Postings | China Accounting Blog | Paul Gillis


Democracy and auditing

The Big Four accounting firms in Hong Kong took out an ad in Hong Kong newspapers opposing the democracy initiatives currently underway. This FT article has a translation of the ad and an analysis.

Twitter erupted with criticism of the firms:

Am I naive or is this outrageous meddling? Big four accounting firms warn Hong Kong over democracy push.
6/28/14, 10:10 PM

When @FT asked big four’s global headquarters for comment, "it emerged they had only learned of the advertisement through press reports."
6/28/14, 5:45 AM

"@SimonCYWong: Big Four audit firms sell out #HongKong: "It’s an act of cowardice" " #spineless Big 4?
6/28/14, 12:08 AM

It is assumed by many that the firms were pressured by their clients (the largest of which are Chinese state-owned enterprises) to place this ad. Certainly there are few instances in the past where the firms have spoken out in one voice for social reforms.  

The arrogance of the firms is stunning. Did they really think their voice would alter the debate? Do they really think people respect their opinions that much? Did they not see that all they were doing is setting themselves up for ridicule while diminishing their brand worldwide? 

Congressional commission takes on VIEs

The U.S.-China Economic and Security Review Commission has issued a staff report titled: The Risks of China’s Internet Companies on U.S. Stock Exchanges. The commission advises Congress on matters related to economic issues in China. 

The report focuses mostly on the variable interest entity structure and heavily cites this blog. There is nothing new in the report that has not been covered here, but it is a good summary of the issues.  

It is noteworthy that the Commission took up the issue. While VIEs are risky to investors, there is unlikely any serious risk to the U.S. economy from VIE problems. The report does point out the $18 billion lost by investors in Chinese reverse mergers. The market cap exposed to VIE risks is considerably higher.  Certainly, having such a high level body raise this issue will increase investor anxiety ahead of the Alibaba offering. 

Opening China and HK audit markets

The proposal by the Ministry of Finance to reform regulation of auditors of overseas listed companies created a firestorm in Hong Kong. Meetings with mainland regulators and interested parties took place in Hong Kong this week. A senior partner of one of the second-tier firms told an academic conference on Tuesday that if the proposal went into effect he would have to fire half of his staff.

The proposal to bring the audits of overseas listed Chinese companies under MOF regulation is an excellent one, and long overdue. This has been a regula-tory hole – ignored by Chinese regulators who blocked foreign regulators from filling the gap.  

The proposal, however, threatens the livelihood of many Hong Kong CPAs. One of the provisions requires overseas firms, including Hong Kong firms, to use a Chinese affiliate selected from the top 100 Chinese firms to do the audit work on the mainland. That is the rule that concerns Hong Kong CPAs.

The Hong Kong Stock Exchange long ago gave a franchise to Hong Kong CPAs by requiring their signature on any listing in Hong Kong. That franchise eroded a little over the years, first as some of the big Hongs like Jardines and Swire left Hong Kong before handover and their audits moved to London. Then China forced open the market to audit H-Shares and now Chinese firms, mostly Big Four affiliates, audit some of the H-Shares. But exchange rules require that all Red Chips and private Chinese companies use a Hong Kong auditor.

MOF plan is good news

Hong Kong accountants are up in arms over a proposal (English translation) by the Ministry of Finance to more closely regulate the auditing of overseas listed Chinese companies. Mainland regulators told Hong Kong officials that they do not intend to close off the mainland to Hong Kong accountants, although the proposed rules may well lead to that. But that is not the most important part of this story.

The MOF is bringing audits of overseas Chinese companies under Chinese regulation.  

That is a good thing. Chinese regulators previously washed their hands of U.S. listed Chinese companies. I am unaware of any executive or auditor of an alleged fraud involving a U.S. listed company ever facing justice in China, yet China also blocked U.S. regulators from doing anything.  Chinese accounting firms have been unfairly maligned by shoddy work done by fly-by-night reverse merger auditors from former U.S. penny stock havens like Salt Lake City and Denver.  China is cracking down on those firms, and establishing regulatory control over the auditing of overseas listed Chinese companies. Some Hong Kong accountants may be unexpectedly caught in the process.

The failure of HKICPA regulation

I wrote last December about a discussion going on in Hong Kong about whether to toughen audit regulation to bring Hong Kong in line with global practices. Hong Kong had suffered the insult of losing regulatory equivalency with the EU in accountancy because of its weak regulatory regime. The Hong Kong Institute of CPAs (HKICPAs) led the debate, and based on comments most members seemed aghast at the concept of tough audit regulation. The HKICPAs concluded its consultation with members on January 17, 2014 and the debate went silent.

I hope the issue gets revived. Hong Kong practices self-regulation in account-ancy. That means the accounting firms regulate themselves. After Enron, the rest of the world pretty much concluded self-regulation does not work. It is not working in Hong Kong. 

I offer as evidence the case of former EY senior partner Anthony Wu. Wu was found to have violated auditor independence rules because he was a member of the client’s executive committee, authorized signer on 13 client bank accounts, had significant personal dealings with client subsidiaries, loaned the client money, and had EY collect a retainer for his services as a financial advisor.  The client, New China Hong Kong Group collapsed in 1999, spawning a series of claims. Eventually complaints were filed with the HKICPAs about Wu, another EY partner and EY itself. Auditor independence is fundamental to the accounting profession, so the allegations were serious. 

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