China Accounting Blog

The pending restructuring of the Big Four was big news yesterday. I spent the day talking to reporters from all over the world and in a TV studio near my home. This morning I Googled my name and found I was quoted in 212 newspapers yesterday. Of course, that is part of what the university pays me to do – to provide to the public my analysis of the important social issues of the day. 

What surprises me is the near complete radio silence by the Big Four. The Big Four public response to what is probably their biggest issue in their 30 years in China is mostly “no comment”. One exception came from one of the colonial remnants in Hong Kong who said that China needed to offer its CPA examination in English. (China offered that in WTO negotiations provided that the U.S. offer its CPA examination in Chinese, an offer that the Americans rejected).

I think it was foolish for the Big Four to allow others to define the meaning of this important issue. The near 100 comments on the Wall Street Journal article mostly reflect concern that the changes will undermine audit quality in a market where audit quality is already suspect. The Big Four need to hire public relations advisors. 

China Ministry of Finance has issued guidelines for the restructuring of the Big Four in China. As I have previously reported, the joint venture terms for the Big Four expire in 2012 for three of the firms with PwC getting an extra five years.  Because of a WTO exception, the joint ventures have allowed control by partners who are not Chinese CPAs. Upon expiration of the JVs, the firms must restructure into limited partnerships, which Chinese law (like most other countries) requires be owned by locally qualified partners.

The MOF guidelines provide significant relief to the Big Four.  The firms can have up to  40% foreign partners with overseas qualifications, ten years of experience and five years in China. The 40% limit drops to 20% by December 31, 2017. Partners have to be at least 40 years old and not older than 65. 

Similar rules apply to the management of the firms. Members of the management committee must not have more than 40% foreigners from 2012. The senior partner must be a Chinese national and a Chinese CPA. None of the present Big Four senior partners meet this requirement. For them, there is also a transition. They can remain in their existing post for up to three years.

The deadline for Big Four restructuring in China is looming. As I have explained earlier, the joint ventures under which the Big Four operate in China expire in 2012 for three of the firms as they reach the end of their twenty-year life. PwC gets an extra five years because it formed a new joint venture in 1997. Back in the summer of 1992 KPMG rushed to become the first joint venture firm. The other firms all established their joint ventures during the last half of 1982, and they will all (except PwC) begin to expire this summer. 

China is forcing the firms to restructure into limited partnerships owned by Chinese CPAs. The problem is that the firms are presently owned in majority by foreign, including Hong Kong and Taiwan, partners. In order to become Chinese CPAs, these partners would have to pass the arduous Chinese CPA examination. Few have succeeded at doing that. 

The Big Four have been silent about this process, until now. Dennis Nally, global chairman of PwC gave an interview to Dena Aubin at Reuters. Nally reported that PwC was participating in the talks with Chinese regulators, even though its joint venture still has five years left. He said the firms are near an agreement with Chinese officials that will provide a transition period of several years before the ownership of the firms has to change. Nally said that PwC was in better shape than some of the other firms, indicating that some of the firms were having difficulty finding enough locally licensed senior partners to take over ownership.  

The fourth round of the U.S.-China Strategic and Economic Dialogue will take place in Beijing this coming Thursday and Friday. Tim Geithner and Hillary Clinton will sit across from Vice Premier Wang Qishan and State Councilor Dai Bingguo.

The last time this group met (May 2011) they agreed to try to find a solution to the PCAOB inspection process:

The United States and China welcome continued dialogue between the bilateral competent authorities on the oversight of accounting firms providing audit services for public companies in the two countries, so as to enhance mutual trust and strive to reach agreement on cross-border oversight cooperation. Both countries agree to make joint efforts to accelerate the process.

The parties got off to a good start. A joint PCAOB and SEC delegation went to China in July 2011 to meet with MOF and CSRC officials. PCAOB Board Member Lew Ferguson and SEC Chief Accountant Mike Starr met with CSRC Chairman Shang Fulin. The PCAOB invited the Chinese regulators to come to Washington last October. The October meeting did not happen. I believe that was because the SEC subpoena for Deloitte’s working papers on Longtop caused the Chinese officials to pause, perhaps recognizing that the inspection access would not be an easy issue.  They finally got together in January in Washington, but did not report any progress. 

The SEC has told many U.S. listed Chinese companies that they must disclose the risk associated with the inability of the PCAOB to inspect the work of their auditors in China.  These disclosures are now beginning to appear in the Form 20F filings for the year ended December 31, 2011. Here is an example from the recent filing by 51Job, Inc:

The Public Company Accounting Oversight Board, a U.S. regulator which oversees the inspections of audit firms which conduct audits of registrants which file financial statements with the SEC, is currently unable, due to governmental and political factors, to inspect the audit work and practices of registered audit firms in China.

Public company auditors are required by law to undergo regular Public Company Accounting Oversight Board, or PCAOB, inspections to assess their compliance with U.S. law and professional standards in connection with their audits of public company financial statements filed with the SEC. Because our auditor is located in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the PRC authorities, the audit work and practices of our auditor, like other registered audit firms operating in China, is currently not inspected by the PCAOB, due to various governmental and political factors. As a result, investors in U.S. markets who rely on audit reports from any Chinese audit firm are not able to factor the publicly reported findings of regular recurring PCAOB inspections of audit firms and their quality control practices into their decision making processes.

President Obama signed the JOBS Act into law today. Proponents, mostly from Silicon Valley and Wall Street, claim it will enable small companies to do IPOs, enabling job growth.  Economists doubt it will create many jobs. Critics, including investor groups and labor unions, argue it will enable fraud. 

For investors in Chinese concept stocks, the JOBS Act is a disaster. Three features in the JOBS Act are likely to increase the number of frauds by Chinese companies. 

The JOBS Act repeals the requirement for newly listed companies with less than $1 billion in revenue to have an audit of their internal controls by their auditor for the five years after listing. The audits are known as Section 404 audits and were brought in under Sarbanes Oxley to fight Enron type frauds. Chinese companies with a market capitalization over $75 million had to have these audits, and the audits have resulted in some interesting findings. Many Chinese companies have disclosed internal control weaknesses as a result of these audits. Most important, however, is the extensive process of building and documenting internal controls that companies undertake before being audited. These internal controls protect investors, and I fear that they will not be put in place if the audit is not required. The repeal likely leads to serious accounting errors and creates the ability to conduct a fraud. 

The State Council Legislative Affairs Office of the PRC has requested public comments on proposed amendments to the CPA Act. The very act of asking for public comments on legislation reminds me how much things have changed in my 15 years living in China. 

The legislation appears to be mostly housekeeping. There is no new policy here, just alignment of existing laws with policy. The most important change is getting rid of all the language about joint venture accounting firms. Instead, accounting firms are required to use either general or limited partnerships, with limited partnerships available only to firms with at least 25 partners and 100 CPAs.

China faced three problems with CPA firms since they first reappeared in 1980. First, all CPA firms were initially affiliated with the state. Of course, in 1980, everything was affiliated with the state. The need for an independent CPA profession was recognized as China’s economy developed, and by the late 1990s all CPA firms were separated from the state. Second, the original CPA law allowed firms to organize as either partnerships or corporations, yet partnerships were unknown in China and it was near impossible to form one. As a consequence, nearly all CPA firms were organized as corporations. That tended to concentrate ownership and management in a single individual, which was considered a poor governance structure for professional accounting firms. The government has been pushing partnerships since the 1990s, and soon it will be the only form available for CPA firms.

Here is a guest post by John Besant-Jones. John is a recent MBA graduate from the Chinese University of Hong Kong. He has been doing extensive research into Chinese frauds.

Boshiwa and Daqing Dairy: Gone in a puff of powder!

The resignation of auditor Deloitte and subsequent suspension from the Hong Kong Stock Exchange (HKEx) of Boshiwa (which has a license for brands such as Harry Potter and Bob the Builder in China) and Daqing Dairy (formerly known as Global Dairies and supplier of milk products, primarily milk powder), represents a significant step up in the issue of accounting misstatements-and possible accounting fraud-for Chinese companies listed overseas. In the US, the well publicized accounting debacles, primarily from US listed Chinese reverse merger companies, were in part supposed to be because investors on the other side of the world had little or no knowledge about the way business is done in China, had limited or no Mandarin language ability, and had limited or no access to Chinese company management. Moreover, the listing requirements for reverse merger stocks were much looser than the standard IPO route. Short sellers are also more active in the US. Consequently, as the thinking goes, these Chinese US listed reverse merger stocks are far more prone to actual or allegations of accounting fraud.

Boshiwa International Holdings, the Hong Kong listed Harry Potter licensee, announced that its auditor Deloitte Touche Tohmatsu had resigned because "certain information" that it requested is "outstanding or explanations provided by the company are not to their satisfaction". It added that this "precludes the completion of the audit". One issue raised was the "existence and commercial substance of recorded prepayments of RMB 392 million with a supplier" as well as the commercial substance of recorded transactions with distributors and suppliers. 

We have heard this story before. In the last fraud season, most frauds were disclosed when auditors resigned. Few recover once the auditor resigns. Boshiwa's stock plunged 42% before trading was suspended. I will be surprised if it ever trades again. 

We are at the stage of calendar year audits where confrontations with auditors are likely to surface. For U.S. listed Chinese companies, the annual report on Form 20F is due on April 30, two months earlier than last year.