Chinese press is reporting today a deal between Chinese regulators and the PCAOB to observe inspections. Lew Ferguson, PCAOB board member, indicated on September 22, 2012, that a tentative deal had been reached. Apparently that deal has now been inked. No formal announcement has been made by the PCAOB.
According to the China Daily report, the PCAOB will be permitted to observe official auditor inspections in China, yet will not be permitted to observe detailed reviews of specific audits.
PCAOB inspections have two parts. First, the PCAOB reviews certain aspects of the firm’s quality control system. This is the part of the Chinese inspections that the PCAOB is being allowed to observe. The second, more substantive part, of the inspections includes reviews of certain aspects of selected audit work performed by the firm. Every audit is not reviewed; rather a sample of audits covering a range of partners and offices is selected. The review of individual audits is the most important part of a PCAOB review, and this is the portion that the PCAOB is not being permitted to observe in China.
The inability of the PCAOB to conduct, or even observe, reviews of individual audits means that the deal is merely a face saving way to kick the can down the road. The PCAOB faces a December 31 deadline to complete inspections of foreign firms, and this deal may provide enough justification to delay the deadline in hopes of reaching a real deal. It is probably wishful thinking to believe that a deal for full inspections can be reached. PCAOB negotiations with China have been going on for nearly a decade, and the deadline was extended once before in 2009.
Now that a “deal” with China has been inked, I expect the PCAOB to move to extend the December 31 deadline. They are well behind schedule on this. In 2009 the extension was proposed in July. Although China has the largest number of audits that the PCAOB cannot inspect, other countries, mostly in the EU, have also blocked PCAOB inspectors. Where no progress has been made in negotiations in those countries can the PCAOB justify extending the deadline? A list of affected issuers are provided on the PCAOB website, and include some well-known names such as Anheuser-Busch InBev (Belgium) and Alcatel (France).
Closely related to the PCAOB inspection issue is the current standoff between Deloitte and the SEC over access to the working papers for Longtop Financial Technologies. In July, the SEC asked for and was granted a six month stay in the action against Deloitte in U.S. Federal Court on the basis of ongoing negotiations with Chinese authorities that the SEC hoped would lead to access to the working papers. The judge ordered the SEC back to court in January to report on the negotiations. If the negotiations fail, I expect the SEC will be asking the judge to sanction Deloitte. These sanctions might include barring Deloitte China from auditing U.S. listed companies and may prompt the SEC and the PCAOB to ban all Chinese CPA firms from U.S. audits. That could lead to the mass delisting of U.S. listed Chinese companies.
Will the SEC reach a deal? With so much at stake I expect every effort will be made to conclude one. I cannot conceive that a face saving compromise can be reached that will satisfy the SEC and the judge. Investors should pay careful attention to this issue.