Postings | China Accounting Blog | Paul Gillis

Postings

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 freppas@gmail.com.

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.

1OCrqhS7K14rJvnhsF_wAiA


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.

15f21d0d5c2f40bdaa4a438cc2cb3f33


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. 

Regulatory equivalency - bad for investors

China has long argued that the Public Company Accounting Oversight Board (PCAOB) should rely on Chinese regulators to examine the work of Chinese accounting firms that are also subject to US inspection under Sarbanes-Oxley. This concept is known as regulatory equivalency, where a regulator is to consider the work of a foreign regulator as the equivalent of doing it itself. The PCAOB has so far refused to accept the concept of regulatory equivalency, insisting instead on at least joint inspections of foreign accounting firms together with local regulators. That may change. 

Shaswat Das, an attorney with Hunton & Williams, has noted an obscure reference in a recent European Union (EU) directive that indicates the EU wants to move away from joint inspections to the US accepting regulatory equivalency. Shas observes that “it now appears that the PCAOB (with the SEC’s concurrence) has determined to proceed along a path of full, mutual reliance that may result in very few joint inspections conducted by the PCAOB in the EU during the coming years – raising questions about the continued efficacy of the PCAOB’s international inspections program.”

Avoiding frauditors

The Public Company Accounting Oversight Board (PCAOB) will be requiring audit firms to disclose the names of audit partners on audits they complete. There is also a requirement to disclose whether other audit firms have participated in the audit.

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. 

PCAOB bans auditor of last resort

On May 19, the Public Company Accounting Board revoked the PCAOB registration of Hong Kong CPA firm AWC (CPA) Limited (AWC), formerly known as Albert Wong & Company. AWC has long been one of the auditors of last resort for Chinese companies listed in the United States, particularly those that came to market through reverse mergers. 

The client that finally brought down AWC was Kandi Technologies Group, Inc. (Kandi). Kandi is a Chinese electric vehicle company that was still using AWC as auditor for 2015.   

Here is a list of AWC’s public companies from its website:

1. Kandi Technologies, Corp. (NASDAQ trading code KNDI), a motor vehicle producer in China.

2. QKL Stores Inc. (NASDAQ trading code QKLS), a supermarket chain store in China. 

3. Shengkai Innovations, Inc. (NASDAQ trading code VALV), a high tech manufacturer in China.

4. Dragon Bright Mintai Botanical Technology (Cayman) Ltd. (NASDAQ trading code DGBMF), a wood products company in China.

5. ACL Semiconductors Inc. (OTCBB trading code ACLO), a semiconductor trader in H.K. 

BABA v the SEC

Yesterday, Alibaba (NYSE: BABA) filed its annual report on Form 20F with the SEC.  Included in the report was a disclosure of an SEC investigation into BABA’s accounting.  BABA is down over 7% today on a day when the market is up triple digits. This is the disclosure that appears to have hammered the stock:

Earlier this year, the U.S. Securities and Exchange Commission, or SEC, informed us that it was initiating an investigation into whether there have been any violations of the federal securities laws. The SEC has requested that we voluntarily provide it with documents and information relating to, among other things: our consolidation policies and practices (including our accounting for Cainiao Network as an equity method investee), our policies and practices applicable to related party transactions in general, and our reporting of operating data from Singles Day. We are voluntarily disclosing this SEC request for information and cooperating with the SEC and, through our legal counsel, have been providing the SEC with requested documents and information. The SEC advised us that the initiation of a request for information should not be construed as an indication by the SEC or its staff that any violation of the federal securities laws has occurred. This matter is ongoing, and, as with any regulatory proceeding, we cannot predict when it will be concluded.

New PCAOB standard

The Public Company Accounting Oversight Board has proposed new auditing standards that will significantly affect audits of US listed Chinese companies. The proposed standards address two of the problems with audits of US listed Chinese companies.  

The first problem relates to the Big Four in Hong Kong signing off on audits that are mostly or completely done by the China member firm. I have called that practice consumer fraud – no different than a Wenzhou shirt maker sewing a made in Italy label on a garment. This practice has caused problems – most notably the case of Standard Water where EY Hong Kong signed off on accounts yet was unable to turn over working papers to SFC when demanded because it actually did not do the work. There is also the problem of some firms having their Hong Kong affiliate sign off US listings even where the work is done by the mainland firm.  

The proposed standard makes it clear that, to act as lead auditor, an audit firm must itself audit a meaningful portion of the financial statements. That will end many of the practices currently used by the Big Four in Hong Kong where the report is issued on Hong Kong letterhead despite most or all of the audit being done by the mainland affiliate. It also creates a conflict on many entities listed both in the US and in Hong Kong. The Hong Kong Stock Exchange (HKSE) generally requires that Hong Kong listed companies be signed off by a Hong Kong CPA firm, not its mainland affiliate. But as we learned in Standard Water, these audits are not necessarily done by the Hong Kong CPA firm, but rather by its mainland affiliate. Hong Kong authorities have tolerated this practice despite the reality that it violates ISA 600, presumably because the practice favors Hong Kong CPA firms. For example, PetroChina, listed in Hong Kong, New York, and Shanghai, has KPMG Hong Kong sign its accounts filed with both Hong Kong and the US. The new rules will require KPMG Hong Kong to have audited a meaningful portion of the financial statements itself, rather than relying on its China member firm. The right answer here is to recognize the reality of the situation, and have KPMG’s China member firm sign the report if it is doing the work, although that may require a change in HKSE rules. 

Shooting the angles

Dan David of GeoInvesting has an interesting post today about how the SEC has done an excellent job protecting Chinese investors who have been ripped off in EB-5 investor scams. The EB-5 program offers green cards to foreigners who make job creating investments in the US. It is really a process of selling green cards to wealthy foreigners, most of whom are Chinese. Even Donald Trump has financed real estate projects with funds obtained from Chinese investors under the EB-5 program. 

David points out that while the SEC has succeeded in helping Chinese investors get back most of their money from EB-5 scams, it has done very little to help US investors get money back from scams by US listed Chinese companies.  

As David points out in his post, the only CEO to be jailed for defrauding US investors was Dickson Lee of L&L Energy. Lee, however, was a US citizen and was arrested on US soil, so Chinese authorities could not protect him. 

Perhaps the most egregious case was Ming Zhao of Puda Coal, who faces a $250 million judgment from the SEC for ripping off U.S. shareholders. But Chinese authorities have not helped the SEC to enforce the judgment, and instead elevated Ming Zhao to the Eleventh Standing Committee of the Chinese People’s Consultative Congress. I guess he is viewed as a model comrade. 

Restricted cash

The Emerging Issues Task Force (EITF)  is a group of accounting experts who help the FASB with complex accounting issues. The EITF has been working on a project to deal with diversity in the balance sheet presentation and cash flow classification of changes in restricted cash – including transfers between restricted cash and unrestricted cash, as well as direct changes in restricted cash (for example, when disbursements occur directly from restricted cash). Some believe that this diversity is also attributed to the lack of definition of restricted cash in U.S. GAAP. 

In earlier meetings, most Task Force members agreed that restricted cash should be defined based on there being contractual or legal restrictions and not extended to self-designations by management. Some Task Force members preferred narrowing the definition to only cash that is controlled by another party, such as where a trustee or escrow agent restricts access to the cash. However, a majority of Task Force members wanted to also include situations where cash access is limited only through some type of economic penalty for failure to comply with the legal or contractual restrictions.

Another VIE collapse

Another VIE arrangement appears to be collapsing. Nutrastar International Inc. (OTC BB: NUIN) (Nutrastar) was listed in the US through a reverse merger. Nutrastar’s primary product is cordyceps militaris, a species of parasitic fungus used in traditional Chinese medicine. 

Nutrastar reports $139 million of cash and only $5 million of debt, yet has a market capitalization of only $6 million.  We have learned that sometimes Chinese companies do not have the cash they report, and auditors have often been duped on this.  In this case, the problem seems to be that the public company, incorporated in the US, cannot access the cash (even if it exists) because it is in a VIE.

Nutrastar’s financial statements omit required disclosures of the assets of the VIE. The SEC should require the company to provide these disclosures and discipline the auditor for not requiring them.  Nevertheless, we can tell from the separate financial statements of the parent that the cash is likely in the VIE, and in RMB, not US dollars. 

CSX deal a threat to investors

The Chicago Stock Exchange Inc (CSX) announced its planned sale to an investor group lead by China’s Chongqing Casin Enterprise Group.

The 134-year old bourse plans to seek approval to list companies that want to access the capital markets but may not meet the standards of Nasdaq or the New York Stock Exchange (NYSE).

The plan appears similar to one earlier announced by former Lehman Bros. CEO Dick Fuld, the so-called “Gorilla of Wall Street”, to reopen the National Stock Exchange (NSX). NSX recently received permission to restart trading operations. 

US markets, particularly NASDAQ and the NYSE were until recently the preferred listing venues for privately owned Chinese companies. US exchanges were preferred over Chinese exchanges because they provided greater regulatory flexibility and good valuations. Consequentially, hundreds of Chinese companies sought listings in the US, many of which came to market as reverse mergers that were lightly regulated. Many of these listings collapsed in a wave of accounting frauds, and NASDAQ and the NYSE tightened listing requirements in a way that stopped the use of reverse mergers. 

PCAOB bans PKF

The Public Company Accounting Oversight Board (PCAOB) has censured PKF Hong Kong and revoked its registration. That means that PKF Hong Kong can no longer audit US listed companies. Three of its partners have also been banned from working for PCAOB registered firms. PKF has a small share of US listed Chinese companies so the action will likely have little effect on the market. All PKF Hong Kong US listed clients need a new auditor. 

On January 9, 2014 the PCAOB issued an order of formal investigation of PKF’s audits of an unnamed client (PKF had resigned that account a year earlier).  In early April 2015 the PCAOB, pursuant to an Accounting Board Demand, insisted that PKF make available people to testify about the audits. PKF refused, saying Chinese law forbid them from doing so, and insisted that the PCAOB go through the enforcement cooperation MOU with the CSRC. The PCAOB argued that it is not bound to go through the MOU but must follow US law. 

I believe this action sends a strong signal to Chinese authorities that the PCAOB is willing to deregister accounting firms that do not cooperate with it. I have heard that the PCAOB has issued an Accounting Board Demand, or something similar to it, to the China Big Four firms in December.  I do not expect the firms will comply with the demand, setting up a scenario similar to PKF.  If the PCAOB follows a timetable similar to the PKF case, it suggests that a disciplinary action might take place this coming summer, assuming that the PCAOB and Chinese regulators are unable to reach an agreement on inspections.  

PCAOB should follow the lead

I previously wrote about how Bank of China’s refusal to turn over customer bank records in a case involving counterfeiters is similar to the Big Four accounting firms refusing to submit to PCAOB inspections. Both situations involve Chinese firms refusing to comply with US law citing conflicting Chinese laws. 

The judge in the Bank of China case was unmoved by arguments that the bank could not turn over documents because Chinese law forbids doing so. He has now imposed a $50,000 a day fine against the Bank of China. The Bank of China has appealed. The judge has done exactly what the PCAOB should do.  

Fines at $50,000 per day amount to $18,250,000 per year. In 2012, PwC China (the largest of the Big Four in China) earned $74 million from auditing US listed Chinese companies. Obviously they can afford the fine, although it would likely make this work unprofitable for them. What it would do is resolve the issue. The Big Four would either get out of the market or convince Chinese regulators to find a compromise. I expect the latter. 

Auditor independence and guanxi

An interesting academic paper was recently published concerning auditor independence in China. Among other things, the paper reported an experiment as to the effect of guanxi on auditor independence. They study found that auditors with a close bond (guanxi) with managers were less likely to recommend adjustments to stop earnings management.  

Guanxi refers to the network(s) of existing informal relationships and favor exchanges that dominate all business and social activity in China. While the social capital created from reciprocal relationships is common in all societies, the Chinese really take it to an art form, and many Chinese seem to spend their entire lives building a guanxi network that they can call on when they need to get something done. 

Auditors are not immune to the pressures of culture. The authors observe that “Chinese auditors are entrenched in the guanxi culture and psychologically bonded to their clients. This psychological tie created by guanxi leads auditors to trust their clients and act as advocates for the client.”  That is not the way auditors are supposed to behave. Auditors are supposed to be independent of management. The presence of guanxi undermines independence and destroys the credibility of audits. The authors say “the strong psychological bond makes it difficult for Chinese auditors to distance themselves from managers and maintain independence in mind during the audit work."

Chinese accounting standards and IFRS

A joint statement was issued this week by the Ministry of Finance and the IFRS Foundation) about convergence of Chinese Accounting Standards (CAS) with International Financial Accounting Standards (IFRS). Both parties agreed that a single set of high quality global accounting standards is a good idea. 

On November 25, 2005, Sir David Tweedie of the International Accounting Standards Board signed a memorandum with the Ministry of Finance declaring that CAS had substantially converged with IFRS. The agreement was premature in my view since several significant differences remained, but the political pressure on Tweedie to bring China into the IFRS fold was immense. In 2006, China launch a successful initiative to amend IFRS related party disclosure rules to exclude companies under state ownership, effectively converging IFRS with CAS on this point. In 2009, China announced it would fully converge CAS with IFRS by 2011 in accordance with a G20 agreement related to the financial crisis. It didn’t happen. But the Tweedie agreement was sufficient for China to get Hong Kong to accept CAS financial statements for Chinese companies listed in Hong Kong.


Copyright ©  2015         Paul L. Gillis all rights reserved