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.
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.
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.
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.
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.
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 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.
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.
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.
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.
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."
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.
Ernst and Young (EY) Hong Kong lost an important case in Hong Kong that may have widespread impact on the profession and the securities markets.
The South China Morning Post reports that the Court of First Instance on Friday rejected EY's plea that it could not hand over to the Securities and Futures Commission the auditors' working papers relating to mainland listing candidate Standard Water as they constituted a "state secret".
This case was particularly embarrassing for EY, since its Hong Kong affiliate served as accountant of record for Standard Water’s proposed IPO, despite doing nearly no audit work. Instead, the audit was done by EY’s mainland affiliate. When SFC asked to see the working papers, EY said they did not have them – a violation in itself, and that its mainland affiliate, EY Hua Ming, had refused to turn them over citing state secrets. EY was finally cornered in Court and had to admit they actually had the work papers on a computer that had been brought to Hong Kong, but said that China’s state secrets laws prohibited them from turning the papers over to SFC.
A new front has opened in the dispute between China and the United States over audit regulation. China has blocked the PCOAB from required inspections of auditors of U.S. listed Chinese companies based on arguments of state secrecy and national sovereignty. Chinese regulators have argued that they cannot allow the inspections of audits where the working papers might include state secrets. An attempt to set up a pilot program apparently fell apart when U.S. and Chinese negotiators were unable to agree on which companies could be excluded from an inspection program. PCAOB Chairman James Doty in remarks to the Standing Advisory Group of the PCAOB suggested that the problem is the myriad of Chinese bureaus that have a say in the matter.
The new front is in banking. Kering SA, owner of the Gucci brand, has sued counterfeiters in U.S. courts and has issued subpoenas to the Bank of China for information about transactions of the counterfeiters. Despite orders from a federal judge, the Bank of China has refused to turn over the information, saying that to do so would violate Chinese law.
Bloomberg reported this week that a final agreement between the PCAOB and Chinese regulators over inspections of Chinese audit firms has fallen through. The article says that the Chinese had so narrowed the terms of inspections that the PCAOB decided it was not worth pursuing the deal.
The PCAOB is the regulator of accounting firms that audit US listed companies, and its most important function is to periodically inspect the accounting firms to make certain that they are following US auditing standards. China has not allowed the PCAOB to conduct inspections in China, even of international firms, since it considers allowing foreign regulators to enforce foreign laws on Chinese soil to infringe on its national sovereignty.
There are no good options left for the PCAOB. Successful short seller attacks indicate that fraud and auditing failures continue to be a problem in China. The only real tool left in the PCAOB toolbox is to deregister the accounting firms that it cannot inspect. But this option would quickly lead to the delisting of Chinese companies from US markets, including companies like Alibaba and Baidu.
Valeant Pharmaceuticals International (NYSE: VRX) (Valeant) was recently the subject of a research report by Citron that alleged the company was the pharmaceutical Enron. The best summary is here by Bronte Capital. The stock price has collapsed and allegations continue to fly. Interestingly, the allegations swirling around Valeant relate to the accounting rule that was created to stop the abuses exploited by Enron – the variable interest entity (VIE).
Citron alleged that Valeant had a network of phantom pharmacies operated by Philidor. Valeant had an undisclosed option to purchase Philidor and consolidated the financial statements of Philidor on the basis that it was a VIE but did not disclose this accounting because the operations were deemed immaterial at 7% of sales. Citron alleged channel stuffing at the phantom pharmacies. Valeant stated that consolidation meant that sales to the VIEs could not be recognized until there was a sale to an outside customer. Valeant’s explanation of the accounting seems plausible, although I question whether the argument that VIE disclosures can be omitted at that level of materiality is correct.
NEEQ has listed 3,365 companies since 2013. The 3,751 listed companies are mostly microcaps. Listing on the NEEQ is easy. Unlike China’s exchanges, there are no requirements that the companies be profitable or growing. China’s security regulator has little involvement and local CPA firms typically audit the listed companies.
Sound familiar? Yes, it appears to be a Chinese version of the reverse merger technique used by many companies to quickly list in the United States. That technique collapsed in wave of fraud. The problem with many reverse mergers was that the market was that poorly regulated and unscrupulous promoters and advisors took advantage of the lack of regulation to perpetrate frauds on the market. There is a big difference, however. US regulators could not investigate or punish fraudsters located in China. Chinese regulators can.
The Public Company Accounting Oversight Board (PCAOB) has not been allowed to inspect accounting firms in China, despite the fact that hundreds of Chinese companies are listed in the United States and their auditors are required to be inspected. China has blocked the inspections because they consider allowing foreign regulators to enforce foreign rules against Chinese persons on Chinese soil to violate China’s national sovereignty, and because of concerns that audit working papers might contain state secrets. Recent academic research suggests it may be in China’s best interest to allow the inspections.
MIT professor Nemit Shroff authored a study titled Real Effects of Financial Reporting Quality and Credibility: Evidence from the PCAOB Regulatory Regime. Professor Schroff examined the clients of non-US auditors that were inspected by the PCAOB and found that audit quality on all of their clients improved, not just those listed in the US and subject to PCAOB and SEC jurisdiction. In other words, there is a spillover effect. PCAOB inspections improve all of the audits, not just the US audits.
A recent activist short selling report on Hong Kong listed China Zhongwang Holdings (1333 HK) alleges an elaborate scheme the heart of which is the alleged sale of billions of dollars of aluminum to companies controlled by the Chairman’s family and proxies. I have no opinion as to whether the allegations are correct, but they do illustrate a problem I see as a major obstacle to corporate governance in Asia.
The report lays out what are alleged to be undisclosed related parties. Hong Kong has strict rules about related party disclosures, probably because Asians seem to have a preference in doing business with the family. That is, of course, of great concern to investors, since profits can easily be tunneled out to insiders by mispricing related party transactions.
From what I can tell, however, most of the alleged undisclosed related parties may not be related parties under the rules, or it may be impossible to prove that they are. The rules that define a related party are set forth in Hong Kong Standard on Auditing 550 and define a related party as one of these situations:
One of the major problems with Chinese companies that use the US capital markets has been the inability of US regulators to effectively regulate them. The Public Company Accounting Oversight Board (PCAOB) regulates auditors of all US listed companies, but has been banned from conducting inspections of these accounting firms in China because China has viewed the enforcement of foreign laws on Chinese soil by foreign regulators to be a violation of its national sovereignty.
The PCAOB has been unsuccessfully negotiating for access for over a decade. A measure of cooperation was reached in 2013 when Chinese regulators agreed to cooperate with the PCAOB on enforcement matters. Enforcement, however, is a small part of the PCAOB’s mandate, and they have remained blocked from doing inspections on Chinese soil. That included Hong Kong to the extent the matters related to the mainland. China has blocked the removal of audit working papers from the mainland, meaning there was no alternative way to conduct the inspections.