KPMG held a press conference last week to announce the formation of its new limited partnership that will replace the joint venture it has used in China for the past 20 years. Stephen Yu, CEO of KPMG China observed that KPMG was the first to be granted a joint venture, which has grown from 30 employees in 1992 to around 9,000 today. The new partnership is called KPMG Huazhen, the same name that was used for its joint venture.
The change to limited partnership form was forced by the expiration of the 20-year terms of the joint ventures. A special exception in China’s WTO accession allowed the Big Four to have unlicensed foreign partners in these joint ventures, an exception that expires with the joint ventures. Like most countries, China follows national treatment for accountancy, which means that locals and foreigners are treated the same. That means both locals and expatriates must have a local license in order to practice accounting; a license that most expatriate partners do not have. The Big Four and MOF negotiated in May that the Big Four could continue to have unlicensed foreign partners in the new limited partnerships that are replacing the joint ventures. Up to 40% of partners can be unlicensed locally this year, with the proportion reducing to 20% over five years.
The Ministry of Finance announced on July 13 that KPMG’s plan to move to a limited partnership had been approved. It said that the new firm would have only 25 partners, of which 15 are locally qualified and 10 are not locally licensed. KPMG has hundreds of audit partners in China but it appears they had difficulty finding locally qualified partners. I have heard that they organized the new firm with a minimum number of partners and plan to add more in the future. Nevertheless, it is an embarrassment for KPMG that it has so few locally qualified partners and it is shameful that the MOF accepted this situation as complying with the spirit of localization. I do not expect that KPMG has fired the hundreds of partners who are no longer partners in their audit practice. Instead, they will simply ask everyone to look the other way as they call these individuals partners when they are not.
The change in the firm sets in motion a high stakes filing with the PCAOB. Under PCAOB rules, a firm that restructures to a new entity must file Form 4 with the PCAOB within 14 days of the restructuring. Form 4 allows a firm to keep the old PCAOB registration rather than submitting a new application. It is extremely important for KPMG to be able to keep its old registration. That is because the PCAOB announced in 2010 that it intends to reject any new applications for registration from firms in countries that will not allow PCOAB inspections.
The PCAOB has said that the transfer of an existing registration using Form 4 is only available where the successor firm is under substantially the same ownership as the predecessor firm. Obviously that is not the case here, since KPMG has designated so few partners to own the new firm. The PCAOB has specifically said that the process is not available where a minority of the firm’s members form a new firm for which they would like to use the old firm’s registration.
I expect that the PCAOB and KPMG (as well as the other Big Four who are in the same boat) have been talking with the PCAOB about this issue for some time. If the PCAOB decides the firms need new registrations, and then do not allow new registrations because of the barriers to inspection, the result will be that most U.S. listed Chinese companies will be without auditors, and will likely be delisted from U.S. exchanges. We are already facing that risk if the PCAOB and China are unable to reach a deal on inspections, but the issues with the Big Four could accelerate that process from the December 31, 2012 deadline for inspections.
The uncertainty for investors is becoming unbearable. A deal between China and the PCAOB is the best option since that would remove any barrier to reregistration for the new Big Four firms (with the possible exception of Deloitte, which may have to answer to the SEC's charges that it violated U.S. securities laws). While Mary Schapiro's recent visit renews hope in a deal, it will be remarkable if it happens in the next few days.