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PCAOB should follow the lead

I previously wrote about how Bank of China’s refusal to turn over customer bank records in a case involving counterfeiters is similar to the Big Four accounting firms refusing to submit to PCAOB inspections. Both situations involve Chinese firms refusing to comply with US law citing conflicting Chinese laws. 

The judge in the Bank of China case was unmoved by arguments that the bank could not turn over documents because Chinese law forbids doing so. He has now imposed a $50,000 a day fine against the Bank of China. The Bank of China has appealed. The judge has done exactly what the PCAOB should do.  

Fines at $50,000 per day amount to $18,250,000 per year. In 2012, PwC China (the largest of the Big Four in China) earned $74 million from auditing US listed Chinese companies. Obviously they can afford the fine, although it would likely make this work unprofitable for them. What it would do is resolve the issue. The Big Four would either get out of the market or convince Chinese regulators to find a compromise. I expect the latter. 

Auditor independence and guanxi

An interesting academic paper was recently published concerning auditor independence in China. Among other things, the paper reported an experiment as to the effect of guanxi on auditor independence. They study found that auditors with a close bond (guanxi) with managers were less likely to recommend adjustments to stop earnings management.  

Guanxi refers to the network(s) of existing informal relationships and favor exchanges that dominate all business and social activity in China. While the social capital created from reciprocal relationships is common in all societies, the Chinese really take it to an art form, and many Chinese seem to spend their entire lives building a guanxi network that they can call on when they need to get something done. 

Auditors are not immune to the pressures of culture. The authors observe that “Chinese auditors are entrenched in the guanxi culture and psychologically bonded to their clients. This psychological tie created by guanxi leads auditors to trust their clients and act as advocates for the client.”  That is not the way auditors are supposed to behave. Auditors are supposed to be independent of management. The presence of guanxi undermines independence and destroys the credibility of audits. The authors say “the strong psychological bond makes it difficult for Chinese auditors to distance themselves from managers and maintain independence in mind during the audit work."

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