by: Paul Gillis, November 14, 2010
China has become the fastest growing market for the Big Four accounting firms. The massive levels of foreign direct investment and huge IPOs of Chinese companies have led to them developing large practices in China, with close to 10,000 employees each. The Big Four have made an outsized contribution to the economic development of China, helping foreign investors navigate their way and helping state-owned enterprises reform and raise capital on the world stage.
The CPA profession in China restarted when China opened up in the early 1980s and the Big Four (there were eight of them at that time) were present from the start. They were not allowed to audit until the early 1990s, but they rapidly developed the largest firms in China. In 2009, the Big Four had 44% of the revenue of China’s top 100 CPA firms, a strong position, but far below the 72% share they hold of the top 100 CPA firms in the United States.
Chinese regulators have long desired that competitive Chinese CPA firms would develop. In 2009, the State Council, China’s top executive body, got serious about changing the competitive dynamics of the accounting market in China by issuing Document 56, which sets out the government’s policies for the development of accounting firms.
China’s new focus on developing its CPA firms, together with regulatory developments abroad, mean the Big Four face some turbulent times ahead, possibly creating the perfect storm. This storm might have implications far beyond China, and over the long haul might change the accounting landscape globally.
Creating Big Chinese CPA Firms
By the mid-1990s Chinese regulators figured out that the model of state-owned CPA firms did not work and set out on a program of reform. Regulators decided to adopt international accounting and auditing standards and to reform existing CPA firms. All CPA firms were privatized by 2000 and tough inspections shut down low quality firms. The remaining firms were encouraged to merge. Nevertheless, by 2006, China had almost 7,000 CPA firms, mostly of small scale.
The Chinese Institute of CPAs put forth plans in 2007 to develop ten large accounting firms capable of competing internationally. In November 2009, the State Council supported these plans in a pronouncement, called Document 56, which made the development of CPA firms a matter of national priority. Document 56 calls for China to develop 10 large CPA firms capable of serving Chinese companies globally with a broad range of services. In addition, the plan calls for 200 middle-sized firms capable of serving large companies and a large number of local firms to serve smaller organizations and rural areas.
Large Chinese CPA firms are encouraged to expand internationally, either by opening offices, acquiring firms or by joining international alliances. The State Council directed the government to provide China’s large CPA firms with help in market research and promotion, getting overseas qualifications, diplomatic liaison and security. The last point is curious, since it suggests the state security apparatus will be deployed to assist the large CPA firms in international expansion.
China’s outbound foreign investment has increased 48 times from 2002 to 2009, and China is now the sixth largest outbound FDI country in the world. Outbound investment is predicted to equal inbound investment by 2015. China’s large domestic accounting firms have begun developing the capabilities of serving Chinese companies as they venture abroad. Eight of the 10 largest CPA firms in China (including the Big Four) have joined in global networks, with BDO, RSM and Crowe Horwath affiliates holding down the three places following the Big Four. Shinewing, the 8th largest firm in China has acquired a firm in Hong Kong and opened offices in Australia, Japan and Singapore. While it has joined the Leading Edge Alliance, a referral network of firms, it has generally decided to follow a go-it-alone strategy. Another leading Chinese firm, Reanda, has taken a different approach, creating its own Reanda International Network with member firms in China, Hong Kong, Macao, Japan, Singapore, Malaysia and Cambodia.
If the Chinese member firms of the second tier are successful in winning the work of Chinese companies investing abroad, they have the potential to transform accounting markets worldwide. The Big Four dominate global accounting markets; with globally fifth ranked BDO being about 25% of the size of the smallest of the Big Four measured by revenue. In China, BDO is 60% of the size of KPMG, the smallest of the Big Four. If BDO and the other second tier firms can win a disproportionate share of China’s outbound FDI, they will develop stronger capabilities in serving global MNCs and potentially close the gap with the Big Four globally.
Rising Economic Nationalism
The Wall Street Journal reported on March 17, 2010: “foreign businesses say that their relationship with China is beginning to sour, as tougher government policies and intensifying domestic competition combine to make one of the world’s most important markets less friendly to multinationals”. Policies in the first 30 years of China’s opening up had been favorable to foreigners, including the Big Four. Document 56 signaled a shift towards promoting the interests of domestic CPA firms.
The Big Four has completely captured the market for large SOEs that have listed in New York and Hong Kong. Because many of these companies are also listed on the Shanghai Stock Exchange the Big Four also have a 76% share of audit fees for companies listed on the Shanghai Stock Exchange, since companies tend to use a single audit firm for all of their listings. Helping local firms crack into the high-end public company market is key goal of Chinese regulators, and it is clear that they are getting ready to play rough.
Document 56 tells large state-owned enterprises, including those listed overseas and those in key industries like banking, energy and telecommunications, that they should choose CPA firms that can protect the safety of national economic information. Clearly this provision is intended to encourage these companies to select local audit firms instead of the Big Four, where the presence of large numbers of foreigners arguably creates the risk that state secrets obtained through audit processes could find their way to foreign governments. China’s WTO commitments generally preclude requiring companies to buy only from domestic companies, but there is a national security exception to these rules that China seems prepared to use.
One of the biggest obstacles for local CPA firms to overcome in order to serve large Chinese SOEs is to obtain the acceptance of their work overseas. Over 200 SOEs have listed either H-shares or Red Chips on the Hong Kong Stock Exchange (HKSE). HKSE exchange rules require that a HK CPA audit all listed companies. Exceptions are possible, but they have only been granted to the Big Four. This has led to the audit market for Chinese companies listed in Hong Kong becoming one of the most concentrated in the world, with over 98% of fees in the hands of the Big Four. Breaking into this market is critical if Chinese CPA firms want to serve large Chinese companies.
There were two main barriers. First, Chinese accounting and auditing standards were different from Hong Kong, which had adopted International Financial Reporting Standards (IFRS). China set out to converge its accounting standards with IFRS and in December 2007, China and Hong Kong signed a declaration that mainland and Hong Kong standards had sufficiently converged that Chinese companies could use Chinese Accounting Standards for filings in Hong Kong. The second barrier was to get the Hong Kong Stock Exchange to accept reports audited by mainland CPA firms.
Over the protests of Hong Kong accountants, the Hong Kong Stock Exchange and Chinese regulators agreed in late 2009 to launch a pilot program allowing select Chinese audit firms to audit H-share companies. The program quickly ran into political headwinds in Hong Kong, as legislators representing the accounting industry raised concerns about whether Chinese auditors would be adequately regulated. In 2010, the Securities and Futures Commission in Hong Kong delayed the implementation of the program and its future is uncertain.
Stalled in their efforts to have their reports accepted in Hong Kong, several of the larger firms set out to acquire firms in Hong Kong or to open Hong Kong offices. Having a Hong Kong CPA firm would put the local firms on a similar footing with the Big Four, which used their Hong Kong member firm to issue reports on Chinese companies listed in Hong Kong. In the most recent development, Grant Thornton, the 16th largest firm on the mainland, expelled its uncooperative Hong Kong member firm and opened a new Hong Kong office under its mainland member firm.
Using their Hong Kong firms, Chinese firms have won some audits for smaller H-share companies, but the larger companies have stayed with the Big Four. As the firms gain more experience and size, they may be able to compete for larger companies. Increased competition will likely put considerable pressure on the pricing of audit services in Hong Kong.
When the Big Four were first given the right to audit in China in 1992, they were required to do so through a joint venture with a state-owned entity. By 2000, the state privatized the accounting profession and the joint venture partners of the Big Four typically became a firm owned by some of its local partners and managers. Under Chinese law the joint ventures had a 20-year operating period that expires for three of the firms in 2012. PwC gets a few extra years because its joint venture was restructured when Price Waterhouse merged with Coopers & Lybrand in 1998. The firms would prefer to simply renew the joint ventures for another 20 years but Chinese regulators are instead insisting that they restructure into limited partnerships.
Limited partnerships are a common form for accounting firms worldwide but they present a big problem for the Big Four in China. The only persons who can become partners in accounting firm partnerships in China are Chinese CPAs. When China entered WTO an exception was carved out to allow the existing accounting joint ventures to have partners who were not Chinese CPAs. If the joint ventures are turned into limited partnerships, that exception goes away, and in order to own an interest in a Chinese CPA firm the partner will have to become a Chinese CPA. Few foreign or Hong Kong partners in the Big Four in China have become Chinese CPAs. The CPA examination is one of the hardest in the world, with a very low pass rate. Few foreign partners have attempted it, some because they cannot write Chinese at the level required, and others because they cannot devote the considerable preparation time required.
The State Council said in Document 56 that the localization of the Big Four joint ventures should be sped up. The pressure to require them to restructure into limited partnerships will help to do that. While the firms have nearly completely localized lower staff levels, foreign, Hong Kong and Taiwan partners still heavily dominate the partner ranks. It generally takes about a dozen years for a new graduate to become a partner in a Big Four firm, and many more years as a partner before they are ready to lead the audits of large public companies. The ranks of local partners in the Big Four have been swelling in recent years in China, but these new partners will need years of additional experience before they are able to take over the audits of China’s giant SOEs. Ready or not, by 2012, the firms may need to turn over the ownership of the practice to those who are licensed as CPAs in China, a group that is made up mostly of fairly junior local partners.
The Big Four will hope they do not have to change the way in which their practices are managed in China. At present all of the firms operate China and Hong Kong as a single practice, and some include other markets in Asia as well. Local regulations often require that local CPAs own Big Four practices around the world. Regardless of the legal ownership of individual country practices, the Big Four often combine and allocate the profits of firms in differing territories based on agreements that centralize their management. It would be very difficult for the Big Four to operate independently in China, since they share management, technical, risk management, human resource and IT resources with their practices in Hong Kong and other territories. Document 56 encourages CPA firms to enter into these sorts of international arrangements, but requires that the arrangements be based on equality and mutual benefits. Regulators might challenge management arrangements among Big Four member firms that transfer substantial profits to partners who are not Chinese CPAs as not meeting the standard of equality and mutual benefits. Certainly, the legal ownership of the China firm by Chinese CPAs will give them greater power within these firms and in the negotiation of management agreements.
Another way to solve the problem would be for the CICPA and the HKICPA to reach a mutual recognition agreement that would allow Hong Kong CPAs to practice on the mainland (and be partners in mainland accounting firms) while allowing Chinese CPAs the same rights in Hong Kong. While this would go a long way towards solving the Big Four's problem in China, it would create new competition at home.
Public Company Accounting Oversight Board
Over 200 Chinese companies have listed their shares on U.S. stock exchanges, creating an audit market that generated over US$ 200 million in fees in 2009. The Big Four dominates this market, collecting 96% of the fees of companies listed on the NYSE and 72% of the fees of companies listed on NASDAQ. In order to audit U.S public companies, auditors are required to register with the Public Company Accounting Oversight Board (PCAOB) and subject themselves to its regulation. As of August 2010, 59 mainland Chinese CPA firms (including the local member firms of the Big Four) have registered with the PCAOB.
PCAOB rules require periodic inspections of registered firms to assess their compliance with U.S. law and professional standards. These inspections are to be conducted at least triennially for the registered firms in China. China has prohibited the PCAOB from conducting these inspections in China on grounds that would violate China’s national sovereignty. China also prohibited the PCAOB from inspecting Hong Kong firms to the extent that the review included mainland clients. Certain European countries have has asserted a similar block to PCAOB inspections.
The PCAOB has published on its website a list of companies and auditors that it has been unable to inspect, cautioning investors that they are being deprived the potential benefits of PCAOB oversight. The PCAOB has included China on the list of countries in which it intends to conduct inspections in 2010, but there is no indication that China will allow it to do so.
On October 7, 2010 the PCAOB announced it would no longer approve applications for registration from firms in countries that prohibit inspections. This does not appear to currently apply to the Big Four firms in China since they are already registered. However, if the firms, as expected, are restructured into limited liability partnerships a new registration might be required, and, based on the current policy, it does not appear likely that it will be approved.
The standoff between China and the PCAOB leaves the Big Four in China largely unregulated with respect to work done on U.S. listed companies. Chinese regulators have shown no interest in reports that not used in China and that have been prepared under US GAAP. Many of the partners who sign these accounts are not licensed in China, but instead are foreigners whose home jurisdiction has no ability to regulate them on work they do in China.
There is no easy solution to this impasse. The PCAOB could take the extreme step of deregistering the Chinese member firms of the Big Four, but that might have the practical effect of delisting the Chinese companies from U.S. exchanges, a result neither the US or China are likely to want to see. A possible compromise might involve some sort of peer review where the firms are inspected by teams assembled from other Big Four firms. Alternatively, China could agree to regulate U.S. filings and the work of foreign CPAs in China and find a way to acquire the necessary technical skills in order to do so. China would need to convince the PCAOB that it was serious about doing this and was capable of obtaining the necessary expertise in U.S. auditing and reporting standards.