The PCAOB today issued Staff Audit Practice Alert No. 8 - Audit Risks in Certain Emerging Markets.
In a broad sense the Alert points out how emerging markets differ from developed markets, and points to the need to modify audit procedures because of these differences. That should not be surprising to anyone, but the recent frauds in China which likely motivated the report indicate that too often Western auditing practices were imported wholesale to China without modification for the differing cultural environment.
I have been developing a hypothesis that because auditing and internal control practices were developed in the West, they are founded on the assumption that collusion between two parties is difficult. The concept of separation of duties is fundamental to the design of any internal control system. As any beginning student of sociology learns, the West has a highly individualistic culture while the East has a collectivist culture (read the famous work of Geert Hofstede on this topic). I believe that Western designed internal control systems (and audit processes intended to test these systems) have failed in China because they have not recognized how these systems are undermined in a collectivist culture. The PCAOB Alert is a good start on recognizing the issues.
Of particular interest in China are the comments in the report about VIEs. The report indicates that a "company might be motivated to consolidate the partnership or VIE to strengthen its reported financial position, even if significant legal restrictions prevent the company from obtaining a controlling interest in the partnership or assets." It appears that the PCAOB is focusing on the issues I have been raising all year - when does the significant uncertainty around the VIEs rise to the level that auditors need to speak up?
The Wall Street Journal today also reports that the PCAOB's planned meetings with China this month appear to have hit a snag. I expect it relates to the Deloitte subpoena. Chinese regulators have likely become aware of the reality that agreeing on joint inspections is one thing, agreeing on what to do when problems arise in those inspections is quite another.