In December, I posted about how Autohome had provided a deferred tax liability on the profits accumulated in its VIE, while other companies in similar situations have not done so. I found an additional company, Soufun, that has also provided deferred taxes on VIE retained earnings. Both Soufun and Autohome are audited by Ernst & Young.
I have been told my post set off a flurry of activity in the accounting firms as they tried to find a way to justify not recording deferred taxes. The IPO filing of Ikang Globin Health Care Group, Inc. shows how accountants plan to deal with the issue.
Aggregate undistributed earnings of the Company’s VIEs and its VIEs’ subsidiaries located in the PRC that are available for distribution to the Company were approximately $8,120 as of March 31, 2013. A deferred tax liability should be recorded for taxable temporary differences attributable to the excess of financial reporting amounts over tax basis amount in domestic subsidiaries However, recognition is not required in situations where the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the enterprise expects that it will ultimately use that means. The Company has not recorded any such deferred tax liability attributable to the undistributed earnings of its financial interest in VIEs because it believes such excess earnings can be distributed in a manner that would not be subject to income tax.
My book, The Big Four and the Development of the Accounting Profession in China, is out in print.
The decision by the SEC’s administrative law judge (ALJ) to ban China’s Big Four accounting firms for six months creates serious uncertainty for U.S. multina-tional corporations (MNCs) with significant operations in China. If the ALJ’s decision stands, the ban would mean that the China member firms of the Big Four would be unable to participate in the audits of U.S. listed MNCs, jeopard-izing the ability of these MNCs to file the financial statements required to remain listed in the U.S. Audit committees need to have a plan B.
The China Big Four firms have appealed the ALJ decision to the full SEC Com-mission. I understand that the Commissioners have seven months to make a decision, although they can extend that period. In a worst-case scenario, they could act tomorrow, but I think it is unrealistic to think that they would do so. A realistic worst case is that they act in September as the seven months ends. While I expect the Commissioners to affirm the ban, I am hopeful that they will restrict it to foreign private issuers, exempting work on MNCs. The SEC asked the ALJ to limit the ban this way, but the ALJ did not believe he had the author-ity under the law to do so. I hope the Commissioners decide they have that authority. If the Commissioners limit the ban to foreign private issuers, there should be no problem for most MNCs. The U.S. Chamber of Commerce ought to be screaming at the SEC to do this. Foreign private issuers (U.S. listed Chinese companies), however, are screwed but their plan B is not the subject of this post.
I came across this one-post blog called Chinese Stock Fraud. The most interest-ing information is a list of Chinese stock frauds in Singapore, Hong Kong, and the U.S. and Canada.
The author lists 121 companies; 54 in the US and Canada, 44 in Hong Kong, and 23 in Singapore. It is the best list I have seen of Hong Kong and Singapore frauds. A number of alleged but unproven frauds are not included, even though some of these remain suspended from trading (i.e. AMBO, FU). The author lists no alleged frauds on Chinese exchanges.
One of the great challenges for academic researchers has been coming up with a comprehensive list of Chinese frauds.Zigan Wang of Columbia wrote a paper explaining the difficulty involved in just identifying U.S. listed Chinese firms. Because these companies are usually incorporated outside of China, a list of Chinese companies listed overseas must be derived from secondary inform-ation, like location of head office or percentage of assets in China.
I am encouraging a graduate student to take on a project to create a compre-hensive list of Chinese frauds. The first task is to define a fraud, and that may lead to several lists. Short seller attacks, auditor resignations, delistings, and class action lawsuits are all indicators of fraud but do not definitively establish that a company is a fraud. Such lists, however, may provide the basic data to determine what factors lead to fraud.
The SEC has paid great attention to the disclosures related to VIEs and investors today have considerably more data to evaluate the risks of these structures. Companies have been forced to disclose much more information. For example, New Oriental’s 2008 financial statements included 494 words discussing VIE arrangements. By 2012 this had grown to 3,024 words. There is so much data available that Fredrik Oqvist has created a database to make sense of it. The database is useful to scholars and investors who are studying the risks of VIEs.
It has been very difficult to evaluate VIE risks of companies listed in Hong Kong. Hong Kong listed companies follow IFRS, which has not required the same disclosures that the SEC requires for companies following U.S. GAAP. It is often difficult to figure out if a Hong Kong listed company even has a VIE structure. That is about to change.
Two years ago I posted about a pending change in IFRS that would require VIE disclosures. That change was effective on January 1, 2013, so we are about to see 2013 financial statements issued under the new rules. PwC has a great book on how the changes will work.
PCAOB Chairman James Doty presented his budget to the SEC Commissioners today. Doty said:
Gaining access to audits of Chinese registered firms has been particularly challenging. But I am grateful to the Secretaries of the Treasury and State for their inviting me, with your support, to participate in the Strategic & Economic Dialogue in each of the last three years.
These meetings proved instrumental to achieving some success. In 2013, we were able to reach an enforcement cooperation agreement with Chinese authorities.
Based on recent discussions, I am also optimistic that we will be able, during 2014, to sign a long-sought agreement to inspect the audit work of PCAOB-registered firms based in China.
In comments to reporters Doty indicated that China and the PCAOB are exchanging draft agreements. The Chinese are having a problem with the PCAOB conducting inspections on the ground in China. Doty indicated they are looking at alternatives including moving the papers and making people available outside of China. Since I am married to a Big Four audit partner, I suggest that the inspections take place in an American location with nonstop flights from China.
Many people have asked me if the Big Four could circumvent the SEC ban by having the U.S. or Hong Kong firms sign the audit opinions. The short answer is no, and for several reasons.
In order for a U.S. or Hong Kong firm to serve as the principal auditor who is allowed to sign the report, the firm:
...must decide whether his own participation is sufficient to enable him to serve as the principal auditor and to report as such on the financial statements. In deciding this question, the auditor should consider, among other things, the materiality of the portion of the financial statements he has audited in com-parison with the portion audited by other auditors, the extent of his knowledge of the overall financial statements, and the importance of the components he audited in relation to the enterprise as a whole (AU 543).
In plain English, that means that in order to sign, you actually have to do the audit, or most of it. The firms cannot just sign the report in the U.S. or Hong Kong; the U.S. or Hong Kong firms must actually do the audit.
Predictably, the Big Four firms are wailing about the SEC decision against them yesterday. One firm has complained that “this is a profession-wide issue, and not one of the profession’s own making”. The judge disagreed; finding that “to the extent the firms find themselves between a rock and a hard place, it is be-cause they wanted to be there”. The China Big Four partners would have prob-ably understood this better if the judge had used a Cantonese idiom: 食得鹹魚抵得渴 (Those who eat salty fish must put up with the thirst). The firms did not have to get into the business of serving U.S. listed Chinese companies.
As much as the firms are feeling sorry for themselves, it is their clients and the investors in those clients who will be hurt if the firms are banned from practice. A ban could lead to the companies being kicked off of U.S. stock exchanges for failing to produce audited financial statements. IPOs would have to be post-poned until the bans were over. Financings would be delayed. Fortunately appeals are likely to delay this for a long time.
Cameron Eliot, Administrative Trial Judge of the SEC, threw the book at the China Big Four today, suspending them from practicing before the SEC for six months in a 112-page opinion, parts of which were redacted because they reported interactions between the SEC and CSRC “more candidly than is customary in diplomatic circles”. While he may have been kind to the CSRC, he took the hide off of the Big Four. The firms, especially PwC, were probably feeling a little raw already from the blistering they received in the ICIJ report yesterday on how they aided Chinese elites to get money offshore.
BDO DaHua was censured by not banned. Dahua has pulled out of BDO and I do not believe it has any U.S. listed clients anymore.
The suspension will not begin until the Commission enters an order of finality. The firms can request review within 21 days or the Commission can decide to review it anyway. If the commission goes ahead and finalizes the decision, the Big Four could appeal to federal Circuit Court of Appeals and ask for a stay of the decision. That could delay the problem for a long time, but that may not be the best outcome for the firms or their clients.
The SEC brought administrative charges against the Big Four and BDO’s then China affiliate on December 3, 2012 for failure to turn over audit working papers to the SEC. Separate charges against Deloitte had been brought on May 9, 2012. At risk is the right of these firms to practice before the SEC. If this right is revoked, U.S. listed Chinese firms may find themselves without an auditor and consequentially be kicked off of U.S. exchanges. Under SEC rules, the presiding administrative law judge is to issue a decision within 300 days. On March 8, 2013, the SEC approved a delay in the case against Deloitte and put the Deloitte case on the same timetable as the rest of the firms – October 11, 2013.
A hearing was held in Washington between July 8 and July 31, 2013.
The CSRC reached an agreement with the PCAOB to release working papers in connection with investigations in May 2013, but continued to block the PCAOB from doing inspections of accounting firms. The CSRC began to release the working papers that the SEC had requested. The firms asked the judge for a summary disposition of the case because the SEC had found another way to get the working papers. The judge dismissed this request on December 6.
Again in 2013, Hong Kong placed first in the Heritage Foundation’s Index of Economic Freedom, which measures its view of the economic freeness of various countries. The index focuses on the presence of the rule of law and the absence of government regulation. On the latter point Hong Kong does particularly well, scoring 98.9 in Business Freedom compared to 90.5 for the United States and 48.0 for China.
Of course, business rarely wants no regulation – after all that might lead to excessive competition. The professions have long sought closure – blocking outsiders from the work of the profession in exchange for regulatory oversight. Milton Friedman in Capitalism and Freedom observed this behavior: “the pressure on the legislature to license an occupation rarely comes from the members of the public . . . On the contrary, the pressure invariably comes from the occupation itself.”
The accounting profession secured a particularly sweet deal in Hong Kong. They blocked access to their lucrative market to accounting firms from outside Hong Kong while convincing regulators to allow them to regulate themselves through the Hong Kong Institute of CPAs (HKICPAs).
There are signs that there may soon be a regulatory breakthrough on overseas IPOs of Chinese companies.
The Singapore Exchange (SGX) and the China Securities Regulatory Commission (CSRC) reached a deal to allow Chinese companies to list directly in Singapore, that is, without using an offshore holding company. While there are hundreds of Chinese companies that have listed overseas, only large SOEs tended to get the necessary permission to list directly. The rest used offshore structures, typically with a Cayman Island holding company, to get around Chinese regulations. The offshore structures contributed to the regulatory mess that ensued, where Chinese regulators did not regulate the companies because they were not Chinese, and foreign regulators could not regulate them because China would not let them have access to the people and records in China.
Now Chinese companies can directly list in Singapore after their applications are approved by both CSRC and SGX. The agreement, however, does not deal with the troublesome variable interest entity (VIE) structure that is used to circumvent Chinese rules restricting foreign investment in certain sectors.
Autohome (NYSE:ATHM) had a successful debut on Wednesday with the shares popping 80% above the offering price. That is the seventh IPO in the U.S. this year, ending a drought. Investors seem less spooked by the VIE structure and risk of regulatory problems with the SEC and PCAOB. None of those issues have been fixed, but investors seem convinced that they will not escalate. Despite recent short seller attacks at Fab Universal (successful) and NQ Mobile (largely unsuccessful) investors seem comfortable that they will not be victims of yet another Chinese accounting fraud.
Unless sentiment changes, I am thinking that 2014 could be like 2007 with perhaps as many as 30 U.S. IPOs. That will hardly make a dent in the backlog of private equity money waiting for an exit, but it will be a good start.
Autohome’s filings present a fascinating new issue. Autohome has accrued a deferred tax liability of $75 million for “outside basis difference”. While this issue has been bouncing around for some time, I believe this is the first time that a company has recorded the liability.
Investors in Chinese companies have been badly burned by CEOs who seem to forget that they have shareholders. Some CEOs have sold assets out of the company and kept the proceeds. Some have just cleaned out the bank accounts. Others have taken the whole company. The variable interest entity (ViE) structure, where companies are controlled with contracts is a common enabler of these scams. Shareholders have little, if any, legal protection when things go wrong with a ViE.
A recent case highlights the problem. FAB Universal (NYSE:FU) came to market in 2012 through a reverse merger with a Pittsburgh headquartered company. The company was listed on the NYSE. Investors would have been prudent to take the company's ticker symbol as prescient.
FU recently came under attack by short sellers. Jon Carnes (aka Alfred Little) is one of the more lethal predators in the pack of short selling research firms that have circled U.S. listed Chinese companies for the last few years. Carnes alleged the company was a scam, selling pirated videos from nonexistent retail locations. A few days later another short selling research firm, GeoInvesting, disclosed a tip it had received that FU's VIE had issued a $16.4 million bond in China and had not bothered to record it in its financial statements.
An essential component of any VIE structure is a service contract between the wholly foreign owned enterprise (WFOE) and the VIE. The purpose of this contract is to enable the WFOE (which is owned by the public company and its shareholders) to extract the profits from the VIE (which is owned by a Chinese individual). Without this contract the public company has no economic interest in the VIE, and cannot consolidate the VIE in its financial statements. More important than the issue of consolidation is that unless the contract is effective, the public company owns nothing and may be worthless.
The problem with these contracts is that companies selectively apply them, if they apply them at all. The contracts usually provide that the WFOE can charge a fee to the VIE for services rendered that is equal to the entire profits of the VIE. There are a bunch of problems with that.
First, these companies often need their cash in the VIE, not in the WFOE. So, if the profits are transferred from the VIE to the WFOE, the VIE may be short of cash. While direct loans between Chinese companies are not allowed, it is possible for the WFOE to loan the cash back to the VIE in the form of entrusted loans. Entrusted loans are permissible for the accumulated earnings of a WFOE, but cannot be used for funds that were contributed to capital of the WFOE.
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 charges related to 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.