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U.S. China Strategic and Economic Dialogue

The fourth round of the U.S.-China Strategic and Economic Dialogue will take place in Beijing this coming Thursday and Friday. Tim Geithner and Hillary Clinton will sit across from Vice Premier Wang Qishan and State Councilor Dai Bingguo.

The last time this group met (May 2011) they agreed to try to find a solution to the PCAOB inspection process:

The United States and China welcome continued dialogue between the bilateral competent authorities on the oversight of accounting firms providing audit services for public companies in the two countries, so as to enhance mutual trust and strive to reach agreement on cross-border oversight cooperation. Both countries agree to make joint efforts to accelerate the process.

The parties got off to a good start. A joint PCAOB and SEC delegation went to China in July 2011 to meet with MOF and CSRC officials. PCAOB Board Member Lew Ferguson and SEC Chief Accountant Mike Starr met with CSRC Chairman Shang Fulin. The PCAOB invited the Chinese regulators to come to Washington last October. The October meeting did not happen. I believe that was because the SEC subpoena for Deloitte’s working papers on Longtop caused the Chinese officials to pause, perhaps recognizing that the inspection access would not be an easy issue.  They finally got together in January in Washington, but did not report any progress. 

Deloitte v. SEC

Deloitte’s battles with the SEC over access to Deloitte’s working papers related to Longtop were in the news again last week. Deloitte filed a 56-page statement with the DC District Court in opposition to the SEC’s attempts to subpoena the working papers. 

Deloitte was the auditor of Longtop Financial, which collapsed in May last year after Deloitte resigned. Longtop was soon delisted, yet the SEC has been investigating the company and none of the culprits have been brought to justice. A Wells Notice, indicating pending criminal charges, was issue to Longtop last August. On May 27, 2011 Deloitte’s legal counsel accepted a subpoena from the SEC. The lawyers told the SEC they had the authority to accept the subpoena. Deloitte fired the lawyers, possibly because of this action, and replaced them with Sidley Austin. The SEC argues that service of the subpoena on Deloitte’s counsel obliterates any territorial limits on enforcement. Deloitte’s current filing devotes five pages to attempt to undermine this argument.

Risk of Chinese auditors

The SEC has told many U.S. listed Chinese companies that they must disclose the risk associated with the inability of the PCAOB to inspect the work of their auditors in China.  These disclosures are now beginning to appear in the Form 20F filings for the year ended December 31, 2011. Here is an example from the recent filing by 51Job, Inc:

The Public Company Accounting Oversight Board, a U.S. regulator which oversees the inspections of audit firms which conduct audits of registrants which file financial statements with the SEC, is currently unable, due to governmental and political factors, to inspect the audit work and practices of registered audit firms in China.

Public company auditors are required by law to undergo regular Public Company Accounting Oversight Board, or PCAOB, inspections to assess their compliance with U.S. law and professional standards in connection with their audits of public company financial statements filed with the SEC. Because our auditor is located in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the PRC authorities, the audit work and practices of our auditor, like other registered audit firms operating in China, is currently not inspected by the PCAOB, due to various governmental and political factors. As a result, investors in U.S. markets who rely on audit reports from any Chinese audit firm are not able to factor the publicly reported findings of regular recurring PCAOB inspections of audit firms and their quality control practices into their decision making processes.

Late SEC filings

I have predicted that many Chinese companies may have difficulty in the current audit season, leading to auditor resignations and late filings of Form 20F. Because of the great interest in this prediction, I will provide a running list of companies that file Form NT-20F.

The first two are listed below. I will add to this list over the next month. SinoTech stopped trading after Ernst & Young resigned last September after allegations of fraud by Arthur Little. Lizhan has a September yearend, and its 20F was due on March 31.  Lizhan already reported disappointing earnings for 2011, down 80% from the prior year. 

The more troubling list of companies that choose to go dark will have to come later. I expect some companies, mostly OTCBB and Pink Sheet listings that came to market through reverse mergers, are just going to throw in the towel and quit filing. 

U.S. Listed Chinese Companies filing Form NT-20F

SinoTech Energy Ltd (NASDAQ:CTE)
Last auditor: Ernst & Young

Lizhan Environmental (NASDAQ:LZEN)
Last auditor: UHY Vocation

JOBS Act signed, Chinese fraudsters rejoice

President Obama signed the JOBS Act into law today. Proponents, mostly from Silicon Valley and Wall Street, claim it will enable small companies to do IPOs, enabling job growth.  Economists doubt it will create many jobs. Critics, including investor groups and labor unions, argue it will enable fraud

For investors in Chinese concept stocks, the JOBS Act is a disaster. Three features in the JOBS Act are likely to increase the number of frauds by Chinese companies. 

The JOBS Act repeals the requirement for newly listed companies with less than $1 billion in revenue to have an audit of their internal controls by their auditor for the five years after listing. The audits are known as Section 404 audits and were brought in under Sarbanes Oxley to fight Enron type frauds. Chinese companies with a market capitalization over $75 million had to have these audits, and the audits have resulted in some interesting findings. Many Chinese companies have disclosed internal control weaknesses as a result of these audits. Most important, however, is the extensive process of building and documenting internal controls that companies undertake before being audited. These internal controls protect investors, and I fear that they will not be put in place if the audit is not required. The repeal likely leads to serious accounting errors and creates the ability to conduct a fraud. 

Another Chinese heist?

As audit season moves to New York, we have our first victim. ChinaCast Education (NASDAQ:CAST) filed a Form NT 10K on March 16 indicating it would not be filing its Form 10K for 2011 on time. On March 27 NASDAQ wrote the company telling the company to give them a plan to get back in compliance by April 10 or face delisting. ChinaCast has been having some problems. A proxy fight in January led to the board removing the Chairman, Ron Chan. At the same time the company was dealing with SEC inquiries that led to restatement of its financial statements for 2010. The auditor is Deloitte. 

Today. the company reports that it is unable to resume normal operations because Chan has taken the chops, business licenses, and accounting records of its Chinese subsidiaries. The company says Chan showed up at the office trying to assert control. We have seen this movie before – Gigamedia. ChinaCast also has a VIE, which is owned by three employees not including Chan. Will Chan be able to seize control of the VIE as well?  ChinaCast’s VIE had 24% of its revenue in 2010.  

Slamming the door on the Big Four

The State Council Legislative Affairs Office of the PRC has requested public comments on proposed amendments to the CPA Act. The very act of asking for public comments on legislation reminds me how much things have changed in my 15 years living in China. 

The legislation appears to be mostly housekeeping. There is no new policy here, just alignment of existing laws with policy. The most important change is getting rid of all the language about joint venture accounting firms. Instead, accounting firms are required to use either general or limited partnerships, with limited partnerships available only to firms with at least 25 partners and 100 CPAs.

China faced three problems with CPA firms since they first reappeared in 1980. First, all CPA firms were initially affiliated with the state. Of course, in 1980, everything was affiliated with the state. The need for an independent CPA profession was recognized as China’s economy developed, and by the late 1990s all CPA firms were separated from the state. Second, the original CPA law allowed firms to organize as either partnerships or corporations, yet partnerships were unknown in China and it was near impossible to form one. As a consequence, nearly all CPA firms were organized as corporations. That tended to concentrate ownership and management in a single individual, which was considered a poor governance structure for professional accounting firms. The government has been pushing partnerships since the 1990s, and soon it will be the only form available for CPA firms.

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