It has been very quiet the past couple of months on the confrontation between the PCAOB/SEC and Chinese regulators over audit working papers and inspections for U.S. listed Chinese companies and their auditors.
The issues were coming to a head in early July. The SEC case against the Big Four and BDO went to a hearing before the administrative trial judge of the SEC on July 9 and the standoff between U.S. and Chinese regulators was on the agenda of the Strategic and Economic Dialogue (SED) between the United States and China that was scheduled that same week in Washingtion.
Chinese regulators blinked first in the standoff. CSRC told the SEC they would turn over 20 boxes of working papers related to Longtop Financial Technologies provided the SEC sent them money for postage. Treasury Secretary Jack Lew announced the breakthrough at the SED. No agreement was reached at the SED on access to conduct audit inspections by the PCAOB.
The PCAOB had earlier reached agreement to share documents with Chinese regulators in connection with investigations, but reached no agreement on inspections. Investigations are a small part of the PCAOB mission; inspections are its main function.
According to the court file, there have been no developments in the separate SEC case in U.S. District Court in DC where the SEC was seeking to compel Deloitte to turnover the working papers on Longtop. The SEC informed the Court of the CSRC notice on July 10 and nothing has been filed since.
The SEC actions against the Big Four and BDO were filed on December 3, 2012, and the SEC said that a decision was to be made within 300 days*. By my count, that is September 29. The SEC did say during the hearings that obtaining working papers through the CSRC was not workable.
I speculate that the CSRC has been busy turning over the working papers for each of the companies that gave rise to the SEC charges against the Big Four and BDO. I expect that leads to the SEC dropping the case and accepting that access to Chinese documents will be at the discretion of Chinese regulators. The SEC won’t like that, but they are not getting an option. I could be wrong, and the case could blow up in the next two weeks, or the deadline could be extended.
I do not believe that the PCAOB is going to make any further progress on inspections. I don’t believe Chinese regulators will agree to joint inspections on sovereignty grounds, and I have been told of Chinese officials saying as much. I think China believes it made an acceptable compromise in the investigations deal, and that the issue is settled. That is how the press and the markets have interpreted the situation. I don’t think the PCAOB has the political capital to push the issue any harder, since the only option they seem to have is the nuclear option – to deregister firms and kick Chinese companies off the U.S. market. The nuclear option is a step too far.
Investors are the big losers. Inspections are needed to help restore confidence in the integrity of audits. I think that the Big Four firms need to step up and offer a solution. I offer a suggested way out.
Before the PCAOB was formed by Sarbanes-Oxley, audit quality was monitored by peer review. The Big Four firms would audit each other in a system of self-regulation. With Sarbanes-Oxley the view was that self-regulation does not work and that gave rise to the PCAOB. While I agree that self-regulation has problems, it would be better than relying totally on internal firm controls.
I propose that the Big Four agree to conduct quality control reviews on each other’s U.S. listings, using reviewers from the U.S. member firms. The U.S. member firms have the expertise in PCAOB standards and U.S. GAAP that is necessary to conduct the reviews. The findings of the reviews should be made public.
The process needs some teeth, and Chinese regulators can provide that. The reviews should be done under the direction of the CSRC and with the participation of CSRC personnel. Serious deficiencies should be punished by the CSRC and MOF. The restructuring of the Big Four’s practices into LLPs has brought most of the partners who sign U.S. listed company accounts under Chinese regulation, so the CSRC and MOF have the power to do that.
What I am proposing is to take the PCAOB out of the process. China’s objections are to the involvement of another government in regulating its companies. What I am proposing is cooperation between private companies under the supervision of the Chinese government. China should not object to that. The U.S. government is out of the loop.
This is not an ideal solution, but I think it may be the best solution possible. The Big Four should step up and make it happen.
Update: A reader pointed out that the judge in the SEC case against the Big Four requested a 100 day extension in the case, which means the decision would not be not due until January 7, 2014. I expect they get it settled before then.