The SEC’s actions against the Big Four and BDO in China may be followed by PCAOB action to deregister accounting firms in China because of the inability of the PCAOB to inspect China based firms. The most apparent result of that action would be to jeopardize the listings of U.S. listed Chinese companies. The action would also potentially have an adverse impact on U.S. multinationals (MNCs) with China operations.
For the last two decades, China has been near the top of the league tables for inbound foreign direct investment, much of which has come from U.S. MNCs. These MNCs are typically audited by the same Big Four firm in the United States and in China. The U.S. firm takes overall responsibility for the audit, but farms out work to its affiliates around the world that then audit local operations.
Under PCAOB rules, any firm that “plays a substantial role in the preparation or furnishing of an audit report” must be registered with the PCAOB. If the China member firms of the Big Four (and second tier firms like BDO) lose their PCAOB registration they can no longer play a substantial role in those MNC audits. That could lead to the inability of the U.S. firm to sign off on the audit of the MNC, since it has no way to audit the China operations.
The definition of "substantial role" is in PCAOB Rule 1001(p)(ii) - Definition of Substantial Role. - The phrase "play a substantial role in the preparation or furnishing of an audit report" means – (1) to perform material services that a public accounting firm uses or relies on in issuing all or part of its audit report with respect to any issuer, or (2) to perform the majority of the audit procedures with respect to a subsidiary or component of any issuer the assets or revenues of which constitute 20% or more of the consolidated assets or revenues of such issuer necessary for the principal accountant to issue an audit report on the issuer.
Let’s test that rule in practice. Yum Brands is one of the larger U.S. MNCs in China, with its ubiquitous KFC stores. Yum Brands is audited by KPMG in the U.S. and its China operations are most likely audited by KPMG Huazhen. I am not picking on Yum Brands for any reason other than they were the first MNC I saw when I looked out my window.
Assuming KPMG Huazhen audits Yum Brands China operations, does it play a substantial role in the audit? Yum Brands reports that 29% of its assets are in China, as are 44% of its revenue and 50% of its gross profits. By the PCAOB standard the audit work on Yum Brands in China is substantial to the audit of Yum Brands under both the asset and revenue test.
So, what happens if KPMG Huazhen is deregistered? Clearly, KPMG in the U.S. needs to have the China operations of Yum Brands audited if it is going to express an opinion on the consolidated financials statements. If they are all deregistered, there will be no accounting firms in China that can play a substantial role in the audit. The only option would appear to be for Yum Brands to allocate the China audit to enough firms so that none of them individually is playing a substantial role. That would appear to require three firms in China for Yum Brands. Following the PCAOB rule on substantial rule, While that can be done, it would be cumbersome, expensive, and would likely reduce audit quality.
Some people have done a Bloomberg screen on this, and tell me there are a number of firms with more than 20% of revenue in China, and they would need to have multiple firms should their auditor be deregistered.
This post has been updated to reflect the PCAOB rule on substantial role that some readers directed me to.