PCAOB progress in China | China Accounting Blog | Paul Gillis

PCAOB progress in China

In an interview with Reuters yesterday, PCAOB Chairman James Doty reported that talks were expected before year-end between Chinese and U.S. officials on access to audit working papers in China. According to Reuters, Doty said that while obstacles remain, the upcoming talks could result in a “major breakthrough”. However, he also told Reuters “no deal was in sight”.

A PCAOB team recently returned from a visit to China where they observed Chinese regulators inspecting Ernst & Young’s China operations. The PCAOB team was not permitted to review actual client working papers; they were only allowed to observe Chinese regulators reviewing internal firm quality practices. As such, the observations fall far short of the PCAOB’s mandate to inspect all accounting firms auditing U.S. listed companies. 

According to the PCAOB’s website, there are currently 47 Chinese accounting firms registered with the PCAOB, although only 9 of those actually issue reports on U.S. listed companies. In addition, there are 48 Hong Kong accounting firms that have registered with the PCAOB of which 16 issue reports. China has blocked the PCAOB from inspecting Hong Kong firms to the extent that the audit relates to mainland clients. 

The PCAOB faces a December 31 deadline to complete inspection of foreign accounting firms. It will miss that deadline and will need to extend it. The deadline was extended once before, from December 31, 2009 to December 31, 2012. PCOAB and Chinese officials need to make significant progress in discussions to justify a further extension of the deadline. 

In a related, but separate, matter, the SEC is in negotiations with Chinese regulators over access to the working papers of Longtop Financial Technologies, a U.S. listed Chinese company that was delisted from the New York Stock Exchange in 2011 under allegations of fraud. Chinese regulators have forbidden Deloitte from turning over the working papers to the SEC. The SEC sued Deloitte in Federal Court, and then asked the judge to stay his decision pending negotiations with China. Doty told Reuters that the SEC would participate in the upcoming talks. The judge has ordered Deloitte and the SEC back to court in January, so the issue urgently needs resolution. 

There is a great deal at stake here. Failure to resolve these issues could lead to the delisting of Chinese companies listed in the United States, as well as create significant headaches for U.S. multinationals in China who would be unable to find U.S. registered auditors. U.S capital markets would be forever diminished. However, the status quo, with U.S. listed Chinese companies effectively unregulated, is unacceptable. 

I believe that the decision is up to China. China must decide whether it wants to continue to use U.S. capital markets to provide capital to its companies – particularly its privately held, entrepreneurial companies that have difficulty raising sufficient capital at home. While China has given signals that it would prefer these companies to list at home, China’s capital markets are simply not ready meet the needs of this sector. Give China’s capital markets another five or ten years, and I believe that they can fully meet the needs of China’s private sector. But if China pulls the plug now, it risks starving its entrepreneurial sector of capital, strangling indigenous innovation, and creating long term damage to its economy.

I think the better approach is to clean up the sector. China should designate the China Securities and Regulatory Commission (CSRC) as the primary regulator and gatekeeper for Chinese companies seeking overseas listings. Chinese regulators will always be more effective than foreign regulators at regulating Chinese companies. Chinese companies should be allowed to directly list aboard and existing companies should be required to get rid of their Cayman Islands holding companies. Private companies uniformly use offshore companies to circumvent Chinese regulation, and that is a big part of the problem. The variable interest entity (VIE) structure should be abolished in favor of dual class share structures that preserve Chinese control of sensitive issues. The VIE structure has been a bane to investors and makes a mockery of Chinese regulation. The CSRC should be given the authority and jurisdiction to work with foreign regulators like the PCAOB and the SEC to jointly regulate overseas listed Chinese companies and their auditors. The CSRC already regulates auditors of companies listed on Chinese exchanges; it is a small step to extend this jurisdiction to include auditors of overseas listed Chinese companies. 

Now is the time for action. 

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