Many people have asked me if the Big Four could circumvent the SEC ban by having the U.S. or Hong Kong firms sign the audit opinions. The short answer is no, and for several reasons.
In order for a U.S. or Hong Kong firm to serve as the principal auditor who is allowed to sign the report, the firm:
...must decide whether his own participation is sufficient to enable him to serve as the principal auditor and to report as such on the financial statements. In deciding this question, the auditor should consider, among other things, the materiality of the portion of the financial statements he has audited in com-parison with the portion audited by other auditors, the extent of his knowledge of the overall financial statements, and the importance of the components he audited in relation to the enterprise as a whole (AU 543).
In plain English, that means that in order to sign, you actually have to do the audit, or most of it. The firms cannot just sign the report in the U.S. or Hong Kong; the U.S. or Hong Kong firms must actually do the audit.
In order to do most of the audit of a Chinese company, the auditor would have to go to China. To do so, the auditor needs a temporary audit practice license from China. While these licenses do not appear to be difficult to obtain, they require compliance with Chinese laws, including the law to keep all work papers in China. Any U.S. or Hong Kong firm that would venture into China to do audits would be setting themselves up for the same problem that the China member firms have – they cannot turn over work papers to the SEC. And when they refuse, they risk losing the right to audit U.S. listed companies anywhere. There is no way the U.S. member firms are going to take that risk.
The Hong Kong member firms already sign some audit reports on Mainland com-panies. KPMG has historically signed all of the reports on U.S. listed Chinese companies in Hong Kong, although I noticed that it signed a December U.S. IPO in the name of its mainland member firm. The other firms have usually had the mainland member firm sign the report, except for companies dual-listed in Hong Kong. For those dual-listed companies, the Hong Kong firm generally has signed due to a HKSE requirement that a Hong Kong CPA sign, although that has changed somewhat due to Mainland CPAs now being allowed to audit H-Shares. For a Hong Kong firm to audit on the mainland, it would need a temporary audit license. KPMG disclosed in the trial that it has one – the other firms did not disclose that. But the firms do not tend to send staff from Hong Kong to do the audits; they outsource the audit to their Mainland member firm. The administrative trial judge in the case against the Big Four found that KPMG was outsourcing almost the entire audit in two of the cases before him.
On “Client D”, a biodiesel company attacked by short sellers, KPMG Hong Kong signed the audit opinion, yet the judge in the SEC case against the firms found that KPMG Huazhen “conducted all or substantially all of the audit”. Similarly with “Client F”, a chemical company that has since been delisted, KPMG Hong Kong was engaged as principal auditor while KPMG Huazhen was responsible for more than 90% of the audit work.
I see no way that KPMG Hong Kong could be treated as the principal auditor of either of those companies. KPMG Huazhen, which actually did the audit, should have signed the audit report as the principal auditor.
EY was doing the same thing on Standard Water, which landed it in court against the SFC. The Hong Kong accounting regulator/advocate issued Alert 18 last March to warn Hong Kong auditors that they ought to at least keep some minimal audit documentation in Hong Kong when they outsource audits to the mainland. Alert 18 will be of little help when KPMG answers to the PCOAB for this behavior. U.S. Auditing Standard AU 543 makes it clear what an auditor must do to be considered the principal auditor. Outsourcing nearly the entire audit to another firm is not going to cut the mustard.
KPMG will probably argue that this is not a serious violation. But it is. Is it any different than a garment manufacturer in Wenzhou who sews a “Made in Italy” label on Chinese made clothing? That is consumer fraud. Investors who saw the KPMG Hong Kong letterhead with the opinion may have been more confident than if the letterhead had been that of a Chinese joint venture firm. After all, KPMG has been viewed as a leading firm in Hong Kong since 1945, unlike the mainland upstart that is now 60% owned by locals. Investors in KPMG clients who got these fake opinions should do the same thing that they would do if they found out that they had bought a fake Italian shirt. Ask for their money back. And the PCAOB ought to help them get it.
The situation shows why the recent PCAOB proposal to require disclosure when major portions of the audit are outsourced to other firms is so important. I doubt this abuse would have taken place if these disclosures were required.