PCAOB Chairman James Doty told 21st Century Business Herald (China’s leading business paper) that the PCAOB is negotiating with Hong Kong for access to do inspections of Hong Kong accounting firms on work related to Chinese listings. A deal to allow inspections in Hong Kong could provide a way out of the impasse between U.S. and Chinese regulators. If the audits of U.S. listed Chinese companies are signed by the Hong Kong member firm a deal might allow the working papers to be inspected. The problem with this kind of deal is that it requires both the CSRC and the PCAOB to turn a blind eye towards what is actually happening.
Mainland authorities have blocked the PCAOB from coming to Hong Kong to inspect audits of companies with mainland operations. Hong Kong regulators must have been given permission by the mainland to have these negotiations, and that signals that mainland regulators are searching for a way out of the problem.
In addition to the PCAOB standoff over audit inspections, Hong Kong’s Securities and Futures Commission is in a court battle with Ernst & Young over its refusal to turn over working papers in the Standard Water case. I am surprised that case has not already been resolved. In May, Chinese regulators reached a deal with the PCAOB for access to working papers in connection with investigations, and I have thought that deal would have led to a similar deal with SFC by now. Hong Kong's weak regulatory system for accountants does not include inspections.
A deal with Hong Kong will require compromises by both the CSRC and the PCAOB that will undermine the process. Any deal by the PCAOB with Hong Kong would have to allow the accounting firms to move working papers out of China into Hong Kong, since I don’t think any audits of mainland Chinese companies are actually done in Hong Kong. Although all of the Big Four’s Hong Kong member firms are registered with the PCAOB, most, if not all, of the audits are actually done by the member firms on the mainland. That is the crux of the SFC case against E&Y. To get a deal done, China may be willing to look the other way when the Big Four transfer working papers out of the mainland, but any deal that rests on non-enforcement of existing laws is a bad one.
The other problem is that the Hong Kong Big Four firms actually don’t do the audits of U.S. listed Chinese companies so they should not be signing the reports. The Hong Kong member firm of the each Big Four firm is the signing auditor on the large state-owned enterprises that are listed in the U.S. For foreign private issuers, which constitute the majority of U.S. listed Chinese companies, three of the Big Four firms sign their audit opinions using their China member firms. KPMG curiously signs all of its audit reports on U.S. listed companies in Hong Kong, although I expect most, if not all, of these audits are actually done by its member firm on the mainland.
PCAOB auditing standard AU 543 requires an auditor to evaluate whether his own participation in the audit is sufficient to enable him to serve as the principal auditor. Just signing the audit report is certainly not enough participation to justify doing so. And of course, if you sign the audit report, you better have audit working papers, which gets to the problem that E&Y is having with SFC. The only way a deal with Hong Kong solves the audit inspection quandry is if the CSRC ignores the firms taking the working papers out of China and the PCAOB ignores that the Hong Kong firm should never have signed the audit in the first place. That is a poor foundation for effective regulation.
Doty also said that negotiations with China are continuing and the two sides will meet in the coming 6-10 months. But if no agreement is reached in a reasonable period, the PCAOB will need to take the appropriate action. That probably means deregistering the accounting firms, which leads to delisting the companies from U.S. exchanges. In other words, the nuclear option is back on the table.