Postings | China Accounting Blog | Paul Gillis


HKICPA piles on to PCAOB action

The Hong Kong Institute of CPAs (HKICPAs) functions as the regulator of the CPA profession in Hong Kong. Nearly every country in the world has abandoned self-regulation of the profession because it is apparent the profession never really regulates itself.  There have been proposals to enhance audit regulation in Hong Kong by transferring regulation from the HKICPA to the Financial Reporting Council. But after a long round of consultations in 2014 nothing has happened, and Hong Kong remains an unfortunate outlier operating well below international standard. It has been promised that legislation will be introduced to establish independent audit regulation by the end of this month.  

There is an interesting disciplinary case by the HKICPAs against a Hong Kong CPA firm and three of its partners because the firm had been banned by the PCAOB for faulty audits. The firm was Albert Wong & Company, that later morphed into AWC (CPA) Limited, and then DCAW (CPA) Limited and in its current incarnation is Centurion ZD (CPA) Limited (Centurion). In its Form 3 filed with the PCAOB to report the Hong Kong sanctions, Centurion admits it is the successor to banned firm AWC (CPA) Limited. I fail to understand why the PCAOB ban did not apply to the successor firm. Despite the fact that AWC (CPA) Limited was banned from PCAOB practice, Centurion remains registered with the PCAOB and has issued 34 audit reports on US listed companies this year. I think they may have pulled one over on the PCAOB.

PCAOB bans small HK CPA firm

The Public Company Accounting Oversight Board (PCAOB) has published disciplinary actionsagainst 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. 

Singles day and GMV

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.   

Know your customer - HNA

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.  

The IFAC’s Code of Ethics for Professional Accountants states: ‘Before accepting a new client relationship, a professional accountant in public practice shall determine whether acceptance would create any threats to compliance with the fundamental principles. Potential threats to integrity or professional behaviour may be created from, for example, questionable issues associated with the client (its owners, management or activities).’ This means that when approached to take on a new client, the firm should investigate the potential client, its owners and business activities in order to evaluate whether there are any questions over the integrity of the potential client which create unacceptable risk. These investigative actions are usually performed as ‘know your client/customer’ or ‘customer due diligence’ procedures, which are also carried out in order to comply with anti-money laundering regulations.

PFICs and VIEs

The United States has the most complicated tax system of any country. A major reason for this is that Congress has added so many provisions in efforts to combat tax evasion; unfortunately, the complexity just creates an opportunity for bright tax planners to find new loopholes, and for the unwary to fall into a trap. I fear that many of the US listed Chinese companies have a tax trap for the unwary.

One of the loophole closing efforts was rules related to passive foreign investment companies. The loophole was that a group of US shareholders could put money in a foreign corporation, earn interest and dividends on the investment, and they pay tax at capital gains rates when they dispose of the stock. Other rules shut down the technique for closely held companies, but the PFIC rules bring in foreign public companies. 

A company is a PFIC if 50% of its assets generate passive income (interest, dividends, rents, royalties, etc.) or 75% of its revenue is passive. US shareholders in a PFIC are subject to special tax rules. These rules basically make sure that any gains are taxed at the highest US tax rates and charge interest on any gains deferred. US investors are wise to avoid PFIC investments, due to the complexity and the adverse tax consequences. Foreign investors are not subject to the rules. 

PCAOB bans Crowe Horwath

The PCAOB has revoked the registration of Hong Kong based Crowe Horwath for refusing to cooperate with document requests related to inspections.  Crowe Horwath argued that Chinese regulators forbid it from providing these documents directly to the PCAOB. The PCAOB had reached an agreement in 2013 with Chinese regulators for document production in the case of enforcement actions, but no agreement has been reached with respect to inspections. 

The PCAOB was set up as an independent audit regulator by the Sarbanes Oxley Act.  It has three primary functions; It sets standards for auditing of US listed companies, it inspects auditors work to determine whether the standards are followed, and it enforces instances of non-compliance. Inspections are the most important function.  All auditors of US listed companies, including foreign auditors are inspected at least every three years, with the largest auditors inspected annually.  

Soon after the PCAOB began international inspections over a decade ago, China balked at allowing inspections of Chinese firms citing national sovereignty and national secrecy concerns. China also forbade the PCAOB from inspecting firms based in Hong Kong to the extent the audits related to mainland companies.  

Accounting and the negative list

China has long restricted foreign investment in sensitive sectors of its economy.  These restrictions appear to have had two primary motivations – protecting state security and social stability, and protecting state owned enterprises from foreign competition. The former has led to keeping foreigners out of media, internet, and defense sensitive sectors. Restrictions protecting SOEs from foreign competition were largely negotiated away during China’s accession to WTO.

Investments were categorized as to encouraged, restricted and prohibited. In 2015 China began a move towards a negative list – investment is allowed unless a sector is on the negative list.  China has just released a new negative list for its 11 free trade zones that goes into effect on July 10, 2017.

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). 

Chinese audit regulators get tough

Chinese regulators have banned the Chinese affiliate of BDO from auditing public companies for two months, the second suspension the firm has faced this year.  In January, both BDO and Ruihua, the Chinese affiliate of both Crowe Horwath and RSM, were banned for two months. The penalties seem harsh by international standards. 

The rules provide that any firm that has two disciplinary actions within two years must face a suspension. RSM and BDO are the second and third largest accounting firms in China, trailing only PwC.  Because the Big Four firms audit few locally listed companies, they are unlikely to trip the two-action wire, while RSM and BDO audit about 1,000 A-share listed companies each and therefore would seem to be at great risk of tripping the wire.  

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. 

Supreme Court decision little help to investors

A recent China Supreme Court decision related to Ambow Education’s VIE appears to provide little comfort to investors in VIE structures.  

I have had a chance to discuss this ruling with some Chinese experts, and provide here a layman’s interpretation while we await a good legal analysis in English. 

The case was a suit brought by Hunan Changsha Yaxing Company (Yaxing) against Ambpw’s VIE. Yaxing had sold a school to Ambow’s VIE in 2009, taking part of the consideration in cash and part in Ambow stock. Ambow stock collapsed after it was delisted from the NYSE and put into receivership in the Cayman Islands. Yaxing sued to get the school back, arguing that the VIE could not legally own the school.

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. 

New China Supreme Court decision on VIEs

There has been an important decision in China with respect to the enforceability of VIE contracts.  

The attached article (in Chinese) explains a decision of China’s Supreme Court upholding the enforceability of Ambow Education’s VIE contracts.  I am going to wait for some Chinese lawyers to better explain the rationale of the case, but it seems to rest on the conclusion that the arrangements do not result in impermissible foreign control of restricted industries. That would seem to be contrary to earlier decisions. 

Queue-jumping initiative

Reuters has an interesting report that says Chinese regulators plan to allow some of China’s largest tech firms to jump the queue to list in China. 

The largest Chinese tech companies have mostly listed in the United States. This was for several reasons. Initially Chinese markets were used mostly for state owned enterprises. That changed with the opening of the SME Board in Shenzhen and especially with the 2009 launch of ChiNext, China’s NASDAQ.  Listing offshore also provided an exit for foreign venture capital investors, who otherwise faced restrictions in investing and currency controls made it difficult to convert proceeds from exits.

Most listings went to the US where both NASDAQ and NYSE competed aggressively for the listings. Initially this was because of a perception that US markets had more liquidity and a better understanding of tech. As the Hong Kong and China markets matured and grew in size, the listings mostly continued to go to the US. A major reason was that the US allows control structures (like two classes of shares) that enable founders to stay in control of companies despite selling down most of the shares. Hong Kong and China do not permit control structures, and the Hong Kong Stock Exchange's unwillingness to change this rule cost them the Alibaba IPO. Nevertheless, a few tech companies, notably Tencent, have listed in Hong Kong (without control structures).

Updated statistics on VIE use

This is a guest post from Fredrik Ökvist, one of my former students who developed a consulting business focusing on overseas listed Chinese companies.  

Last year a couple of academic articles regarding VIEs quoted some statistics I’d produced on the topic way back in 2011. Given all that’s happened since then –de-listings due to fraud allegations, going private transactions, and numerous new IPOs – I thought it might just be time to provide an update to the outdated snapshot of VIE usage among US-listed Chinese companies I produced long ago. I also note that Professor Gillis was asked about the topic briefly in his recent senate hearing.

I did a bit more of a deep-dive into the nature of the VIE structures we see this time, and might come back with some more details in later posts, but for now I’ll stick largely to providing an update on the items dealt with in my old post.

First though, some basics:

1. I used a list of Chinese companies listed in the US from the NASDAQ website, this included names of both NASDAQ and NYSE listings, but I noticed it missed some names. I’ve tried to add in the ones that I’m aware of, but I cannot guarantee the list is complete. It doesn’t include any OTCBB names, nor any companies listed in HK (but neither did my earlier sample).

Cynical PCAOB release

On December 30, 2016, The Public Company Accounting Oversight Board (PCAOB) issued Staff Questions and Answers (Q&A) about the audits of mainland China issuers by registered firms outside of mainland China. The Q&A is not an official PCAOB position, but is intended to guide PCAOB staff when dealing with the relevant issues. 

The Q&A explains how a 2005 Ministry of Finance (MOF) Circular titled Interim Provisions on Auditing Operations Conducted by Accounting Firms Concerning the Overseas Listing of Domestic Chinese Companies (the “MOF Rule”) applies to audits of US listed Chinese companies by overseas accounting firms. The MOF Rule includes provisions related to the conduct of auditors based outside of Mainland China that perform audit work in Mainland China. The rule does not apply to the work done by the mainland affiliates of the Big Four (because they are not considered based outside of mainland China), but it does apply where the Hong Kong firm signs off on work done by the mainland. The Big Four are subject to the same restrictions on providing working papers to the PCAOB or SEC and that was the subject of the case between the SEC and the firms that was settled with fines and a promise to comply in the future. 

China goes local

The struggle between local Chinese and the Big Four accounting firms has been going on since the return of public accounting to China in the early 1980s. China let the Big Eight firms set up representative offices beginning in 1980, and in 1992 allowed the Big Six to enter joint ventures with state controlled firms.  About 2000, all CPA firms including the Big Four were separated from the state. In 2012, China required the required the Big Four to begin the transfer of the firms from expatriate partners to local Chinese partners.  

Chinese authorities had welcomed the Big Four to China in hopes they would help with economic development, transfer knowledge to locals, and then leave. It was never the strategy of the Big Four to leave, since they saw China as a major market and an important link in their international networks. China launched programs to boost local firms. Looking back on the last decade, those programs have worked very well and China is on the cusp of breaking Big Four dominance of its accounting market. 

China’s accounting market update

For the past four years (2011, 2012, 2013, 2014) I have reported on changes in the rankings of China’s largest accounting firms based on the CICPA’s annual rankings. I base my rankings on revenue alone, whereas the CICPA aggregates a number of factors, including quality assessments. The revenue reported is audit revenue alone, since the firms tend to use different entities for consulting services. 

The revenue reported is audit revenue alone, since the firms tend to use different entities for consulting services. Because dues to the CICPA are based on revenue, firms are discouraged from overstatements. 

Revenue growth for China’s top 100 CPA firms slowed in 2015 to 17.2% down from the blistering growth of 32.8% in 2014. Nonetheless, the growth in accounting firm revenue far outpaced the growth in GDP, indicating that China continues to invest in accounting.  The international Big Four firms grew at 7.5% in 2015, significantly down from 18.2% in 2014. Local firms continued to outpace the Big Four in revenue growth, logging a 21.5% increase compared to a 39.5% increase in 2014. That has led to a decline in the Big Four’s share of the Top 100 market to 28% from 31%, continuing a steady slide over the last few years. 

Lead auditors

China Life today announced that it has changed its auditor for the US Form 20-F from Ernst & Young to Ernst & Young Hua Ming. Ernst and Young Hua Ming is the mainland China affiliate of Ernst & Young.

Ernst & Young Hong Kong resigned due to “requirements for project manage-ment”.  Those requirements are likely proposed PCAOB standards that make it clear that the lead auditor must sign the audit report. I am certain that the China Life audit was actually done by the mainland affiliate. The Hong Kong office signed off on the audit because that had become standard practice of the Big Four, even though I believe that the practice violated US and international auditing standards.  

I previously pointed out that KPMG was doing this on many of its overseas listed companies and that the practice was misleading to investors. 

Auditing standards require that the audit be signed by the principal auditor. AS 1205.02 requires the auditor to decide whether his own participation is sufficient to enable him to serve as the principal auditor and to report as such on the financial statements. The PCAOB proposed new rules on April 12, 2016 that make it clear that reports must be signed by the principal (proposed to be called lead) auditor. 

ZTO’s unusual VIE

This is a guest post by Fredrik Öqvist , one of my former students who remains active in this field. Mr. Oqvist can be reached at

VIE structures still appear to be very common among the new Chinese IPOs in the US. They’ve been around for a good while now so investors should be fairly well informed about what they are and how they operate. At this point in time the general set-up has been largely standardized, although not always in ways that I like, but I found an interesting quirk in one of the recent structures.

ZTO (IPO pending) is a company that sits on the delivery side of China’s rising ecommerce tide. As such it sees ideally placed to see strong growth on the back of expressed government support for increased consumption among the general populace. It recently filed to list in the US, and due to regulations in the delivery industry it set up a VIE structure to be able to list the company.

For those that do not know a VIE structure is basically a set of contracts drafted to mimic ownership and allow a listed entity to consolidate the financials of the contractually controlled VIE. In order to meet the requirements for consolidation the listed entity should be able to control the VIE, and also bear the majority of the risks and rewards from the company’s operations.

Attacking shorts

Hong Kong’s Market Misconduct Tribunal has punished Andrew Left of Citron for market manipulation in connection with his short report on China Evergrande.  Left had alleged that the company was insolvent and had engaged in fraud. 

The Tribunal banned Left from trading on the Hong Kong Stock Exchange for five years and ordered him to turn over the HK$ 1.6 million he made by shorting the stock. He was also given a cease and desist order that warns he could face criminal charges if he does it again. 

Short sellers play an important role in financial markets. I liken them to the hyenas of the markets, preying on the sick and weak, while improving the overall health of the herd. They are also the buyers of last resort, providing liquidity to investors in troubled stocks as they cover positions.  

The action against Left follows the eviction of an analyst with a sell recommendation from a company briefing. 

I have long argued that many short sellers use the “kitchen sink” approach to their research – throwing many unsupported allegations at companies in hopes that something sticks. Often we have seen short seller attacks that fail to prove accurate, yet other problems arise during the investigation that bring down the company. Some attacks fail to be proven, often leading to depressed stock prices.  Long investors are particularly frustrated in these situations, since the short sellers usually profit from unproved allegations, yet long investors often pay a long term price. 

My impaired Mobike

I just love new OTO (online to offline) applications, so I was delighted when Shanghai startup Mobike came to Beijing earlier this year.


Mobike offers bike rentals, something I can use to avoid Beijing’s heavy traffic. Mobike’s app opens to a map that shows me the nearest bikes to me, usually only hundred meters or so away.  I can then reserve the bike, follow the map to find it, scan a QR code on the bike and the bike unlocks itself.  When I am finished with it I park it anywhere I wish, push a switch to lock it, and get charged 1 yuan per half hour – essentially free.  I paid a depost of 299 yuan using my Wechat pay account – another amazing app.


Mobike as 10,000 bikes in Shanghai and 3,000 in Beijing and is adding hundreds every day. I have not had a problem finding one in Beijing, although they are scarce during rush hour. 

Mobike is VC funded, and the business model makes no sense to me. Each bike reportedly costs 3000 RMB – they are quite sturdy and some complain about the weight and lack of adjustability. At that cost it is estimated that it will take 25 months to recover the cost of each bike if each does four trips a day. That creates an interesting accounting problem. It appears the bikes are impaired as soon as Mobike puts them into service, necessitating a writedown, because the expected discounted future cash flows are significantly lower than the cost to build them.

Regulatory reform in Hong Kong

There is a turf battle between the Securities and Futures Commission (SFC) in Hong Kong and Hong Kong Exchanges and Clearing (HKEx) over who should regulate new listings in Hong Kong.

Hong Kong is somewhat unusual since regulation of listings and auditors has been delegated to the regulated, a form of regulatory capture. The HKEx regulates listed companies, with the Hong Kong Institute of CPAs (HKICPAs) regulating auditors, leaving government regulators in a supporting role. Unsurprising, self-regulation rarely works, since market participants rarely take actions against themselves.  

Self-regulation is usually the preference of the regulated professions because professionals get the benefits of regulation but control any disadvantages of regulation. Professionals always seek closure – to limit market access to newcomers.  In Hong Kong, CPAs must be licensed by the HKICPAs, meaning that only members can provide audit services.  Yet while limiting market access and competition, the HKICPAs has done a pathetic job regulating its members.  Fines, when they happen, are insignificant and even serious violations by the Big Four get only a slap on the wrist. 

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