Chinese spinoffs: a different story - Paul Gillis

Spinoffs are typically business transactions where the total of all entities increase their value by splitting up their existing business. But not so for Chinese companies, listed in the US, argues Beida accounting professor Paul Gillis. Not the shareholders or the company gains, but mostly management, he explains at his weblog.

Paul Gillis:

Spinoffs are situations where a corporation disposes of part of its business by giving shares in the business to shareholders. When they work, the value of the parts is greater than the value of the whole. “Spinoffs” of US listed Chinese companies work differently. 

A favorite transaction of US listed Chinese companies is to "spin off" parts of the business in a new entity in an IPO transaction. Shareholders of the parent company are not distributed shares of the company that does an IPO although they may benefit if the value of the underlying shares is recognized in the stock price. There have been a number of these transactions and several in the pipeline. 

I have observed, however, that the biggest winners in these transactions appear to be members of management. Management typically ends up with a big chunk of these deals which are structured in a way that does not report as expense the value transferred to them. 

Rather than point to a specific transaction, I am going to examine these transactions through a straw man. When I look at specific transactions, I find the public documents obscure what is going on and add bells and whistles that do not alter the essence of the transaction while providing arguments to counter any attacks on the structure. So, the transaction I describe below is fictitious, although I think fairly represents what is going on. I leave it to others to apply this to specific transactions. I apologize, but this simplified example is still complicated as hell.

The full case 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.  

How did the auditors deal with the ZTE scandal? - Paul Gillis

Paul Gillis

ZTE got itself into trouble by violating a ban on using American components for products it exported to Iran and North-Korea. The punishment - no US components for ZTE for seven years - might kill the Chinese companies, who cannot work without them. What did the auditors do, wonders Beida auditing professor Paul Gillis on his weblog.

Paul Gillis:

The ban came about as a result of ZTE violating the terms of a settlement agreement entered into as part of its 2017 guilty plea for conspiracy to sell telecommunications equipment to Iran and North Korea that included American components that are forbid for export to those countries. ZTE agreed to pay a fine of $892 million and be under probation for seven years. An additional penalty of $300 million was suspended provided ZTE complied with the terms of the probation, which it is reported included the requirement for ZTE to fire four top executives and discipline 35 other employees. ZTE did fire the top executives, but instead of punishing the other employees it paid them bonuses.   

ZTE was also required to undergo independent compliance audits related to its observation of export controls. 

Because ZTE violated the terms of probation they have been banned from acquiring US components (including the Android operating system) and presumably has to pay the remaining $300 million fine. ZTE admitted the behavior, but argues that the penalty is too severe and is trying to negotiate a settlement that would allow the company to survive. 

ZTE reports under Chinese accounting standards. Auditors Ernst & Young (EY) issued an audit report on the 2016 accounts on March 23, 2017. The agreement for the initial settlement became effective on March 22, 2017 and is reported in the 2016 accounts with the penalty of RMB 6.2 billion reported in other expense.  The company stated that it was unlikely they would violate the probation agreement and have to pay the other US$300 million. 

The details of when the bonuses were paid are publicly unavailable. Chinese companies usually pay bonuses at Chinese New Year, which was at the end of January in 2017 and in February in 2018. It seems most likely the offending bonuses were paid by February of 2018, before EY issued its audit report on the 2017 accounts on March 15, 2018. 

So what does this have to do with accounting?  The issue is whether EY should have known that there was serious doubt by March 15, 2018 as to whether ZTE could continue as a going concern. Should they have tested compliance with the probation agreement? 

In its audit report EY states its responsibilities as including to: 

Conclude on the appropriateness of the directors’ use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on ZTE Corporation’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to issue a qualified opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause ZTE Corporation to cease to continue as a going concern. 

EY did not draw attention in their auditor’s report to any events or conditions that may have cast significant doubt on ZTEs Corporations ability to continue as a going concern. I think there was information available to EY (the payment of bonuses in violation of the agreement) that should have led to its questioning the ability of the company to continue as a going concern. I believe that auditors rarely ask these questions, although if this were a loan agreement with covenants, I am quite certain they would have tested compliance with the covenants. 

The company got a clean opinion as of March 15, 2018, although only a couple of months later the survival of the company is in question. Should EY have blown the whistle earlier?

More at the Chinaacountingblog.

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 to manage your China risk? Do check out this list.  

Can a trade war hit the Big Four? - Paul Gillis

Paul Gillis

Import duties - increased during a trade war - focus on goods, not services. Nevertheless, the Big Four accounting firms can still suffer from a trade war, writes Beida accounting professor Paul Gillis on his weblog. But those subtleties might not be spent on China when they are drawn into a full-scale trade war.

Paul Gillis:

Services are not subject to import duties, but China has shown no qualms about punishing foreign business for the sins of their government. The Big Four are technically not American companies. The operations in China are not subsidiaries, but more like franchises owned and operated mostly by local Chinese. But they are generally viewed as American and may face regulatory crackdowns and may see an acceleration of the process of transferring major accounts to local CPA firms. Some smaller US CPA firms operate in China in ways that are technically illegal under Chinese law and would be easy to crack down on. 

It would be easy for the Chinese to crack down on the Big Four. They simply need to strictly enforce their own rules. Few audits can survive a critical examination by regulators, evidenced by the high rate of audit deficiencies identified during inspections by the Public Accounting Oversight Board (PCAOB) of domestic firms. Earlier this year China temporarily banned several local firms for audit deficiencies. 

The Big Four had best watch their back. The Big Four will likely also suffer from a decline in business serving US multinationals. All multinationals must carefully reexamine their global supply chains and some of the China business is going elsewhere even if this spat is settled. Even if this dispute is settled, it has highlighted the risk of overreliance on the Chinese market.

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.

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How KPMG Hong Kong got itself into serious problems - Paul Gillis

Paul Gillis

Beida accounting professor Paul Gillis describes on his weblog how auditor KPMG Hong Kong got itself into trouble for signing off papers on China Medical, a company convicted in 2012 for looting US$400 million from its investors. Problem: KPMG Hong Kong was not really in charge and now the Hong Kong legal system caught up with this omission.

Paul Gillis:

Matt Miller of Reuters has an interesting update on the troubles KPMG is having in Hong Kong with a failed US listed Chinese company. In my view the problems are of its own making. 

KPMG Hong Kong was the auditor of China Medical Technologies Inc., which failed after management was charged by the US Securities and Exchange Commission with looting over $400 million from the company. The company was put into liquidation in 2012 in the Cayman Islands, where it was incorporated. 

Actually, KPMG Hong Kong was not the auditor, and that is the problem. Several years ago I wrote about KPMG’s labeling problem where they had a practice of using Hong Kong letterhead to sign audit opinions on audits done by KPMG Huazhen, KPMG’s China affiliate. To me, this was like a Wenzhou shirt maker sewing a made in Italy tag on a shirt made in China.   ... 

KPMG Hong Kong is in a terrible place. They signed off on an audit without doing one. The Hong Kong Institute of CPAS (HKICPAs), regulator of Hong Kong accountants, should investigate this violation of auditing standards, but I think it is unlikely they will.  The HKICPAs is a feckless regulator and is unlikely to pursue a case against a Big Four firm, especially a case that relates to a company not listed in Hong Kong. There are legislative proposals to strengthen audit regulation in Hong Kong, but the proposals will likely have no effect on this case. 

KPMG was the most egregious at mislabeling their audit work, but all of the Big Four in Hong Kong have had this problem, which I believe came about because the firms failed to recognize the importance of respecting their legal structure. While the China member firms of the Big Four have generally been managed from Hong Kong since the early 2000s, they have always been separate legal entities.

More at the Chinaccountingblog.

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.  

HK audit regulations go downhill to attract US business - Paul Gillis

Paul Gillis

Many Chinese companies took a listing at US exchanges because audits in Hong Kong and on mainland exchanges were stricter. The HK stock market now is watering down regulations for audits, notes Beida accounting professor Paul Gillis on his website to his shock, to pull back those Chinese companies from the US.

Paul Gillis:

The Hong Kong Stock Exchange (HKSE) has issued its latest proposal to weaken corporate governance standards in order to attract Chinese listings that have gone to the US. The US has won most of the listings of China's privately held companies, including bellwethers Alibaba, Baidu and Sina. There are several reasons for that, including the fact that the US permits weaker governance than Hong Kong or China, and that fees for investment bankers are considerably higher with US listings. The weaker governance rules led to the NYSE winning the Alibaba listing over the HKSE. Hong Kong faced the possibility it would not win another major IPO from China because most Chinese founders want a controlling vote, even when they no longer hold a majority of the shares. 

Much to the consternation of corporate governance advocates, Hong Kong proposes allowing control structures (called weighted voting rights - WVR).   Shareholder advocates in the US have opposed the proliferation of these structures in technology companies. Hong Kong is also proposing to relax other listing standards related to profitability. 

The proposed rules essentially allow unicorns to list in Hong Kong with control structures. More flexible rules are proposed for biotech issuers. 

In addition, the path is being cleared to allow overseas listed companies to seek secondary or main listings in Hong Kong after two years of compliance on a foreign exchange. 

Restrictions apply to prevent regulatory arbitrage, where a company lists overseas first in an attempt to circumvent tougher Hong Kong listing standards.

More at the Chinacountingblog.

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.

KPMG partners sued over another US accounting spat - Paul Gillis

Paul Gillis

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.

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.  

Record fine for failed audit - Paul Gillis

Paul Gillis

Shinewing, leading Chinese CPA, got a record fine from China's regulators for a failed audit of a listed company, writes professor Paul Gillis of Practice at Peking University's Guanghua School of Management at his weblog Chinaaccountingblog. He applauds the tough action.

Paul Gillis:

Chinese regulators have fined leading Chinese CPA firm Shinewing a stunning 4.4 million yuan (US$667,000) for a failed audit of a Chinese listed company.  I believe this is the largest fine ever assessed on a CPA firm in China, although many firms have received the death penalty in previous regulatory crackdowns.  Earlier this year China's two of China's largest local firms (RSM affiliate Ruihua and BDO affiliate Lixin) faced short term practice bans. 

Shinewing was the 9th largest Chinese CPA firm in 2015, the latest year for which CICPA data has been released. Shinewing developed from the former joint venture between Coopers & Lybrand and CITIC. It did not join PWC when PW merged with C&L. Shinewing has long held a reputation of being one of the high quality local CPA firms, although it has not gained the market share that its larger competitors obtained by aligning with second-tier networks like RSM and BDO. 

It is a good thing that Chinese regulators are getting tough on CPA firms, since these firms play a vital role in the development of China's capital markets. 

The Shinewing fine exceeds the fine (US$500k) paid by each of the Chinese member firms of the Big Four to the U.S. SEC for failing to turn over audit workpapers to the SEC. 

It is significant that Chinese regulators have not assessed any major penalties against the Big Four in China. The Big Four firms would likely argue that their quality control is higher, but I think that the main reason is the client base. There are about 5,000 companies listed on the major Chinese exchanges, and the Big Four audit only 374. A sizable portion of the Big Four audits are dual listed companies (H-shares in Hong Kong and NYSE listings) The Big Four has about 90% of the dual listed market which includes major state-owned enterprises like the Bank of China and Sinopec. I think it is highly unlikely regulators will find any problems with the accounts of large SOEs, so the Big Four are less likely to be cited by regulators than a large local firm auditing a thousand smaller publicly listed companies. I expect there will be political pressure on regulators to bring a case against a Big Four firm just to even the playing field.

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 previous stories by Paul Gillis? Do check out this list.  

US regulator bans HK accounting firm - Paul Gillis

Paul Gillis

The efforts by the Public Company Accounting Oversight Board (PCAOB)  to get access to Chinese data from US-listed Chinese firms went into a new phase as it banned a Hong Kong accounting firm, reports Beida accounting professor Paul Gillis on his weblog. It could be a new item on Trump's China agenda, he suggests.

Paul Gillis:

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.

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.  

Is Alibaba cooking the Single's Day books? - Paul Gillis

Paul Gillis

China's e-commerce giant booked another record during its Single's Day in 2017. But what figures is the company actually reporting? Beida accounting professor Paul Gillis dives into the figures at his Chinaaccountingblog.

Paul Gillis:

Alibaba had another spectacular singles day, reporting US$25.3 billion of gross merchandise volume settled through Alipay. Business Insider reports that this nearly doubled the $12.8 billion that US retailers sold between Thanksgiving and Cyber Monday last year. 

"More than US$25 billion of GMV in one day is not just a sales figure," said Daniel Zhang, Chief Executive Officer of Alibaba Group. "It represents the aspiration for quality consumption of the Chinese consumer, and it reflects how merchants and consumers alike have now fully embraced the integration of online and offline retail." 

Actually, Zhang is wrong. GMV is not at all a sales figure (although it may well represent the aspirations of the Chinese consumer).  Alibaba does not report GMV as revenue (or sales), Instead Alibaba reports the transaction fees it charges to sellers.  In its fiscal year 2017, Alibaba reported 114 billion RMB of revenue on GMV of 3.8 trillion RMB. 

Analysts love GMV, which they believe gives a more meaningful view as to the volume of business going through the platform. A major problem is that GMV is not a defined accounting term, and the numbers are unaudited.

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.  

Related articles

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Trump: a bit of business, few jobs from China - Paul Gillis

Paul Gillis

The result of Donald Trump's visit to China has been underwhelming, especially when some of the published deals were put under scrutiny. Beida accounting professor Paul Gillis looks at the Washington Post and the opening of financial markets where foreign firms could get a majority share.

The Washington Post:

The changes could be good news for U.S. companies, though experts said they need to know more about the rules and the timing of the changes. “It is a positive step forward,” said Paul Gillis, a professor at Guanghua School of Management in Beijing. “Fifty-one percent [joint ventures] offer control to the foreign investor, although the devil is in the details as to how management and the board are structured.”... 

“China likes to throw bones to foreign visitors, so it was expected that Trump would be given some good news,” Gillis said. “I doubt it is significant, however. It certainly won’t create any U.S. jobs.”

More at the Washington Post.

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 strategy experts at the China Speakers Bureau? Do check out this list.  

What do auditors know about HNA? - Paul Gillis

Paul Gillis

Beida accounting professor Paul Gillis points at his weblog at the rumor Goldman Sachs has decided to suspend work on a HNA subsidiary IPO in the US, because they are unable to get enough information on this Chinese conglomerate. Gillis wonders what auditor PwC knows about their client.

Paul Gillis:

There is a shocking report that Goldman Sachs has suspended its work on HNA’s planned US IPO of subsidiary Pactera because it was unable to meet the bank’s internal “know your customer checks”.  HNA has been criticized for its opaque ownership structure, but it is surprising that Goldman Sachs could not get a look under the sheets. 

Bank of America Merrill Lynch, Citigroup and Morgan Stanley were reported earlier to have dropped HNA because of concerns over completing know your customer checks. 

HNA’s public companies are audited by PwC. This raises the question of how PwC is able to continue as auditor. Auditing standards require auditors to annually assess whether to continue a relationship with a client.

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 strategic experts at the China Speakers Bureau? Do check out this list.    

Bike sharing: catching on - Paul Gillis

Paul Gillis

Bike sharing has met mixed reactions in China, including Beida professor Paul Gillis, who wondered earlier this year whether the investments made business sense, while they are already expanding internationally. The business case still has to be proven, Paul Gillis now admits on North Carolina Public Radio, but bike sharing has changed his urban life for the better.

North Carolina Public Radio:

This concept, dockless bike sharing, has exploded in China over the past two years. 

“Now, there are literally millions of these bicycles on the streets in China. And it has really transformed the urban living experience,” said Paul Gillis, a business professor at Peking University in Beijing. He says for short trips, for that last mile going from the train station to his office, he grabs a bike. 

“It’s much easier than trying to hail a car. The bad part has been that the literally millions of bicycles that are now in China litter the streets. And the sidewalks have become so crowded with these bicycles that it’s hard to walk around.” 

Despite being poorly regulated there, Gillis says bike sharing in China has been a huge positive overall: It’s easier to get around, and there’s less traffic and pollution in Beijing. “I think it’s one of the things that has changed my life in China for the better more than anything in the last 20 years that I’ve been there,” Gillis said.

More at North Carolina Public Radio.

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? Do check out this list.   

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Foreign auditors get more legal space - Paul Gillis

Paul Gillis

China has diminished limits on foreign businesses with its new negative list for 11 free trade zones. That includes accounting, writes Beida accounting professor Paul Gillis at his weblog, although most foreign accounting firms had already workarounds for most legal limitations of the past, he adds.

Paul Gillis:

Accounting was initially off limits to foreign investment. The international accounting firms entered in the early 1980s through representative offices that were not allowed to practice. In the early 1990s they were permitted to enter joint ventures with state-controlled CPA firms. In the late 1990s the state-controlled CPA firms were separated from the state. In the early 2010s the Big Four restructured into special general partnerships (SGP) that allowed up to 20% ownership by unlicensed foreign partners (started at 40% and phased down). 

Allowing any ownership by unlicensed foreign partners was a concession to the Big Four that is unique to China. I believe China is the only country that allows any unlicensed partners in CPA firms. The Big Four were built in China using foreign partners (mainly Hong Kong) although local partners are now in the majority. 

Included in the deal to allow foreign partners was a restriction that said the senior partner of the SGP must be a local Chinese. This restriction likely violated China’s WTO commitments to not have nationality based restrictions, but the Big Four figured out a workaround. They would nominate a local partner to be senior partner of the SGP, but all power was vested in the senior partner of the firm, who typically was a Hong Kong citizen based in Hong Kong. I do not believe any of the Big Four currently have a local Chinese senior partner, but I expect the next generation of senior partners will all be local Chinese. China has removed the nationality restriction on the senior partner of the SGP in the latest iteration of the negative list. I think this will have little effect since the Big Four effectively ignored the rule, although there may be a few Big Four partners with foreign passports whose career prospects have improved.

More at Paul Gillis' weblog.

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 list.

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

Xi Jinping: more control on private companies - Paul Gillis

Paul Gillis

China is bringing more of its private companies to heel, both domestically and their international investments. Peking University accounting professor Paul Gillis sees it as an effort by president Xi Jinping to consolidate its power, he tells the VOA.

The VOA:

China is probing the loan practices of a group of big private sector conglomerates who have been on a high-profile global spending spree over the past few years. And although the review targets only a few of the country’s most politically-connected companies, some analysts see an attempt to increase government control over the role played by the private sector in foreign markets. 

"I think this is an attempt to change the direction (of) the role these Chinese companies play in the Chinese economy," says Paul Gillis, a professor at Peking University's Guanghua School of Management. "To align them more closely with the policies of the government and to reduce the risks that actions of these private companies could end up having a shock effect on the economy as a whole."... 

Peking University's Gillis says it appears the Chinese government is coming to terms with how to effectively regulate private enterprises, companies that behave more aggressively than their state-owned counterparts. But he also sees the move as a further consolidation of power by President Xi Jinping, bringing companies more under the control of the central government. 

"I think many of the companies had a pretty favorable treatment from prior administrations, and I think Xi Jinping is less enamored of these large private companies than some of his predecessors were." 

Expensive acquisitions by companies like Wanda and Anbang have thrust China into the global spotlight. But the news and commentary that followed the companies' mega-deals has not always been positive.

More in the VOA.

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.  

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.

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.  

Supreme court does not declare VIE's illegal - Paul Gillis

Paul Gillis

Company constructions via fiscal paradises, VIE's or variable interest entities, are regular ways to avoid corporate government restrictions in China, and under official attack just for that. The Supreme Court fielded a verdict on transactions by one of those VIE's, but - says accounting professor Paul Gillis on his weblog, it did not clarify whether VIE's might lose their validity.

Paul Gillis:

The court upheld the transaction, saying that the VIE was a Chinese corporation and there was no basis to void a completed contract between two Chinese corporations. The court did ask the Ministry of Education about the nature of the arrangement, and while the Ministry of Education acknowledged it was a conventional VIE arrangement, they did not express an opinion as to whether the arrangement was legal. 

What the decision appears to clarify is that the commercial transactions of a VIE are valid, and do not rest on whether the VIE is operating within the bounds of the foreign investment restrictions.  The decision does not relate to the validity of the VIE contracts between Ambow’s VIE and Ambow’s wholly foreign owned enterprise (WFOE). 

It is the enforceability of the  VIE contracts between the WFOE and the Chinese shareholders of the VIE that are of greatest concern to investors. In the Gigamedia case, these contracts were found to be unenforceable.  That concern remains.

More at the ChinaAccountingBlog by Paul Gillis.

Paul Gillis is a speaker by 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 dealing with your China risk? Do check out this list.  

Bad loans: government avoids bankruptcies - Paul Gillis

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The government has been pulling in bad loans, rather than letting companies face bankruptcy and letting the markets do the job. For China's leaders stability is key, says Beida accounting professor Paul Gillis to Reuters.

Reuters:

Stability is always uppermost in the minds of Chinese leaders, and even more so this year, ahead of the five-yearly party congress this autumn, when a new generation of senior leaders will be selected. 

"China is avoiding the crisis of calling in loans that can't be repaid anyway," said Paul Gillis, professor of accounting at Peking University's Guanghua School of Management. "This buys time to do things in an orderly way."... 

Premier Li also identified debt-for-equity swaps among key items in the toolkit for bringing down corporate debt, and the figures demonstrate their extensive use. 

Since October, China's banks have undertaken nearly 500 billion yuan in such swaps at more than two dozen firms, mostly state-owned coal and steel enterprises, according to analysts. 

That could double to more than 1 trillion yuan by next year, preventing as much as 3.5 trillion yuan in total loans from turning bad in the near future, according to estimates by Hou. 

"A lot of these loans needed to be looked at as equity in the first place," said professor Gillis. 

"There was never any realistic possibility that the companies would be able to pay them back," he added.

More in Reuters.

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.

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Bike hailing does not make business sense - Paul Gillis

Paul Gillis

Bike hailing services got another round of funding this week in hundreds of million US dollars, but Beijing-based observers like Beida accounting professor Paul Gillis just do not see how those companies, involved in a giant competitive war, will ever pay back those loans, he tells QZ.

QZ:

But widespread customer negligence and razor-thin margins could make it hard for these businesses to stay afloat. The very factors that make China’s bike-share services so convenient—low prices and ease-of-use, namely—are the same factors that could spell their death. 

“What they’ve got is a very interesting technology, but a basic business model that makes no sense,” says Paul Gillis, who teaches accounting at Peking University in Beijing... 

All of these factors merely compound the stress placed on an already shaky business model. Mobike and its rivals won’t reveal how much their bikes cost to produce, but an old estimate (which Mobike says has since decreased) places the cost of a standard Mobike at 3,000 yuan (about $437). Professor Gillis says that fares alone will hardly recoup these costs in a timely manner—let alone cover labor and R&D expenses. 

“They rent for one yuan every half hour, and they expect that they might be rented four times a day for a half hour, which amounts to four yuan per day,” he tells Quartz. “If you take four yuan per day and you take that into the 3,000 yuan, you’ve got a long time before you’ve recovered the cost of a bike.”

More in QZ.

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.

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IPO-hungry tech firms might jump the queue in China - Paul Gillis

Paul Gillis

Financial authorities in Beijing are playing with the idea to give tech firms a faster-track IPO in China, says accounting professor Paul Gillis at his weblog. Taking away some of the cumbersome restrictions for IPO's in China might lead to the expected abolishment of variable interest entity or VIE's, a side-track allowing Chinese firms to list in the US, he suggests.

Paul Gillis:

Chinese tech companies often also faced restrictions against foreign ownership. That should have blocked foreign venture capital investments and foreign IPOs, but a workaround was developed. The workaround was the variable interest entity (VIE), which enabled the listing of companies controlled through contracts instead of ownership. VIEs have been a source of pain for many investors, since the contracts proved difficult to enforce and control through contracts proved to be vastly inferior to control through actual ownership. 

A few formerly US listed companies have succeeded in relisting in China. Before doing so they needed to restructure to get rid of the VIE structures and offshore structures (and control features) that had been put in place for the US listings. 

The Reuter’s article points to three companies that may be the initial beneficiaries of the queue-jumping initiative - Ant Financial, the world's most valuable financial technology company, Zhong An Online Property and Casualty Insurance, and security software maker Qihoo 360 Technology Co.  Ant and Zhong An would be doing IPOs, while Qihoo went private in 2016 and would be relisting in China. 

It is not known whether China plans to change its rules to facilitate control structures. Ant is owned by Jack Ma and his associates. Jack Ma insisted on a control structure for Alibaba. It would also appear that it will be difficult for foreign investors to participate in these transactions, since foreigners can only purchase shares on the Chinese exchanges through the Qualified Foreign Institutional Investor (QFII) programs or the Hong Kong Connects. 

I have been hearing rumors that China soon plans to announce that the VIE structure will no longer be tolerated for foreign investment, while at the same time grandfathering existing VIE structures. China had earlier proposed to change the foreign investment rules to exclude companies that were controlled by Chinese from restrictions, effectively encouraging the control structures, but these rules were not adopted when the foreign investment rules were modified last year. 

If VIEs are banned (and the rules are actually enforced), it would likely mean the end of new US listings of Chinese tech (and other restricted sectors such as education and finance) companies. The queue-jumping program might foreshadow that announcement.  The big losers would appear to be US venture capital firms and US investment banks.

More at Paul Gillis' weblog.
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.   

How to end double standards for US-listed Chinese companies - Paul Gillis

Paul Gillis

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.

The full statement by Paul Gillis.(pdf)

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.

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