Postings | China Accounting Blog | Paul Gillis


Rectifying China’s legal profession

The CSRC has fined three Chinese law firms in recent months over shoddy legal work on IPOs. The IPOs in question were all on China’s stock exchanges, and accordingly come under the regulatory authority of the CSRC. It is about time that the CSRC has taken action to raise the standards of legal practice on listed companies. The first crackdown on the accounting profession took place in 1997 and it was brutal. A quarter of Chinese CPAs faced discipline or eviction from the profession in the 1997 rectification. The legal profession is overdue for recti-fication.

The CSRC’s jurisdiction does not extend to overseas listed Chinese companies. Overseas listed Chinese companies of any meaningful size tend to use well-known international law firms. But these international law firms are not allowed to opine on matters of Chinese law, so local firms are used for this purpose.

Some local firms are well known for their willingness to issue clean opinions on variable interest entity (VIE) structures even in the face of considerable doubt as to whether the agreements that underpin these structures are enforceable. Many Chinese lawyers do not believe these agreements are enforceable, but those lawyers are not engaged to issue opinions on VIEs. The SEC has been tough on companies using the VIE structure, but is not in a position to challenge Chinese lawyers on matters of Chinese law. The CSRC does have that power, but it lacks jurisdiction over these companies. That is one of the things that the Singapore Solution can fix.

Singapore Solution

I wrote an Op/Ed in the Wall Street Journal today calling for reforms in China and the US that can achieve three objectives:

1. Allow Chinese people to invest in China’s top companies like Alibaba.

2. Get rid of the seriously flawed VIE structure.

3. Provide a mechanism to solve the regulatory battles between the United States and China.

I call my idea the Singapore Solution, since it is based on an agreement last November between China and Singapore that lets private Chinese companies list directly in Singapore without using an offshore holding company. I think that paves the way for a similar deal with the U.S. that can solve the regulatory problem – assuming regulators are willing to compromise, which is a huge assumption.

The VIE becomes unnecessary if China follows through on promises to liberalize the rules for foreign investment in education and e-commerce.

I hope regulators on both sides find a way to make a deal like this work. We are on a pathway to kicking all Chinese companies off of U.S. exchanges unless both sides start giving a little.

Is China investing enough in accounting?

Accounting is important to China’s development. Zhu Rongji saw that early on and directed considerable resources to develop a CPA profession in China. An investment in accounting is an investment in governance. So is China investing enough in governance?

The chart below measures the growth rates in revenue of the Top 100 CPA firms in China and separately the Big Four and local firms that make up the Top 100 CPA firms. I have measured them against the growth in GDP. The spend on ac-counting fees is an investment in corporate governance.

What the table shows is that over the last ten years, revenue of accounting firms in China has grown at an average annual rate of 22%. Big Four and local firms have grown at the same average rate of 22%, but their annual performance varies quite widely. GDP growth during this period averaged 10%, meaning that the investment in accounting services was more than double the GDP growth. That is great news. Not only has investment in accounting kept up with the growth in the economy, there has been additional “catch-up” investment. Clearly, the catch-up investment is needed and it probably needs to continue for another decade at least.

Audit committee chairmen beware

The Securities and Exchange Commission this week charged a U.S. listed Chi-nese company and six of its officers and directors with orchestrating a massive accounting fraud. AgFeed Industries Inc. is a pig farmer that was formerly listed on NASDAQ.

Dune Lawrence of Bloomberg wrote an expose on Agfeed last December. That earned her a personal attack by TheBlot, a publication allegedly backed by Benjamin Wey.Accounting watchdog Francine McKenna wrote a lengthy piece on the alleged Agfeed scam. All of this is very entertaining stuff.

What is significant about the Agfeed situation is that the charged individuals include audit committee chairman K. Ivan Gothner of Wilbraham, Massachu-setts. While this is not the first time that the SEC has charged an audit com-mittee chairman, it is a rare occurrence and I believe the first against the audit committee chairman of a U.S. listed Chinese company.

The SEC alleges particularly egregious behavior by audit committee chairman Gothner. It alleges he was aware of the fraud, kept it from auditors, and ap-proved false financial statements. Francine McKenna explains how another audit committee member ultimately served as the whistleblower to out the fraud.

Deferred taxes and VIEs revisited

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.

The Big Four in China

My book, The Big Four and the Development of the Accounting Profession in China, is out in print.

book cover

You can get a copy at the publisher or from Amazon.

Copyright 2020 Paul L. Gillis all rights reserved