How do auditors deal with guanxi? - Paul Gillis

Paul Gillis

Guanxi, your informal network of friends and allies, might never be far away in China. But when it comes to the auditors of your firm, guanxi can get tricky. Accounting professor Paul Gillis reviews on his weblog a recent academic paper about this touchy issue.

Paul Gillis:

Auditors are not immune to the pressures of culture. The authors observe that “Chinese auditors are entrenched in the guanxi culture and psychologically bonded to their clients. This psychological tie created by guanxi leads auditors to trust their clients and act as advocates for the client.”  That is not the way auditors are supposed to behave. Auditors are supposed to be independent of management. The presence of guanxi undermines independence and destroys the credibility of audits. 

The authors say “the strong psychological bond makes it difficult for Chinese auditors to distance themselves from managers and maintain independence in mind during the audit work." The authors argue that “many problems relating to Chinese auditing practice can be attributed to the guanxi network where auditors act as an advocate for the manager and even collaborate with the manager in illegal or unethical acts.” In other words, guanxi can lead to an audit failures and we have certainly seen plenty of them in China. 

The Chinese Institute of CPAs is well aware of the practice of guanxi, and its code of ethics, Article 165, specifically forbids auditors from accepting gifts from clients. I don’t know the extent to which that is followed in practice. 

Audit committees should take responsibility for evaluating the independence of auditors. Required rotation of audit partners is helpful, but periodic rotation of firms might also be a prudent step. I would also recommend that audit committees ask difficult questions about personal relationships between company managers and the audit team. As an audit committee member, I would be very skeptical when a new CFO wants to onboard a new CPA firm. Often the CFO has a guanxi relationship with the new CPA firm that makes them part of his team. You don’t want the auditor to be on the CFOs team.

More at the ChinaAccountingBlog.

The reviewed paper is: Ning Du, Joshua Ronen, and Jianfang Ye (2015). Auditors’ Role in China: The Joint Effects of Guanxi and Regulatory Sanctions on Earnings Management.Journal of Accounting, Auditing & Finance, Vol. 30(4) 461–483.

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US inspection of listed China firms "little and too late" - Paul Gillis

Paul Gills

 Under new US rules the Public Company Accounting Oversight Board (PCAOB), the main U.S. audit regulator will start this year to inspect Chinese firms listed at US stock markets in China, Reuters reports. Accounting professor Paul Gillis is not impressed.

Reuters:

The PCAOB has been seeking access to China for audit inspections for years, following a rash of botched audits that led to massive losses for investors in Chinese shares in the United States. China had balked at granting access for audit inspectors, citing sovereignty concerns. Under U.S. law, auditors that check the books of U.S.-listed companies must be registered with the PCAOB and open to inspections. 

"They've gotten very little here, but they're making progress," said Paul Gillis, an accounting professor at Peking University in Beijing. 

"The whole issue is becoming less relevant as these companies flee the U.S. markets to return to China, and that's really the best for all parties," he said. 

Chinese companies have been pulling out of the United States and returning home, where share prices had surged before a recent pullback. In the media and internet sectors alone, 17 U.S.-listed Chinese companies have said this year they will go private, spurred by a chance to re-list on Chinese exchanges, according to a report on Monday from Mizuho Securities.

More in Reuters.

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Missing audits for Tianhe and Sihuan red flags - Paul Gillis

+Paul Gillis 

Two major companies backed by Morgan Stanley, Tianhe and Sihuan, have told security regulators in Hong Kong, they cannot meet the deadlines for filing their audits, reports AP. Two red flags, causing serious problems for Morgan Stanley, says accounting professor Paul Gillis.

AP:

The twin filing delays raise uncomfortable questions for Morgan Stanley, which picked the companies from obscurity then promoted them as multibillion-dollar growth stories. "This is not something an auditing firm would do lightly," said Paul Gillis, a former Partner for PricewaterhouseCoopers LLP in China who now teaches accounting at Peking University. "There are only two reasonable explanations for being late. One is management incompetence. Two is they're fighting with the auditors. And neither one of those is good." Tianhe and Sihuan could eventually receive a clean bill of health, although announcements about earnings delays due to unfinished audits are generally regarded as portending bad news. Any material problems that led to the delay would have to be disclosed once the companies file their financials. 

As U.S. investors increasingly consider Chinese stocks, they rely on investment banks like Morgan Stanley to keep troubled Chinese companies from reaching the market... 

Tianhe was the subject of significant public scrutiny over its financials. In September, a shadowy group tied to speculators betting against Tianhe's stock published allegations that the company had overstated its business in a Morgan Stanley-led public offering just a few months earlier. 

An AP investigation corroborated many discrepancies. Tianhe said records cited by AP were outdated and disputed other findings. But the controversy drew public notice from its auditor, Deloitte Touche Tohmatsu Ltd., which Gillis said would have been expected to put extra emphasis on its next audit process. 

"The auditors have had plenty of time to look into the allegations and dismiss them," Gillis said. "In this case, everybody would have been paying attention."

More from AP.

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China wants overseas auditors for its 113 SOE´s - Paul Gillis

+Paul Gillis 

Overseas operations of state-owned companies have been identified as "hotbeds of corruption", who are seldom audited, writes accounting professor Paul Gillis on his weblog. The State Council has now put out a bit for overseas auditors to clean up the mess.

Paul Gillis:

The large state owned firms are said to have assets of more than 4.3 trillion yuan (US$690 billion) located outside of China. Some of these firms (like PetroChina) are publicly listed in China and overseas markets, and are already audited by independent firms, but the amount of audit work done on overseas operations would depend on materiality. Stand alone audits of overseas operations are likely to be more detailed. 

It is interesting that China has chosen to use independent auditors for this work instead of government auditors. I expect that is because the work will be mostly done overseas, and independent CPA firms have better capabilities to work outside of China through affiliates in those countries. 

While the Big Four may win some of this work, I expect the big winners will be the local Chinese CPA firms that have international affiliations, especially including the local member firms of BDO, RSM/Crowe Horwath and Grant Thornton. I expect that these firms will move aggressively to win this work, in part because winning now will position the firms to win the overall audits when the companies next rotate external auditors in 2020. 

I don’t expect that this work is going to be easy, especially if Dong (Dasheng, former deputy auditor general at China’s National Audit Office (China’s GAO)) is correct in his assessment that the overseas operations are a hotbed of corruption. In fact, the work may be downright dangerous – perhaps another reason why the state decided to use external auditors.  This may be a real test of the independence of China’s independent audit firms. I hope they are up to the task.

More in the ChinaAccountingBlog.

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