Last week saw three significant developments with respect to accounting in China. First, James Doty of the PCAOB told reporters that he anticipated that the PCAOB would reach agreement with Chinese regulators to observe their inspections of Chinese accounting firms. Then the SEC charged Deloitte with securities laws violations for refusing to turn over working papers on a U.S. listed company. Finally, Chinese regulators announced rules for the restructuring of the Big Four into locally controlled entities. Taken together, these three events shape up an interesting six months ahead for U.S. listed Chinese companies and their shareholders, who risk getting caught in a regulatory crossfire.
If Doty is able to close the deal to allow PCAOB staff to observe Chinese regulators as they inspect Chinese accounting firms, he will have achieved a remarkable diplomatic breakthrough. It may set the table for an eventual agreement on joint inspections. I am sure that the Chinese hope that the observations will convince the Americans that they can rely on their inspections. The PCAOB, however, cannot rely on Chinese inspections, and they should not. Chinese regulators are going to be unfamiliar with U.S. GAAP and PCAOB auditing standards. They are also unlikely to have any experience with the major Chinese issue of variable interest entities, since this structure is not used with companies listed in China.
Observing Chinese regulators will put the PCAOB in a difficult position. In 2009 the PCAOB modified its rules requiring inspections by 2009 of foreign accounting firms to allow another three years to negotiate access and complete the inspections. The inspections were to be completed by the end of 2012, and it now seems impossible that that deadline will be met. Observing Chinese regulators is unlikely to be considered as an inspection.
That means the PCAOB needs to make a decision. It could change its rules and defer the inspections for another few years. That would be the prudent diplomatic solution, since it can hardly be expected that the breakthrough Doty achieved in Beijing last week is going to lead to rapid agreement on joint inspections. Such a delay, however, does not deal with the urgency of Deloitte’s Sophie’s Choice between breaking U.S. or Chinese laws. Nor does it deal with political pressure for the PCAOB to solve the matter or deregister the firms.
Deregistering the firms is the other option. That would certainly have diplomatic repercussions, possibly scuttling the progress that has been made. It would satisfy those, like Senator Schumer, who have called for action. The consequences of this action are potentially severe. All U.S. listed Chinese companies would be without a PCAOB registered auditor. While many smaller companies use U.S. based auditors, those auditors should also be deregistered since they are required by Chinese law to leave their working papers in China. Without an auditor, the companies would immediately be out of compliance with exchange rules, which has in the past usually led to a trading suspension and delisting. Eventually, the SEC would deregister the company for failing to provide audited financial statements. The Chinese accounting firms would also be banned from participating to a material extent in the audits of U.S. MNCs with major operations in China. Will Deloitte U.S. be able to sign off on the audits of General Motors and Microsoft if it cannot find a PCAOB registered firm to audit the China operations?
The PCAOB might not even have to take action to deregister the Big Four. The restructuring of the Big Four into limited partnerships owned and controlled by local partners will require that the firms register the new limited partnership with the PCAOB. When they attempt to do that they will run right into a PCAOB rule put in place in 2010 that requires the firms to certify that the PCAOB can inspect them. If the firms wish to proceed anyway, the PCAOB will schedule a hearing specifying the inability to inspect as grounds for disapproval.
There is a way to transfer the firms existing registration to the new firm, which would avoid the need to reregister. It requires that the firm certify that a majority of the owners of the old firm will become owners or employees of the new firm. That is probably going to be tough to meet under the new rules in China, especially since individual partners did not own the old joint ventures. I expect the Big Four lawyers are busy trying to work through this problem.
These are critical problems with serious implications to investors. We need transparency from the firms and the regulators on how they plan do deal with these challenges. Audit committees should be demanding explanations from their auditors about how they plan to keep their right to audit U.S. listed companies from China.