HK to require clean audit opinions | China Accounting Blog | Paul Gillis

HK to require clean audit opinions

Here is a guest post from a reader about an important change in the acceptance of qualified and disclaimer audit opinions.  US exchanges do not accept these opinions and I have only seen them in textbooks, never in the wild.  I understand thay have been accepted in Hong Kong, and the change is appropriate. 

Charles Dery, CFA +1 (438) 558-5498 charles_dery@lyrainsight.com www.lyrainsight.com Twitter:@Lyra_Insight

IMPACT ANALYSIS OF PROPOSED 13.50A RULE

(09/28/18)

INTRODUCTION

In this article, we summarize in a few bullet points HKSE’s consultation paper on new 13.50A rule – which will suspend trading on companies with weak internal control/fraudsters leading to auditor disclaimer or adverse of opinion.

Full paper here (25 pages): https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/September-2018-Adverse-Audit-Opinion/Consultation-Paper/cp201809.pdf?la=en

13.50A RULE– SOURCE: HKSE

“The Exchange will normally require suspension of trading in an issuer’s securities if it publishes a preliminary results announcement for a financial year as required under rules 13.49(1) and (2) and the auditor has issued, or has indicated that it will issue, a disclaimer of opinion or an adverse opinion on the issuer’s financial statements. The suspension will normally remain in force until the issuer has addressed the issues giving rise to the disclaimer or adverse opinion, provided comfort that a disclaimer or adverse opinion in respect of such issues would no longer be required, and disclosed sufficient information to enable investors to make an informed assessment of its financial positions.”

SUMMARY OF CONSULTATION PAPER

 Demystifying scope of new rule against modified audit opinion

1. Out of scope: Qualified Opinion – estimated impact: material but not pervasive

2. Within scope: Disclaimer (or adverse) Opinion – estimated impact: material and pervasive (i.e. undetectable since no audit evidence available)

 Benefits sought from new rule:

1. Enhanced investor protection since improve quality and reliability of financial information

2. Encourage companies and its advisors to act promptly to resolve issues. (12 – 18 months delisting deadline – for GM and mainboard, respectively)

 Resumption conditions:

o Trading may resume provided an updated interim audit or for next period

o Does not detract following period closing balance

 Exceptions:

o There are exceptions to suspension if matters are addressed during same financial year

o FYI – No exceptions for going concern issues

 Current Standing (data)

o 43 companies for the 2017 financial year end published results with disclaimer of opinion

o 24 of 43 issuers received disclaimer of opinion for 2 – 5+ financial years, of which 17 involved going concern issues (amongst others)

o 13 of 43 received disclaimer due to going concern issues (2017 results)

OUR VIEWS – ANALYSIS OF BENEFITS

ON FASTER RESOLUTION OF ACCOUNTING ISSUES

o Our view: useful but not miraculous.

o Many companies appear to feel comfortable being suspended for long periods – hence why many would far exceed the 18 months (mainboard) delisting deadline as per below table showing number of companies still suspended as of below years1.

o We note that Natural Dairy Holdings (462) is still in third delisting stage after 8 years

o Analysing certain cases, we view long financial statement delay as a fraud enabler.

 Enable covering up of frauds and delinquent accounts

 Provides time to find the right external fraud enablers (i.e. risk, forensic, valuator, audits advisors)

o We note that some of these companies used to have market caps worth billions USD and still cannot trade on a public exchange after many years.

 PROTECTING INVESTORS FROM INACCURATE DATA

o Our view: useful but potentially very dangerous

o While a suspension may protect investors from inaccurate financial data, it may precipitate highly levered equity holders into the abyss.

o In fact, there are many smaller companies levered with convertible debt whose trading covenant require instant and complete repayment of debt principal with accrued interest after 90 days of trading halt.

o What’s makes it dangerous is that some of these smaller, levered companies tend have less sophisticated internal controls which makes them more vulnerable to adverse opinions.

o We have seen a case where substantial divestitures at highly unfavourable terms were necessary to avoid bankruptcy while addressing internal control issues. The firm’s market capitalization almost entirely collapsed.

Questions or comments? Please contact us: info@lyrainsight.com 1 www.hkexnews.hk/reports/prolongedsusp/Documents/psuspenrep_mb.doc

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