by Paul Gillis, November 29, 2010
A large number of Chinese companies have sought listings on US stock exchanges, with over 200 companies listed on the NYSE, NASDAQ and ASE and many more traded over-the-counter. Total audit fees on exchange-listed companies total over $200 million. Chinese CPA firms have also benefited from massive investment in China by US companies. Auditors who serve U.S. listed companies or perform significant audit work for U.S. listed companies with Chinese operations must register with the U.S. Public Company Accounting Oversight Board (PCAOB).
Sarbanes-Oxley established the PCAOB and gave it the responsibility to regulate the auditors of public companies listed in the United States. Its responsibilities included the authority to set auditing standards and independence rules. It was also given the authority to inspect whether auditors were in compliance with the rules of the PCAOB and the SEC, and to bring disciplinary action against individuals and firms found to be in violation of these rules.
As of August 13, 2010, there were 59 CPA firms from Mainland China registered with the PCAOB. This includes the Chinese member firms of the Big Four and second tier firms. Few of these firms are listed as the auditor of record on listed companies, so many have likely registered because they play a substantial role in the audit of U.S. listed companies where the principal auditor is located overseas. A further 61 CPA firms from Hong Kong have also registered with the PCAOB, including the local member firms of the Big Four and second tier firms. By comparison, Japan, the 3rd largest global economy after the United States and China has only 15 PCAOB registered CPA firms
PCAOB rules require periodic inspections of registered firms to assess their compliance with U.S. law and professional standards in connection with the audits of US listed companies. Inspections are required annually for firms that regularly provide audit reports for more than 100 issuers, and at least triennially for forms that regularly provide audit reports for 100 or fewer issuers. As of April 2010, the PCAOB had conducted more than 1,300 inspections of registered firms in the U.S. and in 33 non-U.S. jurisdictions. No inspections have taken place in China. China has asserted that allowing the PCAOB to enter China in order to inspect accounting firms violates its national sovereignty. While Hong Kong was generally treated as a separate territory in matters related to international regulation, China asserted its sovereignty over PCAOB inspections in Hong Kong that involved clients with mainland operations, which included virtually all clients of the Hong Kong firms. Some inspections of Hong Kong firms went ahead apparently because the firms did not raise an objection to an investigation.
PCAOB board member Charles Niemeier traveled to Beijing in March 2007 to meet with the Ministry of Finance and CSRC about PCAOB inspections of Chinese firms registered with the PCAOB, but no resolution was reached. The problem is not confined to China. Nineteen European countries have also taken the position that the PCAOB could not conduct inspections within their territory. The CSRC set forth China’s position to the SEC in a comment letter on proposed inspection rules:
Our position remains unchanged, i.e. cross-border inspection must abide by the principles of respecting mutual sovereignty and cooperating as equals… To address the challenges of cross-border inspection which are brought up by listing of public companies in host jurisdictions, the SEC and the CSRC should work together as equals under the existing framework for regulatory cooperation. Therefore, the oversight of Chinese accounting firms should fully rely on the work of the CSRC… We are strongly opposed to PCAOB’s inspection on any Chinese accounting firm before any consensus has been reached between China and the US.
The proposed inspection rules upon which the CSRC was commenting were adopted without change. The rules allowed the Board to postpone, for up to three years, the first inspection of any non-US firm that the Board is currently required to conduct by the end of 2009 and that is in a jurisdiction where the Board has not conducted an inspection before 2009. Given China’s firm position on the issue, the three-year extension merely appears to defer the confrontation until 2012. In the meantime, the PCAOB published the names of accounting firms and issuers that have not been inspected. The list, notably incomplete yet dominated by Chinese firms and issuers, is available on the PCAOB website.
Apparently frustrated with the pace of negotiations over access to conduct inspections, on October 7, 2010 the PCAOB announced proceeds new processes for foreign firms that wish to register with the PCAOB. New registrants will be required to certify that inspections will be permitted. If they cannot do so (such as in China) they can either ask for their application to be held in suspension or ask that it proceed. If they ask that the application proceed, the PCAOB will schedule a hearing specifying as a proposed ground for disapproval of the application the obstacle to the Board’s ability to inspect the firm. The firm will be given the opportunity at the hearing to argue that the registration is in the interest of investors and the public.
The new rules making it difficult for Chinese auditors to register with the PCAOB do not affect the 59 Chinese accounting firms that are already registered. The Big Four, however, may face a different challenge. In 2012, the joint venture licenses for three of the Big Four joint ventures in China will expire (PwC gets a few extra years due to a restructuring when PW and C&L merged). It appears that China will not allow the Big Four to renew these joint ventures, and instead are pushing the firms to reorganize as limited partnerships. The problem is that only locally licensed CPAs can own an interest in a Chinese CPA firm, leaving the foreign partners, who make up the majority of partners today, in an uncertain position. The Big Four obtained a special exception under China’s WTO agreement to allow non-Chinese CPA ownership in their joint ventures, but that exception appears to disappear when the term of the joint ventures ends. Locally licensed CPAs (who can be foreigners, but few are) currently are a minority in the Big Four in China, yet if the restructuring proceeds as indicated, they will be the only owners of the Big Four member firms in China.
PCAOB guidelines indicate that the new firms may be required to register anew. In order to continue the old registration, the firm is required to certify that the new firm is a continuation of the old firm. The certification includes a statement that a majority of the individuals who held equity ownership interests in the predecessor-registered firm have become employees of or holders of equity ownership interests in the successor. That is not going to be an easy rule to apply, given that the joint ventures were owned by the Hong Kong firms and a few of the local partners. The rule seems to allow that foreign partners could become employees, which may help to solve the problem. Big Four lawyers are going to be busy with this issue.
CSRC’s assertion that the PCAOB should fully rely on the work of the CSRC has significant flaws. First, the regulatory power of the CRSC extends only to Chinese CPA firms with securities licenses in China. All of the Chinese firms registered with the PCAOB do not have securities licenses in China and are not subject to CSRC inspections, although they do remain under MOF jurisdiction. Hong Kong CPA firms are not subject to the regulatory jurisdiction of either MOF or the CSRC, although they are subject to regulation by the Hong Kong Institute of CPAs. As a result the CSRC is unable to fulfill the PCAOB role with respect to all registered firms in China and Hong Kong. While all of the registered firms are subject to either MOF or HKCPA regulation, there are no processes in place that would require inspections of the nature required by the PCAOB. Second, CSRC inspections relate only to audits of issuers of securities on Chinese exchanges and accordingly would not include the many Chinese companies that, while listed on US exchanges, are not listed in China. MOF examiners focus on reports prepared under CAS and do not examine the audits of financial statements prepared for use outside of China. Third, CSRC, MOF and HKCPA examiners are not expert in PCAOB auditing standards or US GAAP and would be unable to assess compliance with these standards. It is highly doubtful that examiners from these agencies would be willing to enforce foreign rules that are stricter than local rules. It is also unlikely that employees of these agencies, already struggling with the implementation of IFRS, would devote the training resources to develop the necessary skills to evaluate the auditing of US public companies.