There is growing concern that the Securities and Futures Commission (SFC) suit against Ernst & Young in Hong Kong for failure to produce working papers could lead to the same delisting risk that U.S. listed Chinese companies face. I think that concern is misplaced. Hong Kong is not going to delist Chinese companies, but it might blow up its own accounting profession to keep them.
The current issue relates to Standard Water, a company with a failed IPO in Hong Kong. E&Y Hong Kong was the reporting accountant. But when SFC came to ask for the working papers, E&Y demurred, saying it was actually their Mainland affiliate who did the work and that China’s state secrets laws precluded it from turning over the working papers.
While that seems similar to the cases that have put Deloitte in China at odds with the SEC, there is a big difference. In the Standard Water case, it was E&Y Hong Kong that actually signed the audit report. That matters.
If you sign an audit report, you are first supposed to do an audit. While you can subcontract out parts of the audit to others, the signing auditor still has to do most of the work and take full responsibility. And taking that responsibility also includes keeping a set of working papers that support the audit opinion.
When the H-share market in China opened in 1992, the Hong Kong offices of the Big Four (actually the Big Six back then) were hired as auditors. There were no Chinese firms capable of this work at the time since they were all still state controlled. The Big Four were allowed to begin auditing in China in 1992 as well, but about all the nascent Mainland offices could do was supply some staff to help the Hong Kong firm. Over the succeeding years, the Mainland offices grew to the point that they are now considerably larger than the Hong Kong office. Many of the Hong Kong partners relocated to Mainland offices. Nevertheless, audit reports on H-shares, and the later red-chips and p-chips continued to be signed by the Hong Kong office, even though the work was increasingly being done on the Mainland. Hong Kong rules required that a Hong Kong CPA firm sign off on all Hong Kong listings.
In 2009, Mainland regulators approached Hong Kong under the Closer Economic Partnership Act (CEPA), a trade agreement between the Mainland and Hong Kong, requesting that H-share companies be allowed to use Mainland auditors and prepare accounts under Chinese Accounting Standards. Despite an uproar in Hong Kong, a pilot program was approved late in 2010. The changes turned out to be benign. The accounting firm was often changed from the Hong Kong firm to the Mainland firm of the same Big Four firm, yet the audit team usually stayed the same, since the work had long before migrated to the Mainland office. There has been a trend towards some of the smaller H-shares switching to large local firms on the Mainland, but not for any of the big companies. Analysts were pleasantly surprised to find out that Chinese Accounting Standards actually provide more complete disclosure than the IFRS used in Hong Kong.
Enoch Yiu, Chief Business Reporter at the SCMP, calls for reversal of the 2010 agreement to prevent Mainland auditors, including the Big Four on the Mainland, from auditing Hong Kong listed companies. She has that backwards. We are more likely to see an expansion of the program as a result of the Standard Water case.
Standard Water exposes that the Big Four are signing audit reports in Hong Kong yet having the Mainland office do the work. The firms have tried to operate as a single firm in Hong Kong and the Mainland. But they are not a single firm; they are separate firms that do not even have the same owners. The Mainland firms are moving into firms that are controlled by locals.
What Hong Kong regulators need to do is the take disciplinary action against firms that sign reports in Hong Kong while outsourcing the entire audit to another firm on the Mainland, even if those firms share the same brand. This would be an action based on failure to follow auditing standards, not for failing to produce working papers that are in China. If the Hong Kong firms want to sign reports on Chinese companies, the Hong Kong firm needs to do most of the audit. Otherwise the firm that does most of the work – the Mainland firm - should sign the report. The regulator of accounting firms in Hong Kong is the Hong Kong Institute of CPAs (HKICPAs). Self-regulation of the accounting profession has not worked very well in most countries, and the HKICPAs has a weak track record in taking on the Big Four, so I am not expecting them to take up this issue.
The implication of this is that the Mainland office should sign audit reports on most red-chips and p-chips. But with the exception of the H-share pilot program and some big companies like HSBC, Hong Kong rules require that a Hong Kong CPA firm sign the report.
Hong Kong is not going to delist Chinese companies because its regulators cannot get access to audit working papers. Unlike on the U.S. exchanges, Chinese companies are the raison dętre for the Hong Kong Stock Exchange. China is not likely to budge either. Instead I see the most likely result is that the pilot program for Chinese CPA firms to audit H-shares will be expanded to include red-chips and p-chips. All of these audits will move out of Hong Kong and onto the Mainland. Most, of course, have not been done in Hong Kong for years; the Hong Kong firm simply signed the opinion.
For investors, this change is likely to be as uneventful as the change in audit firms for H-share companies –only the letterhead on the audit opinion will change. It will, however, open up the Big Four to increased competition from local Chinese firms for the red-chip and H-share market. Increased competition from Chinese firms is a guaranteed part of the future for the Hong Kong accounting profession, but it may be coming sooner than expected.