Postings | China Accounting Blog | Paul Gillis


China deals with US listings

Readers will have observed that my posts have become infrequent. I am slipping towards retirement.  My commentary on current events will move principally to my Twitter account @profgillis. A number of readers have asked for my commentary on the recent developments in China, so I will go out with this likely final post.

U.S. listed Chinese companies have found themselves in the crossfire between the U.S. and China. First the trade war, then the Holding Foreign Companies Accountable Act, then executive actions banning investment in Chinese companies tied to the PLA or Xinjiang. From the Chinese side companies have faced increased regulatory supervision with respect to anticompetitive behavior and failure to accept the primacy of the state. Most recently, DiDi has been challenged on the application of the pending data security law. It has been proposed that overseas IPOs will be subject to review prior to the IPO. Wilmer Hale has an excellent analysis of the new rules.

In my opinion, there are several factors at work here. Firstly, China is putting in place regulations that were overdue. Many of the companies have engaged in practices that hurt consumers and would never have been allowed in any developed market. When China introduces new regulations, it tends to adopt best practices from each country around the world, and this often leads to stricter rules in China than the rest of the world.  Secondly, some of the response may be a reaction to U.S. actions against Chinese companies.  For example, the data security issues on DiDi seem remarkably similar to the since rescinded Trump order on TicTok. I believe that China is disappointed that Biden has not softened the U.S stance on bilateral relations. I think China may have sent a message to U.S. investors that decoupling would likely lead to huge losses for them and is hoping these investors put some political pressure on the U.S. government.

Deloitte and the whistleblower

Global Times today reported that the China Securities Regulatory Commission has commenced an investigation into Deloitte China based on a whistleblower report. The whistleblower report (alleged copy here) was apparently written by a low-level Deloitte staffer unhappy with the firm's response to internal complaints. 

We used to call exuberant young auditors “audit rambos”. Often, they did not see the whole picture and would get overly worked up about immaterial matters or issues that look quite differently when the big picture is considered.  

I express no opinion on these allegations but observe that when regulators get involved the stakes go up considerably and regulators are often staffed with “audit rambos” that wash out of accounting firms.  

Kennedy bill goes to President’s desk

The House of Representatives today passed the Holding Foreign Companies Accountable Act (The Kennedy Bill) by voice vote. The Senate has already passed the act, so it now goes to the President’s desk to be signed into law.  

The act will kick Chinese companies off of US exchanges after three future audits that cannot be inspected by the PCAOB. That means that the ban will not take place for calendar year companies until April 30, 2023 which is when their Form 20F for the third consecutive year (2022) will be due.  

Certain disclosures are also required, including government ownership, and names of Communists on the board of the company or operating entities, and whether the articles of incorporation contain the charter of the Communist Party.   

The passage of the Kennedy bill likely ends any plan by the SEC to do the same through regulation, as well as the unworkable recommendations of the President’s Working Group. This issue has been in existence since Sarbanes Oxley was passed in 2002. The SEC and PCAOB have always had the ability to do this but lacked the will to do so.  

Trump rages against China

Bloomberg reported today that the SEC is rushing a new regulation that will ban Chinese companies from being listed on US exchanges.  

The Wall Street Journal says the proposed regulation is expected to be issued for public comment in December but would be finalized under the Biden administration. It appears to be part of Trump’s attempt to rush through policies before he is removed from office, betting that Democrats will not have the political will to reverse them.  

There are no details available at this time. The SEC and PCAOB have always had the power to do this, but it was considered a ‘nuclear option” that would be a step too far for the regulators. Congress stepped in to propose legislative changes, and the President established a working group that made similar recommendations as the proposed legislation.  

I expect the proposed regulation will have a long transition period of at least a year. In the end I expect the issue will be resolved through normal diplomacy, with China agreeing to allow inspections by the PCAOB.   

Antitrust and VIE

China has proposed new legislation on how the antitrust laws apply to the platform economy. Many of China’s internet companies provide platforms for other companies (like restaurants and retailers) to push their wares. Some of these platforms are alleged to have engaged in monopolistic behavior, such as requiring that companies list only on their platforms. I think the legislation is focused on protecting consumers and the behaviors being banned would also be banned in most any Western country. If this proposed law is implemented, it may reduce the profitability of many overseas listed Chinese companies, and consequentially the share values of these companies have been hammered in recent days. 

There is a provision that deals with variable interest entities (VIEs). VIEs are extensively used by overseas listed Chinese companies to circumvent Chinese restrictions on foreign investment in certain sectors, including internet related companies. The draft legislation (Article 18) states that VIE arrangements fall within the scope of the proposed provisions and require advanced reporting to the Anti-monopoly Law Enforcement Agency of the State Council. It appears VIE arrangements cannot be implemented if not declared in advance. How this applies to existing VIE structures is unclear. 

Rubio introduces new anti China proposal

After a flurry of activity this past summer, there have been few developments in the battle over Chinese companies listed in the US. Ant has proposed the largest IPO in history in Hong Kong which may have partly been because of the uncertainty in US markets. But other IPOs have continued, even during the virus-related shutdowns. 

I don’t expect anything to happen in the next few months, even if Trump wins reelection.  

This week Senator Marco Rubio introduced some new legislation – the American Financial Markets Integrity and Security Act which purports to delist Chinese companies that are Communist Chinese Military Companies and to forbid SEC registered funds from investing in these companies. It would also revoke the tax-exempt status of pension funds that invest in these stocks. 

Rubio introduced the Equitable Act to delist Chinese companies whose auditors could not be inspected by the PCAOB. For reasons that appear to relate to internecine conflicts in the Republican party a similar bill by Senator John Kennedy was instead passed by the senate but has not been enacted. Rubio’s Equitable Act has gone nowhere, and I expect that is the fate of this bill. 

Luckin gets a new auditor

Luckin Coffee has a new auditor. Marcum Bernstein and Pinchuk (MBP) has replaced EY as Luckin’s auditor. MBP has picked up a number of Chinese companies where the Big Four auditor quits or is dismissed, including AMBOW and NQ Mobile.  

Separately, the PCAOB banned Marcum LLP (Marcum) and two of its partners from auditing Chinese companies for three years. The ban does not appear to apply to MPB which is a JV between Marcum and U.S. based CPA firm Bernstein and Pinchuk. According to the PCAOB notice, MBP did field work on the audit that led to ban but did not sign it. The ban raises a few questions about MBP. I understand it operates in China through a WFOE (wholly foreign owned Chinese incorporated subsidiary) that has a business scope as a consulting firm, not an auditing firm. The China WFOE is not registered with the PCAOB, which would be required if it participated in significant work on an audit signed off by Marcum. In addition, since Marcum is not a Chinese accounting firm, it is unclear to me why the PCAOB accepted having a non-accounting firm perform part of the audit. Additionally, MPB is inspected by the PCAOB, which must mean they are removing audit working papers from China in apparent violation of Chinese law. My guess is that MBP has been too small for US and Chinese regulators to focus on, but now that they have signed on to Luckin they are likely to get a lot more attention. 

What is the end game?

Last week I wrote that the President’s Working Group proposal to make the U.S. Big Four  (the Big Four audit all Chinese companies of any substance) the principal auditors of Chinese listed companies was naïve and unworkable, and that that might have been the plan. The proposal requires the U.S. member firms of the Big Four to assume liability for the audits of their Chinese member firms, and for China to allow the U.S. Big Four to remove audit working papers potentially containing state secrets from China. I don’t believe either will happen. 

The Washington Post has a story that explains this is a well-used tactic of the Trump administration. Propose an unworkable solution and either get your way or force your opponents to spend considerable effort to defeat it.

I understand that the PCAOB is no longer involved in the negotiations. They have been taken over by the White House and the SEC, which is working closely with the Big Four. Some corporate governance types fear the objective is to weaken or eliminate PCAOB inspections, and not just for Chinese companies.  The parties all know that China will not allow the U.S. Big Four to conduct audits in China and to remove working papers. The end game is said to allow the Big Four to self-inspect its China member firm’s audits as a substitute for PCAOB inspections.  

President’s Working Group

The President’s Working Group (PWG) issued its report on July 24, 2020. The report makes five recommendations for the SEC to implement. While the PWG says it has considered the Holding Foreign Companies Accountable Act (HFCAA), it proposes to solve the problem using rules instead of laws—with regulation, not legislation. In my view, the PWG’s proposed solution is both naïve and unworkable. 

The PWG proposes to ban companies from listing on U.S. exchanges after 2022 if the auditor of the company cannot be inspected. New IPOs’ auditors must be inspectable immediately. 

An exception is provided. If a foreign auditor cannot be inspected, it may appoint a U.S. member firm to serve as principal auditor. While existing PCAOB rules allow the U.S. member firm to use the work of foreign affiliates, the proposal requires that the U.S. member firm serve as principal auditor. Under this recommendation, because the U.S. Firm would be the principal auditor and would be required to maintain the work papers in the U.S., the PCAOB would have the ability to inspect the audit work and practices of the U.S. Firm. This is most easily understood with respect to the Big Four audit firms, which audit most U.S. listed Chinese companies by market capitalization. For local Chinese firms not affiliated with U.S. member firms, the solution would be more complicated, but there are few, if any, of these auditing U.S. listed companies. 

Luckin Coffee Fraud

Luckin Coffee (Luckin) has taken the spotlight as the largest and perhaps most audacious Chinese fraud yet. On April 2, Luckin said that Chief Operating Officer Jian Liu and some subordinates might have faked more than $300 million in revenue, more than a quarter’s worth of reported sales. Luckin’s NASDAQ traded stock collapsed from $50 per share to $3 per share and faces likely delisting. 

The company says the fraud was in three quarters of 2019. If the fraud extends to 2018 it could mean the original IPO was fraudulent with serious consequences for the company, auditors, and investment bankers.  

Luckin’s auditor is the Chinese member firm of Ernst & Young, Ernst & Young Hua Ming. Normally auditors are silent when their clients are accused of fraud.  EY issued an extraordinary statement regarding Luckin, essentially saying they found the fraud. PCAOB standards formerly included this statement, although it was removed in a later revision: The auditor has an ethical, and in some situations a legal, obligation to maintain the confidentiality of client information. 

Sherman slips in amendment

My friend and old colleague Andy Bishop pointed out that while Senator Kennedy’s attempt to insert the Holding Foreign Companies Accountable Act into the Senate version of the Defense Authorization Act failed, Representative Brad Sherman was successful in introducing an amendment to include it in the house version which has passed. Sherman’s amendment was included in a large batch of amendments that appear unrelated to defense.   

Because the House and Senate versions of the Defense Authorization Act are different, a conference committee will be convened to reconcile the differences. The final version must be pass both the House and Senate and then be signed by the president before it becomes law. 

I speculate that the Sherman amendment gets dropped in the Conference because it is apparent that the issues are not straightforward. I still think the House will take up this legislation, perhaps even before the election.

Defense Bill passes Senate without PCAOB

Senator Kennedy said he would introduce the Holding Foreign Companies Accountable Act  (HFCAA) as an amendment to the Defense Authorization bill, and he did, but the Senate never took up his amendment.   

So the HFCAA bill, which passed the Senate by unanimous consent, still awaits action in the House. Kennedy’s gambit was to attach the bill to must pass legislation like the Defense Authorization Bill, but apparently senate leaders did not think that was a good idea. 

Perhaps Senate Majority Leader Mitch McConnell wanted to wait for the administration’s report that is due on August 3 that will recommend how to deal with China and US securities markets.  Perhaps he delayed because of concerns that the bill hurts Americans more than Chinese. Or perhaps rumored SEC pushback on the bill and recommendations for changes to protect multinationals were a factor. 

I don’t expect the house to take action until after the August 3 report and based on the poor state of relations between the US and China we could see action very quickly after that.  

How will Chinese companies react to HFCAA?

I published a report that I coauthored with Ray Tang Hou of the UVA law school  on the Holding Foreign Companies Accountable Act with GMT Research.  GMT is a Hong Kong based research firm that focuses on accounting analysis.  GMT has generously allowed me to republish the report here

The report was published before the comments by China reported on this blog and the introduction of the bill as an amendment to the defense bill. 

Passing the PCAOB bill

The John Kennedy (R:LA) bill to kick Chinese companies off of US stock exchanges if their auditors are not inspected by the PCAOB passed the senate unanimously in May but has gone nowhere in the house.

Now the bill has been introduced as an amendment to the National Defense Authorization Act. A common legislative technique binds proposed legislation to “must pass” legislation in order to get it enacted.  

“I don't want to start a cold war with China,” said Kennedy of the effort, but he noted that things like the ongoing Luckin Coffee (LKscandal are a “fiasco.” He said an audit would have made sure companies like Luckin “are not lying about their products and therefore defrauding investors.”

What Kennedy gets wrong is that PCAOB inspections are unlikely to stop frauds like Luckin.  

Luckin executives admitted to booking fake sales. Luckin's auditor Ernst & Young claimed to have found the fraud – a claim that appears to violate accounting ethics rules to keep client’s information confidential. If EY’s claim is accurate, the fraud was attempted in 2019 and did not extend to the financial statements for 2018 that were used in the IPO. So, according to EY’s telling, the audit worked, the fraud was exposed and EY is the hero not the goat. Ethics be damned.

China blinks on PCAOB

Caixin has reported($$ paywall) some amazing comments from CSRC chairman Yi Huiman. Yi reportedly said that: “As long as the U.S. side is truly willing to solve the problem, we can definitely find a way for China and the U.S to cooperate on audit regulation”  HT to Donald Clarke for tipping me off on this. 

Yi further added: Chinese law stipulates that exchanging information, such as providing audit working papers for overseas regulators, should be conducted through regulatory cooperation and comply with security and confidentiality regulations. Carrying out joint inspections is a common practice of international cooperation on this issue.

I doubt Yi is unaware of the fact that China has blocked inspections since the passage of Sarbanes Oxley in the early 2000s. The U.S. has certainly shown its willingness to solve the problem, even agreeing to a joint trial inspection that was called off when Chinese regulators would not allow the PCAOB to see documents or ask questions.  

Yi is correct that joint inspections are the common practice of international cooperation. I believe this is the first time Chinese authorities have sanctioned that approach. Formerly they argued for regulator equivalency, where US regulators would rely on Chinese regulators to examine auditors.  The PCAOB has long rejected that approach, although it was adopted by the EU. 

Kennedy Bill and MNCs

This post is more in the weeds about the Kennedy bill.   Although I believe the intent of this bill is to force China to allow PCAOB inspections of Chinese auditors, the way it gets there may have unintended consequences. 

The bill essentially bans trading in companies whose auditors are not able to be inspected by the PCAOB. The bill is limited to covered issuers (essentially any public company) that are audited by an auditor with a branch or office in a foreign jurisdiction that does not allow inspections.  

Those definitions obviously bring most US listed Chinese companies under the jurisdiction of the Kennedy Bill. They are public companies and are mostly audited by the Chinese member firms of the Big Four accounting firms. 

But what about multinationals like IBM? IBM is audited by the US firm of PwC which uses PwC Zhong Tian CPAs, its China firm, to audit China operations.  PwC Zhong Tian is a Chinese limited liability partnership, not an office or branch of the US firm. The Big Four accounting firms are structured more like a franchise operation than an MNC.  Local operations tend to be owned by local partners.   On its face, I don’t think that Big Four firms in China constitute a branch or office of the US firm. This is not an insignificant point. The PCAOB has identified 207 multinationals where it can inspect some, but not all of the audit. 

Ban on Chinese companies passes senate

Readers will have recognized that I have reduced my blog postings significantly in the last year. I was trying to ease towards retirement but activity has increased so much I feel compelled to write from quarantine. I was in California at Chinese New Year and got stuck.  

This week the Senate passed by unanimous consent Kennedy’s bill titled Holding Foreign Companies Accountable Act. Kennedy’s bill was one of three bills that had been introduced on the topic. I am unclear why Kennedy’s bill was chosen over Marco Rubio’s Equitable Act, but the Kennedy bill is shorter and had more co-sponsors including Florida’s other senator.  

The bill now has to pass the house and be signed by the President. I don’t think that is certain, given that I expect considerable lobbying pressure to kill it from US institutions that would be adversely affected. 

If the bill is enacted it does two things: 

1) Of minor significance is a requirement for companies to disclose party affiliations including whether a foreign government has control, and whether any board members are CCP members and whether the articles of incorporation contain any language from the party. No penalty is provided for failure to do this. 

Subsequent events and corona virus

On Wednesday, the SEC said that it had asked accounting firms to keep an eye on the impact of the corona virus on audit quality, since it had caused personnel disruptions in China and Hong Kong. SEC Chairman Jay Clayton said in a joint statement with the PCAOB chairman: “How issuers plan and respond to events as they unfold can be material to an investment decision, and we urge issuers to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable.”

Because most US-listed Chinese companies have a calendar year end and because the impact of the virus is mostly in 2020, the important accounting question is what should be recorded or reported in the 2019 financial statements that will be released sometime in 2020.   

I believe the most important accounting guidance is found in reporting of subsequent events. There are two types of subsequent events. 

The first type consists of those events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements.  Type 1 events require the year-end financial statements to be adjusted to report the impact of the events, even when they partially occur after year end. 

Accounting and the Corona Virus

The corona virus is certainly altering my life. I am in California between semesters but have been told not to return to school until further notice. My return flight was cancelled by the airline so it may have been difficult to return anyway.  The crisis is likely to create a lot of accounting woes for Chinese companies. It already seems to be having a negative effect on markets.

It is Chinese New Year holiday time, so most companies staff took last week off and most have been ordered to take off this week. Some companies, including most of the Big Four, have told staff to work from home this coming week. 

Annual reports for public companies are normally due early in the year. The US Securities and Exchange Commission requires Form 20F to be filed for calendar year companies by April 30. The Hong Kong Stock Exchange due date for these companies is March 31. The Shanghai Stock Exchange has already extended the due date to April 30.

In a normal year, the preparation of accounts by companies and audit by independent accountants follows a furious pace once people return from the New Year holiday. Since most companies are delaying the return of employees this year it may prove difficult to get annual reports out on time this year.  

Bank NPL crisis in China

This is another post by Martin Miszerak ( He is teaching at Remnin University next semester. 

Long time readers have seen that I have not posted much lately.  I had turned by efforts more to radio and TV.  But with recent developments in the areas I cover, I plan to return with some new posts soon. 

Over the course of 2019, much of the financial news out of China has centered on the condition of China’s smaller banks.  The most recent resolution of Hengfeng Bank is only the latest in a procession of smaller bank rescues, including Baoshang Bank Co. Ltd and Bank of Jinzhou Co. Ltd.  What we don’t know yet is whether such rescues are isolated incidents, often triggered by corruption, or symptoms of a systemic NPL crisis in China’s smaller bank sector, which is said to number over 3.000 lenders.  No financial information on these failed lenders has been released, while some of them have not published annual reports for years, such as Hengfeng Bank.  

Last July, Jason Bedford, a former UBS research analyst specialized in China’s banks, predicted that the 250 institutions he was covering were facing a capital shortfall of about RMB 2.4 trillion, concentrated, however, in the smaller banks.  Bedford questioned the integrity of many bank accounts, claiming that loans were often disguised in their accounts as “investments” and consequently the “true” NPL ratio of the entire banking sector was much higher than the official 1.74% at the end of 2017, as published by the People’s Bank of China in the most recent Financial Stability Report.  However, we may be able to gain a better insight into loan quality trends in China’s smaller banks early next year, as all mainland-only listed banks were required to transition on January 1, 2019 from IAS 39 to IFRS 9.  These banks will be fully disclosing the impact of that transition on their net loans and total equity in their 2019 annual reports.  

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