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.

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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.

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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.  

New rules take failing auditors off the hook - Paul Gillis

Paul Gillis

The Public Company Accounting Oversight Board (PCAOB) will demand companies to identify senior partners of auditors who perform audits from January 31, 2017. But that means also that auditors responsible for hundreds of dodgy Chinese IPO´s in the US will never be identified, writes Beida accounting professor Paul Gillis on this weblog.

Paul Gillis:

The rule is effective for audits completed after January 31, 2017. That means it will not be possible to identify the engagement partner on the many notorious audit failures that have happened in recent years among US-listed Chinese companies, since the information will be prospective only. Nevertheless, this is a good step forward, and will help to protect investors in the future. 

The information is not required to be included in the company’s annual filings. Instead, the audit firm makes a separate filing with the PCAOB that will be available in a searchable database. I think companies should voluntarily disclose the name of their audit partner in their annual report to make this process easier for investors. 

While auditor rotation is not required in the US (it is required for state owned enterprises in China), the audit partner on US listed companies must be rotated every five years. Audit committees should carefully vet proposed audit partners and ask direct questions about prior engagements the partner has been associated with. I know some large US-listed Chinese companies have rejected proposed audit partners because they were associated with frauds in the past.

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.

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