The end game: 200 Chinese firms might get delisted from NYSE and Nasdaq – Paul Gillis

 

Paul Gillis

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.”

More at Market Place.

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US ban of Chinese listings is unlikely – Paul Gillis

 

Paul Gillis

After the Senate also the House of Representatives approved this week the bill to ban Chinese companies at US stock markets, the Holding Foreign Companies Accountable Act (The Kennedy Bill) if they do not allow inspections by the American PCAOB. But accountant expert Paul Gillis does not expect will materialize, he writes at his Chinaaccountingblog.

Paul Gillis:

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.

More at the Chinaaccountingblog.

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Trump’s last ditch effort to ban China’s listed companies – Paul Gillis

 

Paul Gillis

In a last-ditch effort to cross China and hinder the president-elect Biden to set his own course, US President Trump has introduced regulation to ban Chinese companies from listing at US stock markets. Accountant specialist Paul Gillis looks at the ChinaAccountingBlog at the possible effect.

Paul Gillis:

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.

More at the ChinaAccounting Blog.

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What will happen when US stock regulators check Chinese firms - Paul Gillis

Paul Gillis

US legislators might support a bill to force Chinese firms listed in the US to let the US stock regulators, The PCAOB, check their files. But those checks will not prevent frauds like those by Luckin as some US senators claim, warns audit expert Paul Gillis on his weblog Chinaaccountingblog. Some predictions on what will happen after the bill has been adopted.

Paul Gillis:

EY in China is not inspected by the PCAOB. Would a PCAOB inspection have stopped the Luckin fraud? No, PCAOB inspections are after the fact, and EY had already discovered the fraud. Additionally, the PCAOB is not going to inspect every audit, but rather a selection of them and there is no guarantee that Luckin would ever have been inspected. Would EY have audited Luckin differently had it been subject to PCOAB inspections? Possibly, but I think that is unlikely. The Big Four member firms in China are not subject to PCAOB inspections but are regularly subject to inspections by teams from their own networks. While self-inspection is never as effective as independent inspection, I believe that the auditing culture of these firms has been effectively implemented in China, and that inspections would provide for a marginal increase in quality but would be unlikely to prevent future fraud. I believe that PCAOB inspections are useful, but the threat of inspections and the existence of inspections elswhere in the world has already brought those audit  practices to China. The bigger problem for the firms is a shortage of experienced partners – who are sometimes called the no hair/gray hair partners. The firms have been recruiting and auditing in China since the early 1990s, but the firms only became large in the early 2000s. Given it takes 15-20 years for an accountant to make partner in these firms, and another five before they are ready to serve as engagement partner on public companies, the firms are seriously short of highly experienced partners. Partner/staff ratios are completely out of whack for the Big Four in China. For example, PwC reports 720 partners and 20,000 staff in its China firm (which includes HK, Taiwan and Singapore) for a partner/staff ratio of 27.8. The US firm of PwC has 3,249 partners and total staff of 30,000 for a partner/staff ratio of 9.2. While I would not argue more partners means higher audit quality, the difference between the two staffing models is too extreme. 

I believe that this legislation will pass but China will moot it by agreeing to some form of inspections. The sticking point is likely to be state secrets. China will want to vet the working papers to make certain no state secrets are inadvertently disclosed. China does not seem to have focused on the fact that many audit partners are foreigners and the internal inspection teams include foreigners who see these state secrets.  Auditors should cooperate with regulators to minimize the presence of state secrets in working papers. I call for joint training sessions between auditors and regulators to determine what must be in working papers and what should not be recorded. I expect that most of China’s concerns can be alleviated if unnecessary state secrets are omitted from working papers in the first place.

More at the Chinaaccountingblog.

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China blinks at the PCAOB - Paul Gillis

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 Gilles at 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.

More at the Chinaaccountingblog.

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The Kennedy bill has unintended consequences for MNC's - Paul Gillis

Paul Gillis

US legislators are preparing a law to allow US PCAOB inspectors to check US-listed Chinese firms. But - warns auditing expert Beida professor Paul Gillis - the so-called Kennedy law might have unintended consequences for all multinational companies, he writes on this Chinaaccountblog. 

Paul Gillis:

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.

More at the China Accounting Blog.

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Companies need guidance in dealing in auditing process - Paul Gillis

Paul Gillis

The ongoing coronavirus in China is going to disrupt the regular auditing process, warns Beida professor Paul Gillis on his weblog Chinaaccountingblog. Even for companies who do not get into financial problems, some guidance on how to deal with this crisis and the auditing process is urgently needed, he adds.

Paul Gillis:

Even when there is no going concern issue because the company is adequately capitalized, the issue of whether to accrue corona virus related losses in 2019 or to report them in 2020 is important. There are two significant components to this: 

Most companies will have done little business in January and February, 2020 first because of the normal Chinese New Year holiday and then because of mandatory closures related to the virus. Companies, however, are required to continue to pay employees. Should losses related to the virus be accrued as of December 31?  The event that caused the loss began in 2019.  By the time that financial statements are issued (April or later) the amount of loss can likely be determined. 

Secondly, each company must determine in the preparation of 2019 financial statements if any assets are impaired. Any impairment is recorded as an expense. Of particular concern will be intangible assets such as goodwill. Many Chinese companies have considerable goodwill on their balance sheet due to acquisitions. Goodwill is typically tested for impairment by looking at future cashflows from the related business. Those cash flows have been altered by the virus, and potentially significantly enough that goodwill must be impaired. 

I think it would be useful if accounting standard setters or the Emerging Issues Task Force would issue guidance as to the application of the subsequent event rules to the facts of the corona virus.

More at the Chinaaccountingblog.

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Private companies: not free of government control - Paul Gillis

Paul Gillis

The Hangzhou government raised eyebrows as it announced last week it would send 100 officials to private companies to check on them. Professor Paul Gillis at Peking University’s Guanghua School of Management did not see that much news, he tells Bloomberg.

Bloomberg:

Government agencies may also be heightening their monitoring of the vast private sector at a time the Chinese economy is decelerating — raising the prospect of destabilizing job cuts as enterprises try to protect bottom lines. 

Alibaba is hosting its annual investors’ conference this week in Hangzhou against the backdrop of a worsening outlook for the country. 

“They might be checking whether the [Chinese] Communist Party [CCP] units are working effectively within the companies,” said Paul Gillis, a professor at Peking University’s Guanghua School of Management. 

“While China legitimized capitalism, the level of government influence was never intended to disappear. Occasionally private entrepreneurs forget about this and are reminded of it,” Gillis added. 

Zhejiang is considered the cradle of modern Chinese private enterprise, home to a generation of self-made billionaires from Alibaba’s Jack Ma (馬雲) and Geely founder Li Shufu (李書福) to Wahaha’s Zong Qinghou (宗慶后).

More in Bloomberg.

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Big four accounting firms: winning again in China - Paul Gillis

Paul Gillis

The Chinese government has tried to promote local CPA's on the expense of the Big Four, but - says  Beida accounting professor Paul Gillis - the 2018 top-10 CPA ranking shows the Big Four are back winning market shares, with PwC, Deloitte and E&Y in the top three, he writes at his Chinaaccountingblog.

Paul Gillis:

China had a policy to promote the development of local CPA firms, but it no longer seems to be on that path. The first indication was mandatory audit rotation on companies with state ownership. The first large scale rotation was in 2012 and somewhat surprisingly nearly all of these companies simply moved from one Big Four firm to another, albeit with significant fee reductions. The government strongly encouraged companies to select a non-Big Four auditor, but they were largely ignored. The next round of audit rotation takes place in 2020, and if local firms do not win some of the large state-owned enterprises I think the Big Four will be cemented into these slots. 2020 is shaping up to be one of the most significant years in the development of the CPA profession in China.  If the Big Four can retain the large state controlled enterprises in the 2020 audit rotations they are likely to retain a strong market position for the foreseable future. 

The Big Four have over 27,000 employees in China, led by PwC at 9,460 out of 250,000 PwC employeees worldwide. Overall, there are 120,604 people working for accounting firms in China. 

Big Four firms do not release information on profitability.  But since payroll is the largest expense for accounting firms, a good measure is revenue per employee. As expected, the Big Four have significantly higher revenue per employee than local firms, with a notable exception of PwC. PwC has revenue per employee of RMB 540,635 compared to an average of RMB 652,390 for the other Big Four.  This suggests PwC is likely less profitable than the other firms and is potentially overstaffed.

More (including the 2018 ranking) in the Chinaaccountingblog.

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US stock markets get hostile for China firms - Paul Gillis

Paul Gillis

The tech giant Alibaba listing on the Hong Kong stock market is already a sign things are changing for the US markets, and the ongoing trade war will stop many Chinese firms to list in the US, as they did in the past, especially when a bill by US Senator Marco Rubio is adopted or not, says Beida accounting professor Paul Gillis in Forbes.

Forbes:

The U.S. environment is getting increasingly hostile for China-related IPOs. 

Earlier this month, a bipartisan group of lawmakers, including Republican Senator Marco Rubio and Democratic Senator Bob Menendez, introduced a bill that would require U.S.-listed Chinese firms to comply with increased financial oversight–such as providing access to auditing–or face delisting. The Public Company Accounting Oversight Board (PCAOB) in the U.S. routinely inspects the accounting practices of U.S.-listed firms, but China, citing national security concerns, has barred overseas regulators from examining the companies’ audit and financial records. 

Whether the bill would become law probably depends on trade negotiations between the U.S. and China, as it could likely be resolved as part of any deal that comes out of those talks, says Paul Gillis, professor of practice and co-director of the IMBA program at Peking University's Guanghua School of Management. He warns that “there is likely to be no more listings” from China on U.S. markets if the bill is passed because no China-based accounting firm is currently inspected by the PCAOB and Chinese law forbids them from handing financial records over to foreign regulators. 

“It [passing the law] would be troublesome for U.S. stock exchanges and investment banks,” he says.

More in Forbes.

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Are Chinese companies kicked out of the US stock markets? - Paul Gillis

Paul Gillis

US Senator Marco Rubio is drafting a law, the Equity Act, to kick out 156 Chinese companies from US stock markets, unless they comply with the oversight by the Public Company Oversight Board (PCOB) of their information. Beida accounting professor Paul Gillis believes this act might be passed, and although it is not the hottest issue in the ongoing trade war between China and the US, companies will have three years to move, for example to Hong Kong, he writes in the Chinaaccountingblog.

Paul Gillis:

The proposal effectively says that Chinese companies will be kicked off US exchanges in three years if a breakthrough in PCAOB inspections does not take place. At this stage, I would call it an even bet as to whether China negotiates a settlement. I don’t think this is a critical issue for China, and I think China could craft a deal, but I can’t see what the US would offer in exchange. 

I think this legislation has a good chance of passing, and that will start the three-year countdown for negotiations or for the companies to find another listing home. I expect most of them will move their listings to Hong Kong. Mainland exchanges are not ready for most of these companies. There will likely be some regulatory changes required in Hong Kong to make this happen. Most of the companies have weighted voting rights, and Hong Kong now allows for IPOs of unicorns with weighted voting rights, but most of these companies would likely need special accommodation. 

If the move to Hong Kong is not seamless, there may be trading opportunities present. 

Many mutual funds are not permitted to hold illiquid securities, and it is possible that there will be a period of time while the listings move where the stock cannot be traded. Prices may temporarily suffer until the listing is restored in Hong Kong. 

Hong Kong could speed the relocation process by allowing the companies to use SEC documents and US GAAP financial statements for the initial listings. Hong Kong generally requires companies to prepare financial statements under Hong Kong Financial Reporting Standards, which are equivalent to IFRS.  The Rubio proposal is a full employment act for accountants and lawyers.

More in the China Accounting Blog.

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How the new income tax will drive out expats - Paul Gillis

Paul Gillis

The reform of the income tax in China will drive many expats out of the country as it will kick in by 2021, as foreign and local taxpayers will fall under the same taxation rules, says financial expert Paul Gillis on his weblog. Especially the equal treatment for housing and education costs will become too costly for expats, or their companies.

Paul Gillis:

Tax reform will lower the tax burden on lower- and middle-income people, while leaving the top rates intact. China has a progressive tax system with rates topping out at 45% on income over 960,000 RMB (US$143,000). 

Foreigners used to get special treatment. While China taxes its own people on worldwide income, expatriates were only taxed on worldwide income after they had been resident for five years. The five-year period could be restarted by leaving China for 30 consecutive days or 90 days in a year.  The 30 day “tax break” was the most popular tax provision in the world. Initial proposals would have revoked this rule, but the final version makes it even better. It retains the 30-day tax break but requires it only every six years. The 90 days in a year provision is gone. 

More important for expatriates was the allowance of special exclusions from income for housing, education and home leave expenses. These expenses are very high in China.  A home in the Yosemite development near the international schools rents for 55,000 RMB per month ($98,500 per year) and tuition for two kids at the International School of Beijing (ISB) runs 600,000 RMB ($89,500 per year).  Local nationals did not get to exclude these costs. 

The new law treats locals and expatriates the same.  Both will obtain deductions for housing and education, but the benefit for rent is limited to 18,000 RMB (US$ $2,700) a year, far below what most expatriates pay. Education is limited to 12,000RMB (US$1,800) per child. 

That will be a tax cut for locals, and a big tax increase for many expatriates. While it may be fair to treat foreigners and locals the same, fairness is in the eyes of the beholder. 

Expatriates can stay under the old system through December 31, 2021. After that some expatriates will see staggering increases in tax. The expatriate living in Yosemite with two kids at ISB will see taxes increase as much as $82,000.  Since most expatriates at that level are also tax equalized, the total cost increase to their companies is likely to be as much as $149,000. That will force many companies to reconsider whether they can keep these expatriates in China.

More at the Chinaaccountingblog.

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China does not need to kill the VIE's anymore - Paul Gillis

Paul Gillis

The new foreign investment law is no longer mentioning the ban on VIE's like an earlier edition did in 2015. The tool to circumvent Chinese regulations by channeling investments through foreign tax havens is no longer needed, says financial expert Paul Gillis, a professor at Beida University. Controlling capital streams have become more efficient, and a crackdown on VIE's is no longer needed, he argues at his website.

Paul Gillis:

The new law does not discuss VIEs, and I do not think that portends a coming crackdown.  I think it just continues the status quo, where the government turns a blind eye towards the structure. I would also observe that there have been statements that companies with VIEs and control structures will be allowed to issue Chinese Drawing Rights (CDRs) on the new Shanghai Technology Board. That is about as close to official acceptance of VIEs that we are likely to see. 

I think Chinese regulators would like to fix the VIE problem, since it makes a mockery of the rule of law, but a workaround has proven elusive. These companies are now a big part of China’s economy, and I find it inconceivable that the government is going to shut them down. 

Seven years ago I wrote a summary of VIEs for Forensic Asia that became the most cited work on VIEs. I just updated that article together with Fredrik Oqvist, and GMT Research, successor to Forensic Asia, has distributed it to their subscribers. I will make it available here in a month or two. Our key point is that as VIEs mature they are becoming increasingly unworkable because of the difficulty in moving cash into and out of the VIE.

More at the Chinaacountingblog.

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US accounting regulators join trade war - Paul Gillis

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 Gillis at 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.

More at the ChinaAccountingBlog.

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What makes Chinese accounting different from Western standards? - Paul Gillis

Paul Gillis

Accountants have to figure out what is happening in a company, and the difference between Western and Chinese practices makes that often hard, says Paul Gillis, accounting professor at Peking University, and author of the leading website ChinaAccountingBlog to Young China Watchers.

Young China Watchers:

YCW: You have a wealth of experience as a certified public accountant (CPA) across many countries. At a high level, is there anything specific that analysts and observers should take into account when trying to understand financial statements and general business practices in China? 

PG: One of the biggest challenges has been adapting Western accounting and auditing practices to Chinese business practices, where personal relationships can overshadow contracts and laws. In the West, internal controls often rely on the separation of duties on the premise that it is hard to get two employees to agree to commit a fraud. What we found in China is that the existence of 关系(guanxi) relationships between actors often overrode controls. There was a big problem with bank confirmations. A standard audit practice is for the auditor to ask the bank to confirm the bank account balances of clients. In China, it proved not very difficult for many companies to lean on the bank branch manager to confirm a false balance. Auditors needed to find other ways to audit to overcome these problems, but there were many frauds in the meantime.    

YCW: A lot has been said about Beijing’s intention to open up China’s financial sector. How do you see this impacting the audit industry? Have you observed any broad trends recently as a result of the latest round of market reforms? 

PG: Accounting is not directly affected by the opening up of the financial sector. Foreign accounting firms in China are structured like the firms elsewhere in the world: Local partners own the local firm. There has always been a lot of talk about allowing foreigners to own interests in local accounting firms—they already can, but the biggest obstacle is passing China’s CPA exam, which is the toughest in the world! It actually makes sense for local partners to own and operate the firms in China. They have local expertise and since most of them are now local Chinese, they better understand the cultural aspects of doing business.    

YCW: A lack of transparency has always concerned investors and lenders in China, perhaps unjustifiably so. While the perception is changing, can you identify any obvious steps to be taken at the state and firm levels to speed up this process, or has all the low-hanging fruit been picked? 

PG: Disclosures of public companies in China, particularly those listed abroad are pretty extensive. The greatest difficulty often lies in opaque ownership structures where it is hard to figure out who is ultimately in control. One thing I have observed is that Chinese companies often do not do things in the most straightforward manner. For example, it is not uncommon to put the ownership of companies in the names of friends or relatives. I guess that gives people plausible deniability if problems come up, but it often scares investors and business partners who think they are trying to hide something. I think a lot of this is a legacy of earlier times when being a “capitalist roader” (走资派, zou zi pai) was a bad thing.

More at the Young China Watchers.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more experts on managing your China risk at the China Speakers Bureau? Do check out this list.  

In China, small print can kill you - Paul Gillis

Paul Gillis

Registering offshore, through so-called VIE' or variable interest entities, is more popular than ever for Chinese companies, even though the Chinese government tries to stop this circumventing trick. Tencent Music Entertainment was the last one to use it for its IPO and get away with it because investors seldom read the disclosure, says Paul Gillis, accounting professor at the Peking University, at the Nikkei Asian Review. And for good reasons.

The Nikkei Asian Review:

As with the Tencent Music prospectus, VIE risks are regularly disclosed in the IPO process -- for those paying enough attention. 

Referring to Tencent Music's discussion of its use of VIEs, Paul Gillis, an accounting professor at Peking University in Beijing, said: "It is extensively disclosed, but the filling is 300 pages long. Many investors do not read it." 

Meanwhile, it remains unclear when Beijing will move forward with the draft foreign investment law, as Tencent Music's prospectus notes. 

Said Gillis, "If investors cannot stand ambiguity, they should stay out of China."

More at the Nikkei Asian Review.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more financial experts at the China Speakers Bureau? Do check this list.  

The big four are back in China - Paul Gillis

Paul Gillis

The big four accounting companies - KPMG, EY, PwC, and Deloitte - are back in China, writes Beida accounting professor Paul Gillis at his website ChinaAccountingBlog. The method of counting market share has changed, but Gillis sees around 20% growth, he says.

Paul Gillis:

The rankings have changed quite a bit. The last two years have been very good for the Big Four, which have grown 20% while local firms experienced a minor decline in revenue of less than 1%. The Big Four share of the Top 100 market has grown from 27% to 34%, a remarkable reversal of the market share declines of earlier years. 

I believe that the poor performance of local firms can be explained by regulatory actions. Early in 2017 Chinese regulators shut down two of the largest local firms for several months due to audit failures.  Ruihua, which was ranked second in 2015 and which I thought might climb over PwC to first place, experienced a revenue decline of 29%. BDO, ranked third in 2015, slide to fourth with anemic revenue growth of 5%. While I support strict audit regulation, I fear that the Chinese system is unfair to large local firms that audit thousands of listed companies. 

For the first time, the CICPA has disclosed the split between audit and non audit revenues at the firms. The Big Four earn 84% of their revenue from audit while local firms earn 86%. Those ratios are much higher than accounting firms in other countries. The measures of market concentration reveal an Herfindahl-Hirschman Index of 498, higher than the two years ago measure of 444, but well below the 1500 typical of Western economies.

More at the ChinaAccountingBlog.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more financial analysts at the China Speakers Bureau? Do check out this list.  

Why the investors did not buy Xiaomi's valuation - Paul Gillis

Paul Gillis

The Hong Kong IPO of China's success story Xiaomi disappointed greatly. Beida accounting professor Paul Gillis explains at Quartz why the investors did not buy the company's valuation. "I think it is hard for investors to buy the valuation."

Quartz:

What accounts for the listing’s tepid response? One read is that retail investors didn’t buy Xiaomi’s pre-IPO narrative any more than early subscribers did. In the run-up to the IPO, found Lei Jun described the company’s business model as a “new species” and a “triathlon model” with three components—smartphone sales, third-party hardware sales, and “internet service” sales, namely ads and media. While smartphones drive most of the revenue, the company hopes that internet services will eventually drive most of the profit (currently at about 40%)... 

It’s an unprecedented structure with many uncertainties. The Android smartphone business is notoriously unstable and has turned giants like Sony, HTC, and Nokia into casualties. Meanwhile, there has never been a tech company to successfully sell undifferentiated, commodity hardware as a means to boost an internet business unit—which might account for investor skepticism. 

“I think it is hard for investors to buy the valuation. The company has to transform to justify the valuation and there is too much uncertainty about whether it can do that,” says Paul Gillis, who teaches accounting at Peking University in Beijing.

More at Quartz.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more experts in managing your China risk at the China Speakers Bureau? Do check out this list.  

An emerging China tech IPO bubble? - Paul Gillis

Paul Gillis

China tech companies feel the pressure from their investors to join the emerging IPO wave, and that might not be a good development, says Paul Gillis, Beida accounting professor, at Nextunicorn.ventures.

Next Unicorn Ventures:

Hurun Research Institute reports that 151 companies in China have attained unicorn status by the end of the first quarter, with half of these unicorns incubated or backed by industry titans such as Alibaba and Tencent Holdings. Their combined valuations exceeded 4 trillion yuan (about US$630 billion). 

Moreover, according to a professor of accounting at Peking University Paul Gillis, there’s a fear of missing out and Chinese tech companies might receive pressure from investors to join in and join big. He added that Meituan-Dianping’s valuation target of US$60 billion is hard to understand, given that the company has revealed a steep loss of US$2.9 billion last year from share-based compensation.

More at Next Unicorn Ventures.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more experts in managing your China risk at the China Speakers Bureau? Do check out this list.

HK auditors: still not up to standards - Paul Gillis

Paul Gillis

Five years ago Hong Kong, once a center of international finance, was demoted by the European Union as a financial regulatory area on a similar footing. Beida accounting professor Paul Gillis applauds that after five years the HK legislators start to move to reform the auditors, but feels the action is far from enough, he writes on his weblog.

Paul Gillis:

Five years ago Hong Kong’s capital markets were dealt a humiliating blow by the European Union (EU). Hong Kong was removed from a list of jurisdictions deemed to have regulatory equivalency with the EU. The move happened because Hong Kong did not have an effective independent audit regulator, since the auditing profession in Hong Kong was self-regulated by the Hong Kong Institute of CPAs.  I have written many times about how the HKICPAs is a feckless regulator, reluctant to take on the big firms and when it is finally forced to enforce the rules, doling out miniscule penalties. 

It has taken five years, but finally Legco is preparing to take action. The Financial Reporting Council (Amendment) Bill of 2018 is working its way through the legislative process in Hong Kong. Unfortunately, the proposal falls far short of what is needed. I fear that the legislators have fallen into the trap of finding themselves up to their ass in alligators while forgetting that their original objective was to drain the swamp. The proposal has the fingerprints of the profession all over it, and has been weakened to the point of being mostly useless. 

There are two key problems from my perspective. The first is the composition of the supervisory board of the FRC. The second is adequate funding to make certain that the FRC can effectively function.

More at the Chinaaccountingblog.

Paul Gillis is a speaker at the China Speakers Bureau. Do you need him at your meeting or conference? Do get in touch or fill in our speakers' request form.

Are you looking for more financial experts at the China Speakers Bureau? Do check out this list.