Weblog with daily updates of the news on a frugal, fair and beautiful China, from the perspective of internet entrepreneur, new media advisor and president of the China Speakers Bureau Fons Tuinstra
Two hundred Chinese companies listed in the US thought they would get a pass when the PCAOB accepted late last year the auditing process for those companies. But financial analyst Winston Ma warns there are still significant uncertainties for those firms, as the SEC still indicates on its website those companies are still in danger of being delisted, he tells CNBC.
After two decades of negotiations, the end game of the struggle between the US and China on listed companies at the NYSE and Nasdaq seems to head into a delisting of 200 listed Chinese firms. Accounting expert Paul Gillis looks back at twenty years of tug wars at Market Place. Moving home, like to the Hong Kong Exchange, might not solve the need for capital, according to Gillis. “The Hong Kong exchange has arguably less liquidity than the U.S. exchanges,” Gillis said. “The investors may find it a little more difficult to get good prices when they’re selling stock.”
Market Place:
Allegations of fraud against U.S.-listed Chinese firms stretch back to the 2000s, when private firms from China began listing on U.S. stock exchanges, according to Paul Gillis, an accounting professor at Peking University’s Guanghua’s School of Management in Beijing.
“Some of them were just outright frauds, and the short sellers attacked these companies in the mid-2000s and had great success at bringing them down,” Gillis said. “That got the attention of U.S. regulators who wanted to try to protect investors by stopping that fraud.”
It has been difficult because China’s government has blocked these efforts…
Under the 2002 Sarbanes-Oxley Act, the Public Company Accounting Oversight Board was created to set audit rules for companies listed on U.S. stock exchanges. The PCAOB also has the power to inspect and enforce the rules. It does not interact with listed companies directly, but instead the PCAOB oversees the auditors.
“When [auditors] do an audit, [they] prepare a set of working papers that document what work they have done to reach the conclusion that the financial statements are correct,” Gillis said.
The PCAOB wants full access to the working papers, but China’s government says this could threaten its national security…
The U.S. worries that China’s definition of state secrets can be broad.
“The PCAOB was able to negotiate the ability to do inspections in every country, except for China,” Gillis said. “China’s also one of the few countries that uses the U.S. capital markets as extensively as it does.”
Negotiations have been on and off for the past 20 years…
“There has been a lot of people who seem to think that these PCAOB inspections are going to be some kind of magic bullet that is going to make fraud in Chinese companies go away,” accounting professor Gillis said. “I don’t believe that is true.”
Chinese firms in need of capital can turn to other stock exchanges, but they are not as appealing. Mainland China’s markets are underdeveloped. Hong Kong’s stock exchange might be the next best alternative to the United States. A few firms are moving in that direction already, but not all U.S.-listed Chinese companies are eligible to list in Hong Kong. American investors can buy stocks of Chinese firms in Hong Kong, though that prospect may not be very attractive.
“The Hong Kong exchange has arguably less liquidity than the U.S. exchanges,” Gillis said. “The investors may find it a little more difficult to get good prices when they’re selling stock.”
I do not believe the ban will ever come into effect. China made an offer on April 3, 2020 that the PCAOB rejected but which I believe is a reasonable offer. I fear their response was political and a case of putting the perfect ahead of the good. China has since sent another proposal to the PCAOB in August and has indicated that it is willing to deal.
I expect the issue will be settled by China agreeing to inspections. Biden has indicated he is not going to repeal Trump’s phase one trade deal immediately, but rather begin a multilateral discussion with former allies. I expect PCAOB inspections will be one of China’s concessions in reaching a new deal. There is no real urgency given the long transition period.
Inspections are not going to change much. I believe that the Big Four firms in China (which audit substantially every company of any meaningful size) are currently doing the audits under PCAOB standards. They have internal reviews of these audits by teams from outside of China (although I expect these reviews have been suspended under Covid-19).
PCAOB inspections have been tough, with a substantial share of audits found defective. Companies generally learn of problems with their audit when auditors show up to do remediation work, and shareholders rarely learn of problems. PCAOB inspections often result in financial sanctions against audit partners by the firm (the PCOAB itself only sanctions partners for serious offences such as altering working papers). I believe the rules should be amended to require disclosure of any sanctions against the partner (by the firm or regulators).
The fear of financial sanctions may change the behavior of audit partners, who may become more skittish and conservative. While sometimes that may be appropriate, it does undermine the independent judgment of partners.
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.
China has been banning US regulators at the PCAOB from getting access to information of Chinese companies at US stock markets, as they should do according to US regulations to protect its state secrets. But things are changing, notes auditing expert Paul Gillesat his weblog Chinaaccountingblog. "I suspect that Yi’s comments are a signal that China will back down on this issue, allowing joint inspections with adequate controls to protect state secrets," writes Gillis.
Paul Gillis:
Paul Gillis
Caixin has reported($$) 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.
I suspect that Yi’s comments are a signal that China will back down on this issue, allowing joint inspections with adequate controls to protect state secrets.
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.
I don’t think the Kennedy bill is intended to impact MNCs, and based on my analysis in the previous paragraph, I don’t think it does. However, Big Four firms would be wise to carefully review existing business operations to make sure the US firm has not inadvertently established a branch or office in China. I know many of the Big Four firms in China have seen firms in their network sneaking into China to do projects. There will be heightened concern over these activities out of fear they could be treated as a branch or office that would result in serious problems for their multinational clients, even where the activities of that branch or office had nothing to do with the audit.
Two financial regulators in the US, the SEC and the PCAOB, have joined the trade war of their country against China's accounting practices, writes Beida accounting professor Paul Gillisat his weblog. While the complaints are not new or surprising, he wonders about the timing, Gillis adds.
Paul Gillis:
For those have not been following the issue, the PCAOB is mandated by Sarbanes-Oxley to inspect accounting firms that audit U.S. listed companies, including foreign accounting firms. When the PCAOB attempted to come to China to inspect firms (mainly local affiliates of the Big Four) auditing U.S. listed companies China blocked them on the basis of national sovereignty. Attempts to find alternatives also foundered on arguments that the working papers might contain state secrets. The PCAOB was also blocked from inspecting Hong Kong firms to the extent the work related to the mainland.
After the wave of frauds by U.S. listed Chinese companies in the past ten years, the SEC finally got fed up with the intransigence of the Big Four firms about producing their working papers and brought charges against the firms. The firms argued to a SEC administrative trial judge that they were caught between a rock and hard place, having to decide whether to break Chinese or American law, and the judge appropriately observed that if that were the case, it was only because the firms put themselves in that position when they decided to do U.S. audits for Chinese companies. The judge threw the book at the Big Four, and BDO.
The firms appealed and settled with the SEC paying a $500,000 penalty each and promising not to sin again.
The PCAOB has succeeded in agreeing on enforcement cooperation with Chinese regulators, but has been unable to reach agreement on inspections, arguably a more important issue for investors than enforcement. Inspection are used to make certain that audits of U.S. listed companies comply with U.S. auditing standards, which is especially important in a market like China, where accounting practices are often “flexible”.
The primary champion of getting PCAOB inspections in China was former PCAOB chairman James Doty, who together with the rest of the PCAOB board and much of its management was forced out in a purge after the Trump election. This is the first comment on the issue that I am aware of by Doty’s replacement, Republican loyalist William Duhke III.
The remedy to China’s refusal to allow inspections has been what is referred to as the nuclear option. The PCAOB could deregister accounting firms that it cannot inspect. The consequence of that would be that most U.S. listed Chinese companies (and some multinational firms) would be unable to file audited financial statements with the SEC and without being granted an exception would be delisted from U.S. exchanges. This has been viewed as a step too far for the PCAOB, since it would likely hurt investors in the Chinese companies. Most of these investors are Americans, since it is difficult for Chinese to buy shares of companies listed in the U.S. because of currency restrictions. The result of a mass delisting would likely be a surge of IPOs on the Hong Kong exchange.
I suspect the SEC and PCAOB are raising this issue at this time because of the trade war. Allowing inspections would not seem to be a huge concession for China to make in a settlement of the trade war. Threatening to cut off access to U.S. capital markets for Chinese companies is yet another way for the U.S. to escalate the trade war.
China and the US worked out a deal on the age-old argument where Chinese firm are not allowed to hand over paperwork to US institutions for audits. But the agreement is not valid for Hong Kong, and so close to a hundred current and former KPMG partners got sued over the case of the bankrupt US-listed China Medical, reports Beida accounting professor Paul Gillis last week at his weblog.
Paul Gillis:
It is a bad day for KPMG. Reuters reports that the Hong Kong High Court has issued a contempt summons to 91 current and former KPMG partners for their failure to hand over audit working papers for US listed China Medical. China Medical is in liquidation and the court apparently has been overseeing the liquidation of Hong Kong subsidiaries. The case is a repeat of an earlier spat with EY over working papers for Standard Water, which was resolved when EY “found” the working papers on a server in Hong Kong.
KPMG says it cannot turn over the working papers without permission from mainland regulators. The US PCAOB reached an enforcement agreement with China that allowed it access to working papers in connection with investigations (but not inspections). Hong Kong has no such arrangements, and this is private litigation.
China has argued national sovereignty and state secrets concerns trump foreign laws requiring the production of documents on Chinese companies listed abroad or doing business abroad. Hong Kong, while part of China, is being treated the same as the United States, presumably to avoid undermining arguments used against the U.S. I seriously doubt there are any state secrets in these working papers.
The Public Company Accounting Oversight Board (PCAOB) has published disciplinary actions against a small Hong Kong CPA firm, Anthony Kam & Associates and Anthony Kam himself (Kam). Kam and his firm have been fined, censured, and banned from doing audits of US listed companies for at least five years because of shoddy work on Sino Agro Food, Inc (SIAF), a Chinese reverse merger.
Kam was found to have signed off on the 2012 audit of SAIF without actually conducting an audit. Kam had taken over the audit from another firm and reissued the financial statements without doing any work other than obtaining a representation letter from the client and getting a copy of the prior auditors working papers. Serious deficiencies were found in the 2013 and 2014 audits.
The PCAOB lamented that it should have inspected KAM at least twice since 2009, but was unable to do so because China blocks access. Somehow the PCAOB was able to pursue this action; possibly it was done under the 2013 Enforcement Cooperation Agreement. If Trump wants to get tough on China, he might start by demanding the Chinese comply with US laws or else delist their companies from US markets.
Oversight of Chinese companies listed in the US has been ongoing troublesome, as auditors miss access to much information considered a state-secret in China. Peking University accounting professor Paul Gillis told the U.S.-China Security and Economic Commission 26 January how to solve the conundrum. (here in pdf)
Paul Gillis:
In my opinion, the major problem with respect to U.S. listed Chinese companies is the inability of the PCAOB to conduct inspections of China based accounting firms. This has resulted in a situation where there is a double standard in regulation. All auditors of companies listed in the U.S. must be inspected, except for auditors of Chinese companies (and companies of a few other minor countries), which are not inspected. While this fact is routinely disclosed in the issuer’s filings, the double standard makes a mockery of U.S. regulation.
In my view, there are two alternatives to eliminate the double standards. First, Sarbanes Oxley could be amended to remove the requirement that the PCAOB inspect foreign accounting firms. Instead, the PCAOB could follow the lead of the European Union and negotiate regulatory equivalency under which the PCAOB would accept the work of Chinese regulators as their own. I do not think this is the best option, since I think it is unlikely that Chinese regulators will rigorously examine overseas listed companies nor do they have the necessary expertise in U.S. accounting and auditing rules.
The second option is to terminate the registration with the PCAOB of any auditors that the PCAOB is unable to inspect. The U.S. should require companies that seek to list in the U.S. to agree to follow all U.S. laws. If China determines that a company has state secrets that cannot be disclosed, a company with such secrets should not be permitted to list in the U.S.
Termination of accounting firm registrations would lead to the delisting of shares of companies audited by the deregistered firms, since financial statements audited by a PCAOB registered accounting firm are a requirement for continued listing. Delisted companies are likely to seek to relist in China or Hong Kong, although they may be required to restructure to eliminate control structures and/or variable interest entity arrangements that may not be permitted in the other jurisdiction. The PCAOB has so far been unwilling to go this far, likely due to opposition from capital markets.
Another problem with U.S. regulation is the overlapping jurisdiction of financial regulators. There is little secret that there is considerable tension between the SEC and the PCAOB. I believe this both confuses Chinese regulators as well as creating opportunities for Chinese bureaucrats to play one regulator off the other. I think Congress should consider abolishing the PCAOB, transferring the inspection and enforcement activities to the SEC and sending standard setting back to the American Institute of CPAs.
Both Baidu and Alibaba might be the first US-listed Chinese companies whose books are going to be checked buy the US regulator PCAOB, after a decade-long stale-mate where China refused such controls, citing state security. Accounting professor Paul Gillis is carefully optimistic, he tells the Wall Street Journal, but warns it is not yet a done deal.
The Wall Street Journal:
It is still possible the Alibaba- and Baidu-related inspections might not proceed. The audit documents provided to the PCAOB may be heavily redacted and the board may face other restrictions in conducting the inspections, said the people familiar with the situation, raising questions about whether the board will be allowed to conduct the thorough inspections it is seeking.
The move toward inspections is a “good first step” in thawing relations between U.S. and Chinese regulators, said Paul Gillis, an accounting professor at Peking University’s Guanghua School of Management. “But that doesn’t mean that the inspections will be meaningful.”
Mr. Gillis says he expects audit work papers to be moved to Hong Kong for inspection, a way to ease the Chinese government’s concerns about foreign regulators working on Chinese soil....
In theory, the impasse over inspections could lead the U.S. to bar audit firms that haven’t been PCAOB-inspected from auditing U.S.-traded companies, which would force those companies to find an acceptable auditor or be delisted. U.S. regulators have continually held back from such a step, however.
The Chinese “are trying to do whatever is necessary to prevent a disaster, which is their companies being delisted,” said Mr. Gillis. “U.S. regulators are trying to make this problem go away.”
On January 9, 2014 the PCAOB issued an order of formal investigation of PKF’s audits of an unnamed client (PKF had resigned that account a year earlier). In early April 2015 the PCAOB, pursuant to an Accounting Board Demand, insisted that PKF make available people to testify about the audits. PKF refused, saying Chinese law forbid them from doing so, and insisted that the PCAOB go through the enforcement cooperation MOU with the CSRC. The PCAOB argued that it is not bound to go through the MOU but must follow US law.
I believe this action sends a strong signal to Chinese authorities that the PCAOB is willing to deregister accounting firms that do not cooperate with it. I have heard that the PCAOB has issued an Accounting Board Demand, or something similar to it, to the China Big Four firms in December. I do not expect the firms will comply with the demand, setting up a scenario similar to PKF. If the PCAOB follows a timetable similar to the PKF case, it suggests that a disciplinary action might take place this coming summer, assuming that the PCAOB and Chinese regulators are unable to reach an agreement on inspections.
Sarbanes Oxley legislation precludes the PCAOB from disclosing pending disciplinary actions until they are final, and likely Big Four appeals of any PCAOB action may delay this information from becoming public for some time.
There are signs that a breakthrough may be near. This summer the PCAOB was allowed to inspect Deloitte in Hong Kong. Word on the street is that the inspection did not go well – Deloitte had few working papers in Hong Kong related to China engagements since those jobs are usually done by the mainland affiliate. That should have had the PCAOB raising questions about who is the principal auditor who should be signing the reports.
Everyone I talk to at the accounting firms expects the PCAOB will be back next year to do inspections on the mainland. I expect an announcement of an inspection deal will be made during the state visit of Xi Jingping to Washington in the middle of this month.
Many Chinese companies have announced their intention to delist from US markets in order to seek a listing in China.
The recent turmoil in the markets raises some questions about whether that will happen. I have also heard that Chinese regulators are aware of the moral hazard present in these companies delisting at low values and relisting at much higher values in China. I am told that they are considering allowing US listed Chinese companies to seek a dual listing in China. That could be a major win for investors, and the continued efforts of the SEC and the PCAOB to police this sector may provide the most important protection for shareholders, since I am skeptical that Chinese regulators will be up to the task of effectively rooting out fraud in these companies.
