Killing a chicken to scare the monkeys | China Accounting Blog | Paul Gillis

Killing a chicken to scare the monkeys

There is a well-worn Chinese proverb that you must kill a chicken to scare the monkeys (杀鸡猴).  Regulators commonly follow this proverb with a highly publicized prosecution meant to send a message to others to reform.

This week the SEC threw the book at Moore Stephens Wirth Frazer and Torbett LLC (MSWFT) and managing partner K. Dean Yamagata.   The SEC found that MSWFT’s engaged in improper professional conduct in connection with its audit of China Energy Savings Technology, Inc (China Energy) in 2004 and 2005.  China Energy was delisted from NASDAQ in 2006 and has been the subject of SEC prosecutions through 2009.  There were two main problems.  The SEC found that MSWTF should have exercised heightened skepticism over revenue recognition.   Significant portions of revenues were discovered to not exist.  In addition, MSWFT was found to have impaired its independence by performing the calculation of earnings per share.  It is the company’s responsibility to do these calculations for the auditors review.  When the auditor performs the calculation, it ends up auditing its own work and that is considered a violation of independence rules.   This is a common problem in China because companies often do not have the skills required to do complex calculations like earnings per share and income taxes. 

 MSWFT was fined $129,500, which was the amount of fees they earned, plus interest.  They are required to hire a consultant to review their audit practices and are forbidden from accepting new clients in China until the consultant’s work is done.   Yamagata is banned for two years. 

 MSWFT was the Frazer of scandal plagued Frazer Frost during 2009.  Frazer Frost was formed in January 2010 in a merger of MSWFT and Frost & Co.   On December 1, 2010, the merger was rescinded following the emergence of the RINO scandal, and the firms now operate separately.  With Yamagata out of the picture, the China practice of MSWFT will continue to be led by Susan Woo, who was the engagement partner on RINO.    It is unlikely that MSWFT will survive given they have yet to answer to the SEC for the RINO problems and will likely face further disciplinary action from the California Board of Accountancy.  

 On Tuesday, December 20, the Wall Street Journal reported that the SEC was launching a crackdown on the accountants, lawyers and bankers who have brought hundreds of Chinese companies to US markets through reverse mergers with dormant public shells.   Reverse mergers in the US are a much easier way for a Chinese company to go public than to list on China’s stock exchange.   Most of the reverse merger deals trade on the over-the-counter bulletin boards, but about 15% have found their way to NASDAQ or the NYSE.  The Wall Street Journal reported that the House financial services committee might hold hearings on Chinese company accounting in 2011. In September, 2010 the committee sent a letter to the SEC and the PCAOB raising concerns about Chinese auditing and asked the agencies how they intended to deal with the problem.

 A number of bloggers and short sellers have been targeting the clients of US based CPA firms that serve smaller Chinese companies listed in the US.   In addition to Frazer Frost, short sellers have targeted clients of Kabani & Co., Goldman Kuland Mohidin, and Sherb & Co.  

 It appears the initial focus of the SEC will be on companies that came to market by means of a reverse merger rather than a traditional IPO.  Most of these companies are audited by small US based auditors that can easily be examined by the PCAOB.  The larger companies listed on NASDAQ and the NYSE are mostly audited by the Big Four in China.   As the table below indicates, the Big Four in 2009 had 95% of the audit fees of Chinese companies listed on the NYSE and 71% of the companies listed on NASDAQ.  

Unless a company is already well along in the process, it will be difficult for firms to upgrade auditors for the 2010 fiscal year.  In 2011, I expect two trends to develop.  First, companies will seek to upgrade to a larger accounting firm – mostly to the Big Four and BDO, Crowe Horwath and Grant Thornton who have sufficient on the ground resources in China to take on the additional work.   With the exception of the Big Four, few Chinese CPA firms have served US listings.   In the case of BDO and Crowe Horwath it has been their Hong Kong firm that is involved.  Grant Thornton recently expelled its Hong Kong firm in order to build a practice that will be more integrated with its China member firm.  

During the IPO book in 2006 and 2007 the Big Four were tapped out and rejected some firms that they will likely accept today.  During 2010 there has been a tendency for US listed Chinese companies to upgrade auditors.  In December there were five notable upgrades:

China Biologic Products Inc. (CBPO) from Frazer Frost to KPMG

China Automotive Systems (CAAS) from Schwartz Levitsky Feldman to PwC

China Integrated Energy (CBEH) from Sherb to KPMG

Skystar Biopharmaceutical (SKBI) from Frazer Frost to Crowe Horwarth

Wonder Auto (WATG) from PKF to PwC

In my opinion, any Chinese company with a market capitalization above $100 million should be using one of the top seven firms (Big Four, BDO, Crowe Horwarth, Grant Thornton). The average audit fee for a Chinese company listed on NASDAQ was $637,000 in 2009, so many of these companies will be paying significantly more, yet I believe they will increase their value much more.   However, some may find the change to be difficult.  Duoyuan Printing tried to upgrade to Deloitte from Frazer Frost only to find Deloitte’s auditing too rigorous.   They fired Deloitte, lost their CFO and audit committee, and have yet to find a new auditor.

I expect that many of the smaller US based auditors who have been serving Chinese clients will withdraw from the market under the increase scrutiny of the PCAOB and SEC.  It is likely to become difficult for many small firms to find an auditor and some may face delisting as a consequence. 

I expect that the PCAOB and the SEC will be able to clean up the smaller Chinese listings once they devote adequate resources to the task.  Congress, however, may be more concerned with the larger listings done by the Big Four.  China has barred the PCAOB from inspecting Chinese based accounting firms (including the Big Four) on national sovereignty grounds.   China has argued that the PCAOB should rely on Chinese regulators, yet Chinese regulators have assumed no responsibility for regulating accounting reports used overseas. 

The dispute between the PCAOB and China is likely to be a focus of the 2011 hearings of the House financial services committee.   Congress might take the position that if China wants access to US financial markets it will need to submit to US regulation.  China might take the view that it is outgrowing its need for access to the US markets.  The Hong Kong and mainland markets have perhaps developed sufficiently to meet China’s needs. 

If Congress were to direct the PCOAB to deregister all Chinese CPA firms, including the Big Four, all Chinese companies listed on US exchanges would need to find new auditors outside of China.  The Big Four might be able to find a way to make this work by using their US firm to undertake the assignments and having the staff and partners involved join the US firm.  They would, however, need to keep the working papers in the US.  That is not difficult, since they are mostly in electronic form these days, but China may have national security concerns.  

In this game of chicken, all the monkeys might get killed.  

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