I am frequently asked for my opinion as to whether audits done by the Big Four in China are equivalent to audits done by the Big Four in the United States. It is a difficult question to answer. The firms work very hard to ensure consistent audit quality around the world, particularly with respect to companies with cross border listings. Each of the firms has American partners with expertise in U.S. accounting and auditing present in China. KPMG even has a former Associate Chief Accountant of the SEC in Beijing. Without independent verification, however, it is impossible to determine whether the firms are successful at ensuring audit quality. That is why PCAOB inspections of Chinese CPA firms, especially the Chinese member firms of the Big Four (which audit most U.S. listed Chinese companies), are so important.
There has been a fair amount of academic work that usually, but not always, concludes that the Big Four have higher audit quality than local Chinese firms. Those studies are sensitive to the research methodology used. Local firms have different types of clients, and from my experience local firms tend to be more detailed and less strategic in their audit approaches. I am not aware of any studies that have compared the quality of Big Four audits of Chinese companies with Big Four audits of U.S. companies. I have been thinking about how to do that.
I have some observations that are shaping my thinking.
In the Big Four firms in China, there are 27 professional staff for every partner. My data come from 2008, but I don’t think the picture has changed much. In the United States, using 2010 data, the Big Four partner to staff ratio is 9 to 1.
High partner staff ratios have been characteristic of the Big Four across Asia for decades. These high partner staff ratios have led to very high partner compensation levels. For most of the firms, the Hong Kong partners have been the highest paid in the network for many years. High partner staff ratios are possible when the work is simple and mostly clerical in nature. The clients have changed, with these firms now auditing some of the world’s largest corporations, yet the business model has not changed.
When dealing with complex and risky accounting situations, quality audits do not come from throwing more people at the problem. These complex and risky situations need the experience and judgment of well-seasoned auditors. Could many of the accounting problems at Chinese companies been avoided had there been more partner time focused on the accounts?
Auditors are supposed to audit financial statements prepared by management, and they impair their independence if they help to prepare those statements. When auditors help make accounting decisions or actually do accounting calculations they end up auditing their own work.
Chinese clients have often not had the expertise to deal with the complexities of public financial reporting, particularly for those companies that report in U.S. GAAP. Reporting a material weakness in this area is commonplace for U.S. listed Chinese companies.
In practice, Chinese auditors commonly prepare important parts of financial statements, often handling complex issues like consolidations, equity transactions, and income tax accounting. Rarely is another accounting firm hired to do this work, which would preserve the auditor's independence.
Quality of staff
In terms of raw intellect, it is my opinion that Chinese auditors are smarter than their U.S. counterparts. Much of that is attributable to recruiting. In China, the Big Four get a significant number of their recruits from China’s top universities, including top tier institutions like Peking University, Tsinghua University, and Fudan University. In the United States, the Big Four have few, if any, recruits from comparable universities like Harvard, MIT, or Stanford. The quality of raw material matters, and this bodes well for audit quality in China.
The demand for new staff outstrips the supply of accounting graduates. Many accounting graduates from the top tier schools choose to go to investment banking or consulting firms. Consequentially, the Big Four recruit many non-accounting majors. In 2008, of the 5,787 new graduates hired by the Big Four, only 32% were accounting majors. How does that affect audit quality? Lack of accounting and auditing knowledge would appear to reduce it, but does the diversity of educational backgrounds actually improve it? This is an important issue for the accounting profession worldwide and China has set up a huge laboratory in which the issue can be examined. It is time for some academic researchers to dive in and figure this out.
One of the reasons for the diversity in academic backgrounds of new Big Four recruits is the need for high levels of English competency. Are bilingual auditors doing much of their work in a second language as effective as auditors working in their native language?
These are fruitful areas for academic research. The implications of many of these issues go far beyond China.