Regulators start to punish auditors - Paul Gillis

Paul Gillis

China's auditing regulators have issued temporary bans for the Chinese affiliate of BDO and Ruihua, the Chinese affiliate of both Crowe Horwath and RSM, over the past few months. Harsh measures to get auditing firms in line, even for international standards. Beida auditing professor Paul Gillis has his doubts, he writes at his weblog.

Paul Gillis:

The January ban came during the audit season, causing the firms to lose many clients. 

I have a mixed view on these actions. First, I think they are a good thing, reflecting that China is taking audit quality seriously. Audit quality is essential to the orderly development of China’s capital markets. On the other hand, I think the penalty is too severe and may hurt the development of the profession. I fear the short-term result may slow the development of the capital markets. 

The CPA profession in China is young, and is currently entering its third phase of development. The first stage, infancy, began with the reemergence of the profession in 1980 and continued through the separation of CPA firms from the state about 1999. The second stage, adolescence, saw the firms grow into sizable, but clumsy teenagers. The largest firms now have over 10,000 accountants and have contributed significantly to the development of China. We are now beginning the third stage where the firms enter adulthood.  As adults, regulators are now holding the firms to task for their responsibilities as independent auditors essential to the integrity of capital markets. 

I understand that many of the problems are coming from the lightly regulated National Equities and Exchange Quotation, commonly known as China’s Third Board. There are thousands of small companies listed on this board, which was created to allow small private companies access to capital. I believe this board has rampant accounting fraud, yet it has been tolerated by regulators who dealt with the risk by limiting access to the market to wealthy investors. I expected that someday regulators would clean up this market, probably by getting tough on auditors, and it appears that day has arrived. 

The CPA firms need to respond to these actions by focusing on quality instead of growth. Client acceptance processes need to be tightened, and internal quality review processes strengthened. The culture of the firms needs to change, shifting the focus from winning new clients and growing quickly to doing a better job auditing and managing risk. The firms are going to have to learn to say no more often. That will be a painful shift, and some accounting firm partners are unlikely to be able to make the change. Those partners will need to find a new profession, because this one needs umbrella holders, not rainmakers. 

Regulators should also reconsider their approach. I think the bans against the large firms are too harsh and hurt too many innocent people. In the short term, they will hurt the integrity of the capital markets by disrupting audits. The trip-wire approach of suspending firms with two disciplinary actions unfairly targets large firms that audit many companies. Instead, regulators should punish individual partners and punish firms only if they have ineffective quality control processes.

More at Paul Gillis' weblog.

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