What will the PCAOB do next? | China Accounting Blog | Paul Gillis

What will the PCAOB do next?

The SEC case against the Big Four and BDO has gotten the headlines this week. Shares of U.S. listed Chinese companies fell sharply after the announcement, but they appear to have stabilized by the end of the week. My hypothesis, not supported by hard data, is that conservative investors such as mutual funds that cannot risk a period of illiquidity have sold and will sit this out. Investors with a willingness to risk illiquidity while the companies find a new place to list see value and have stopped the slide. 

Legal experts think that the SEC case will be resolved faster than the 300 days that the judge is allowed. That is because the facts are straightforward and the legal issues have already been developed for the Deloitte case. The SEC has restarted the Deloitte case that was stayed in July, and a decision could come quickly. All the lawyers I talk to seem to think the case against the firms is a slam dunk for the government. The judge will have a wide range of punishments available, but the most meaningful would be to revoke the practice rights of the firms. That would mean their clients need new auditors, and that is likely to be difficult for them since all the big firms in China have been charged. I expect, however, that the firms will appeal the decision, delaying its implementation for some time.

We are now waiting for the other shoe to drop. That is the one held by the PCAOB. The PCAOB faces a December 31 deadline to complete inspections of foreign firms. It will miss that deadline, and I expect they will do something before that happens. At that point, the PCAOB process is probably more important for investors than the SEC case. In any event, I expect that the timetables for final resolution will converge for both the SEC and PCAOB actions. 

PCAOB Chairman James Doty recently told an auditing conference in New York that “the current state is not sustainable. We are coming to a crossroads where we will have to make some important decisions about how to best protect investors.” I think they have reached that crossroads. 

PCAOB Board Member Lewis Ferguson gave an exclusive interview this week to Chinese reporter Ji Zhenyi. The interview would have been conducted in English, Ji reports it in Chinese, and I am working from this English translation. Expect some loss in translation. 

Ferguson’s comments suggest there may be some hope of a deal between the PCAOB and China. He is reported to say that “we still remain optimistic on final agreement, but we need to deal with the current problems now”. Ferguson reported that the PCAOB met with Chinese regulators last week and had a wide ranging discussion on sharing audit materials, enhancing investigations, and enforcement cooperation. The PCAOB also presented an proposal to the Chinese officials. I expect that proposal calls for joint inspections. 

I think the SEC action will make it difficult for Chinese regulators to reach a near term agreement with the PCAOB. Agreeing to PCAOB requests now might be perceived as caving in to U.S. demands, with the attendant loss of face. I expect the PCAOB is going to be forced to “deal with the current problems now”. I think that action will be to begin the process of deregistering Chinese accounting firms. While starting that process will increase pressure on Chinese regulators to cut a deal, it also makes it more difficult to reach a face saving solution.  

While PCAOB action could take many forms, I think the most likely is a proposal to modify PCAOB rules. The proposal would say that the PCAOB will not register firms that it cannot inspect, and that it will terminate the registration of any registered firms that it cannot inspect. The proposal would then go through the PCAOB’s rule making process, which includes public comment, possibly public hearings, and eventual adoption. Before the rule can take effect it must be approved by the SEC. That process likely takes a minimum of six months, but I don’t think the PCAOB and SEC are going to be in a hurry. I would suggest that they set an effective date well into the future - say June 30, 2014. That would give plenty of time for diplomacy to work, and would give companies plenty of time to figure out how they might exit U.S. capital markets.

The PCAOB will also have to be careful that any proposal not have unintended consequences for MNCs. They may need to also modify the rules that require PCAOB registration for firms playing a substantial role in the audit of an MNC. I don't think those rules will be a problem for most companies

It is going to be an interesting month for U.S. listed Chinese companies and their auditors. Hopefully I am wrong and a deal gets announced this week. 

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