inspection deal in the next two months, and a 60% chance that the PCAOB will have to propose deregistration. Even if deregistration is proposed, there is probably at least a year left for diplomacy to work before Chinese companies listed in the U.S. face delisting. 

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