Back in May I raised the question of whether PwC Hong Kong is the principal auditor of Alibaba given that most operations are on the mainland. The SEC has now released its correspondence with Alibaba and I found that they raised this issue with Alibaba. Here is the SEC’s question (italics) and Alibaba’s response (bold).
We note that your audit report is signed by PricewaterhouseCoopers - Hong Kong, although the majority of your operations appear to be in mainland China. We also note your risk factor disclosure that “[i]f the affiliate of [your] independent registered public accounting firm were denied, temporarily, the ability to practice before the SEC, [you] would need to consider with [your] Hong Kong based auditor the alternate support arrangements they would need in their audit of [your] operations in mainland China.” Please tell us how you concluded that it is appropriate to have an audit report issued by an auditor in Hong Kong, in light of the location of your corporate offices, your principal operations, and your principal assets. Please also tell us your understanding of the nature and extent of the work conducted by each firm, including the participation of your Hong Kong based audit firm with respect to the work of its affiliated firm in mainland China.
According to a Reuter’s report by Soyoung Ho that is currently behind Reuter’s paywall, PCAOB chairman James Doty said some discouraging things at the recent meeting of the PCAOB’s Standing Advisory Group about the prospects for an inspection agreement with China.
Doty is quoted to have said that the PCAOB’s effort to inspect auditors in China is “in a difficult and frustrating place”. Doty indicated that he was still hopeful that an agreement could be reached. However, according to the report he said: “It’s getting late to plan an inspection for 2015. That’s what’s discouraging about this. It’s not impossible, but it’s getting late to plan for the 2015 cycle.
According to the Reuters report, proposed agreements “are now in the hands of more senior Beijing officials, and it’s not clear what decision they’ll reach, or when. If PCAOB inspectors are allowed to review audit documents in the People’s Republic, it may not happen before 2016 at the earliest.”
In addition to the PCAOB inspection issue, the SEC decision against the Big Four firms has yet to be resolved. Filings in the appeal have been extended to the end of the year to allow time for settlement, and perhaps Chinese officials want to settle both issues simultaneously.
On November 4, China updated the Catalogue for the Guidance of Foreign Investment Enterprises, which categorizes businesses into encouraged, restrict-ed, or prohibited for foreign investment. Dezan Shira’s China Briefing has a good summary of the changes.
Noteworthy is the inclusion of accounting and auditing as an encouraged in-dustry. Auditors will now be allowed to conduct these services using wholly foreign owned enterprises (WFOEs).
The Big Four currently conduct their auditing practices using limited liability partnerships that originally had 60% locally licensed partners and 40% un-licensed partners. The 40% reduces to 20% over the next few years, and I think it is at 35% for most of the firms right now.
The Big Four conduct their consulting practices (including tax) in wholly foreign owned enterprises that are typically owned by their Hong Kong member firm.
So, will this change result in the Big Four moving their auditing practices to WFOEs? I don’t think so. Under present Chinese rules, a partner in a CPA firm must be licensed as a CPA in China and I expect these rules will also apply to the shareholders of a WFOE. If ownership by unlicensed persons is allowed, then China has just opened the door wider than any other country on earth. Licensing requires the partner to pass the notoriously difficult Chinese CPA examination and meet other not so difficult requirements. The present rules, allowing a per-centage of owners to not have local licenses, is better for the Big Four than al-lowing them to have a WFOE. Additionally, an increasing number of Big Four partners are PRC citizens, and the WFOE alternative does not work for them.
I have recently published two articles on how the accounting standard developed to prevent another Enron was perverted to create Chinese variable interest entities. Accounting standard setters ought to take a hard look at how this standard is being applied.
I remain hopeful that China will, as promised, revise the rules on foreign investment in e-commerce and education and make the VIE structure obsolete.
NQ Mobile (NYSE:NQ) filed its annual report on Form 20F on Monday, nearly 6 months late. NQ was the subject of a Muddy Waters report on October 24, 2013 that sent the stock price tumbling. A board initiated special investigation found no evidence of fraud, but reported that certain information had been erased from electronic devices. Auditor PwC demanded that it be allowed to expand the scope of its work, and NQ fired PwC and replaced them with Marcum, Bernstein and Pinchuk (MBP) a U.S. based auditor that specializes in smaller U.S. listed Chinese companies. MBP was ultimately able to complete the audit and issue the report.
PwC refused to consent to the use of its prior reports on 2011 and 2012, so MBP had to reaudit those years. Curiously, PwC did not withdraw its opinions on those years – it simply refused to consent to their use in the current filing.
One of the issues Muddy Waters raised in their initial report related to the classification of bank deposits as Level 2 assets in the financial statements. Muddy Waters suggested that meant the cash balances were highly likely to not be real. I disagreed with Carson Block on that matter, and got into a twitter fight with him and the lovable and reformed convicted felon Sam Antar of Crazy Eddie fame. In my view, Level 2 is just a description of how the asset is valued, and while practice varies, I believe that Level 2 is the right description for these assets. I was amused to see that all of the bank deposits are still classified as Level 2. I guess that is a fitting ending to my coverage of the NQ saga.
A short selling research group called Anonymous Analytics (AA) published a short report on Hong Kong listed Tianhe Chemicals Group Ltd (1619:HK) on September 2. Tianhe, listed only this past June, was the seventh company at-tacked by AA. While the people behind AA are not identified, I am told by a re-liable source that I know all of them, which suggests they are prominent shorts operating under a pen name. There is the usual menagerie of allegations, and AA published a letter to Tianhe’s auditor Deloitte pointing out some matters Deloitte should be looking into, a technique first used in Muddy Water’s attack on China Media Express in 2011. Deloitte has said nothing publicly, and they won’t unless they either prove the fraud or find that management has lied to them, in which case they will resign.
Tianhe asked the Hong Kong Stock Exchange to immediately suspend trading. That can be a smart strategy since it prevents the shorts from covering while they continue to pay for borrowed stock. Trading resumed a month later after the company responded to the 20 page AA allegations with a 55 page response alleging that AA had fabricated documents, forged signatures, and hacked email. Shares dropped 40% on resumed trading. The company and AA have since trad-ed insults but the stock remains down 54% from its high, suggesting investors believe AA over management.
Alibaba’s record IPO overcame concerns about Chinese stocks. Investors had been badly burned by Chinese stocks in the past few years, but they were en-thusiastic about Alibaba. There was considerable discussion of the risks of Chin-ese stocks, and in particular the variable interest entity (VIE) structure used by Alibaba and many other overseas listed Chinese stocks. These risks remain, al-though Alibaba’s offering might have changed the picture.
Variable Interest Entities
At the top of the list of concerns about Alibaba was the variable interest entity structure. I just searched Google news for variable interest entity and found 881 results. When I first wrote about VIEs in March 2011 nobody was talking about VIEs. It seems difficult to find anyone who is not aware of the structure today. The Alibaba IPO called considerable attention to the structure, including a report from a congressional commission and a letter from Senator Casey to the SEC. Certainly Chinese officials heard an earful about VIEs.
Carson Block of Muddy Waters is shorting 500.com (NASDAQ: WBAI), which did an IPO at the end of 2013. One of the reasons for his short position is the un-usual tax position of the company, which recorded a tax benefit in 2013 equal to 84% of net income.
The tax benefit comes from reversing deferred taxes related to the retained earnings of the companies VIEs. EY is 500.com’s auditor, and I have previously written about how EY clients follow the unusual (although probably correct) ap-proach of providing deferred taxes for the tax cost of transferring profits out of the VIEs.
500.com has revised its VIE agreements and now argues it no longer has to provide those taxes, so they have been released to income.
500.com did this by having its wholly foreign owned enterprise (WFOE) assign certain of these contracts to its Cayman Islands company. It argues that assign-ment makes the Cayman Islands company the principal beneficiary of its VIE. It then takes advantage of an old accounting standard known as APB 23 to argue that the profits are indefinitely invested in the VIE and do not require deferred taxes to be recorded. APB 23 only applies in cross border situations, so it was unavailable when the WFOE was the principal beneficiary of the VIE. but by making the Cayman Islands company the beneficiary, it creates a cross border situation.
BDO’s China member firm, Lixin (BDO China), is currently the fourth largest CPA firm in China, ahead of both KPMG and EY. Lixin is not to be confused with BDO Da Hua, a Chinese firm formerly affiliated with BDO that withdrew from the BDO network and abandoned U.S. listed client audits after being sued by the SEC in the working papers dispute.
BDO China is currently in a tussle with BDO’s Hong Kong member firm. BDO China set up two firms in Hong Kong – Shu Lun Pan Union (HK) CPA Limited and BDO China Shu Lun Pan (HK) Management Limited. BDO HK argues that setting up these companies clearly violated BDO’s territorial regulations and has insisted that the companies be closed immediately.
Why would BDO China need an operation in Hong Kong when there is already a BDO member firm there? It is because the two firms do not share profits. They are separate firms with different owners.
BDO China needs to have a Hong Kong CPA firm sign off on Red Chips (state controlled mainland companies with offshore holding companies listed on the HKSE like China Mobile) and P Chips (privately owned companies with offshore holding companies listed on the HKSE like Tencent). A 2011 deal between China and HK allows BDO China to sign off on H-shares, but not Red Chips or P-Chips. Why not use BDO HK to sign off? This is probably because BDO HK probably wants to do the audit and keep all the fees.
Revenue recognition is always one of the most important accounting issues under US GAAP. Management is often under pressure to book sales before the end of a period, and salesmen are usually not paid commissions until the sale qualifies to be booked as revenue by the company.
Present US accounting standards (Concept Statement No. 5) require that four conditions exist before revenue is recognized:
1. Persuasive evidence of an arrangement exists;
2. Delivery has occurred or services have been rendered;
3. The seller’s price to the buyer is fixed or determinable; and
4. Collectability is reasonably assured.
This post focuses on the first condition – persuasive evidence of an arrange-ment. The SEC has provided guidance on this point in SAB Topic 13 – Revenue Recognition. The SEC says that if a company has a business practice that uses contracts, then persuasive evidence of an arrangement means a final agreement that has been executed by properly authorized personnel of the customer. In other words, before you can recognize income, you need a contract that is sign-ed by someone with the authority to sign.
There are two recent papers on reverse mergers that may be of interest to my readers.
The first, by Jordan Seigel of Harvard and Yanbo Wang of Boston University, is the most thorough analysis of reverse mergers I have come across. They find there were 444 reverse mergers of Chinese companies into U.S. shells between 1996 and September of 2012. While companies in other countries have done reverse mergers with U.S. companies, only Canada (with 405 in the same per-iod) comes close to China.
Seigel and Wang posit that there are two reasons why a Chinese company might do a reverse merger with a U.S. company. First, it would be to access the sup-erior corporate law of the U.S. That is nuts. While Zhu Rongji chose to list some of the largest SOEs in the U.S. in order to use U.S. corporate governance pract-ices to help reform the companies, I would wager that not a single private bus-inessman in China would incorporate in the U.S. to give his shareholders greater protection. The second reason they advance is that companies do this to commit fraud. That might be possible in some cases, but I don’t think the majority of reverse mergers set out on a plan to commit fraud.
The Hong Kong Institute of CPAs (HKICPAs) has finally gotten around to pun-ishing Ernst & Young and its former senior partner Anthony Wu for a serious independence violation. The disciplinary process was finally concluded nearly 20 years after the violations took place. Anthony Wu was a high profile CPA in Hong Kong and HKICPAs was obviously reluctant to pursue the case.
The case against Wu was a slam dunk. He signed checks for an EY audit client. His defense was laughable – he only did it when other signatories were unavail-able and had approved the payments. He also served as an advisor to the com-pany, and was involved in loans to the company. Wu’s only credible defense was that, by taking 20 years to prosecute him, his defense was undermined. But he and EY had been told to preserve documents and had not done so.
EY was found guilty of not supervising Wu. EY’s management committee had been informed of what Wu was doing and did not stop him. Neither did the audit partner, Catherine Yen, who was found guilty of violating independence rules as well for signing despite Wu’s activities impairing EY’s independence.
Drew Bernstein, Co-managing partner of Marcum Bernstein & Pinchuk LLP has written a response to my recent post about NQ Mobile’s auditor change. I have a great deal of respect for Drew. As I said in my post I think he is among the best of the non-Big Four firms working the Chinese market. He might actually be better than many of the Big Four audit teams working on U.S. listed clients. But the Big Four brand is expected by many market participants, and this will always prove a challenge for specialty firms like Drew’s. Nonetheless, MarcumBP was probably the best alternative for NQ Mobile in this situation.
I would like to thank Paul for his regular stream of sharp, well-informed observ-ations about auditing Chinese companies listed overseas, as well the positive comments about my firm, MarcumBP, in this piece. At the same time, I would like to clarify some issues that might cause confusion for the casual reader of this commentary.
As Paul knows firsthand, auditing U.S.-listed Chinese companies is a complex business. To be effective, an auditor must have in-depth knowledge of China’s business practices and regulatory framework, and be highly trained in ever evol-ving SEC accounting rules. While China has grown into an economic superpower, its legal and business information practices are still that of a developing country. An American auditor without experience in China might have great dif-ficulty adequately testing the financial statements. High-level expertise in U.S. GAAP and SEC accounting issues are still in short supply in China.
NQ Mobile (NYSE:NQ) fired auditor PwC Zhong Tian and replaced them with Marcum Bernstein Pinchuk LLP (MBP). MBP is a joint venture between 14th ranked U.S. CPA firm Marcum and unranked Bernstein Pinchuk. The joint venture audits 18 SEC registrants, ranking it 4th by number of SEC registered clients in China (but much smaller if ranked by revenue). I have considered MBP to be among the best of the small firms working the China market. Unlike some of their peers they understand China and actually do audits. The 2013 PCOAB inspection of MBP found no deficiencies in their audit work.
NQ Mobile was the subject of a report by Muddy Waters last October alleging widespread fraud. Some of Muddy Waters allegations were easily dispelled. A special investigation by Deloitte and Shearman & Sterling failed to uncover evidence of fraud, but did report missing data.
The company missed the deadline (April 30) for producing its annual report on Form 20F apparently because PwC would not sign the required audit report. The company announced that its audit committee chairman had resigned (ostensibly for personal reasons). The stock was badly beaten up.
Bloomberg today reported that the Alibaba offering is sailing through regulatory review at the SEC. That is not surprising, since it appears Alibaba assembled an army of advisors to make that happen.
Senator Robert Casey of Pennsylvania wrote to SEC Chairwoman Mary Jo White to ask her to focus on the VIE structure and the risks it poses for American investors. Casey asked the SEC to give him an analysis of how the SEC reviews VIEs. I hope he releases that analysis.
I think the SEC is doing its job with respect to VIEs. The quality of disclosures has improved significantly over the past few years. Investors who read those disclosures are informed, and they obviously think that the risks are worth taking.
The Big Four accounting firms in Hong Kong took out an ad in Hong Kong newspapers opposing the democracy initiatives currently underway. This FT article has a translation of the ad and an analysis.
Twitter erupted with criticism of the firms:
Am I naive or is this outrageous meddling? Big four accounting firms warn Hong Kong over democracy push. http://t.co/DucKB7N1pa
6/28/14, 10:10 PM
When @FT asked big four’s global headquarters for comment, "it emerged they had only learned of the advertisement through press reports."
6/28/14, 5:45 AM
"@SimonCYWong: Big Four audit firms sell out #HongKong: "It’s an act of cowardice" http://t.co/dwcGTimuWK " #spineless Big 4?
6/28/14, 12:08 AM
It is assumed by many that the firms were pressured by their clients (the largest of which are Chinese state-owned enterprises) to place this ad. Certainly there are few instances in the past where the firms have spoken out in one voice for social reforms.
The arrogance of the firms is stunning. Did they really think their voice would alter the debate? Do they really think people respect their opinions that much? Did they not see that all they were doing is setting themselves up for ridicule while diminishing their brand worldwide?
The U.S.-China Economic and Security Review Commission has issued a staff report titled: The Risks of China’s Internet Companies on U.S. Stock Exchanges. The commission advises Congress on matters related to economic issues in China.
The report focuses mostly on the variable interest entity structure and heavily cites this blog. There is nothing new in the report that has not been covered here, but it is a good summary of the issues.
It is noteworthy that the Commission took up the issue. While VIEs are risky to investors, there is unlikely any serious risk to the U.S. economy from VIE problems. The report does point out the $18 billion lost by investors in Chinese reverse mergers. The market cap exposed to VIE risks is considerably higher. Certainly, having such a high level body raise this issue will increase investor anxiety ahead of the Alibaba offering.
The proposal by the Ministry of Finance to reform regulation of auditors of overseas listed companies created a firestorm in Hong Kong. Meetings with mainland regulators and interested parties took place in Hong Kong this week. A senior partner of one of the second-tier firms told an academic conference on Tuesday that if the proposal went into effect he would have to fire half of his staff.
The proposal to bring the audits of overseas listed Chinese companies under MOF regulation is an excellent one, and long overdue. This has been a regula-tory hole – ignored by Chinese regulators who blocked foreign regulators from filling the gap.
The proposal, however, threatens the livelihood of many Hong Kong CPAs. One of the provisions requires overseas firms, including Hong Kong firms, to use a Chinese affiliate selected from the top 100 Chinese firms to do the audit work on the mainland. That is the rule that concerns Hong Kong CPAs.
The Hong Kong Stock Exchange long ago gave a franchise to Hong Kong CPAs by requiring their signature on any listing in Hong Kong. That franchise eroded a little over the years, first as some of the big Hongs like Jardines and Swire left Hong Kong before handover and their audits moved to London. Then China forced open the market to audit H-Shares and now Chinese firms, mostly Big Four affiliates, audit some of the H-Shares. But exchange rules require that all Red Chips and private Chinese companies use a Hong Kong auditor.
Hong Kong accountants are up in arms over a proposal (English translation) by the Ministry of Finance to more closely regulate the auditing of overseas listed Chinese companies. Mainland regulators told Hong Kong officials that they do not intend to close off the mainland to Hong Kong accountants, although the proposed rules may well lead to that. But that is not the most important part of this story.
The MOF is bringing audits of overseas Chinese companies under Chinese regulation.
That is a good thing. Chinese regulators previously washed their hands of U.S. listed Chinese companies. I am unaware of any executive or auditor of an alleged fraud involving a U.S. listed company ever facing justice in China, yet China also blocked U.S. regulators from doing anything. Chinese accounting firms have been unfairly maligned by shoddy work done by fly-by-night reverse merger auditors from former U.S. penny stock havens like Salt Lake City and Denver. China is cracking down on those firms, and establishing regulatory control over the auditing of overseas listed Chinese companies. Some Hong Kong accountants may be unexpectedly caught in the process.
I wrote last December about a discussion going on in Hong Kong about whether to toughen audit regulation to bring Hong Kong in line with global practices. Hong Kong had suffered the insult of losing regulatory equivalency with the EU in accountancy because of its weak regulatory regime. The Hong Kong Institute of CPAs (HKICPAs) led the debate, and based on comments most members seemed aghast at the concept of tough audit regulation. The HKICPAs concluded its consultation with members on January 17, 2014 and the debate went silent.
I hope the issue gets revived. Hong Kong practices self-regulation in account-ancy. That means the accounting firms regulate themselves. After Enron, the rest of the world pretty much concluded self-regulation does not work. It is not working in Hong Kong.
I offer as evidence the case of former EY senior partner Anthony Wu. Wu was found to have violated auditor independence rules because he was a member of the client’s executive committee, authorized signer on 13 client bank accounts, had significant personal dealings with client subsidiaries, loaned the client money, and had EY collect a retainer for his services as a financial advisor. The client, New China Hong Kong Group collapsed in 1999, spawning a series of claims. Eventually complaints were filed with the HKICPAs about Wu, another EY partner and EY itself. Auditor independence is fundamental to the accounting profession, so the allegations were serious.