PCAOB chairman James Doty recently did an important interview with Caijing, which I have had translated into English. There has been little news on the PCAOB’s struggles with China since a deal was cut to allow sharing of documents with respect to investigations. The more important issue of inspections remains outstanding, and the interview exposes Doty’s increasing frustration with lack of results after nine years of negotiations. Doty indicates the nuclear option of deregistering accounting firms and kicking Chinese companies off the U.S. exchanges is very much alive. “We don’t want to come to this situation, but unfortunately there’s not much time left”
Doty expresses hope that the comprehensively deepening reforms that come from China’s Third Plenum will break the deadlock. I share that hope. The Third Plenum announcements say nothing about the PCAOB, or overseas listed Chinese companies either, but I they set a framework that might allow for resolution of two of the major overhangs for Chinese companies listed in the U.S. – regulatory standoffs with the PCAOB and SEC, and variable interest entities.
Included in the detailed reform plan that came out of the Third Plenum meetings was an odd statement that restrictions on foreign investment in accounting and auditing firms would be relaxed. What is odd about that is that China already has the loosest rules for foreign investment in auditing and accounting on the planet.
Last year China struck a deal with the Big Four accounting firms to convert their expiring joint ventures into limited liability partnerships. China, like virtually every other country, requires owners of CPA firms to be CPAs. That was a problem for the Big Four, since many of their partners are expatriates (mostly from Hong Kong) who are mostly not Chinese CPAs. The Chinese CPA examination is open to foreigners, but it iis notoriously difficult and more than a few Big Four partners have been humiliated by it. The Big Four firms negotiated a sweet deal with Chinese regulators. They would be allowed to have up to 40% unlicensed partners (the partners are required to have some sort of foreign license) in their limited liability partnership, although that 40% will ratchet down to 20% over five years.
The SEC yesterday banned Sherb & Co. from auditing public companies. The firm was also fined an insignificant $75,000 to settle the charges. Sherb stood accused of audit failures on China Sky One Medical, China Education Alliance Inc., and Wowjoint Holdings Ltd., all Chinese reverse mergers.
Sherb failed to properly plan and execute audits, failed to obtain sufficient audit evidence on sales, revenue, and bank balances, and ignored clear red flags.
This is the second action by the SEC against Chinese reverse merger auditors in recent months. On September 30, the SEC banned Patricio and Zhao LLC (P&Z) from auditing public companies. P&Z was found to have done a failed audit on Keyuan Petrochemicals, Inc. I expect to see more actions like this against CPA firms that audited reverse mergers in the coming months as the SEC completes its efforts to bring to account the gatekeepers on failed Chinese reverse mergers.
Both of these firms were based in the United States and had been inspected by the PCAOB. The PCAOB cannot inspect accounting firms in China but since these firms were based in the U.S. they were inspected, even though the act of removing the audit work papers from China likely violated Chinese law.
There was an interesting article by Dune Lawrence and Belinda Cao of Bloomberg looking at the status of Muddy Water’s attack on NQ Mobile. The article reaches a mixed conclusion on the accounting.
Several experts interviewed by Bloomberg said the high days sales outstanding (DSO) was a red flag. High DSO usually is a red flag, but a fraud perpetrated in this way would be quite small compared to what Muddy Water’s alleges. Muddy Water’s says that over 90% of the business is fake, and you can’t cover that up by edging up DSO.
The second issue is whether the cash is there. I consider that the true test of whether the company is a fraud. If the cash is there, I see no way that any fraud could be of the scale alleged by Muddy Waters. The company is taking some extraordinary steps to clear this issue up. The Level 1/Level 2 controversy is meaningless.
The movement of funds is more interesting. Muddy Water’s alleged that it was impossible for NQ Mobile to transfer the proceeds of the offering to the VIE without violating Chinese law. A couple of experts disagreed with that.
Muddy Waters continued its assault on U.S. listed Chinese companies with an attack on NQ Mobile. As is typical of short seller attacks, Muddy Waters has made a number of allegations, but the one that has been filing up my inbox relates to a disclosure of cash and short-term investments.
This is the table from NQ Mobile’s 20F that has everyone worked up. You will find a similar one in every financial statement.
What got Muddy Waters worked up was a comparison of this table to the prior year’s table.
As you can see, NQ Mobile has moved its cash and cash equivalents from Level 1 to Level 2 in 2012 and did not tell us why. That is a self-inflicted wound since an explanation probably would have headed off this part of the Muddy Waters attack. Instead, Muddy Waters suggests that the change implies the cash might have been diverted and is not there.
Financial assets like cash and short-term investments are reported at fair market value on the balance sheet, rather than at their original cost. This valuation is done at every balance sheet date, and the assets are “marked to market” to reflect the current valuation. Differing approaches to doing this led to great confusion during the financial crisis of 2008, and the FASB and IASB conformed US GAAP and IFRS in 2011 to get consistency. Included in those reforms were expanded disclosures about how investments were priced, and it is those expanded disclosures that are getting all the attention in China today.
We have had several Chinese companies file for IPOs in the US recently. 500.com is an online sports lottery company.58.com is China’s copy of Craigslist. Sungy Mobile is mobile internet, mostly games.Qunar Cayman Islands is similar to Kayak.
Auditors of these companies are:
Sungy Mobile KPMG
Deloitte won none of these engagements although it previously had the largest market share by number of companies. Some private equity people have told me that they have been avoiding Deloitte for fear that their SEC problems might get in the way of a timely offering. The problems that the Big Four are having with the SEC get extensive coverage in the risk factors, with three of them saying that if the SEC acts against the China Big Four, they will not be able to file financial statements and may be delisted. I was pleased to see that KPMG signed Sungy’s report using its mainland affiliate, breaking from its former practice of signing these reports in Hong Kong. The mainland affiliate does the audits; it needs to sign the reports.
The Securities and Futures Commission (SFC) in Hong Kong has released a report on independent audit oversight. I have been calling for reform of Hong Kong’s notoriously weak system of audit regulation and this is a welcome development.
Hong Kong has retained a system of self-regulation of the profession by the Hong Kong Institute of CPAs. The rest of the world learned its lesson after the Enron scandals of the last decade and toughened the oversight of auditors by putting in place independent regulators. Hong Kong accountants succeeded in preserving control of the process by conceding only to symbolic reforms. With the rise of the importance of the Hong Kong Stock Exchange to world financial markets and the increasing number of accounting frauds in Hong Kong and China, reform of the oversight of the accounting profession is critical.
SFC retained Deloitte to prepare the report. While I had concerns about the letting the fox guard the henhouse, Deloitte has done a commendable job. The report is fair, and calls for the reforms that I think are necessary.
PCAOB Chairman James Doty told 21st Century Business Herald (China’s leading business paper) that the PCAOB is negotiating with Hong Kong for access to do inspections of Hong Kong accounting firms on work related to Chinese listings. A deal to allow inspections in Hong Kong could provide a way out of the impasse between U.S. and Chinese regulators. If the audits of U.S. listed Chinese companies are signed by the Hong Kong member firm a deal might allow the working papers to be inspected. The problem with this kind of deal is that it requires both the CSRC and the PCAOB to turn a blind eye towards what is actually happening.
Mainland authorities have blocked the PCAOB from coming to Hong Kong to inspect audits of companies with mainland operations. Hong Kong regulators must have been given permission by the mainland to have these negotiations, and that signals that mainland regulators are searching for a way out of the problem.
In addition to the PCAOB standoff over audit inspections, Hong Kong’s Securities and Futures Commission is in a court battle with Ernst & Young over its refusal to turn over working papers in the Standard Water case. I am surprised that case has not already been resolved. In May, Chinese regulators reached a deal with the PCAOB for access to working papers in connection with investigations, and I have thought that deal would have led to a similar deal with SFC by now. Hong Kong's weak regulatory system for accountants does not include inspections.
China-Biotics has been one of my poster children for accounting frauds in China. It blew up in 2011 after it was attacked by Citron. At the time, I observed that with 54% of its assets in cash, the proof would be in whether the auditors were able to confirm the cash balances.
A month later auditor BDO resigned after they discovered that the company had sent them to a fake bank website to confirm the cash balances. There have been a number of problems with bank confirmations for Chinese companies, but this was probably the most audacious.
The SEC suspended trading in the stock and in February 2012 an administrative trial judge revoked the company’s securities registration for failing to file annual reports. The SEC has revoked the registration of many Chinese companies when they “go dark”.
What is unusual about China-Biotics is that unlike most other deregistered Chinese companies it did not just disappear. An appeal was filed against the SEC action. The company found a new auditor, Weinberg and Co., a small CPA firm based in Boca Raton, Florida. Weinberg audits a number of Chinese reverse mergers. Its most recent PCAOB review found deficiencies in four of five audits reviewed that were so serious that the PCAOB concluded that Weinberg had not obtained sufficient competent evidential material to support the opinion on the issuer’s financial statements. That is about as bad as it gets in a PCAOB report. PCAOB disciplinary procedures are so slow it could be years before Weinberg faces accountablilty for those audits. In the meantime, investors in their clients are exposed.
On September 30, 2013, the SEC threw the book at a small U.S. based accounting firm because of a deficient audit of a Chinese reverse merger that had found its way onto NASDAQ. The auditor, New Jersey based Patricio and Zhao (P&Z) and partner John Zhao, have been banned from auditing U.S. listed companies for three years.
The audit in question was for Keyuan Petrochemicals Inc. which had completed a reverse merger and later upgraded its listing to NASDAQ. It has since been kicked off of NASDAQ and is traded on the pink sheets. P&Z was its initial auditor. According to the 2010 PCAOB inspection report on the firm that was issued in 2012, P&Z audited 12 U.S. listed companies.
On January 17, 2011, Keyuan fired P&Z and hired KPMG. After the accounting frauds began to appear in mid-2010, many U.S. listed Chinese companies tried to upgrade auditors to the Big Four to provide confidence to skittish investors. Many of those “upgrades” did not end well for anyone. More often than not, the Big Four firm was unable to complete an audit, leading to the delisting of the company. That appears to have been the case here.
It has been very quiet the past couple of months on the confrontation between the PCAOB/SEC and Chinese regulators over audit working papers and inspections for U.S. listed Chinese companies and their auditors.
The issues were coming to a head in early July. The SEC case against the Big Four and BDO went to a hearing before the administrative trial judge of the SEC on July 9 and the standoff between U.S. and Chinese regulators was on the agenda of the Strategic and Economic Dialogue (SED) between the United States and China that was scheduled that same week in Washingtion.
Chinese regulators blinked first in the standoff. CSRC told the SEC they would turn over 20 boxes of working papers related to Longtop Financial Technologies provided the SEC sent them money for postage. Treasury Secretary Jack Lew announced the breakthrough at the SED. No agreement was reached at the SED on access to conduct audit inspections by the PCAOB.
The PCAOB had earlier reached agreement to share documents with Chinese regulators in connection with investigations, but reached no agreement on inspections. Investigations are a small part of the PCAOB mission; inspections are its main function.
All has been quiet on the U.S. front with respect to the SEC’s case against the Big Four and BDO over turning over working papers. Ernst & Young (E&Y) were in court in Hong Kong on Thursday to make final arguments on their failure to turn over the working papers for Standard Water to the Securities and Futures Commission (SFC).
Ernst & Young seems to keep opening up cans of worms in this case. It is the Hong Kong affiliate of E&Y that the SFC has dragged into court because that is the firm that was the accountant of record. E&Y had to make the embarrassing admission that it did not have any working papers because it didn’t actually do the audit. The audit was done by E&Y Hua Ming, its mainland affiliate who refused to turn over the working papers because China won’t allow it. E&Y Hong Kong has not explained how it can be the signing accountant when it does not do audits. The Big Four in China have often overlooked the principal auditor rule that requires the audit firm that does most of the work to sign the report. The problem in Hong Kong is that the Exchange requires a Hong Kong accountant to sign most red chips, and the Big Four have ignored their legal structure and the way they do audits to accommodate this requirement.
I gave an address to CEOs at the China Best Ideas Conference today. There are over 400 people, both investors and executives from Chinese companies at the conference. There is optimism that the U.S. markets might reopen for Chinese companies soon.
Remarks by Professor Paul Gillis at China Best Ideas Investment Conference, September 9, 2013.
Chinese entrepreneurs have had tough time getting capital. The shadow banking system is collapsing, the Chinese A share market is closed, private equity money has dried up, and U.S. exchanges are all but closed.
I am going to talk about the three things that have really hurt this market. I call them the three terrors of investors in Chinese stocks. I am hopeful that we are going to going to come to terms with these issues and that the markets are going to soon recover.
I don’t have to tell you that we have had a lot of accounting fraud among Chinese public companies. Over 150 cases in just the last few years. A lot of investors were wiped out. McKinsey says that investors in U.S. listed Chinese companies lost 72% of their investment in the last two years.
I have not posted lately, mainly because I have been working towards a deadline to get my book to the editor. The Big Four and the Development of the Accounting Profession in China will be out sometime this fall. It is being published by Emerald, a leading academic publisher. It will be most interesting to people working in the profession and academics working in the area.
I recently wrote an article for Dr. Jim Walker's Forensic Asia, which publishes an excellent newsletter out of Hong Kong. I periodically write for them, and they generously allow me to republish the information here after their readers have had some time with the material.
The attached article is about a month old, but is still current. It outlines the current status of the three terrors affecting foreign investors in Chinese stocks – accounting fraud, regulatory holes, and variable interest entities.
The annual Strategic and Economic Dialogue has come to a close a few hours ago. If past practices are followed, fact sheets on what was agreed will come out in a few more hours.
China’s securities regulator announced that it will begin providing certain requested audit work papers to our market regulators, an important step towards resolving a long-standing impasse on enforcement cooperation related to companies that are listed in the United States.
Those remarks are consistent with reports in the Chinese press from earlier this week. No mention is made of the issues with respect to PCAOB inspections. Maybe that will be in the fact sheets, but I think it would have been significant enough for him to mention, especially in response to the Reuters question.
My reading is that the Chinese have decided to diffuse the SEC case by providing the requested audit working papers, but are unprepared to concede the principle that they control access to these working papers and that PCAOB inspectors cannot operate on Chinese soil.
The Chinese Institute of CPAs is out with their annual rankings of the Top 100 CPA firms in China. The big news is that KPMG is no longer in the Big Four in China. It has been replaced by Ruihua China CPAs, the firm formed by the merger of Crowe Horwath and RSM, which also pushed E&Y to 4th place. The merger did not take place until April 30th of this year, but the CICPA apparently decided to make it effective for their list as of 2012.
The top 10 firms in China for 2012 are:
The new Ruihua firm have asked to remain members of both RSM and Crowe Horwath, but that seems unlikely to work. I believe they will ultimately have to make a choice, and I expect they will choose RSM, which is the larger network (RSM goes by McGladrey in the United States). The decision may be critical to the future of both the winning and losing network. China appears to be the place where the global dominance of the Big Four has been broken, and the firm that allies with Ruihua will be well positioned to serve Chinese companies as they venture abroad. The loser needs to tie up with one of the unaffiliated firms on this list, and it needs to do fast.
This is probably the biggest week in the 30-year history of the Big Four in China.
Today, the hearings before the administrative trial judge of the SEC commenced at 10 am in an auditorium at the SEC headquarters in Washington. At stake is the right of the China affiliates of the Big Four and BDO to audit U.S. listed companies, and more importantly, the ability of U.S. listed Chinese companies to keep their listing.
On Wednesday, the U.S. and China will begin their annual Strategic and Economic Dialogue (SED). I expect that resolution of the standoff between U.S. and Chinese regulators over audit working papers will be on the agenda and I am hopeful that a diplomatic breakthrough will be reached.
The accounting firms and U.S. listed Chinese companies should hope that I am right. I do not think the SEC case will go well for the accounting firms. The final round of pre-trial sparring ended in a ruling requiring the firms to disclose their fees from auditing U.S. listed companies. The firms resisted providing this data, but the judge noted …”it would be helpful to know if a permanent bar on practicing before the Commission for any purpose, even in connection with performing audit work for non-China-based U.S. issuers, would essentially put a Respondent out of business entirely.” I know the answer to that question. No, it would not put the firms out of business entirely, but it will hurt really badly.
The Wall Street Journal printed an op/ed about the auditing of China’s big banks. The op/ed makes a number of misleading or incorrect statements about what is going on with the auditing of China’s big banks.
The piece says that Chinese banks are about to select new auditors because of Chinese rules “seemingly designed to unfairly promote the interests of less-experienced-and more easily influenced-local accounting firms”. What they are talking about is the mandatory audit rotation rules that have been put in place for state-controlled enterprises. What the authors seem to have missed is that this rotation has already taken place.
All of the Big Four banks have already rotated auditors. I wrote about this process last October. Rotation is required every five years, and three of the Big Four banks rotated auditors for 2013. China Construction Bank fired KPMG in 2010 over a fee dispute and selected PwC. CCB will rotate again in 2015, the others in 2018. Despite the author’s fear that “less-reputable” accounting firms will get the work, the Big Four accounting firms captured all of the Big Four banks. Despite the “rule” cited by the authors that no accounting firm can have two banks, PwC now serves two.
LightInTheBox Holding Co. debuted on the NYSE yesterday, jumping 22% in its first day of trading. It has been a long drought in the U.S. IPO market, and many investors are hoping that this is a sign that the MOU between the PCAOB and Chinese regulators might remove enough uncertainty to get the money flowing again.
But just as it looks like it might be safe to get back in the water, up comes the VIE problemagain. Neil Gough had an interesting piece in Dealbook about the late Hong Kong tycooness Nina Wang. It turns out Ms. Wang was using a VIE-like structure to control a Chinese bank starting back in 1995. The VIE and its owner apparently decided to ignore the contracts put in place to give Ms. Wang control, leading her to sue in 1997. Chinese courts can operate slowly, and the case finally led to a ruling by China’s Supreme People’s Court last October. The ruling is a stunner. The court ruled the contractual arrangements invalid because they had clearly been intended to circumvent China’s restrictions on foreign investment, and amounted to “concealing illegal intentions with a lawful form”.
My Wall Street Journal Op/Ed explains my view that the MOU falls well short of what is needed, but I remain optimistic that these issues will soon be resolved. Here is how I see the end game working out.
I believe that the breakdown in the SEC’s negotiations over access to audit working papers that led to charges being filed against the accounting firms caught Chinese regulators by surprise. They had been playing a cat and mouse game with the PCAOB and SEC and had finally been called out on it. My initial assessment was that the SEC actions were going to make it very difficult for both the PCAOB and the SEC to make a deal, since any deal would have to involve China backing down. We know that the CSRC and MOF made some recommendation to the State Council in December, and while we don’t know what that was, we do know that nothing happened for months.