Cheetah Mobile Inc. (Cheetah) has filed for an IPO with the SEC, joining what is shaping up to be a long line of U.S. IPOs this year. Its main product is Clean Master, the number 6 application worldwide on Google Play. The company previously listed on the Hong Kong exchange as Kingsoft and they now seem to be listing a holding company further down the chain. Fredrik Oqvist has tweeted that Cheetah may be the best name for a Chinese company since FU listed on the NYSE.
By my calculations, Cheetah’s earnings for 2013 would have been 36% higher if it had selected a different accounting firm. That is because Cheetah uses Ernst & Young (EY), which appears to be taking the position that deferred taxes are required on the undistributed earnings of variable interest entities (VIE). In 2013, Cheetah booked RMB 34 million of deferred tax expense related to “outside basis difference” which I believe relates to the undistributed earnings of the VIE.
This is the third EY client where I have seen this accounting treatment (the others are Autohome and Soufun). I have not seen this treatment on any other U.S. listed Chinese company.
The CSRC has fined three Chinese law firms in recent months over shoddy legal work on IPOs. The IPOs in question were all on China’s stock exchanges, and accordingly come under the regulatory authority of the CSRC. It is about time that the CSRC has taken action to raise the standards of legal practice on listed companies. The first crackdown on the accounting profession took place in 1997 and it was brutal. A quarter of Chinese CPAs faced discipline or eviction from the profession in the 1997 rectification. The legal profession is overdue for recti-fication.
The CSRC’s jurisdiction does not extend to overseas listed Chinese companies. Overseas listed Chinese companies of any meaningful size tend to use well-known international law firms. But these international law firms are not allowed to opine on matters of Chinese law, so local firms are used for this purpose.
Some local firms are well known for their willingness to issue clean opinions on variable interest entity (VIE) structures even in the face of considerable doubt as to whether the agreements that underpin these structures are enforceable. Many Chinese lawyers do not believe these agreements are enforceable, but those lawyers are not engaged to issue opinions on VIEs. The SEC has been tough on companies using the VIE structure, but is not in a position to challenge Chinese lawyers on matters of Chinese law. The CSRC does have that power, but it lacks jurisdiction over these companies. That is one of the things that the Singapore Solution can fix.
I wrote an Op/Ed in the Wall Street Journal today calling for reforms in China and the US that can achieve three objectives:
1. Allow Chinese people to invest in China’s top companies like Alibaba.
2. Get rid of the seriously flawed VIE structure.
3. Provide a mechanism to solve the regulatory battles between the United States and China.
I call my idea the Singapore Solution, since it is based on an agreement last November between China and Singapore that lets private Chinese companies list directly in Singapore without using an offshore holding company. I think that paves the way for a similar deal with the U.S. that can solve the regulatory problem – assuming regulators are willing to compromise, which is a huge assumption.
The VIE becomes unnecessary if China follows through on promises to liberalize the rules for foreign investment in education and e-commerce.
I hope regulators on both sides find a way to make a deal like this work. We are on a pathway to kicking all Chinese companies off of U.S. exchanges unless both sides start giving a little.
Accounting is important to China’s development. Zhu Rongji saw that early on and directed considerable resources to develop a CPA profession in China. An investment in accounting is an investment in governance. So is China investing enough in governance?
The chart below measures the growth rates in revenue of the Top 100 CPA firms in China and separately the Big Four and local firms that make up the Top 100 CPA firms. I have measured them against the growth in GDP. The spend on ac-counting fees is an investment in corporate governance.
What the table shows is that over the last ten years, revenue of accounting firms in China has grown at an average annual rate of 22%. Big Four and local firms have grown at the same average rate of 22%, but their annual performance varies quite widely. GDP growth during this period averaged 10%, meaning that the investment in accounting services was more than double the GDP growth. That is great news. Not only has investment in accounting kept up with the growth in the economy, there has been additional “catch-up” investment. Clearly, the catch-up investment is needed and it probably needs to continue for another decade at least.
The Securities and Exchange Commission this week charged a U.S. listed Chi-nese company and six of its officers and directors with orchestrating a massive accounting fraud. AgFeed Industries Inc. is a pig farmer that was formerly listed on NASDAQ.
Dune Lawrence of Bloomberg wrote an expose on Agfeed last December. That earned her a personal attack by TheBlot, a publication allegedly backed by Benjamin Wey. Accounting watchdog Francine McKenna wrote a lengthy piece on the alleged Agfeed scam. All of this is very entertaining stuff.
What is significant about the Agfeed situation is that the charged individuals include audit committee chairman K. Ivan Gothner of Wilbraham, Massachu-setts. While this is not the first time that the SEC has charged an audit com-mittee chairman, it is a rare occurrence and I believe the first against the audit committee chairman of a U.S. listed Chinese company.
The SEC alleges particularly egregious behavior by audit committee chairman Gothner. It alleges he was aware of the fraud, kept it from auditors, and ap-proved false financial statements. Francine McKenna explains how another audit committee member ultimately served as the whistleblower to out the fraud.
In December, I posted about how Autohome had provided a deferred tax liability on the profits accumulated in its VIE, while other companies in similar situations have not done so. I found an additional company, Soufun, that has also provided deferred taxes on VIE retained earnings. Both Soufun and Autohome are audited by Ernst & Young.
I have been told my post set off a flurry of activity in the accounting firms as they tried to find a way to justify not recording deferred taxes. The IPO filing of Ikang Globin Health Care Group, Inc. shows how accountants plan to deal with the issue.
Aggregate undistributed earnings of the Company’s VIEs and its VIEs’ subsidiaries located in the PRC that are available for distribution to the Company were approximately $8,120 as of March 31, 2013. A deferred tax liability should be recorded for taxable temporary differences attributable to the excess of financial reporting amounts over tax basis amount in domestic subsidiaries However, recognition is not required in situations where the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the enterprise expects that it will ultimately use that means. The Company has not recorded any such deferred tax liability attributable to the undistributed earnings of its financial interest in VIEs because it believes such excess earnings can be distributed in a manner that would not be subject to income tax.
My book, The Big Four and the Development of the Accounting Profession in China, is out in print.
The decision by the SEC’s administrative law judge (ALJ) to ban China’s Big Four accounting firms for six months creates serious uncertainty for U.S. multina-tional corporations (MNCs) with significant operations in China. If the ALJ’s decision stands, the ban would mean that the China member firms of the Big Four would be unable to participate in the audits of U.S. listed MNCs, jeopard-izing the ability of these MNCs to file the financial statements required to remain listed in the U.S. Audit committees need to have a plan B.
The China Big Four firms have appealed the ALJ decision to the full SEC Com-mission. I understand that the Commissioners have seven months to make a decision, although they can extend that period. In a worst-case scenario, they could act tomorrow, but I think it is unrealistic to think that they would do so. A realistic worst case is that they act in September as the seven months ends. While I expect the Commissioners to affirm the ban, I am hopeful that they will restrict it to foreign private issuers, exempting work on MNCs. The SEC asked the ALJ to limit the ban this way, but the ALJ did not believe he had the author-ity under the law to do so. I hope the Commissioners decide they have that authority. If the Commissioners limit the ban to foreign private issuers, there should be no problem for most MNCs. The U.S. Chamber of Commerce ought to be screaming at the SEC to do this. Foreign private issuers (U.S. listed Chinese companies), however, are screwed but their plan B is not the subject of this post.
I came across this one-post blog called Chinese Stock Fraud. The most interest-ing information is a list of Chinese stock frauds in Singapore, Hong Kong, and the U.S. and Canada.
The author lists 121 companies; 54 in the US and Canada, 44 in Hong Kong, and 23 in Singapore. It is the best list I have seen of Hong Kong and Singapore frauds. A number of alleged but unproven frauds are not included, even though some of these remain suspended from trading (i.e. AMBO, FU). The author lists no alleged frauds on Chinese exchanges.
One of the great challenges for academic researchers has been coming up with a comprehensive list of Chinese frauds.Zigan Wang of Columbia wrote a paper explaining the difficulty involved in just identifying U.S. listed Chinese firms. Because these companies are usually incorporated outside of China, a list of Chinese companies listed overseas must be derived from secondary inform-ation, like location of head office or percentage of assets in China.
I am encouraging a graduate student to take on a project to create a compre-hensive list of Chinese frauds. The first task is to define a fraud, and that may lead to several lists. Short seller attacks, auditor resignations, delistings, and class action lawsuits are all indicators of fraud but do not definitively establish that a company is a fraud. Such lists, however, may provide the basic data to determine what factors lead to fraud.
The SEC has paid great attention to the disclosures related to VIEs and investors today have considerably more data to evaluate the risks of these structures. Companies have been forced to disclose much more information. For example, New Oriental’s 2008 financial statements included 494 words discussing VIE arrangements. By 2012 this had grown to 3,024 words. There is so much data available that Fredrik Oqvist has created a database to make sense of it. The database is useful to scholars and investors who are studying the risks of VIEs.
It has been very difficult to evaluate VIE risks of companies listed in Hong Kong. Hong Kong listed companies follow IFRS, which has not required the same disclosures that the SEC requires for companies following U.S. GAAP. It is often difficult to figure out if a Hong Kong listed company even has a VIE structure. That is about to change.
Two years ago I posted about a pending change in IFRS that would require VIE disclosures. That change was effective on January 1, 2013, so we are about to see 2013 financial statements issued under the new rules. PwC has a great book on how the changes will work.
PCAOB Chairman James Doty presented his budget to the SEC Commissioners today. Doty said:
Gaining access to audits of Chinese registered firms has been particularly challenging. But I am grateful to the Secretaries of the Treasury and State for their inviting me, with your support, to participate in the Strategic & Economic Dialogue in each of the last three years.
These meetings proved instrumental to achieving some success. In 2013, we were able to reach an enforcement cooperation agreement with Chinese authorities.
Based on recent discussions, I am also optimistic that we will be able, during 2014, to sign a long-sought agreement to inspect the audit work of PCAOB-registered firms based in China.
In comments to reporters Doty indicated that China and the PCAOB are exchanging draft agreements. The Chinese are having a problem with the PCAOB conducting inspections on the ground in China. Doty indicated they are looking at alternatives including moving the papers and making people available outside of China. Since I am married to a Big Four audit partner, I suggest that the inspections take place in an American location with nonstop flights from China.
Many people have asked me if the Big Four could circumvent the SEC ban by having the U.S. or Hong Kong firms sign the audit opinions. The short answer is no, and for several reasons.
In order for a U.S. or Hong Kong firm to serve as the principal auditor who is allowed to sign the report, the firm:
...must 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. In deciding this question, the auditor should consider, among other things, the materiality of the portion of the financial statements he has audited in com-parison with the portion audited by other auditors, the extent of his knowledge of the overall financial statements, and the importance of the components he audited in relation to the enterprise as a whole (AU 543).
In plain English, that means that in order to sign, you actually have to do the audit, or most of it. The firms cannot just sign the report in the U.S. or Hong Kong; the U.S. or Hong Kong firms must actually do the audit.
Predictably, the Big Four firms are wailing about the SEC decision against them yesterday. One firm has complained that “this is a profession-wide issue, and not one of the profession’s own making”. The judge disagreed; finding that “to the extent the firms find themselves between a rock and a hard place, it is be-cause they wanted to be there”. The China Big Four partners would have prob-ably understood this better if the judge had used a Cantonese idiom: 食得鹹魚抵得渴 (Those who eat salty fish must put up with the thirst). The firms did not have to get into the business of serving U.S. listed Chinese companies.
As much as the firms are feeling sorry for themselves, it is their clients and the investors in those clients who will be hurt if the firms are banned from practice. A ban could lead to the companies being kicked off of U.S. stock exchanges for failing to produce audited financial statements. IPOs would have to be post-poned until the bans were over. Financings would be delayed. Fortunately appeals are likely to delay this for a long time.
Cameron Eliot, Administrative Trial Judge of the SEC, threw the book at the China Big Four today, suspending them from practicing before the SEC for six months in a 112-page opinion, parts of which were redacted because they reported interactions between the SEC and CSRC “more candidly than is customary in diplomatic circles”. While he may have been kind to the CSRC, he took the hide off of the Big Four. The firms, especially PwC, were probably feeling a little raw already from the blistering they received in the ICIJ report yesterday on how they aided Chinese elites to get money offshore.
BDO DaHua was censured by not banned. Dahua has pulled out of BDO and I do not believe it has any U.S. listed clients anymore.
The suspension will not begin until the Commission enters an order of finality. The firms can request review within 21 days or the Commission can decide to review it anyway. If the commission goes ahead and finalizes the decision, the Big Four could appeal to federal Circuit Court of Appeals and ask for a stay of the decision. That could delay the problem for a long time, but that may not be the best outcome for the firms or their clients.
The SEC brought administrative charges against the Big Four and BDO’s then China affiliate on December 3, 2012 for failure to turn over audit working papers to the SEC. Separate charges against Deloitte had been brought on May 9, 2012. At risk is the right of these firms to practice before the SEC. If this right is revoked, U.S. listed Chinese firms may find themselves without an auditor and consequentially be kicked off of U.S. exchanges. Under SEC rules, the presiding administrative law judge is to issue a decision within 300 days. On March 8, 2013, the SEC approved a delay in the case against Deloitte and put the Deloitte case on the same timetable as the rest of the firms – October 11, 2013.
A hearing was held in Washington between July 8 and July 31, 2013.
The CSRC reached an agreement with the PCAOB to release working papers in connection with investigations in May 2013, but continued to block the PCAOB from doing inspections of accounting firms. The CSRC began to release the working papers that the SEC had requested. The firms asked the judge for a summary disposition of the case because the SEC had found another way to get the working papers. The judge dismissed this request on December 6.
Again in 2013, Hong Kong placed first in the Heritage Foundation’s Index of Economic Freedom, which measures its view of the economic freeness of various countries. The index focuses on the presence of the rule of law and the absence of government regulation. On the latter point Hong Kong does particularly well, scoring 98.9 in Business Freedom compared to 90.5 for the United States and 48.0 for China.
Of course, business rarely wants no regulation – after all that might lead to excessive competition. The professions have long sought closure – blocking outsiders from the work of the profession in exchange for regulatory oversight. Milton Friedman in Capitalism and Freedom observed this behavior: “the pressure on the legislature to license an occupation rarely comes from the members of the public . . . On the contrary, the pressure invariably comes from the occupation itself.”
The accounting profession secured a particularly sweet deal in Hong Kong. They blocked access to their lucrative market to accounting firms from outside Hong Kong while convincing regulators to allow them to regulate themselves through the Hong Kong Institute of CPAs (HKICPAs).
There are signs that there may soon be a regulatory breakthrough on overseas IPOs of Chinese companies.
The Singapore Exchange (SGX) and the China Securities Regulatory Commission (CSRC) reached a deal to allow Chinese companies to list directly in Singapore, that is, without using an offshore holding company. While there are hundreds of Chinese companies that have listed overseas, only large SOEs tended to get the necessary permission to list directly. The rest used offshore structures, typically with a Cayman Island holding company, to get around Chinese regulations. The offshore structures contributed to the regulatory mess that ensued, where Chinese regulators did not regulate the companies because they were not Chinese, and foreign regulators could not regulate them because China would not let them have access to the people and records in China.
Now Chinese companies can directly list in Singapore after their applications are approved by both CSRC and SGX. The agreement, however, does not deal with the troublesome variable interest entity (VIE) structure that is used to circumvent Chinese rules restricting foreign investment in certain sectors.
Autohome (NYSE:ATHM) had a successful debut on Wednesday with the shares popping 80% above the offering price. That is the seventh IPO in the U.S. this year, ending a drought. Investors seem less spooked by the VIE structure and risk of regulatory problems with the SEC and PCAOB. None of those issues have been fixed, but investors seem convinced that they will not escalate. Despite recent short seller attacks at Fab Universal (successful) and NQ Mobile (largely unsuccessful) investors seem comfortable that they will not be victims of yet another Chinese accounting fraud.
Unless sentiment changes, I am thinking that 2014 could be like 2007 with perhaps as many as 30 U.S. IPOs. That will hardly make a dent in the backlog of private equity money waiting for an exit, but it will be a good start.
Autohome’s filings present a fascinating new issue. Autohome has accrued a deferred tax liability of $75 million for “outside basis difference”. While this issue has been bouncing around for some time, I believe this is the first time that a company has recorded the liability.
Investors in Chinese companies have been badly burned by CEOs who seem to forget that they have shareholders. Some CEOs have sold assets out of the company and kept the proceeds. Some have just cleaned out the bank accounts. Others have taken the whole company. The variable interest entity (ViE) structure, where companies are controlled with contracts is a common enabler of these scams. Shareholders have little, if any, legal protection when things go wrong with a ViE.
A recent case highlights the problem. FAB Universal (NYSE:FU) came to market in 2012 through a reverse merger with a Pittsburgh headquartered company. The company was listed on the NYSE. Investors would have been prudent to take the company's ticker symbol as prescient.
FU recently came under attack by short sellers. Jon Carnes (aka Alfred Little) is one of the more lethal predators in the pack of short selling research firms that have circled U.S. listed Chinese companies for the last few years. Carnes alleged the company was a scam, selling pirated videos from nonexistent retail locations. A few days later another short selling research firm, GeoInvesting, disclosed a tip it had received that FU's VIE had issued a $16.4 million bond in China and had not bothered to record it in its financial statements.
An essential component of any VIE structure is a service contract between the wholly foreign owned enterprise (WFOE) and the VIE. The purpose of this contract is to enable the WFOE (which is owned by the public company and its shareholders) to extract the profits from the VIE (which is owned by a Chinese individual). Without this contract the public company has no economic interest in the VIE, and cannot consolidate the VIE in its financial statements. More important than the issue of consolidation is that unless the contract is effective, the public company owns nothing and may be worthless.
The problem with these contracts is that companies selectively apply them, if they apply them at all. The contracts usually provide that the WFOE can charge a fee to the VIE for services rendered that is equal to the entire profits of the VIE. There are a bunch of problems with that.
First, these companies often need their cash in the VIE, not in the WFOE. So, if the profits are transferred from the VIE to the WFOE, the VIE may be short of cash. While direct loans between Chinese companies are not allowed, it is possible for the WFOE to loan the cash back to the VIE in the form of entrusted loans. Entrusted loans are permissible for the accumulated earnings of a WFOE, but cannot be used for funds that were contributed to capital of the WFOE.