The reverse merger problem | China Accounting Blog | Paul Gillis

The reverse merger problem

Anyone who follows the market for U.S. listed Chinese companies cannot have missed the growing number of accounting and auditing scandals, mostly with companies that have listed in the U.S. through reverse mergers.  Most of these scandals are still unwinding, but the rash of auditor resignations and delayed annual reports indicates we have not yet seen the end.   Clearly, the situation demands regulatory action, and I am encouraged by increasing numbers of SEC investigations.  I am hearing on the street that the SEC comment letter process has become more frequent and rigorous.  Comment letters are where the SEC staff send questions to the company and demand responses.  Often comment letters result in restatements of financial statements or amendment to annual reports.   All of this becomes public in time, but it will be a few more months before we understand the scope of what they are doing. 

There needs to be a robust debate in China and in the U.S. about the many scandals that have come to light in the past year.  From a public policy viewpoint, is it really appropriate for small Chinese companies to seek capital in the U.S., or should they be strongly encouraged to do it at home?  Should the U.S. raise its standards for listing at least as high as China’s to discourage the weaker companies from taking what they now perceive as the easier route to a public listing in the U.S.?  Should China be allowing companies to so easily circumvent their rules related to foreign investment in prohibited sectors and offshore listings?  How can U.S. and Chinese regulators work more closely together to police these markets?  This is an important debate that needs to be held, yet hopefully it does not become overly politicized in the run-up to elections in the U.S.  It will be tempting for politicians to turn this into a China bashing exercise, which will make it all the more difficult to find the cooperative solution between the U.S. and China that is needed. 

My focus is on the accounting and auditing issues related to U.S. listed Chinese companies.  Here are my recommendations for improving the performance of audits of these companies:

1. Require that all CPA firms auditing Chinese based companies have an office in China.   Audit teams that fly in from America to do the audit are not going to develop the local knowledge required to fully understand Chinese business practices.  China should require that China offices of foreign CPA firms register as CPA firms in China (most now register as consulting firms to avoid this).   The Ministry of Finance, The China Securities Regulatory Commission (CSRC) and the Chinese Institute of CPAs  (CICPA) should figure out how to regulate these firms.  The office in China must be registered with the PCAOB. That is already a requirement, but it is being ignored by some of the smaller firms who have set up consulting companies in China.  This proposal will result in fewer firms, and larger firms, serving U.S. listed Chinese companies, and that will improve audit quality. 

2. Require that all audit partners who sign reports on Chinese based companies speak and read both Chinese and English.  A partner who is not fully bilingual cannot effectively serve as an audit partner on U.S. listed Chinese companies.  A partner must be able to read both source documents as well as financial statements, and have discussions with the client in a language that the client can effectively use.  There will be Big Four partners in China who have a problem with this rule, as will most of the partners from U.S. based firms. 

3. Require foreign partners to register with Chinese regulators. All foreign licensed partners who sign reports for companies based in China should be required to register with MOF, CICPA or CRSC and consent to being subject to their regulation.   China needs to develop a regulatory structure for these CPAs, who are currently unregulated.. China forbids the PCAOB from coming to China to inspect these CPAs, yet China has no oversight on them.  They operate in a regulatory hole. 

4. The PCAOB and Chinese regulators must agree on an inspection system.   I don’t see China backing down on its national sovereignty claims, so I suggest reviving the peer review system for China based auditors.  Let the firms audit each other, under the joint supervision of the PCAOB and the CICPA or CSRC.  This is the system that was in effect in the U.S. before the PCAOB.  While it is not ideal, it certainly is better than what we have today.  

Many solid, honest, Chinese companies are being unfairly punished because of the misdeeds of others, and as a consequence of the poor state of accounting and auditing of U.S. listed Chinese companies.  Many investors have been robbed blind.  We really need the PCAOB, the SEC, the CICPA and the CSRC to band together and take on this problem.

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