Postings | China Accounting Blog | Paul Gillis


State Council and PCAOB/SEC

Securities Times reports today that the Ministry of Finance and CSRC submitted recommendations to the State Council on how to resolve the impasse over regulation of auditing. There is no report on the nature of the recommendations, only that the State Council attaches great importance to the matter. Bloomberg has reported on this. 

The recommendations were apparently submitted before the end of last year. 

Accounting wars

I recently penned a piece for Forensic Asia called Accounting Wars: Transnational Regulation in China. It summarizes my previous writings on this topic.  I recommend Forensic Asia for those who follow Asian securities. 

The SEC has responded to Deloitte’s request that the case related to Longtop’s working papers remain stayed until the SEC case against the rest of the Big Four and BDO is resolved.  The SEC points out that the cases have differing objectives. In the Longtop case the SEC wants working papers to be produced. In the administrative proceeding the SEC is seeking to censure or revoke the right of the firms to practice before the SEC (page 6).   

There has been no news from the PCAOB. The recent fiasco at Caterpillar will up the pressure on the PCAOB to resolve the inspection situation, since it illustrates that accounting problems in China extend to multinationals as well. The Caterpillar case appears to be a failure in due diligence, rather than an audit failure – indeed Caterpillar’s auditor appears to have not been involved in the transaction, which blew up before an audit was completed. Reports have said that two Big Four firms (other than Caterpillar’s auditor) were involved in the due diligence.  

Caterpillar's reverse merger

Caterpillar announced last Friday that it had uncovered accounting misconduct at a recent Chinese acquisition and that it would be taking a non-cash $580 million goodwill impairment.

In June 2012, Caterpillar had acquired ERA Mining Machinery Limited (ERA), a Cayman Islands company listed on Hong Kong’s GEM market.  ERA’s operations were mostly conducted through Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. (Siwei). ERA had gone public in Hong Kong through a reverse merger. 

Caterpillar says this about the scandal:

Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition. This review is ongoing.

Is the SEC suing the wrong audit firm?

Deloitte has filed papers with Federal District Court arguing against the SEC’s motion to lift the stay. The judge had agreed to stay the case while the SEC tried to negotiate with the CSRC to obtain access to the working papers sought from Deloitte in the Longtop case. The SEC threw in the towel on negotiations, and asked the judge to lift the stay and proceed to rule on whether Deloitte must produce the working papers. 

Basically, Deloitte argues it would be mean to Deloitte to continue this case, since it might result in them getting punished ahead of the other firms that have since been charged with similar misconduct. I recall using a similar argument when I was in the third grade to defer punishment, and my appeal was denied. I expect that Deloitte gets the same treatment from the judge that I got from my third grade teacher.

There is a statement in the filing that appears incorrect to me, and it raises some significant issues. 

The filing says: Effective January 1, 2013, DTTC changed its name to “Deloitte Touche Tohmatsu CPA LLP (LLP). I don’t think that is what happened. Like all of the Big Four firms, Deloitte is required to move its audit practice into a new entity. It used to practice in Deloitte Touche Tohmatsu CPA Ltd. (LTD). LTD is a Sino-foreign joint venture.  That joint venture passed the end of its 20-year life. Deloitte, like the other Big Four firms, was required to establish a new firm in the form of a special general partnership.  The special general partnership is essentially the same as a limited liability partnership in other countries, and Deloitte appears to have adopted the LLP term in the name of its new China entity. 

Transparency of deregistration process

I have said that I think the most likely outcome should PCAOB negotiations with Chinese regulators fail is a rule-making proposal from the PCAOB that will move to deregister all firms it cannot inspect. 

A reader has pointed out another option for the PCAOB.  The PCAOB could begin the process of administering an administrative sanction against each individual firm that it cannot inspect. Under PCAOB Rule 5100, the PCAOB can issue a temporary suspension or a permanent revocation of the registration of firms it finds to have violated SEC or PCAOB rules and standards. 

If this approach were taken, it is likely that the PCAOB would bring a separate action against each of the 9 mainland firms and 17 Hong Kong firms that issue reports on U.S. listed companies.

The problem with this approach is that it is unfair to investors and U.S. listed companies. 

One of the big problems with the PCAOB is that Sarbanes-Oxley provides that investigations of registered accounting firms are confidential.  The PCAOB cannot advise the public that a firm is under investigation. The public is only informed when the disciplinary action is made public at its conclusion. Because firms can delay the final disciplinary action through appeals and other tactics, it may be years before the public is made aware that there is a problem. During this period investors may continue to rely on audits that the PCAOB has determined are defective, since auditors may continue to issue audit reports while the disciplinary process works its way through the system.  

The inspection cliff

I was wrong. The PCAOB was supposed to complete its inspections of registered foreign accounting firms by December 31, 2012. This deadline was extended from December 31, 2009 by a previous rule making action of the PCAOB that was approved by the SEC. The PCAOB failed to complete the required inspections because of difficulty in securing agreements with a number of countries, most notably China. And it did nothing.

I had predicted that the PCAOB would not go off the “inspection cliff” without taking action of some sort. I thought that action would be in the form of a rule proposing to revoke the registrations of firms it could not inspect. It did not happen. PCAOB board member Lewis Ferguson told Reuters “we’ve had periods before where we ran over deadlines while trying to get things done”. Ferguson indicated that Chinese regulators were reviewing a PCAOB proposal they received in November and that “there is forward movement” and “the number of issues … has been narrowed significantly”.

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