Hong Kong accountants are up in arms over a proposal (English translation) by the Ministry of Finance to more closely regulate the auditing of overseas listed Chinese companies. Mainland regulators told Hong Kong officials that they do not intend to close off the mainland to Hong Kong accountants, although the proposed rules may well lead to that. But that is not the most important part of this story.
The MOF is bringing audits of overseas Chinese companies under Chinese regulation.
That is a good thing. Chinese regulators previously washed their hands of U.S. listed Chinese companies. I am unaware of any executive or auditor of an alleged fraud involving a U.S. listed company ever facing justice in China, yet China also blocked U.S. regulators from doing anything. Chinese accounting firms have been unfairly maligned by shoddy work done by fly-by-night reverse merger auditors from former U.S. penny stock havens like Salt Lake City and Denver. China is cracking down on those firms, and establishing regulatory control over the auditing of overseas listed Chinese companies. Some Hong Kong accountants may be unexpectedly caught in the process.
A number of small U.S. CPA firms set up shop in China. Some of them established companies in China so they could hire local accountants to do the work. They organized their companies as consulting WFOEs, and auditing was clearly not in the business scope of these companies. So they have been operating illegally in China. Other firms outsourced the audit to small local CPA firms, and some were busted by the PCAOB for signing off on audits without doing them. The proposed rules will shut down these practices. If the firms want to do this work going forward they must work with a Top 100 Chinese CPA firm (or one with a securities qualification - all of which are currently in the Top 100). Good luck with that – I expect many of the remaining reverse merger companies are going to have a tough time finding an auditor and they may have to leave the U.S. markets.
The proposed rules require that domestic firms that want to work on overseas listings must both register with foreign regulators (i.e. PCAOB) and comply with laws, regulations and auditing standards - presumably both Chinese and foreign auditing standards. Foreign firms associated with audits of overseas listed Chinese companies must report to MOF within 45 days of the audit report, and if they don’t MOF will “order them to make corrections” and turn them in to the overseas regulator.
These requirements are promising. China is acknowledging the role of foreign regulators with respect to overseas listings of Chinese companies. Requiring Chinese auditors to register and comply with foreign rules on overseas listings may foretell greater cooperation between China and foreign regulators on overseas listed Chinese companies. It is not a big step from here for the MOF to allow the PCAOB to “ride along” on inspections of the audits of U.S. listed Chinese companies. I expect China is going to insist on handing out any punishment to Chinese firms that do bad audits, but the PCAOB should not be in this for the fine money anyway.
The notice also refers to situations where an overseas firm issued an audit report, but when challenged attributed the responsibility for the audit to a mainland firm. I think they are talking about how EY HK was the accountant of record on Standard Water but pointed to EY China when SFC demanded to see the working papers. The proposed rules will make the foreign firm take responsibility for the work.
That is where the problem with the proposal comes in. The proposed rules contemplate that audit reports will be issued by the foreign accounting firms. One reason given for this is foreign listing regulatory requirements. Hong Kong does require (except for H-shares) that a Hong Kong auditor sign audit reports. The United States only requires that a PCAOB registered auditor sign reports, and over 50 Chinese CPA firms are registered with the PCAOB. But the proposed MOF rules require that the audit work in China be done by a China affiliate. This is where the proposed rules become unworkable with present practice.
Under both U.S. and Hong Kong auditing standards, auditors are not permitted to outsource substantially all of an audit and yet still sign the audit report. So, to comply with the MOF rules, auditors will have to violate professional standards, and that is where they should draw the line.
The mainland Big Four member firm signs the audit report on most U.S. listed companies. On those engagements these proposed rules have no effect, other than to bring the audits under Chinese regulatory control. The major exceptions are companies dual listed in Hong Kong and the U.S., which are signed by the Hong Kong firm, and KPMG’s clients, which are inexplicably signed by the Hong Kong firm even when the audits are done in China.
The biggest problem is the many Chinese companies listed in Hong Kong. With the exception of some H-Shares, Hong Kong auditors sign the audit opinions on these companies. That is required by the Hong Kong Stock Exchange. Over the last decade, however, the Big Four firms moved most of these audits to the mainland, where they are done by the mainland affiliate. But the opinions continue to be signed by the Hong Kong firm, in apparent violation of Hong Kong Standards on Auditing Section 600. The Hong Kong firm cannot serve as group auditor if it does not actually audit the group.
The proposed rules will have little effect on the Big Four, since they have already moved most of the audits to the mainland. The practice of signing reports in Hong Kong must end. It misleads investors and violates auditing standards. But this will require that the Hong Kong Stock Exchange to allow mainland firms to sign off on listed companies.
Many of Hong Kong’s smaller accounting firms do send staff to the mainland to do audits, and for them, the new rules will be devastating.