Postings | China Accounting Blog | Paul Gillis

Postings

Hong Kong audit reform falls short

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 (Hong Kong’s legislative body) 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.

Spinoffs - Chinese style

Spinoffs are situations where a corporation disposes of part of its business by giving shares in the business to shareholders. When they work, the value of the parts is greater than the value of the whole. “Spinoffs” of US listed Chinese companies work differently.

A favorite transaction of US listed Chinese companies is to "spin off" parts of the business in a new entity in an IPO transaction. Shareholders of the parent company are not distributed shares of the company that does an IPO although they may benefit if the value of the underlying shares is recognized in the stock price. There have been a number of these transactions and several in the pipeline.

I have observed, however, that the biggest winners in these transactions appear to be members of management. Management typically ends up with a big chunk of these deals which are structured in a way that does not report as expense the value transferred to them.

Rather than point to a specific transaction, I am going to examine these transactions through a straw man. When I look at specific transactions, I find the public documents obscure what is going on and add bells and whistles that do not alter the essence of the transaction while providing arguments to counter any attacks on the structure. So, the transaction I describe below is fictitious, although I think fairly represents what is going on. I leave it to others to apply this to specific transactions. I apologize, but this simplified example is still complicated as hell.

ZTE - Where were the auditors?

The US Department of Commerce has banned Chinese tech company ZTE (HK 763) from purchasing American components for seven years. Because American components are essential to its products, there is serious doubt as to whether the company can survive. The stock has been suspended from trading on the Hong Kong Stock Exchange.

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.

What does the trade war mean for accounting?

Donald Trump has declared a trade war against China by threatening higher import tariffs on $153 billion of Chinese exports. China has said it is only polite to reciprocate.

Services are not subject to import duties, but China has shown no qualms about punishing foreign business for the sins of their government. The Big Four are technically not American companies. The operations in China are not subsidiaries, but more like franchises owned and operated mostly by local Chinese. But they are generally viewed as American and may face regulatory crackdowns and may see an acceleration of the process of transferring major accounts to local CPA firms. Some smaller US CPA firms operate in China in ways that are technically illegal under Chinese law and would be easy to crack down on.

It would be easy for the Chinese to crack down on the Big Four. They simply need to strictly enforce their own rules. Few audits can survive a critical examination by regulators, evidenced by the high rate of audit deficiencies identified during inspections by the Public Accounting Oversight Board (PCAOB) of domestic firms. Earlier this year China temporarily banned several local firms for audit deficiencies. The Big Four had best watch their back.

The China Hustle

A documentary on the many stock frauds in China was released this past weekend.

I have a cameo role in the movie, which has a rating of 74% on Rotten Tomatoes. It was released by Magnolia Pictures (owned by Mark Cuban) and is available for streaming and in selected theatres.

I think it is worth watching as a good review of the past decade in China investing.

KPMG in deep trouble in HK

Matt Miller of Reuters has an interesting update on the troubles KPMG is having in Hong Kong with a failed US listed Chinese company. In my view the problems are of its own making.

KPMG Hong Kong was the auditor of China Medical Technologies Inc., which failed after management was charged by the US Securities and Exchange Commission with looting over $400 million from the company. The company was put into liquidation in 2012 in the Cayman Islands, where it was incorporated.

Actually, KPMG Hong Kong was not the auditor, and that is the problem.

Several years ago I wrote about KPMG’s labeling problem where they had a practice of using Hong Kong letterhead to sign audit opinions on audits done by KPMG Huazhen, KPMG’s China affiliate. To me, this was like a Wenzhou shirt maker sewing a made in Italy tag on a shirt made in China.

KPMG Hong Kong issued the audit report, yet when liquidators asked to see their working papers they said they did not have them since the actual audit was done by KPMG Huazhen, its mainland affiliate which was prohibited under Chinese law from sharing them. Auditing standards require that the principal auditor sign the audit report. Only the principal auditor can sign the report. It appears that KPMG Huazhen was the principal auditor of China Medical and should have signed this audit report. Had they done it right, this case would never have ended up in a Hong Kong court.

HK races to bottom in corp gov

The Hong Kong Stock Exchange (HKSE) has issued its latest proposal to weaken corporate governance standards in order to attract Chinese listings that have gone to the US. The US has won most of the listings of China's privately held companies, including bellwethers Alibaba, Baidu and Sina. There are several reasons for that, including the fact that the US permits weaker governance than Hong Kong or China, and that fees for investment bankers are considerably higher with US listings. The weaker governance rules led to the NYSE winning the Alibaba listing over the HKSE. Hong Kong faced the possibility it would not win another major IPO from China because most Chinese founders want a controlling vote, even when they no longer hold a majority of the shares.

Much to the consternation of corporate governance advocates, Hong Kong proposes allowing control structures (called weighted voting rights - WVR). Shareholder advocates in the US have opposed the proliferation of these structures in technology companies. Hong Kong is also proposing to relax other listing standards related to profitability.

Drown HK audit regulation in a bathtub

Hong Kong has finally releasedproposed legislation(over 250 pages) to reform audit regulation in Hong Kong. This processbegan in 2014after the European Union withdrew regulatory equivalency from Hong Kong citing its ineffective system of audit self-regulation. Although most members of the profession publicly supported the proposed legislation, privately they have been resisting it, which is why the process has taken so long.

If the legislation is enacted, the Financial Reporting Council (FRC) will become the regulator of auditors of public interest entities in Hong Kong, much as the US’s PCAOB and Canada's Public Accountability Board (CPAB) took over regulation of auditors of public companies in the US and Canada.

Section 20F provides that the HKICPA Council may impose any condition on registration of auditors that it considers appropriate. The PCAOB has refused to register any more Chinese or HK CPA firms on the basis that they are unable to agree to turn over working papers for inspection. The PCAOB has not chosen to revoke existing registrations of firms that are unable to turn over working papers, although it has picked on a couple ofsmall firms. I don’t see that firms will be required to consent to turning over working papers as a condition of registration in Hong Kong.

A lump of Christmas coal for KPMG

It is a bad day for KPMG.Reuters reports that the Hong Kong High Courthas issued a contempt summons to 91 current and former KPMG partners for their failure to hand over audit working papers for US listed China Medical.China Medical is in liquidation and the court apparently has been overseeing the liquidation of Hong Kong subsidiaries. The case is a repeat of an earlier spat with EY over working papers for Standard Water, which was resolved when EY “found” the working papers on a server in Hong Kong.

KPMG says it cannot turn over the working papers without permission from mainland regulators.The US PCAOB reached an enforcement agreement with China that allowed it access to working papers in connection with investigations (but not inspections).Hong Kong has no such arrangements, and this is private litigation.

China has argued national sovereignty and state secrets concerns trump foreign laws requiring the production of documents on Chinese companies listed abroad or doing business abroad.Hong Kong, while part of China, is being treated the same as the United States, presumably to avoid undermining arguments used against the U.S.I seriously doubt there are any state secrets in these working papers.

Shinewing faces huge fine

Chinese regulators have fined leading Chinese CPA firm Shinewing a stunning 4.4 million yuan (US$667,000) for a failed audit of a Chinese listed company. I believe this is the largest fine ever assessed on a CPA firm in China, although many firms have received the death penalty in previous regulatory crackdowns. Earlier this year China's two of China's largest local firms (RSM affiliate Ruihua and BDO affiliate Lixin) faced short term practice bans.

Shinewing was the 9th largest Chinese CPA firm in 2015, the latest year for which CICPA data has been released. Shinewing developed from the former joint venture between Coopers & Lybrand and CITIC. It did not join PWC when PW merged with C&L. Shinewing has long held a reputation of being one of the high quality local CPA firms, although it has not gained the market share that its larger competitors obtained by aligning with second-tier networks like RSM and BDO.

It is a good thing that Chinese regulators are getting tough on CPA firms, since these firms play a vital role in the development of China's capital markets.

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 beenbanned 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.



Copyright 2018 Paul L. Gillis all rights reserved